reputation risk

Enterprise Risk Advisory, LLC

May 9 2007

Michel Rochette

REPUTATION RISK

Also known as the Cinderella Asset!

©Enterprise Risk Advisory, LLC 2

Presenters

Dr. Leslie Gaines-Ross, Chief Reputation Strategist at Weber Shandwick in NY where she leads the firm’s consulting services and proprietary thought leadership in reputation risk management. She is the creator of www.reputationRX.com, a web site dedicated to reputation issues

Mr. Scott C. NewQuist, Managing Director at Perception Partners, which specializes in providing advice on identifying and managing reputation risk, corporate governance and reporting.

Michel Rochette, an ERM consultant at Towers Perrin in NY who specializes in ERM and the management of non-tradeable risks!

http://www.reputationrx.com/


Reputation Risk

Context: Why is it important to financial institutions?

What is reputation? Definitions and comparisons

Value of reputation: Drivers and evaluation measures

Reputation risk: Definitions

Reputation risk: Qualitative and quantitative measures

Examples of reputation risk

Reputation risk: Management approaches

Reputation risk: Framework

Rating agencies and regulators’ points of views

Case studies

Questions.


Citations by Warren Buffet & Goldman Sachs

―It takes twenty years to build a reputation

and five minutes to destroy it.‖ (W. Buffet)

―If you lose dollars for the firm, I will be

understanding. If you lose reputation, I will be

ruthless.‖ (W. Buffet)

―Our assets are our people, capital and

reputation. If any of these are ever

diminished, the last is the most difficult to

restore.‖ (Goldman Sachs Business

Principles)


Importance of Reputation and Trust

Information asymmetry

Outsiders don’t know as much about a company as insiders, so a good reputation alleviates and allow customers to make a choice.

Important for all companies but crucial and vital to insurers as we sell distant promises.

Important for insurers that have one global brand: AIG, ING, Aegon, Met Life, Sun Life, Manu Life, AXA, Allianz, Zurich, etc.

In essence, we exchange money for a promise to pay in the future. (Money for Paper!)

More important in a period of rapid changes, globalization, internet blogs, activism, mass media.


Importance of Reputation to Stakeholders

Employees: Are more loyal to a company with good reputation. Help with recruiting

Investors and business partners: Will take risk in a company that they can thrust based upon its reputation. (More than 90% think about reputation in investment decisions: 40% care about reputation, 50% care partially).

Lawmakers and regulators: Reputation can help lessen the legal burden on a company.

Public at large: Preserve ―social license‖ to operate

Customers and suppliers: Support loyalty to company

Competition: Barrier to entry


Reputation Risk: Number 1 Risk for CROs

Reputational Risk

(52)

Regulatory Risk

(40)

Human Capital Risk

(40)

IT RISK

(35)

Financial, Market, Credit and Insurance Risk

(30)

Crime, security, political, natural hazard, FX, Terrorism, Country Risk

(20)

Source: Economist Intelligence

Unit, 2005

Max Scale: 100


Reputation and Financial Impact: Corporate

Reputation Watch by Harris Interactive


Value of Reputation: National Corporate Survey

Microsoft: 1st place

Johnson and Johnson: 2nd

Google: 4th

Berkshire Hathaway Inc. 21st

American Express Company: 34th

Wells Fargo & Company: 36th

State Farm Insurance: 42nd

Allstate: 51st

No Life companies included. Have your companies rated!

Consult Fortune’s annual survey of America’s Most Admired

Companies.


What is Reputation: General Definitions

A corporate reputation is a collective representation of

a firm’s past actions and results that describe the

firms’ ability to deliver outcomes to multiple

stakeholders. It gauges a firms’ relative standing both

internally and externally. (Fombrun/Foss: Developing a

Reputation Quotient, 2000)

Reputation is public information regarding a players’

trustworthiness. A players’ reputation reflects the

information that third parties have on how trustworthy

his behavior has been in the past. ( Ripperger 1998)


Comparison of Reputation and Image

Reputation:

Corporate Actions and Conduct that

Create Trust

As Experienced by different Stakeholders.

Serves as a reservoir of goodwill in time of crises.

Image

Belief and personal evaluation of a firm

Tied to the firm directly, not to actions by the firm.

If image is positive, reputation will improve

However, reputation evolves more slowly than

image because it is tied to actions.


