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By NIR KOSSOVSKY, CEO of Steel City Re, a risk management and assurance company specializing in corporate reputation protection based in Pittsburgh, Pa.

It takes years of effort and substantial resources to build a reputation that customers trust and investors recognize. It takes one story hitting the Internet that blares the results of an unfortunate executive decision or failure in a critical business process to destroy that reputation.

So far, 2008 has been another bad year for almost any business sector where managing reputational risks is important. But by and large this year's headlines were grabbed by ailing financial services firms.

The insurance industry has not been immune. Many companies in this sector have a good reputation. But some of the mighty, with AIG being the best publicized and largest example, have fallen; fallen far, to the brink of collapse.

Reputations take shape from perceptions stakeholders have about an enterprise's intangible, or nonbalance sheet, assets.

To wit, a company owns its brand and a company's stakeholders own its reputation.

In business, intangible assets comprise business processes, governing ethics and integrity; quality, safety, sustainability, security, and innovation; patents and trademarks. They represent approximately 70 percent of the market capitalization of the average company.

To arrive at that percentage, Pittsburgh-based Steel City Re, a risk management and assurance company, conducts some simple arithmetic. It merely calculates the difference between the book value of a company, the material assets listed on its balance sheet and the market value of the company.

Risk management, a business process, is also an intangible asset. In the insurance sector, risk management and the other intangibles together represent 32 percent of the market capitalization of the average insurance company, affirming the critical role of insurance company balance sheets, compared to other sectors.

But balance sheet value, as recent lessons remind us, depends on risk management. Stakeholders' confidence in risk management, and therefore the reputational value of risk management, can be quickly lost.

Steel City Re manages an index that monitors the reputational value of management's stewardship of a company's intangible assets. Data Steel City Re has collected since late 2005 affirms that superior intangible asset stewards experience greater sales, net income, earnings multiples and stock price stability and reward shareholders with above average returns.

As an industry, the average intangible asset (IA) index ranking in August 2007 placed the insurance sector in the 63rd percentile. This proxy for reputational standing slipped to the 57th percentile by early October 2008.

Within the industry, there is a hierarchy of intangible asset value. The major brokerage firms that depend on their human assets for much of their success ranked in the 84th percentile in August 2007. Reinsurers ranked in the 72nd percentile; life & health and multiline ranked on average around the 64th percentile, and property & casualty insurers ranked in the 56th percentile on average. All experienced reputational deterioration in the intervening period except for the latter group which rose to the 58th percentile. The multilines deteriorated on average to the 39th percentile by October 2008.

These initial standings and movements in the IA index rankings were associated with differences in economic return. Against an industry that overall returned -20 percent since August 2007, the major brokerage firms also returned -20 percent to their stakeholders. Reinsurers slightly outperformed the average at -19 percent; life & health and multiline diverged with the former returning -27 percent and the latter returning -43 percent. Property & casualty insurers outperformed their peers with only a 13 percent loss.

In general, firms that distinguish themselves with extraordinary intangible asset stewardship benefit from reputational value enhancement. Superior stewardship entails management of the business processes that create value in the intangible assets, communication to stakeholders of the value of the intangibles, and protection of the value of the intangible assets through risk mitigation and risk transfer.

The firm with the greatest sector reputation, and at times the greatest market reputation by the IA index, Berkshire Hathaway, returned a 20 percent on equity to its shareholders during this same period. Other firms in the sector that improved their intangible asset index ranking and their reputational value during this period included the property and casualty firms Darwin Professional Underwriters Inc. (41 percent return on shareholder equity), Harleysville Group Inc. (8 percent), AmCOMP Inc. (59 percent), State Auto Financial Corp. (-1 percent), Donegal Group Inc. (Class A) (16 percent), Infinity Property & Casualty Corp. (7 percent), FPIC Insurance Group Inc. (49 percent), SeaBright Insurance Holdings Inc. (-27 percent), and Selective Insurance Group Inc. (14 percent).

Among brokers, Marsh & McLennan showed the greatest increase in their IA index ranking and returned 12 percent to shareholders. IPC Holdings was the reinsurer showing the greatest improvement in IA index ranking and reputational value and returned to shareholders 9 percent. Among life & health insurers, it was Unum Group with a return of -1 percent, and among multiline carriers, it was Assurant Inc. with a return of -2 percent.

Second-tier perfomers included Montpelier Re Holdings Ltd. among reinsurers; Philadelphia Consolidated Holding Co, RLI Corp., and ACE Ltd. among property and casualty insurers; Aon and Arthur J. Gallagher among brokers; Nationwide Financial Services and AFLAC among life & health insurers, and American Financial Group Inc. among the multiline insurers.

It was not always the case that the markets widely valued a company's intangible asset stewardship. Excluding companies long known for their valuable brands, intangible asset value comprised on average 20 percent of a company's market value only 20 years ago. In those days it was known as goodwill and nobody paid much attention to it.

Intangible assets are those assets that are known to create value but have no form of recordation on company balance sheets. Because they cannot be measured by standard accounting methods, intangible assets are at risk for being under-managed. Like the elements of a Roman arch, together they create value but loss of any one can destroy value.

Regulators have recently promulgated accounting rules that seek to regulate the reporting of intangible assets. Independently, investors have turned to sources of extra-financial information.

A survey in 2005 by Thomson Extel showed that only 6 percent of buy-side brokers devoted material resources to extra-financial data to determine intangible asset value. One year later, a follow-up survey showed that 32 percent did so. In 2007, the Enhanced Analytics Initiative, an international extra-financial investment information cooperative, reported that its membership had a total of $2.4 trillion of assets under management.

In response to the recent market turmoil, further regulatory regimens and additional investor interest in the intangible assets, their corporate stewardship, and their value should be reasonably expected.

The Intangible Asset (Reputation) Financial Performance Index is an objective decision-market metric Steel City Re uses to project the expected financial gain or loss arising from reputational enhancement or loss.

Data reported previously, viewed retrospectively, show that companies whose index rankings place them in the top 25 percent of the 2,483 companies studied during the 28-month period from December 2005 to February 2008 rewarded their shareholders with an average (portfolio) return of 18 percent, which is about three times the (then) market return of 6 percent.

Moreover, companies whose IA management was very good and who continued to improve, delivered outstanding returns. Among the companies whose average index ranking was in the top 25 percent, those whose index rankings held steady or improved during the 28-month period, numbering 290, rewarded their shareholders with an average (portfolio) return of 50 percent, about three times the group average. Companies whose index rankings declined, numbering 331, rewarded shareholders with average (portfolio) returns of -6 percent.

This superior return, on the order of three times greater than their peers, reflects differences in management's perception of the role of intangible asset stewardship and in their proficiency in managing it. Those views are summarized as:

--Intangible asset management as the price of doing business (the "as little expense as possible" and/or defensive approach).

--Intangible asset management as a strategy (standardize across the operation to strengthen IAM but rationalize the cost).

--Intangible asset management as a strategic opportunity (seize opportunities to gain multiple benefits from IAM investments).

The analysis of the insurance sector affirms these general findings and suggests to managers that, notwithstanding the importance of balance sheet integrity, risk management and other intangible assets are recognized by the markets as important.

Superior stewardship may be one of the most assured management strategies for creating value.

December 1, 2008

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