Denise Williamee of Steel City Re outlines what role a captive can play in insuring against reputational risk
What role can captives play in insuring against reputation risk?
Captives today can play a vital strategic role in reputation risk management as companies embrace the conceptual value of environmental stewardship, social justice, and responsible governance (ESG).
That role is a discernible capstone to the conceptual value of the operational and governance systems helping firms mitigate risks to address their stakeholders’ ESG expectations.
Simply put, institutional investors, proxy advisers, and bond raters today all value authenticated reputation risk management. The quality of a firm’s reputation risk management helps shape asset allocation decisions, proxy voting guidelines including items such as CEO pay, and bond ratings.
Reputation insurance provided through a captive makes the conceptual value of reputation risk management easy to understand. With actuarial sound underwriting, it represents authentic, objective validation of an ‘ESG-woke’ management that created both a financial solution and an arm’s length risk management practice to protect the value of the parent’s reputation. That makes captive insurances strategically valuable to both a captive’s parent and to the capital market constituents who must always be prepared to combat second-guessing in the courts of law.
Captives can be most valuable when they can cover the short-term cash flow shortfalls of a reputational crisis tactically and communicate the parents’ excellence in reputation risk management strategically.
Why is a captive more suitable for insuring against reputation risk compared to using commercial insurance?
I think there is a hierarchy of suitability, with the combination of a captive partially reinsured by commercial insurance being the most compelling strategy for financing reputation value loss. The reasons for this are both conceptual and discernible.
Investors, advisors and now regulators are clamouring for reliable measures to quantify the conceptual value of reputation and the numerous ESG components. One measurement strategy uses the type of proven indicators of reputation premium, based on behavioural economics, that Steel City Re has been using for nearly two decades with great effect in the equity markets. This strategy uses the financial ‘shadow’ cast by conceptual value.
Captives represent this shadow. Captives provide unassailable evidence to capital market constituents — who themselves have to look over their shoulder should they be second-guessed by unhappy investors. Use of a captive — with third-party underwriting — shows that due diligence has authenticated the firm’s reputation risk management, that a credible third-party has (re)authenticated the captive’s arm’s length relationship, and that the enterprise has ‘put its money where its mouth is’ in insuring the risk. A captive enhances the company’s storytelling to capital markets and reinforces the defensive barriers against both investors and regulators who may second guess management or a board down the road.
Another benefit is that parents of reinsured captives providing reputation risk covers could see benefits in their directors and officers (D&O) liability insurance premiums. After all, a parent firm tuned in to the issues most likely to anger investors is a firm that is less likely to be successfully sued by those investors.
What trends are you seeing around reputational risk?
After so many businesses suffered losses from non-physical damage as a result of fear, political anger, and social justice movements, there is a much greater appreciation for the genuine materiality of behavioural economic perils. For us, that is translating into three business trends.
First, we are as likely to be contacted by a firm’s chief legal officer as we are by a risk manager or insurance broker. With reputation risk management’s value being explicitly affirmed by bond raters and institutional investors, boards are dutifully turning to their most trusted senior legal advisers for help protecting reputation, a mission-critical asset of most firms. Also driving this trend is the continuing surge in litigation alleging board liability in damage to a firm’s reputation.
Second, beyond insurance, we are seeing a surge in demand for integrated risk management and governance solution. This involves advisory-driven tweaks to governance, a new approach to enterprise reputation risk management, and an appreciation that publicising reputation risk management is a critical and effective value-creation strategy.
Third, we are seeing non-traditional sources of risk capital entering the reputation risk reinsurance market. These sources are familiar with the parametric mathematics we use to price and trigger reputational value losses — which are well known to the alternative investment community.
What are the biggest challenges associated with insuring reputation risk?
I think prospective insureds need to overcome three hurdles. The first is legacy organisational resistance to the very notion of insuring and managing reputation risk because of the mistaken impression that marketing is reputation risk management.
For marketing to be a useful prong to reputation risk management there first needs to be the substance of risk management for marketing to publicise. That substance involves governance, leadership controls and insurances. Otherwise, marketing efforts are mere puffery. In re Signet, settling for about $240 million proved that “puffery” can no longer be relied upon as a defense against plaintiffs who claim to have relied on those statements.
The second is the legacy organisational belief that risk to the conceptual value of enterprise reputation can be mitigated through conventional legal strategies. While such strategies work well for targeted stakeholder groups, they may fail the enterprise. A recent example is Wells Fargo, which when sued by investors for misrepresenting its new focus on ethics, argued in court that promotion of its new ethical posture was obviously only marketing “puffery.”
The third is value-at-risk quantification. This being difficult outside of a parametric model, such as ours, that is informed by behavioural economics, financially-oriented firms are mistakenly tempted to set reputation risk aside as a non-financial peril.
I would like to point out that capital market constituents understand and appreciate parametric insurance models. This appreciation boosts the strategic value of reputation risk insurances that take a parametric approach.
