Three Reasons Why Midmarket Insurance Companies Need to Focus on ESG
Environmental, social, and governance (ESG) factors have become increasingly important to companies, including insurers, to improve the transparency of risks not captured by conventional financial metrics. A study from BlackRock stated that 78 percent of insurers believe COVID-19 has accelerated their focus on ESG.
Here are three reasons why midmarket insurance companies need to focus on ESG:
- ESG Is Now Incorporated into the Ratings of AM Best & Other Major Insurance Company Rating Agencies
- ESG Information Can Improve the Investment Portfolio
- ESG Improves Risk Management Processes & Company Reputation
1. ESG Is Now Incorporated into the Ratings of AM Best & Other Major Insurance Company Rating Agencies
AM Best signed the United Nations Environment Programme (UNEP) Finance Initiative’s Principles for Sustainable Insurance (PSI) (see press release). Per the UNEP, “The purpose of the PSI Initiative is to better understand, prevent and reduce environmental, social and governance risks, and better manage opportunities to provide quality and reliable risk protection.”
AM Best states that ESG factors are increasingly becoming key drivers for insurance credit rating actions. Some positive rating actions have been given because of insurers leveraging strong ESG practices. Most of AM Best’s ESG-related credit rating actions are negative. Weather-related events (including wildfires, hurricanes, droughts, floods, and other storms) and governance were the two main aspects of ESG-related credit rating actions. These items are treated as being related, as the failure to manage catastrophic risk is viewed as an indicator of weak governance.
To form its credit opinions, AM Best identifies the effect of risks, including climate risk, through these lenses:
- Balance sheet strength
- Operating performance
- Business profile
- Enterprise risk management
Insurers, especially property and casualty insurers, are expected to manage weather-related risk, including the effects of climate change, and be able to absorb potential losses financially.
Life and health issuers also can expect increased attention to the effects of climate change on human health as the current U.S. administration has established the topic as a priority. On January 27, 2021, President Biden directed the Secretary of the U.S. Department of Health & Human Services to establish an Office of Climate Change and Health Equity (OCCHE) to address the effect of climate change on the health of the American people. OCCHE was established on August 30, 2021. The OCCHE figure below shows how climate change affects human health.
AM Best’s rating methodology can be found here.
2. ESG Information Can Improve the Investment Portfolio
Incorporating ESG information into investment portfolio decisions can lead to positive risk-adjusted returns and outperforming the market.
The NYU Stern Center for Sustainable Business, partnering with Rockefeller Asset Management, examined the relationship between ESG activities and financial performance through a meta-study of 1,141 peer-reviewed papers authored between 2015 and 2020 (see report). The study found a positive relationship between ESG and financial performance for 58 percent of the corporate studies focused on operational metrics or stock prices, with only 8 percent showing a negative relationship. The study also found that managing for a low-carbon future improves financial performance.
The NYU study concluded that ESG investing appears to provide downside protection, especially during a social or economic crisis, and provides improved financial performance that becomes more apparent over longer time horizons.
A company’s consistently low ESG ratings may indicate poor risk management, which increases the chance of a controversial incident, such as an oil spill, an ethics scandal, or a cybersecurity breach. These controversies can be devastating to investment performance.
ESG investment integration strategies appeared to perform better than negative screening. An ESG investment integration strategy incorporates ESG information into the traditional security selection processes. Negative screening avoids companies or sectors based upon specific ESG criteria.
3. ESG Improves Risk Management Processes & Company Reputation
An effective risk management process can give an insurer a competitive advantage and bring positive underwriting results. Insurers should be proactive in addressing the effect of climate change on underwriting and pricing. Historical loss data used by catastrophe models are likely less useful than in past years, so credit rating agencies are looking for how an insurer’s risk modeling factors in climate risk. Insurance companies exposed to greater and higher levels of climate risk are likely to experience a higher cost of capital.
Insurers should include climate risk in the enterprise risk management framework and bring the oversight of climate-related risks directly under the board of directors or executive committee. Climate risks are expected to increase over the medium to long term, and regulations to address climate-related risks may be a short-term risk for carbon-intensive companies.
Sharing ESG credentials in new products and markets may help insurers attract new customers and employees. Conversely, insurers that are not perceived to make progress on ESG factors could face reputational damage, especially from younger consumers and workers. In addition, insurers can gain a competitive advantage by adding products or product features that incentivize responsible behavior in areas of safety, health, or the environment.
Being proactive in navigating the changing expectations of ESG can improve an insurer’s credit rating and financial performance. For assistance in navigating these issues, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.