News of the US Internal Revenue Service’s (IRS) investigation of Caterpillar for its use of overseas tax shelters should have been a warning siren for corporate America that it’s now time to review any special purpose financial instruments and vehicles to ensure they meet the stringent requirements of the US tax code.
News of the US Internal Revenue Service’s (IRS) investigation of Caterpillar for its use of overseas tax shelters should have been a warning siren for corporate America that it’s now time to review any special purpose financial instruments and vehicles to ensure they meet the stringent requirements of the US tax code.
This could create a specific challenge for firms that have created captive insurance companies as a means of both risk management and capital efficiency—and particularly as it relates to a relatively new product: reputation insurance.
The concept of reputation insurance arises out of a recognition that typical forms of business coverage, including directors and officers coverage, do nothing to protect companies, directors and executives in the court of public opinion. It’s becoming increasingly evident that reputational damage is closely linked to tangible, measurable financial damage.
In fact, recent research by Steel City Re found that financial losses linked to reputational damage at public companies have increased by 461 percent over the past five years, due to a combination of generalised public anger, outsized expectations about corporate performance (leading inevitably to disappointment), and the weaponisation of social media.
This analysis of 7,500 companies over the five-year period, included more than 60 million data points, concluded that, in a world where anger, false news and unrealistic expectations all battle with truth for the minds of stakeholders, companies need a strategy for defending themselves before negative tweets and rumours start to circulate. Anger directed at companies is being personalised, placing directors and executives at greater risk than ever before. Companies need to communicate the quality of their governance with tools that insulate their brands and their leadership teams before damaging insinuations, moves by activist investors, and potential governmental involvement erode stakeholder confidence and depress share price.
Compounding these issues are that, when a reputational crisis hits, companies almost always underestimate the impact. Initial losses in market cap may seem small and a preliminary assessment of stakeholder reactions may seem muted. But as time goes on and the news sinks in, especially when government officials threaten to intervene, losses mount significantly, not only for the companies, but also for the officers and directors who often personally become targets.
Most commercial insurance policies available in the market today don’t cover reputational risk, even though it applies to every company and its impact can translate into disloyal customers, disengaged employees, distracted suppliers, distrustful creditors, dismissive investors, determined litigators and regulators.
Clearly, though, given the trends we’ve described, reputation insurance products are a worthy part of any company’s risk management strategy. When the reputation insurance products offered by commercial carriers are not sufficient in terms of capacity or other technical requirements, captive insurance solutions are useful alternative strategic instruments. Issues may arise, however, when the IRS scrutinises such policies offered by captive carriers.
The IRS requires companies and their captive insurers to show an actuarially sound basis for pricing, an underwriting process for accepting the risk, and clear indemnification terms for when events trigger claims. If they fail that test, the IRS could determine that investments in the captive insurance company were simply an effort to evade taxes and assess large financial penalties and potentially pursue criminal actions.
How does one meet that standard? And how does one provide expressive value—signalling to both the IRS and stakeholders that the coverage is based on sound principles and, so, reducing the likelihood of a challenge? Our experience of working with hundreds of captives may be instructive.
Corporate reputation is the sum of stakeholder expectations of corporate performance, which leads stakeholders to behave in financially relevant ways, such as how creditors set borrowing rates, how suppliers set terms, how customers respond to products and prices and how effectively employees perform their jobs. Reputation value lost, which is the cost of disappointment, is similarly the sum of economic value arising from behaviour. Simply put, angry stakeholders destroy value.
Reputation protection solutions must manage emotions, measure the financial impact objectively and indemnify going-forward losses, which most commercial insurance products today don’t do. They may measure financial losses or the costs incurred in trying to repair a firm’s reputation, but they do not address the emotional element, nor are they designed to address going-forward losses.
Steel City Re has been measuring this behaviour for more than 15 years and has created indexed measures of reputation value evidenced by the telltale signatures left by stakeholders. That enables us to form actuarially sound conclusions about insureds based on information that includes:
From these metrics, we conduct underwriting, set rates and provide products that offer clear instrumental value as well as credible expressive value, communicating the quality of governance and deterring attacks in much the same way as a security alarm sign in front of a house.
Clearly, we are in an environment where more and more companies are looking at captives as an attractive option. They can allocate equity in the captives to key executives and directors, giving those individuals greater incentive to make decisions and take actions that reduce risks and avoid claims that adversely impact the long-term value of the firm.
This can also address some of the weaknesses in traditional compensation plans that are mainly short-term oriented and provide greater assurance that the amount and timing of payouts reflect long term results and value creation.
How to structure the coverage captives provide, however, particularly as it relates to reputation insurance, requires a rigorous approach, utilising public market based parametric triggers/indicators and parameters applicable to captive based risk bearing.
But this is not merely an exercise in how to structure a complex loss-absorption vehicle in ways that meet IRS muster. With the changing communications and political landscape, reputational insurance products can provide valuable protection, not only to the business entity, but to individuals in leadership positions.
Today, it’s not only brands that are at risk—it’s personal. And whether it is fake news or real news, attacks by a small number of individuals or a significant portion of the marketplace, it can permeate the environment and cause massive damage in a short period of time.
Directors are learning the hard way that they may personally be more vulnerable than the well-known corporate brands they oversee. Directors are being targeted and replaced, with 16 percent of board members at companies we studied having been replaced after reputational events.
On average, a corporate board member makes about $250,000 per year to sit on a board and usually serves on more than one. If a reputational attack leads to that board member stepping down—and potentially not being asked to serve on additional boards—it could represent significant lost personal income.
For all these reasons, companies are finding reputation insurance a timely form of protection and the captive an attractive vehicle for providing it. The key is designing products that provide both instrumental and expressive value, as well as the many benefits that captive insurance vehicles can offer, while standing up to increasing regulatory scrutiny.
