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Financial Losses Stemming From Reputation Damage? There’s an Insurance Policy For That

By Wisconsin School of Business

September 10, 2015

New Study from Wisconsin School of Business Provides First Comprehensive Analysis of Reputation Risk Insurance and Challenges Facing Such Policies

From Subway to BP (formerly British Petroleum), companies have come to understand that in today’s fast-moving social media environment, reputations that took years to build can take only hours, even minutes, to destroy – and hurt the bottom line. Whether it’s the arrest of a former spokesperson, an allegation of corporate wrongdoing, or even a major credit card security breach, companies face the real danger of operational losses due to crisis events that damage their reputation and their relationship with customers.

A new study from the University of Wisconsin-Madison’s Wisconsin School of Business provides what is believed to be the first analysis of the emerging reputation risk insurance industry and details the challenges facing both policyholders and insurers. Joan Schmit, professor and chair of the Risk and Insurance Department at the Wisconsin School of Business, and colleagues Nadine Gatzert and Andreas Kolb of the Friedrich-Alexander-University of Erlangen-Nuremberg in Germany, looked at the relatively new type of insurance coverage and identified constraints in growing the market. At the time of their study, there were only six policies in existence solely for reputation risk.

“There’s a great deal of interest in reputation risk insurance because corporate leaders see how damaging stories spread like wildfire through social media and how customers want to do business with socially responsible companies,” says Schmit. “However, the hazy nature of what constitutes a direct loss resulting from reputation damage have led to policies that are limited in scope and come at a high cost, which is holding back demand.”

Schmit identified several of the difficulties involved in insuring reputation risk:

Measurement of risk damage/loss. Identifying how much a crisis event damaged a company’s reputation and directly led to losses can be tricky. An incident such as the Gulf oil spill harmed BP and seems to be a perfect example of the value of reputation risk insurance—a clear-cut event led to a boycott of the company and demonstrable financial losses. But the situation involving the Subway sandwich chain is more complicated. While Subway may have suffered reputation damage arising from the arrest of its former spokesperson, the company was already hearing complaints from franchisees about meeting growing demands for healthier, locally-sourced food options and addressing a corporate leadership crisis resulting from the illness of its long-time founder and CEO. If sales decline, is it due to the reputation event, or changes in the competitive environment?

Spillover effects. A company might suffer losses due to reputational damage that impact an entire industry caused by the actions of another company. For example, when stories emerged about bed bugs found in several large-city hotels, even hotels that were not involved were negatively affected by the public’s perception of the safety and cleanliness of hotels in the area.

Risk concentration. An insurer offering both reputation risk insurance and insurance against events that may trigger reputation damage could be held responsible for covering losses related to the same event twice. An example is with product liability insurance. Liability exposure from a defective product could lead to significant reputation damage if reports of litigation over the defective product alter public perception of the company. Toyota’s exposure from a 2010 recall of vehicles with a sticky gas pedal is an illustration of this. The insurer pays the liability losses and then also pays for the effects of a damaged reputation.

Moral hazard. When a company holding a reputation risk insurance policy knows that it will be compensated for reputation loss, company leaders might decide to forego spending money on reputation maintenance efforts, such as public relations or crisis communications services, exposing the organization to long-term reputation damage in the process.

“We believe insurers will gradually develop more innovative and sustainable policies, but in the meantime, forward-looking organizations need to develop effective plans to manage their reputation risk as part of an overall strategic approach,” says Schmit. “A strong reputation risk management process, with insurance becoming one component of that effort, may give companies the focus and direction necessary to effectively respond to crisis events.”