Comparison of Reputation and Brand

Brand:

What differentiates us from the competition

Marketing of the company including advertising and

publicity

Refers to logos and names of companies

Reputation:

Cannot be enhanced by just a name change.

Larger concept as it includes other elements as we

will see.

Often referred as ―Emotional Capital‖ of the firm

Thus, if capital, it is subject to risk.


Value of Corporate Reputation: Drivers

Client Service

New products

New services

Pricing

External factors

Social/Environmental

Responsibilities

Pressure Groups

Human Capital/Talent

Culture

Corporate Ethical Values

Communication

Disclosures

Crisis Management

Corporate Governance

Regulatory Compliance

Long-term

Financial Performance

Reputation


Value of Reputation to the Firm

A good reputation encourages consumers to buy products and

services.

Suppliers are willing to do business with you, thus expanding

opportunities.

Top notch employees want to join and stay with your organization,

thus enhancing its innovation capabilities and value.

Favorable outlook from regulators and rating agencies, thus

decreasing financing cost and increasing value.

Investors want to hold shares, thus increasing value.

Positive feedback from media and pressure groups increase

value.

In a crisis mode, investors give the company the benefit of the

doubt, thus easing short-term decrease in value.


Value of Reputation: Qualitative Measures

It is the sum of how all constituencies view and

perceive the organization.

National Corporate Reputation Survey by Harris

Interactive

Specific company’s reputation survey: Ex. Swiss Re

does one every 2-3 years.

Media evaluation of public opinions. Ex. Media

Tenor International reports, % of negative/positive

reports, Awareness Threshold of 3%( Below 3%

leads to higher risk), Value Reporting of company’s

value drivers.


Value of Reputation: Quantitative Measures

An Intangible asset which doesn’t show up in the balance sheet. It

is sometimes referred as ―Emotional Capital.‖

It has a current value and influences future value of the firm.

Best approach is by the Court of Financial Opinion: Stock Market!

Estimated value of reputation = Market Value of Company -

Balance Sheet Value - Intellectual Property – Brands( Cos like

Brandz, Core Brand) – Copyrights - other Intangible Assets.

Usually, reputation is the largest component of intangible assets.

Reputation reflects the rise of the ―non-physical economy‖,

especially in the developed world. Some surveys have shown

ratios of market value to balance sheet value between 10 and

100.


Reputation Risk: Regulatory Definitions

FSA: The risk that the firm may be exposed to

negative publicity (Trust) about its business practices

or internal controls (Actions), which could have an

impact on the liquidity or capital of the firm or cause a

change in its credit rating. (Affecting its stakeholders).

US Federal Reserve(2004): ―Reputation risk is the

potential loss that negative publicity regarding an

institution’s business practices, whether true or not, will

cause a decline in the customer base, costly litigation,

or revenue reductions (financial loss).


Business Definitions of Reputation Risk

US Federal Reserve(2004): ―Reputation risk is the potential loss that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions (financial loss).

ADD other business elements:

Loss value of key employees.

Loss value of key suppliers.

Increased cost of regulatory actions.

Financial impact of rating agencies’ decisions.

Financial impact of new products


Reputational Risk: A Risk by Itself or a

Consequence (Second tier) of Other Risks?

According to Economist Intelligence Unit(2005) survey,

―52% consider reputation risk as a risk by itself, while

48% consider it as a consequence of other risks‖ like

operational risk – people, process, systems and

external events – compliance and financial.

Appears that if first risks are more quantitatively

analyzed – market, credit, operational … -

Reputational risk appears as a second tier risk –

mostly within financial institutions – while it appears as

a risk of its own in the corporate world – like Hilton,

Cruise companies where emphasis is on their

products/services -.


Reputation Risk: Qualitative Measures

Complaints by all stakeholders act as an early warning system: Monitor and analyze trends.

Identify and monitor your company’s HOT SPOTS in relation to all your stakeholders’ interests, particularly in periods of rapid change. Ex. Organizational changes, new products/services.

Compliance/Audit functions. Are they proactively identifying and following-up on issues?

Assess flows of risk information in the institution.

Assess the link between compensation programs and desired behaviors.

Is reputation risk part of the new product approval process?

Is there a Code of Ethics? Reward ethical behavior? Penalize misbehavior?

