An organization’s reputation is everything, and, in the digital age, it can be ruined more quickly than ever before—by news of a credit card security breach or an industrial accident or even accusations (founded or unfounded) of company wrongdoing or negligence.
Some insurers have responded by offering reputation risk insurance, yet the coverage remains rare and tends to be expensive.
My colleagues Nadine Gatzert and Andreas Kolb of the Friedrich-Alexander-University of Erlangen-Nürnberg and I analyzed examples of this relatively new type of insurance coverage to understand the risks and benefits in more detail. At the time of our study, there were only six policies in existence solely for reputation risk.
Insurers face a number of challenges in protecting against risks associated with reputation. One issue is the difficulty in measuring reputation and, therefore, the loss associated with reputation. If a negative story comes out about a firm and sales decrease, is that due to the story or are there other factors such as a downward trend in the industry or in the economy as a whole? When payment for loss differs from the actual loss value, it is termed “basis risk,” and can cause upset among the policyholders when payment is below loss value as well as poor behavior when payment exceeds loss value.
That potential for poor behavior is called “moral hazard.” When an insured firm knows that it will be compensated for reputation loss (and sometimes paid more than the loss value), company leaders might determine that it is uneconomical to prevent reputation damage. Efforts to limit loss are expensive. When an insurer will pay for the resulting loss, incentives for mitigation decline. These situations are undesired not only for insurers but also society as it wastes resources.
Insurers are concerned as well with “spillover,” or systematic risk, that is, when an entire industry might lose value from the behavior of just one member. For example, when stories emerged of bed bugs found in several large-city hotels, those hotels not involved in the situation might be lumped together in the public’s perception about the safety and cleanliness of any hotel in the area. Such spillover may make it difficult to spread risk across insureds, given that they may all experience loss simultaneously.
These various challenges have caused insurers to write policies with numerous limitations and at a high cost. Demand, therefore, is unclear. Furthermore, as with any new coverage, the introduction of reputation risk insurance is likely to be followed by litigation regarding the policy’s interpretation, adding to the costs of providing coverage.
Ultimately, demand for reputation insurance is uncertain. The current coverage is narrowly focused, and coverage that is too narrow will not sell enough policies to make the offering profitable. Interest in reputation risk coverage, however, is high, particularly with increasing exposure to cyber-related losses, the rapid spread of information through social media, and changing cultural norms that are more focused today on socially responsible organizations. We anticipate that these demands will lead to innovative and sustainable products in the long run.
In the meantime, we anticipate that forward-looking organizations will develop plans to manage their reputation risk as part of their overall strategic focus.
A strong reputation risk management process offers solid strategic direction, with insurance ultimately becoming just one piece of that strategic effort.
For more on this topic, see our paper “Assessing the Risks of Insuring Reputation Risk” in The Journal of Risk and Insurance.
Joan Schmit is American Family Insurance Distinguished Chair of Risk Management and Insurance, and professor of risk and insurance at the Wisconsin School of Business.