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Supporting Strategic Success through

Enterprise-Wide Reputation Risk Management

Nadine Gatzert, Joan Schmit

Working Paper

Department of Insurance Economics and Risk Management

Friedrich-Alexander University Erlangen-Nürnberg (FAU)

Version: October 2015

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SUPPORTING STRATEGIC SUCCESS THROUGH ENTERPRISE-WIDE

REPUTATION RISK MANAGEMENT Nadine Gatzert, Joan Schmit*

This version: October 30, 2015

ABSTRACT Concern over an organization’s reputation is at a heightened level and has become a top strategic business risk. Reputation creation, enhancement, and protection are critical to an organization’s success, yet highly challenging given the wide ranging and somewhat opaque nature of the concept as well as the variety of potential events causing harm. These qualities call for a strong enterprise risk management (ERM) approach to reputation that is holistic and integrative, yet existing knowledge of how to do so is limited. The aim of this paper is to evaluate and synthesize existing reputation literature in developing an enterprise-wide reputation risk management framework incorporating necessary steps, processes, and considerations. We address risk strategy, risk assessment, risk governance, and risk culture as key elements of ERM and conclude with suggestions for future research.

1. INTRODUCTION Reputation broadly is considered at the core of organizational value, with one study estimating that reputation’s asset value represents 22% of the S&P 500’s total market capitalization (Decyk, 2015). The enormous effects of reputation-damaging events on firm value can also be seen when considering the experiences of BP (2010 oil spill) and TEPCO (2011 Fukushima Daiichi nuclear power plant accident).1 Scott and Walsham (2005) further suggest that changing social norms combined with advanced communication technologies make reputation more fragile than ever, a notion supported by surveys of executives who list reputation as a top strategic business risk (Deloitte 2014). Academics have noted the relevance of reputation to corporate value. Numerous empirical studies suggest that investment in positive reputation creation (and maintenance through risk management) yields strong returns. In general, a good reputation, including investment in reputation building, serves as a signal regarding the quality of products and services offered. This is especially relevant against a background of information asymmetry (Shapiro, 1983; Klein and Leffler, 1981). Firms with a high reputation are further assumed to have potentially

* Nadine Gatzert is at the Friedrich-Alexander University Erlangen-Nürnberg (FAU), Chair of Insurance

Economics and Risk Management, Lange Gasse 20, 90403 Nuremberg, Germany, Tel.: +49 911 5302 884, nadine.gatzert@fau.de, Joan Schmit is at the University of Wisconsin-Madison, American Family Insurance Distinguished Chair in Risk Management and Insurance, jschmit@bus.wisc.edu.

1 BP is said to have lost 50% of its market value while TEPCO lost 80% (Aon, 2012)

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significant competitive advantages as compared to competitors with low reputation (Fombrun and Shanley, 1997), which is why it is also considered as a strategic intangible asset (Hall, 1992). In particular, strong empirical evidence indicates that a positive corporate reputation positively affects stakeholder behavior. Especially important is the effect on customer behavior. Among the findings are that positive reputations imply a higher “willingness to pay” by customers (Graham and Bansal, 2007), positively impact spending and share of wallet (Walsh et al., 2012), and generate purchase intention (Yoon et al., 1993). They also positively affect customer loyalty (Walsh et al., 2009; Walsh et al., 2012), word of mouth (Walsh et al., 2009), as well as trust and identification (Keh and Xie, 2007). Similarly, suppliers are affected by a buyer’s positive reputation, often offering better contractual terms because of the impression of lower credit risk (Van den Bogaerd and Aerts, 2015). When investors perceive an organization positively, they often allow easier access to capital (Shane and Cable, 2002; Dollinger et al., 1997) and lower financing costs along with more flexibility with respect to the type of financing instrument (Wang et al., 2012). Firms with a better reputation also generally have an advantage in hiring employees, generating more job applicants as well as a higher quality of applicants (e.g. Turban and Cable, 2003). In line with the positive effects of better reputations on stakeholder behavior, several studies demonstrate empirical evidence for a significant positive relationship between the level of reputation (over time) and firm performance using various measures of reputation and financial performance (e.g., McGuire et al., 1990; Deephouse, 2000; Roberts and Dowling, 2002; Raithel and Schwaiger, 2014). Roberts and Dowling (2002) and Raithel and Schwaiger (2014) further observe that non-financial components of reputation may even contribute more to financial performance than do financial components. Given the wide array of influences on reputation, the fact that many researchers from a wide range of fields have studied reputation is not surprising. Much of that research is focused on the definition and measurement of reputation, however, and much less on risks associated with reputation and their management (Gatzert et al., 2015). A few exceptions exist, including an entire issue of the Geneva Papers devoted to insurer reputation risk exclusively, including Eccles and Vollbracht (2006) with focus on the relevance of strategic management communication based on empirically observed long-term media reputation, and Gaultier- Gaillard and Louisot (2006) with respect to definitions and drivers of reputation (risk). Others are similarly focused in perspective, such as considering the reputational effects of accounting restatements along with the effect of reputation repair programs (Chakravarthy et al., 2014), reputation as part of social responsibility (Hogan and Lodhia, 2011), and the relationship