Evaluation of media coverage of companies

Monitor internet blogs


Reputation risk: Indicators

Rate your organization:

Low if

— Management anticipates well changes in market and

regulatory nature

— Franchise value minimally exposed

Moderate if

— Management adequately responds to changes in market

— Franchise value is controlled

High if

— Management doesn’t anticipate reputation risk

— Weaknesses are present

— Franchise value substantially exposed to in litigation,

consumer complaints.


Reputation Risk: Quantitative Measures

Measured as the market value impact of an event which is above

the direct value of the event itself, the excess is qualified as the

reputational impact.

Ex. Federal Reserve Bank of Boston measured Reputational

impacts of operational events:

Internal Fraud: The market value impact was more than 6

times the value of the internal fraud itself, which is due to lack

of control by the company and lack of confidence in actual

management.

Externally caused events: No reputational impact.

Thus, seems to confirm the initial definition of reputation as

being based on ACTIONS by company.

Fines account for less than 10% of total market value loss.


Reputation Risk: Quantitative Measures

Failures by companies that have a reputational impact have a lasting financial effect on the market value of companies:

1/3 of financial analysts say that their evaluation of a company will take into account the impact of a failure in reputation up to 3 years after the event. (Hill/Knowlton 2006 survey)

Companies take up to 3 years to recover from a crisis that affected their reputation. (Burson/Marstelle Market research)

Model developed by UK-Based OxFord Metrica called ValueReaction Model: Analyze impact of reputation crisis on company stock price. Will company recover from a crisis? If management handles crisis badly, investors conclude that management cannot handle unexpected events.

Set up Loss Data Base of operational events and their reputational impacts.

Scenarios modeling of major threats using expert judgment


Reputation Risk: Model Quantitative Financial

and non Financial Impacts of Damage: Factors

Stock decline

Run on the bank

Spike in policy surrenders

Outflow of assets under management

Drop in sales, decline in market share

Ratings downgrade

Regulatory investigations, license withdrawal, fines

Shareholders’ litigations and class-actions

Political fall-out, discontent in communities

Negative media coverage

Pressure groups and public opinion

Employees and contractors withdrawals.


Reputational Risk: Importance of companies’

actions on Historical Reputation Events.

Client Service

New products

New services

Pricing

47%

External factors

Social/Environmental

Responsibilities

Pressure Groups

Human Capital/Talent

Culture

Corporate Ethical Values

58%

Communication

Disclosures/Security Breaches

57%

Crisis Management

Corporate Governance

Regulatory Compliance

66%

Long-term

Financial Performance

Reputation


Unit, 2005

% of respondents.


Examples: Non financial Sectors

Catastrophe: Three Mile Island

Safety Issue: Union Carbide chemical leak in Bhopal in 1984.

Environmental issue: Home Depot promising to stop selling wood from protected forests after Rainforest Group Action intervention, Exxon Valdez

Catastrophe: Concorde crash and impact on both Air France (less impact ) and British Airways (larger impact due to slow response).

Product Recall:

Tylenol tampering scare in 1982 due to cyanide. Limited impact due to Johnson and Johnson quick responses in the end. In fact, Johnson and Johnson has been rated top in reputation by Harris Interactive.

Perrier suffered longer from toluene traces found in its waters due to lack of crisis management.


Examples: Financial Sectors

Scandals/Fraud:

Arthur Andersen co. fell almost entirely due to its

damage to its reputation after Enron’s scandal in

2002.

Interesting case in the field of reputation. Similar to

Barings in the field of operational risk.

One year earlier in 2001, the Chief Executive was

saying: ―There is extraordinary power in our name

because it stands for time-tested values, a unique

one-firm global operating approach and recognized

superior performance.‖



Fraud: KPMG paid 456 million dollars but escaped indictment that

could have crippled the firm.

External events: SARS had huge impact on tourism both in

Toronto and China.

Market Timing/Fraud in 2003/2004 at Putnam Investments

Paid 4 million in fines.

Fired top management of international funds.

Lost 14 billion of assets under management in a week (5%).

Assets under management from 272 billion (03) to 192 (07).

Never recovered from institutional clients.

Putnam sold to Great-West Life in Feb. 07 ending a history

dating back to 1937.



Accounting Scandals at Fannie Mae:

Direct impact: 400 million dollars in fine to SEC and

OFHEO.

Indirect impact: Fannie Mae ordered to limit

mortgage holdings at 727 billion dollars. Thus,

company cannot grow anymore. This situation will

last until ― it has implemented internal controls and

risk management. We are talking years…‖

Scandal at Marsh. Stock declined by 40%, Moody’s

downgraded company due to decline in reputation.


