Robert Chase explains the difficulties – and importance – of managing intangible assets and the associated reputation risks.

We all know what tangibles are, but the problem with intangibles is that the very word tells us nothing about them – except what they are not.It is hardly surprising, then, that many of us instinctively shy away from the baffling world of intangibles, and most insurers have to be included in that number. So how should risk managers and insurers approach intangibles, in an effort to cut through all the fog of abstract generalities and gain a practical understanding of how to deal with them?

Firstly, distinguish between the value of intangible assets and the risks associated with them: monetary, property and reputation. Then think of their value in two stages, firstly the type of value and secondly the monetary value. When considering the risks associated with intangible assets, the word “assets” encourages us to think about intangibles as property. This is helpful in making another important distinction; property risks encompass one aspect of intangible risk – that associated with ownership issues and the rights to use that property. In other words, while everyone associates “reputation” risk with intangibles, reputation is not the whole story.

Given these four aspects of value- it is then helpful to look at where all these intangibles came from. Back in 1975, tangible assets accounted for over 60% of the shareholder value of the Fortune 500 companies. By 1995 that figure had dropped to around 25% – leaving 75% of their value attributable to intangibles. No wonder risk managers are so interested in the subject, but why not insurers too?

The staggering change in these ratios is not down to shareholder sentiment. What these ratios tell us is that the way companies do business has profoundly changed. A simple business model can demonstrate how we have reached this point.

Imagine that we run a little company, operating in some past golden age, when life was simple and the business environment benign! The company makes nails. It consists of a single factory building, containing one production line. Raw materials arrive at one end and boxes of nails are shipped to our customers from the other. Our nails have “caught on”, and there seems to be an almost insatiable demand for them.

This idyllic picture continues, until we introduce some competition. Other companies are also making nails now, so in the second stage of its existence our company has to compete on price. Soon the third stage arrives. Other companies can match our price and customers are more demanding about when they get their nails delivered. So now we compete on speed and promptness.

Meanwhile, our range of nails has become ever more sophisticated, with different types used for ever more specialised jobs, so we very quickly enter the fourth phase. (Note that not only have the changes to the business environment been fast, but the pace of change continues to accelerate). In this fourth stage, competitive pricing and speed of response are taken for granted, because now we compete on a much wider range of quality issues. As you would expect, no sooner has quality become our touchstone than our customers expect more, ushering in the fifth stage: customers recognise our ability to respond to the changing world out there by developing different types of nails (and, thereby, making ourselves rich in intellectual property), but now they want us to work more closely with them and make nails to their own specific requirements.

Looked at from various perspectives, these stages illustrate some important trends. From the viewpoint of the company itself, we started out seeing our company as a self-contained unit, with little thought for the customer. To compete on price, we pressurised our supplier in a selfish effort to retain our position with our customers - our first thoughts about life beyond the factory gates. From that stage on, we were driven by our customers' needs, until eventually we recognised our business had to be totally customer focused.

By now we were trying to place a value on our customers and found our customer/supplier relationships were opening up in ways we would never have imagined. In short, the whole transformation can be characterised as the realisation that what started out as a company manufacturing a “commodity” has to be managed primarily as a service provider. We happen to have retained an in-house manufacturing capability, but we might equally have chosen to outsource this in the latter stages.

Shareholder value
What happened to our shareholder value during all those changes? Initially, our value was based upon our land, building, plant, stock, money in the bank and little more. But as time went by, shareholders realised our value lay not in our tangible assets but in the way we used them and managed our suppliers. Then shareholders recognised that our real value was actually in our intellectual property, our know-how, and in our ability to apply all that to maintain customer relationships. Ultimately, they value us less on how financial snapshots of our company suggest we are performing and much more to do with our ability to perform in the future. Our current value has become our perceived future value, based on an estimation of our ability to keep re-creating ourselves as market demands change.

More practically, how would we want to value our company's assets for insurance purposes during these changes? Prior to the appearance of competition, the assets are the factory, stock and machinery. The stock would need to be insured for its sales price and the production line for its written down value. Business interruption cover might be sought to cover continuing costs.

When the price war begins, we worry that if something happens to our machinery we need to replace it, so let us insure it for replacement cost. And if our supplier's factory burns down, we may face increased prices from alternative suppliers; we need some form of supplier's extension on our business interruption cover.

The real change comes with the next stage – timing competition. If something goes wrong now, we will not be able to get our market share back so easily, because we will have let our customers down. So now we do not need BI cover just for our downtime; we also need cover which will respond to lost long term or repeat customer contracts.Inadequacies of BI
When competition on quality is in full swing, even that sort of BI cover is insufficient. Our reputation is on the line, and if we get something wrong we do not just lose existing customers, we will fail to win new ones. And our worries are much wider than physical damage to our tangible assets or those of our suppliers. What about our other (intellectual) property? We might lose a patent on one of our key processes or a trademark in a major market. And what about our reputation risk? We might have to recall some faulty nails, or some of the compounds used in our more sophisticated ranges might turn out to be toxic. What are risk managers and insurers to make of all this? Clearly, the type of intangible values that should primarily concern them is their future earnings potential (some intangibles have no other quantifiable value). Putting a monetary value on such potential may be subjective, but it is surely not beyond the wit of risk managers and insurers to come to an agreement on such figures.

Equally clearly, one of the risk manager's functions has become the constant re-working of what if scenarios for the business. Again it should be possible to convert many of these into the “triggers” or “insured events” of insurance policies.

What is required of insurers is a willingness to contemplate business projections as a basis of claim and wrench themselves away from historic accounting. Like shareholders, insurers must come to recognise that the relevant “values” here are those of the future, not those of the present or past. This has to be coupled with the realisation that in the world of intangible risk each company is unique and will require manuscripted trigger events in any policy wording; insurers, too, must recognise they are no longer in the commodity business.

These are the very principles we have tried to apply to reputation risk and the field of intellectual property in our 4Thought policy, but if any insurers believe they can safely ignore the new world of intangibles and continue to insure the tangible assets of companies in splendid isolation, our simple nail-manufacturing example contains a salutary lesson. The reputation of the company can equally be destroyed by a fire at its factory, so unless the factory insurer is prepared to embrace the notion of insuring the full projected earnings, the coverage he offers is virtually useless; even tangibles cannot escape the impact of the intangible.

Robert Chase is underwriter of Kiln Marine & Special Risks, Lloyd's syndicate 510 combined. Tel: + 44 (0) 20 7886 9000; fax: +44 (0) 20 7488 1848; e-mail: Internet: