Compensation consultants say hazard duty pay for board service can help offset directors' heightened personal reputation risks. But is it enough? Directors accustomed to personal insurance protection may be surprised to learn that directors and officers (D&O) liability insurance does not cover reputation loss. Boards seeking broader coverage will need to nudge their risk managers and insurance carriers to present reputation insurance options.
Reputation risk, the frequently uninsured cousin of the risk of personal liability, is materially different from its kin.
Liability risk is a legal construct adjudicated in a court of law. The prevalence of liability risk, and the near-universal penetration of D&O liability insurance, are results of cultural changes in the mid-1980s that gave rise to the idea that a firm's officers and directors were plausibly liable to investors for sudden falls in corporate share prices. In addition to insurance protections, new risk management strategies anchored by the Caremark standards and the “business judgment rule” since then have helped to protect directors in courts of law.
Reputation risk is a cultural construct related to trust and the psychological (read, behavioral economic) phenomenon of expectation-driven behaviors. Reputation risk was formally recognized as a financial institution peril in the 1990s. Its modern-day prevalence in all sectors is due to cultural changes over the past decade that gave rise to the idea that stakeholders' expectations had equal or superior standing to those of investors. Corporate reputation risk surged after 181 CEOs signed Business Roundtable's statement on corporate purpose, committing themselves to serving the interests of “all stakeholders,” especially communities, the environment and investors.
When managing reputation risk, Caremark standards are irrelevant and the business judgment rule is not exculpatory. Neither have standing in the courts of public opinion.
The risk of economic damage from the actions of suddenly disappointed emotional stakeholders is the essence of reputation risk. Just as the purest form of reputation risk, such as a run on a bank, can be triggered by something seemingly random like “sunspots”, according to Nobel Laureates, anger from unmet expectations is impossible to forecast and can happen to any company or its board. Features of corporate reputation events include customers boycotting, employees fleeing, regulators enforcing; and social license holders protesting. These actions can materially impact cash flow, leading markets and investors to become progressively more interested in both reputation risk governance and risk management.
This year, institutional investors and proxy advisors have explicitly shared their expectations that firms protect their reputation value. Reputation risk governance is now an implicit director duty.
Also personalizing directors' exposure is a change in their relationships with corporate reputations. According to PwC's 2020 survey, 72% of directors reported that going through a recent reputational crisis reflected negatively on the board members themselves. Among younger directors, nearly four out of five expected to see “an impact on their personal brand.”
While personal losses for directors are currently limited to opportunity costs of board service compensation and future professional opportunities — both being direct consequences of public humiliation — clawbacks could be just over the horizon. Clawbacks of CEO compensation for reputation harm are already in force in a third of S&P 500 companies.
There are three reputation insurance options:
- Add-ons to D&O liability policies
- Dedicated parametric policies for reputation risk or ESG risk
- Captive insurance solutions
An immediate, practical board benefit of reputation insurance would be more relaxed operations. Insurance could help mitigate the fear of personal financial exposure, which causes increasingly vexatious board dynamics. A “record-high” 25% of board directors want two or more peers gone, according to a recent PwC survey. A strategic benefit would be making the board “look smart” to peers.
For these two benefits, boards will need to let their risk management apparatus know that they want protection from reputation risk. The more sophisticated enterprise risk managers and risk counsel already appreciate that the risk environment has evolved this past decade. They recognize that Marchand v. Barnhill extended governance to all operational intangibles that might be mission-critical to firms, and that many board decisions are primarily driven by social, cultural and political concerns. Some may already coordinate reputation risk management with their peers in investor relations or corporate communications.
Some risk and insurance managers may push back. They may still think that reputation risk is either an uninsurable secondary consequence or best managed exclusively as a public relations issue. But most risk professionals are attuned to notions of connected, complex, disruptive and nonfinancial risk of which reputation damage is actually an insurable outcome.
Boards may also need to let their carriers hear that the D&O insurance policies they are offering are not good enough. Carriers looking for creative solutions to keep or grow market share in this softening market are likely to be receptive.
Some carriers will push back. They will decline the opportunity to provide coverage, as many declined offering D&O liability coverage in the mid-1980s. These carriers will claim that a request for this type of insurance is a red flag for moral hazard.
Innovative carriers, on the other hand, recognize that the term “moral hazard” with respect to reputation risk is a canard. They appreciate that cultural changes are impacting the insurance market broadly (e.g., social inflation, political risk and reputation risk.)
As they did for D&O, these carriers will help clients successfully explain that coverage is a reputation asset. Simply put, because of its scarcity, only the better firms can obtain it. That's why early adopters will look smart.
D&O liability insurance and new risk management practices for governance brought directors nearly four decades of personal protection for their service. Just as they did at the dawn of the liability crisis, directors will need to demand personal protection for this new exposure. Reputation insurance, along with hazard duty pay, is what directors should reasonably expect for the personal reputation risk of board service today.