Example in the insurance industry: AIG

Following investigations in a finite reinsurance, investigations led

to other investigations in accounting and fraud.. starting in March

2005

Result:

Paid 1.6 billion in fines in February 2006

Share decline by 10 billion dollars in absolute terms when

investigations began.

Relative share value destruction of 40 billion dollars

considering the insurance sector performance between March

2005 and February 2006 when settlement occurred.

Share price still hasn’t recovered in spite of increased

profitability. Will take time to get back the reputation of the

―world’s leading, rock solid insurance company.‖

AIG didn’t have a reputation recovery plan in place.


Example in the insurance industry: AFLAC

Japan

Situation: Following investigations by the Japanese Regulator

about non payment of valid supplemental medical claims over 5

years– 10 cos. - Aflac and others had to review claims processes.

Clearly an operational risk event.

90% of companies on Tokyo Stock Exchange offer Aflac products!

Continuous media coverage of the investigations.

Operational impact on Alfac:

Process and IT events: 19 169 errors

Direct additional cost: 16 million dollars in additional claims.

Represented .45% of all benefit payments, .01$ per share

Possible fine by the FSA

Costs to investigate, correct situations, publicize results.


Example in the insurance industry: AFLAC

Japan

Reputation impact on Alfac:

New sales dropped by 5% and 10%.

Slow recovery

Share price drop in early March 07:


Management of Reputation Risk: Align with

Risk Drivers

Crisis Management (80%)

Unplanned events but not necessarily unexpected.

Mismanagement of crisis can seriously damage a reputation.

Media attention is high.

Crisis team made of Board and technical people.

Different from business continuity planning.

Need to make strategic decision with little information.

Ex. Katrina was a crisis mismanaged by all from President,

FEMA to insurance companies. September 11 was better

handled by former NYC mayor. His reputation was enhanced.

Quote from Madeleine Albright: ― ..Being prepared for a crisis

is never a waste of time.‖


Unit, 2005


Develop Corporate Social Responsibility programs:

Build ―goodwill‖ vis-à-vis stakeholders.

Enhance internal ethical programs. (61%).

Establish Code of Conduct by employees.

AXA established a Sustainable Development Department in 2001 to coordinate a variety of environmental, community, educational and charitable programs.

Integrate environmental impact studies in investment decisions and publicize.

Monitor external perceptions of company by all stakeholders (61%)

Proactively monitor external threats. (56%). Ex. Sales practices, bid rigging, failure of insurers, regulatory investigations, market timing on competitors and determine our possible reactions to them. Reactive or proactive and how to face the issue?


Unit, 2005

Management of Reputation Risk


Management of Reputation Risk

Establish Group Issue Processes. Ex. Swiss Re

Establish an internal whistle blowing approach. A crisis

or an attack on reputation never come at a surprise.

Someone knew something within the organization.

Integrate communications strategies: right message,

delivered by right people to right audiences via a mix

of channels is critical.

Economic capital: Integrate reputation impacts into the

calculations of other risks, in particular operational

risks. In financial industry, 30% feel that they can’t

quantify while 66% feel that they can quantify in the

energy sector.


Framework for Governance of Reputational

Risk

Is reputation risk part of the overall risk policy?

―Traditional Approach‖: CEO is in charge (84%)

Reflects focus on crisis management only, reactive

Reputation is focused only on organization's own

operations.

Dedicated personnel or dedicated task force

CRO, head of business units, communications

manager (42%). Reputation risk management is

more than PR.

External parties expect dedicated resources like for the

other risks. Source: Economist Intelligence

Unit, 2005


External Views

Rating agencies

AM Best bases it evaluation on 3 criteria:

— Balance Sheet Strength

— Operating Performance

— Business Profile: Affected by reputation now and in the future. Affected by all reputation risk drivers.

— Bases its rating on trust in management, enhanced by strong reputation, which is intrinsically linked to its capacity to manage its risk profile.

Insurance regulators

Reputation is a strategic asset of insurers. Each institution should manage it proactively involving the Board and senior management as part of its overall ERM framework.

US Banking regulators

OCC expects that reputation risk management will not be done in isolation but will involve CRO, Board, Audit, Compliance, Customer complaint, HR

OCC expects that compensation programs will support desired behaviors

reputation risk

Economy & Finance