Risk Management

How to Use Captive Insurance to Manage Reputation Risk

Among many new threats to enterprise value, reputation risk is now in its fifth straight year of topping the charts, according to one survey.
Peter Gerken and John J. KellyFebruary 12, 2015

Having assumed ultimate managerial responsibility for enterprise risk management subject only to board oversight, many of today’s CFOs are struggling to control costs while dealing with an increasing diversity of emerging material enterprise risks.

John J. Kelly

John J. Kelly

These include the now ever-present strategic complication of reputation risk. Experience shows that many operational risks arising from potential catastrophic events – including major environmental incidents, global supply chain interruptions, and cyber risks – invariably threaten to mushroom into reputation risk.

CFOs will welcome news that this complex strategic exposure can now be managed through captives –insurance companies established and owned by a non–insurance business or organization primarily to insure their own risks. Significantly, these arrangements can satisfy regulatory requirements to qualify as true risk transfer, which provides a range of capital-efficiency benefits. Further, with specialized reinsurance and quantitative controls, reputation risk management can be appreciated by stakeholders in a way that brings added enterprise value to an organization.

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Among many new threats to enterprise value, reputation risk is now in its fifth straight year of topping C-suite imperatives according to the 2014 Reputation at Risk survey from Deloitte/Forbes Insights. For businesses in all industries, reputation is a complex risk in which managing expectations and perceptions are as important as managing operations and execution.

Peter Gerken

Peter Gerken

“A company’s reputation,“ Deloitte’s survey states, “should be managed like a priceless asset and protected as if it’s a matter of life and death, because from a business and career perspective, that’s exactly what it is.” If your company discloses reputation risk in its 10K annual report (see Item 1A), your operational risk controls are mature, and your corporate communications efforts are prudent, then it is probably ready to capture the next level of reputational value: by using your captive insurer to formally fund management of this material enterprise risk.

Captives, which first flourished in the 1990s, are still delivering strategic value to their parent companies – especially in their historical roles of helping to address material risks that are difficult or costly to insure in the commercial insurance market. In recent years, captives have been able to weather challenges posed both by the falling pricing of conventional insurance and by tax reforms that have eroded some tax benefits of captives and added significant penalties for regulatory non-compliance. Captives have also proliferated despite lackluster returns on investments in the conservative, fixed-income instruments they generally must use.

Their strategic role has benefited from improved data management and analytical technologies and progressively granular risk-quantification techniques. Those technologies and techniques enable captives to create more precise actuarial models and underwrite traditional and emerging risks more effectively. And more reinsurers are working directly with individual captives, giving them greater opportunities to expand their portfolios and cover a wider range of emerging risks.

For example, new commercial entrants in the reinsurance market are willing to insure the financial consequences of reputational damages to a corporation. This contrasts with traditional insurance policies that essentially indemnified companies for added public relations expenses following a crisis. With the new products, losses in the value of reputation, an intangible asset, are approximated using an index based on observable market expectations of traditional financial performance indicators. (By using their captives to buy reinsurance, corporations have been able to avoid buying property-casualty insurance, which tends to be more costly than reinsurance.)

Indexing is a well-known technique in niche sectors of the risk community where direct measurements are challenging. Such methods have made it possible to insure property losses associated with windstorms and other natural hazards, or losses to crops from extreme weather conditions. In these cases, losses in asset value are indexed to observable conditions such as wind speed, rainfall, or temperature. The precision of these proxy measures enables better risk modeling, which lowers insurance premium costs.

Now, big data aggregation and indexing are being used to underwrite reputational risks with coverage triggered by changes to a combination of observable proxies for reputational value. These include variations in perceptions of myriad corporate stakeholders delineated by objective measurements such as employee turnover, credit terms provided by suppliers, and credit ratings, among other factors.

This objective approach to the underwriting, pricing and potential sharing of an organization’s reputational risk, as well as for determining what qualifies as a compensable loss event, positions captives to satisfy appropriate statutory and tax requirements and overcome obstacles to addressing reputational risk that confronted them in the past.

Another key benefit of reputational risk management is the ability to signal the markets that the company’s controls are sufficient to qualify the firm as an insurable risk. These controls vary by industry sector but typically include: the implementation of rigorous financial protocols and safeguards; business continuity and crisis management plans; routine operational reviews; trading partner evaluations; technology risk assessments; and product-recall risk analysis.

When stakeholders appreciate improvements in governance, controls and risk management that help reduce volatility, such as those that address reputation risk, they can upgrade their long-term expectations and raise equity values.

Indeed, history shows that corporate commitments to better governance as demonstrated by quality safety, ethics, and sustainability can also help restore value. In recent years, numerous companies, including Nike and Monsanto, emerged successfully from crises and were able to restore the confidence of stakeholders and investors. In the age of hyper-transparency, formal efforts to manage reputational risk can provide material value.

Overall, better reputations result in better terms from employees and vendors for services, as well as for capital from creditors and equity investors. For customers, they mean shorter sales cycles, larger unit volumes, and customer willingness to accept premium product pricing.

Reprising their historical roles of helping to address material risks that are difficult or costly to insure in the commercial insurance market, captive insurers can help CFOs today manage reputation risk while creating enhanced value for the organization.

John J. Kelly is a managing partner at Hanover Stone Partners, LLC, and Peter Gerken is a senior vice president at Steel City Re, LLC.