Has COVID-19 had an impact on reputational risk?
I think COVID-19 helped governance, legal and risk professionals understand the very notion of conceptual value, and how protecting conceptual value through risk management and insurance can translate that value into something everyone can see. Simply put, to protect market capitalisation, managing risks to an enterprise from emotional stakeholders is essential. COVID-19’s economic impact, as hundreds of court decisions have clearly affirmed, was not due to any discernible loss /physical damage. It was due to the conceptual loss of safety and because safety could not be assured, the emotional state of fear among all classes of stakeholders prevailed.
Firms and companies seeking to mitigate the reputational risk associated with fear pre emptively implemented risk management processes that emphasised safety, followed through on those promises and then not only demonstrated this safety but communicated it. Think of how the major hotel chains and airlines such as Hilton, Marriott, United and Delta realised that they needed to publicise their cleaning protocols authenticated by the Mayo Clinic, Clorox, Lysol etc. — risk management by another phrase — to mitigate the fear of guests and passengers.
Simply put, COVID-19 demonstrated the strategic value of a reputation risk management best practice: implementing risk management processes, ideally authenticated by a third party, and then publicising the details.
Have you seen an increase in interest around insuring against reputation risk using a captive?
Yes. I believe interest is increasing for several reasons, and I believe Steel City Re has been instrumental in this change. As a result, our business is growing, Clearly, the risk is not new. Reputation risk was recognised as a peril that could trigger a liquidity crisis in the banking system 25 years ago, causing regulators to begin mandating reputation risk management disclosures among the leading financial institutions. As early as 2005, the Economist Intelligence Unit crowned reputation as the ‘risk of risks’. Its materiality to corporate operations has never been in question.
Reputation risk management, however, has been an evolving concept with its roots in marketing and communications. The rise of behavioural economics helped create comfort in financial circles around the inherent fuzziness in quantifying behaviour, psychology, value, and communications. It was behavioural economics that provided the framework within which Steel City Re rolled out a measurement method for exposing firms’ reputation value premium. Over the past two decades, we’ve been able to prove that these metrics provide reliable, repeatable, and scalable results useful in both equity markets and risk insurance markets.
25 years ago, banking regulators left the definition and measurement of reputation risk to the private sector. Today, the SEC is taking an increasingly active interest in how companies are quantifying the conceptual values of environmental stewardship, social justice, and responsible governance (ESG). Because of the strong overlap between reputation and ESG, insurance captives help make what is conceptual more easily discernible to regulators, financial markets, and other stakeholders.
How are risk managers seeking ways to finance this reputation risk?
With the growing influence of chief legal officers in overseeing reputation risk management at an enterprise-level rather than as a legal or marketing problem, I believe funds are being shifted from the various scattershot efforts in marketing, social responsibility, and risk management pockets. In doing so, what were risk management expenses have become investments in equity value appreciation.
Reputation risk is a family of perils that arises exclusively from the gap between stakeholder expectations and experiences. Traditionally, within companies, different silos are responsible for managing expectations, creating experiences, and allocating resources. It is inherent in the competing expectations of stakeholders that one or more groups will find their interests pitted against each other, making disappointments inevitable.
Reputation risk perils are most costly when stakeholders are most angered.
The value of an integrated reputation risk management strategy is that it can focus existing resources into a coherent, cost-effective plan that minimises anger among the costliest stakeholder groups — all while maximising shareholder returns.
The strategic argument that reputation risk management directs existing resources to increase enterprise value, reduce board liability, reduce meteoric jury verdicts, increase employee engagement, reduce the cost of debt, reduce the risk of regulatory opprobrium, and increase customer interest is compelling.
Do you expect an increase in firms using captives to insure against reputational risks? And why?
Yes. It’s actually difficult to envision well- governed, best practices firms not implementing and embracing a reputation risk management strategy and exploiting their existing investment in captives. Here are three reasons.
First, reputation risk management is now strategically vital. For clarification, I am referring to a risk management strategy complete with both governance and management upgrades, captives and reinsurances, and a coherent risk management communications plan to realise the desired ‘reputation premium’ in enterprise value.
Second, insurance and reinsurance rates are expected to further harden through 2022 as insurers and reinsurers reduce their risk appetites and tighten capacity. As the costs of historic underwriting errors—read mispricing—are being socialised, captives have become more cost-effective risk financing instruments.
It would behove insurers to appreciate that reputationally risk-aware firms are better governed and therefore present lower D&O risks. This creates an underwriting arbitrage opportunity. As AIG happily discovered in the 1930s, this simple path of arbitrage to insurance business profitability is oftentimes not evident to others.
Third, the capacity available for risk transfer in the traditional commercial markets is still lingering in the neighbourhood of $100 million for even the largest firms.
While this level is sufficient to reinsure captives and further authenticate reputation risk management through a captive to the capital markets, it may be tactically insufficient to cover, under the best of circumstances, the temporary shortfall in working capital from a material crisis.