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between reputation management and crisis management (Coombs, 2007; Kim et al., 2011). Some focus on the strategic use of resources to create and protect reputation (Eccles et al., 2007; Louisot, 2004), while still others focus on governance aspects including the role of the Board of Directors (Tonello, 2007) or how organizations can improve the value of their ERM taking into account corporate reputation (Rogers et al., 2010). The closest work to our paper is Regan (2008) who offers a broad reputation risk management approach. In this paper, we contribute to the literature by presenting a framework for enterprise-wide reputation risk management that applies across industries, thereby addressing risk strategy, risk assessment, risk governance, and risk culture as key elements of enterprise risk management (ERM). In contrast to previous work, we offer a broader perspective on the underlying causes and consequences of reputation damage based on empirical evidence and insight from the academic literature and provide additional detail in identification of reputation determinants, antecedents, and drivers. While much of this information exists in various places in the literature, it has not been organized into a cohesive framework nor employed in developing an ERM strategy. The framework is intended to support overall organizational strategic objectives through identification of successful methods to protect and support an organization’s reputation. To achieve this outcome, we begin with a discussion of ERM generally, and then follow with specific consideration of each element, focusing on reputation risk. Detail includes extensive consideration to important questions such as how to define and measure reputation and reputation damage, as well as reputation’s determinants, antecedents, and drivers. We follow with a presentation of an enterprise-wide reputation risk management including risk strategy, identification, assessment, and response, as well as risk governance and risk culture based on an evaluation and synthetization of existing reputation literature. We conclude with consideration of the most relevant areas for future research in this field. 2. REPUTATION DEFINITION AND FUNDAMENTAL ERM FRAMEWORK 2.1 Reputation definition, measurement, and antecedents 2.1.1. Reputation definition The definition of corporate reputation typically incorporates the concept of a multidimensional social construct involving the aggregate perceptions of a firm’s stakeholders on financial and non-financial aspects of a firm (Fombrun, 1996). Fombrun and van Riel (1997, p. 10), for instance, define reputation as “a collective representation of a firm’s past actions and results that describes the firm’s ability to deliver valued outcomes to multiple

