ESG means business

By John Bowers Actuarial Product Director, EMEA, at RNA Analytics

John Bowers takes a look at the increasingly pressing environmental, social and governance-related considerations for actuaries.

The acronym ‘ESG’ has long been a familiar one amongst actuarial modellers, referring to the economic scenario generator tool used to produce realistic or real-world stochastic investment-related assumptions. The last few years, however, have seen the acronym take on a new meaning – with implications not only for the actuarial function. Today, environmental, social and governance issues increasingly dominate governmental agendas, as well as column inches across the globe. And not without good cause. ESG is not just the latest business buzzword; in fact, the World Economic Forum (WEF) posits that a combination of stakeholder capitalism, shareholder activism and increased appetite from companies to use ESG targets and metrics, as well as ESG-based investments, are together re-shaping the global financial and economic landscape.

The new ESG encompasses a great many elements and activities. The environmental element covers energy, waste, carbon emissions and climate change. Social criteria includes an organisation’s relationships with other institutions and communities, diversity and inclusion and workers’ rights. Governance encompasses the procedures, practices and controls an organisation puts in place both to operate in a compliant and ethical manner, and also to incorporate the ‘E’ and ‘S’ elements outlined above. Each of these elements has a direct impact on the perception of an organisation, and therefore its reputation – which has its own value, albeit a difficult one to measure. As the ESG net widens, companies that fail to define ESG-related goals and then deliver on those commitments will lose out to competitors that do.

Implications for general insurance

Considering the wide range of ESG factors and understanding the risks and opportunities related to them is essential for insurers. ESG-related activities currently seen in the insurance market range from reducing greenhouse gas emissions, promoting diversity and inclusion, addressing gender equality and supporting local communities. Other carriers have gone further, the develop tailored ESG products and services.

In addition to the drivers noted by the WEF, the combined pressures of stakeholder activism, ‘traditional’ activism and regulatory obligations weigh heavy on insurers in particular. Whilst climate adaptation, specifically, is expected to reduce costs in the long term, in the short term, the greater regulatory burden represents a cost to all firms. By successfully integrating ESG factors into their risk assessment and understanding processes, insurers may be able to mitigate their losses from a growing number of ESG risks, where reserving, coverage and pricing will all be affected.

The pressure to invest with ESG in mind is felt across the entire investment community. Mazars’ April 2022 C-suite barometer suggests that some 75% of all companies plan to increase investment in sustainability initiatives. Insurers are under particular scrutiny and pressure when it comes to sustainability issues, as investors increasingly demand that firms make the most ethical choices, and traditionally favoured long term investment choices, such as oil and gas, gradually fall out of favour.

The role of the actuary

A new and dynamic approach to integrating ESG into risk modelling, investment and business operations needs to be implemented – and quickly.

Climate change in particular has enormous implications for the work carried out by actuaries; tackling climate-related risk from not only the perspective of modelling but also in terms of ethics, management and legal liability, will be an integral component of their work going forward.

Insurers will need to allow for line-specific ESG factors on their liabilities and assets. For liabilities, they may need to tweak, amend – or even replace – parts of their modelling process to capture heightened natural catastrophe perils, for instance. Swiss Re figures show that natural catastrophes resulted in insured losses of US$111 billion in 2021 – the fourth highest on their records, in a continuing long-term trend that sees average increases of 5-7% a year globally. Embedding an appropriate risk management approach is essential to maintaining financial stability, providing effective coverage and meeting policyholder expectations in the event of large volumes of claims in a short timeframe.

Depending on the insurer’s size, capital buffer and risk appetite, we anticipate a range in how much margin companies add to cover these new uncertainties, and the market can expect a period of adjustment as carriers continue to assess and monitor their own developing views of the risk factors, as well as those of their competitors.

Climate change will affect the asset side of the balance sheet, where there is an exposure to transition risk, through methods such as profitability modelling. Actuaries are increasingly being called upon – and not just by insurers – for their insight into energy modelling, agricultural adaption and scenario analysis. The risks of a disorderly climate transition have also been widely studied, with the WEF outlining a number of downsides in this area alone. It is also in the climate change arena where the greatest regulatory pressures are being felt, and part of the widening remit of the actuary will be in supporting insurers with the necessary disclosures.

Current actuarial methods will need to evolve to adapt to these new risk realities, as actuaries begin treating climate change as a primary risk, support firms in creating new products based on new market needs, and curb underwriting risk.

ESG still introduces a high degree of uncertainty, and insurers will need to price for that uncertainty to ensure profitability and stable shareholder returns. Those insurers that take an early, proactive stance on these factors will better position themselves for what’s to come.