A focus on ESG is essential for sustainable underwriting

Introduction

Issues that were once seen as purely reputational or part of corporate social responsibility are becoming integral to sound corporate governance and strong financial performance.

Environmental, social and governance (ESG) concerns relate to the sustainability of a company’s business model and its ability to adapt to a changing economic environment. ESG extends beyond climate change and environmental issues to diversity and inclusion, business and human rights, as well as social mobility.

The ESG acronym is being increasingly seen in requirements for insurance companies to demonstrate their business model is “sustainable”. But sustainable means more than having environmentally friendly policies. What ESG really means is ensuring the business model can adapt to what is expected to be a very different commercial and social environment over the coming years. It means looking at the health of a company beyond quarterly or annual reporting to see whether or not it has the “right” values for investors in the longer term. It is a means by which investors and the public can judge the quality of a brand and its ability to reflect external societal values and meet the challenges of climate change.

Through product development, insurers can differentiate themselves by incentivising sustainable outcomes by helping insureds to proactively manage their risk exposures or by developing products that replace insured assets with sustainable alternatives

Although historically captured in “non-financial reporting”, ESG outcomes can have a serious impact on businesses’ financial performance and is becoming part of financial hygiene. Getting ESG right is no longer only about doing the right thing; it is also about embedding a sustainable business model for the new economic environment.

For insurance companies, there are particular challenges in pivoting towards the ESG agenda. New expectations for reporting exposure to climate-related risks will require data on exposures that has not previously been collected. Understanding how climate change will have an impact on risk exposures means reviewing existing books of business to model climate change scenarios based on future (not past) events and understanding the impact of different correlations where climate-related events occur.

The traditional one-year time horizon (which is hard-wired into capital requirements at present) cannot capture the changing exposure to climate-related damage, which may take years to materialise. Capturing the exposure to transition risks (the risks inherent to economies moving away from carbon) requires looking at investment portfolios to understand how decarbonisation might affect the value of assets held against liabilities. But it is not just environmental issues that will challenge the industry. Addressing this exposure is a challenge firms are just starting to undertake.

Diversity

A sluggish response to the need for organisations to be more inclusive of difference has meant the insurance sector has focused later than some other industries on the need to ensure its workforce is suitably diverse. Often overlooked is the need for businesses to ensure they have the right people working in the right way to drive the business over the next few years.

As risk managers in the wider economy, insurance companies are being asked to be a catalyst for change. Through product development insurers can differentiate themselves by incentivising sustainable outcomes by helping insureds to proactively manage their risk exposures or by developing products that replace insured assets with sustainable alternatives (for example, by “nudging” insureds towards green vehicles or more environmentally friendly building materials). Long-term products may need to appeal to investors concerned about carbon assets and sustainability. Insurance company boards need to act decisively to manage the change in expectations from customers, regulators and the public – and do so quickly.

In the UK, domestic policy initiatives have pushed the ESG agenda from being an issue of social responsibility into a regulatory concern. What were voluntary requirements are becoming rules. An insurance company failing to address exposure to transition risk in the UK will lead to some difficult conversations with the Prudential Regulation Authority (PRA), which in turn could lead to financial penalties and decisions about the suitability of senior managers. PRA supervisory statement 3/19, Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change, requires UK insurers to embed the consideration of climate risks into their governance, apply long-term scenarios analysis to capture climate risks and disclose where their financial vulnerabilities to climate risks lie.

The UK government has announced its intention to make the disclosures recommended by the Taskforce on Climate-related Financial Disclosures (TCFD) mandatory across the economy by 2025. TCFD has been designed to support more informed decision-making by stakeholders that can better understand where exposures to carbon-related assets lie. The UK government strategy is for all large asset owners, including insurance companies, to be disclosing in line with recommendations by 2022.

In the EU, the Non-Financial Reporting Directive obliges companies to report on a wide variety of ESG-related metrics, while the Taxonomy Directive established a classification system of environmentally sustainable economic activities. Amendments to suitability assessments under the Markets in Financial Instruments Directive and conflicts of interest and product oversight in the Insurance Distribution Directive seek to encourage sustainable investment and “long-termism” in financial products. Adopted amendments to Solvency II require the integration of climate change risk scenarios into risk management and governance systems. The business model must take into account changing claim patterns, changing product requirements and a shift towards “long-termism”.

Liability exposures

Insurers, of course, are not only concerned about ESG issues in respect of their own business. The changing business environment will affect their underwriting exposures, both in terms of physical risks but also liability risks, as their insureds are sued if they fail to adhere to new sustainability requirements.

The landscape for third-party claims against insureds for management and governance errors in respect of sustainability has developed over the past couple of years. The directors and officers of carbon-intensive industries and investment companies may be held personally accountable for failing to consider the impact of climate change on corporate strategy and decision-making and for failing to disclose information relating to climate risks.

This risk exists also for other businesses that fail to take into account the impact of climate change on their advice to clients such as accountants, architects, engineers and those involved in the construction sector. Similar exposures exist for failing to be transparent about environmental damage, supply chains or modern slavery issues.

The green finance agenda, which in the EU is driven through the Green Deal and in the UK through the Green Finance Strategy, requires firms to ensure future risks and opportunities from climate and environmental factors are integrated into mainstream decision-making and product development, essentially hard-wiring sustainability into the business model. These green finance initiatives have created a new ecosystem of compliance obligations, which can lead to significant liability exposures. New taxonomies of sustainable products, reporting and disclosure standards, as well as ESG-related shareholder activism, all have to be skillfully navigated to avoid exposure.

As companies increasingly become required by law to measure and report their exposure to ESG-related risks and are under much greater scrutiny in terms of the sustainability of their business model, insurers will face increasing exposure whether in respect of their own business or from their liability to insureds.