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stakeholders.” Reputation can differ across stakeholder groups (Walker, 2010), where key stakeholders often include customers, suppliers, (potential) employees, and investors. Conducting a meta-study of research published between 2000 and 2003, Barnett et al. (2006) define reputation as “observers’ collective judgments of a corporation based on assessments of the financial, social, and environmental impacts attributed to the corporation over time” (p. 34). Reviewing literature published in heavily-cited management journals from 1999 through 2008, Lange et al. (2011) conclude with a three-pronged conceptualization as: being known; being known for something; and generalized favorability. They note that most authors start with the notion first proposed by Fombrun (1996) that reputation “exists in the minds of beholders.” Definitions of “reputation risk” incorporate implied definitions of reputation as well. For example, Solvency II and Basel III define reputation risk as the “loss in confidence in the integrity of the institution” (Solvency II definition, see CEA, 2007). Scott and Walsham (2005, p. 311) suggest a broader definition of reputation risk as “the potential that actions or events negatively associate an organization with consequences that affect aspects of what humans value” in order to take into account social, political, and ethical aspects of relevance for “a wide range of stakeholders” and thus beyond shareholder value. In particular, reputation risk often results from other underlying risks such as operational risk events.2 The focus of each tends to be on reputation generating from the perspective of various stakeholders. 2.1.2 Reputation measurement Given the multiple definitions of reputation, it is not surprising that its measurement is equally varied. In general, the most appropriate measure depends on how reputation is being viewed. Measurement is affected as well by who is perceiving the reputation such as an investor, employee, customer, regulator, or other (Lange et al., 2011). Several commonly- used reputation measures are listed in Clardy (2012), including surveys or questionnaires (in case of reputation as general knowledge or beliefs), external rankings (in case of reputation as evaluative judgment),3 interviews (reputation as brand knowledge and beliefs, or as personality), as well as Tobin’s q, Goodwill, or Brand Equity (reputation as a financial (intangible) asset). Deephouse (2000) and Rindova et al. (2007) measure media reputation

2 This is also one reason why the reputation risk policy by Allianz insures risks (crisis events) that are covered

by other insurance policies, which also ensures that the risk is well defined (Gatzert et al., 2015). 3 External rankings typically exhibit further limitations due to an overweighting of financial aspects, amongst

other aspects (Fombrun and Shanley, 1990), and due to its public availability, the construction may influence the ranking, which is why representative surveys are more recommendable (Lange et al., 2011).

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based on a content analysis of print media statements about the firm, including the extent of coverage, favorability of coverage, and content of coverage. Ultimately, the proper measurement technique will depend on the organization’s purpose and the situational context, including relevant stakeholders. Table 1: Selected determinants, antecedents, and drivers of reputation from the literature

2.1.3 Reputation drivers and antecedents In addition to understanding what reputation is, and some sense of methods to measure reputation, successful management of it also requires identification of drivers and/or antecedents through which reputation is developed (Rindova et al., 2005, 2010) and which can contribute to reputation building and reputation repair (Rhee and Valdez, 2009). These drivers and/or antecedents, if adversely affected (or positively affected), will in turn harm (or enhance) the organization’s underlying reputation. In risk management terms, these may be

Determinants, antecedents, risk drivers Reference / described in (e.g.) Determinants (Fombrun et al., 2000)

Financial performance Fombrun et al. (2000), Roberts and Dowling

(2002), Rhee and Valdez (2009, p. 151) Emotional appeal Fombrun et al. (2000) Products and services Fombrun et al. (2000) Vision and leadership Fombrun et al. (2000) Workplace environment Fombrun et al. (2000) Social responsibility Fombrun et al. (2000) Antecedents

High status affiliations (borrowing reputation from affiliates; distinguish from competitors); especially relevant for new firms

Rhee and Valdez (2005), Rindova et al. (2005, 2010), Lange et al. (2011, pp. 180f)

Media (as an information medium, network approach, reputation endorser)

Scott and Walsham (2005, p. 309), Rhee and Valdez (2009, p. 151, 153),

Rankings / certifications from institutional intermediaries (as an information medium, network approach)

Rhee and Valdez (2009, p. 153), Rindova et al. (2005)

Firm characteristics (institutional ownership, advertising intensity and diversification, specialization, organizational age, longevity and past performance, (complexity of) firm’s market action profile, corporate culture and identity)

Rhee and Valdez (2009, p. 151, 152f), Lange et al. (2011, p. 177), Basdeo et al. (2006), Fombrun (1997, p. 8)

Reputation spillover (“reputation commons” problem; spillover within and across sectors)

King et al. (2002), Cummins et al. (2011)

Congruence between reputation claims and context Scott and Walsham (2005, p. 312) Risk drivers Internal risk drivers (corporate governance, human rights, human resources, community involvement, environment, business behavior)

Scandizzo (2011)

External risk drivers (project, counterparty, country, sector risks)

Scandizzo (2011)

Changes in technology and social norms Scott and Walsham (2005), Eccles et al. (2007)

Reputation-reality gap Eccles et al. (2007)

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