Abstract: Maintaining a high level of system availability is the fundamental gurantee of the profitability of firms operating mission-critical equipment in an environment characterized by low-frequency, high-impact events such as equipment failures. Once an operational disruption occurs, the firm hardly affords significant operational downtime and often causes financial distress. To mitigate the severe impact of the unexpected disruptions, a proper incentive mechanism has to be in place so that the service supplier would commit the necessary capacity for recovery. Meanwhile, the financial distress risk can be mitigated by transferring the financial liability away to a third party insurer. Performance-based contracting (PBC) is an emerging incentive mechanism where the supplier receives compensation based on realized availability. Business interruption insurance (BI) can protect against the potentially financial risk for the firms. In the paper, the principal-agent contracting models are proposed for an outsourcing setting in which the firm cannot write the supplier's service capacity decision directly into the contract but instead must incentivize the supplier using the PBC and where the firm makes decision on purchasing the BI to eliminate the downtime loss and transfer financial distress. The service performance of the PBC between the firm and the supplier is measured by not only the cumulative downtime but also the individual service experience. The PBC contract design model is presented firstly as the benchmark, in which the firm has to choose the optimal pair of contract terms consisting of the fixed payment and the penalty rate to maximize profit composing the expected production profit of the equipment uptime, the payment to the supplier, production downtime loss, financial distress loss and the goodwill loss, while the supplier chooses optimal service capacity to maximize his utility composing the payment from the firm and the capacity cost. Secondly, the PBC contract model with the BI is proposed, where the insurance premium term is added and the downtime loss and financial distress loss are eliminated in the firm's objective function. Finally, it is explored how the BI impacts on the optimal PBC contract terms and whether the BI need be purchased. The major insights from our analysis are followed: (1) the frequency of disruptions is an important factor in determining contract terms and the supplier's capacity investment decision. (2) The BI and the performance incentive of the PBC contract are partly substitutable. (3) The BI can reduce the sensibility of which the frequency of disruptions influences on the the supplier's capacity, contract terms and the firm's profit. The study is a first attempt on the understanding of the interplay between operation and insurance in the maintenance service of the mission-critical equipment. The theoretical results contribute to the decision-making of the operation-finance interface in the firm operating mission-critical equipment.

Key words: performance-based contracting, business interruption insurance, maintenance services, mission-critical equipment, operation-finance interface