There has been a shift in investor expectations in recent years, with shareholders judging companies on a broader spectrum of criteria, rather than solely on financial metrics. Insurers and reinsurers, with their unique societal role as risk managers, risk carriers and investors, have not been immune from the trend to adapt and consider environmental, social and governance (ESG) risks and opportunities in their operations and assess what kind of impact they might have on their credit ratings, according to a new briefing by A.M. Best.
The recent Best’s Briefing, titled, “Considering Environmental, Social and Governance Factors from a Credit Rating Perspective,” said that insurers and reinsurers are facing consumer demands that they take positions on issues ranging from climate change to gender equality.
In addition to elevated public interest, companies are under pressure from non-government organisations and regulatory authorities, particularly in Europe.
At present, Best’s Credit Rating Methodology (BCRM) does not explicitly cite ESG in its building blocks, which consist of balance sheet strength, operating performance, business profile, and enterprise risk management.
However, some ESG factors are incorporated in the analysis. For example, climate-related risks are considered through the stress testing conducted in Best’s Capital Adequacy Ratio (BCAR) or in demographic changes in the analysis of life companies, and governance practices captured in the ERM assessment (as well as discussions of a company’s own view of risk)
The first principle of the United Nations’ Principles for Sustainable Insurance (PSI) is the commitment to embed ESG issues relevant to the insurance business in the decision-making process. To address this, a number of actions can be implemented across the organisation, ranging from company strategy and insurance underwriting, to product development and claims management.
Many insurers in both mature and emerging markets are already embedding ESG risks into their underwriting process. The most prevalent risk for non-life insurers is their exposure and vulnerability to climate change, with widespread recognition of climate change as a business risk, with it often included in a company’s emerging risks register.
A.M. Best noted that some insurers have begun integrating ESG factors into their investment processes relatively recently, with asset managers leading the way. The primary driver behind this strategy is the pressure that asset managers receive from investors, asset owners, and the overall competition for the limited pool of sustainable assets. In contrast, insurers tend to introduce ESG criteria in their investment activities in response to regulatory changes (e.g. pension fund legislation) or following the introduction of stewardship codes.
Apart from being seen as doing the right thing, the potential downside risk of having poor ESG risk management could adversely impact several of the rating building blocks of a (re)insurer. For example, elevated reputational and litigation risk, amplified by social media, might lead to customer dissatisfaction and loss of business. Litigation can later turn into contingent liabilities or realised provisions which could impact balance sheet strength. A company which does not consider ESG factors in its operations, may be less attractive to investors when compared to one which is included in sustainability indexes, thereby potentially limiting its financial flexibility, said the rating agency.
Ms Jessica Botelho, financial analyst, A.M. Best said: “Overall, this shift in focus toward understanding how companies are managing ESG risks and opportunities is not simply a fad that is likely to fade. Moreover, as insurers conduct their business with long-term time horizons, European market leaders in particular have committed to embedding ESG into the cultures of their organisations.”
The report states ESG risks vary by industry and are considered material when it is likely that companies will incur substantial financial costs in connection with them. For insurers, perhaps the most obvious risk is climate change, which has the potential to lead to an increase in the severity and frequency of severe natural catastrophe events.
Conversely, ESG opportunities focus on a company’s ability to identify and capitalise on relevant challenges for profit, such as developing new products for the renewable energy sector.
With no industry-wide ESG standards in place, it can be overwhelming for insurers and reinsurers, particularly small- to medium-sized entities, to understand fully how to implement and disclose ESG practices. Although there has been significant progress in the harmonisation of methodologies and standards, further improvements concerning the definition of key metrics and educating users on the importance of ESG in financial analysis are still required.
As ESG is a rapidly growing subject of interest, A.M. Best will continue to study how (re)insurers are considering, incorporating, and managing these risks and opportunities. The ratings agency said it will continue to monitor ESG developments and determine what impact, if any, they have on credit ratings.