The destructive potential of reputation risk
Over the past few years, behavioural economic theory has spawned a rational risk management model while big data have yielded actuarially useful reputation risk metrics. Captives have increasingly provided practical reputation risk financing and access to the parametric reinsurance markets. These advances in the risk industry make clear that reputation risk is measurable, manageable and insurable.
“The risk manager needs to serve as the central intelligence function for the enterprise risk management apparatus.”
The early years
Reputation risk is not a new risk for companies or their insurers. Two early case studies illustrate how the instrumental and expressive power of insurances mitigated reputation risk by directly targeting the unique emotional features of the peril—in these cases, fear.
In 1838, the prospects of the burgeoning Prussian railways system, which needed passenger service to offset costs, were in peril. Frequently exploding locomotives powered by coal-fired steam boiler engines gave the railway a terrible safety reputation. National insurance through the Prussian Railway Liability Act provided a strategic solution.
Timed to coincide with the opening of the Berlin–Potsdam railroad and major improvements in engineering, the liability insurance helped mitigate fear and economic damage—features of reputation risk—by telling a simple story that improvements in engineering made the railroads safe to ride.
In the mid 1800s, US economic expansion through steamships was similarly at risk because of their terrible safety reputation. This culminated in the steam boiler explosion and sinking of the SS Sultana while repatriating Union prisoners of war. By warrantying their engineering work quality, Hartford Steam Boiler Inspection and Insurance Company helped mitigate fear by convincing crew that the inspected ships offered a safe working environment. It signalled to passengers that the ship was reliable, and reassured shippers that their cargo was safe. Creditors felt more confident that their collateral was safe.
21st century peril
Reputation risk in the 21st century risk is the same as it was in the 19th century. The peril of economic harm from disappointed, angry or fearful stakeholders, whose expectations have not been met, has not changed. Customers, employees, vendors, creditors, equity investors and regulators can all react badly when a board or senior management are not living up to promises they made.
The promises made, not unlike the issues of the 19th century, include safety as well as ethics, security, sustainability, quality and innovation.
Features of a reputation crisis
The peril of economic harm from the actions of angry or disappointed stakeholders manifests as impaired cash flows. Boycotts, strikes, altered vendor terms and steep regulatory fines—all of which impair cash flows—are exemplary noisy manifestations.
More subtly, disappointed stakeholders can precipitate revenue losses via longer sales cycle times and customer price resistance. They can trigger greater costs through lower labour efficiencies, higher HR turnover costs and steep retention bonuses.
Making the intangible tangible
Reputation risk is unplanned. It is neither a necessary consequence of an adverse event, nor must there actually be an adverse event to precipitate a crisis. The three elements of reputational risk are higher stakeholder expectations, lower stakeholder experience and media amplification.
The following vignette is based loosely on a real event that illustrates how a food quality issue could blossom into a full-on reputational crisis.
On July 1, TransUSA Airlines served mouldy cheese dip in its popular in-flight meal to a passenger. Unfortunately, that passenger happened to be an influencer, with 1.4 million Instagram followers and 1.9 million YouTube subscribers, who shared her horror in real time through an inflight connection.
An LA-based Food and Drug Administration food inspector on the flight took the mouldy food container and insisted on inspecting all cheese packages being served on the plane. He found five additional mouldy samples.
A celebrity attorney was also on the flight, and began posting online, including a video of his demanding explanations from a beleaguered flight attendant. He collected names of other passengers who “may” have received tainted food and threatened to sue TransUSA Airlines for unspecified damages.
A TransUSA spokesperson said: “We are sorry to hear that on this occasion the food product was not up to our usual high standard. We have reached out to the customer directly to apologise and will review this matter with our catering supplier.”
Blossoming into a crisis
Mediagenic passengers’ expectations were not met, and they expressed their initial disappointments online with millions of connections. Widely-read social media stories led to traditional media coverage, which in turn placed TransUSA’s food safety protocols on the radar of regulators and politicians.
The furore opened doors to others with grievances. A disgruntled flight attendant alleged that TransUSA’s social responsibility campaign to reduce food waste was resulting in food being served beyond its freshness date. Plaintiffs’ lawyers mobilised.
TransUSA found itself facing off against angry litigators, regulators and bloggers. The cascade continued and became a distraction to management and a concern to equity investors, precipitating a stock price drop. The bond market took note and added a few points to the airline’s cost of debt.
Finally, food vendors and suppliers, worried about collateral reputational damage, sought to insulate themselves contractually and with insurances that raised their own costs, subsequently affecting airline food prices.
Managing reputation risk strategically
The goal of reputation risk management is to win the battle for the minds of stakeholders. Winning means two simple things: stakeholders (i) discount an adverse story as fake news/not reflective of reality/a malicious hit job; or (ii) accept the story and exculpate the party, considering it an anomaly in an otherwise well-run company.
Losing means trial and conviction in the court of public opinion. Stakeholders will jump to the conclusion that the event is a symptom of a larger issue, is likely to happen again or might manifest as something even worse.
If TransUSA had responded with a factually rich statement, instead of issuing a somewhat generic statement as the crisis unfolded, it might have mitigated the outrage, and slowed the flow of negative information long enough to present its side of the story.
Such a statement must meet three requirements: it must contain (i) an apology; (ii) an acknowledgement that a named process failed; and (iii) a statement that the process is being rectified so that it will not happen again.
The only way to have “enough” time, given the near instantaneous viral spread of negative content, is already to have built up goodwill and prepositioned simple, easy to understand and completely credible favourable stories about processes, their controls and risk governance tools.
Managing reputation risk tactically
Pre-positioning evidence-based goodwill is not easy. It requires a close collaboration among a number of corporate silos. The risk manager needs to serve as the central intelligence function for the enterprise risk management apparatus. To speak in a simple and completely convincing way about policies, processes, procedures and governance, the marketing department needs to be fully tuned to the work products of enterprise risk management.
Enterprise risk management needs to create reputation resilience by deploying elements that an unaffected stakeholder can readily trust as authentic.
Insurance is part of that story. Just as they did long ago with railroad and steamship stakeholders, these financial structures and instruments tell a company’s stakeholders in a simple, clear, compelling way that the company—and objective third parties—is putting its money where its mouth is.
If insurances tell a story, captives shout it. Delivered on a platform of authentic process controls, loss absorption capacity and reinsurance, captives can tell a story of a woke, compliant governance and operational structure targeting the expectations of stakeholders.
They signal to the bond market and credit analysts that there are cash flow reserves. Parametric risk transfer and reinsurance solutions, such as those pioneered by Steel City Re, make it possible.
Reputation risk is a 21st century peril representing a failure of expectation management with the grievances of disappointed stakeholders being amplified by the media. The prevalence of social media, and its ability to rapidly escalate a problem, shift the onus of mitigation to active risk management and preemptively winning the battle for the mind of stakeholders.
Story telling is a key weapon in this battle, and the expressive power of insurances and captives are proven effective narratives—starting more than 180 years ago.
Nir Kossovsky is chief executive officer of Steel City Re. He can be contacted at: firstname.lastname@example.org