ESG in the insurance industry

Europe

An evolving landscape

The ESG landscape is changing rapidly for the EU and the UK insurance markets, as firms move to embed ESG principles in their business practices, including underwriting processes.

The challenge facing the market (and the wider financial services sector) is clear, with stakeholders and activists making clear their desire for swift and positive change, both in the risk and investment spheres.

Alongside these pressures, the regulatory landscape is also developing significantly with:

• Climate stress tests, e.g. the Climate Biennial Exploratory Stress Test for the UK’s largest banks and insurers by the Bank Of England taking place, and results published in May 2022 and the 2022 climate risk stress test by the European Insurance and Occupational Pensions Authority (EIOPA).
• The new Financial Conduct Authority (UK) rules on climate-related financial disclosures that involve insurers coming into effect on 1 January 2022 in the UK, and the Corporate Sustainability Reporting Directive (CSRD) proposed by the EU Commission.
• Proposed changes to the EU Solvency II Directive requiring insurance and reinsurance undertakings to include an assessment of their exposure to climate change risks in their own risk and solvency assessment.
• Proposed changes to the EU Insurance Distribution Directive Delegated Regulations (IDD Framework) incorporating sustainability aspects in the distribution of insurance policies.

It is clear that opportunities abound and that the insurance market has the ability to drive positive change, in particular through investment activities and underwriting standards. 

Sustainability driving policyholder behaviour

Sustainability concerns are becoming increasingly important for policyholders. A recent German study indicated nearly half of the population was willing to take out policies with insurers committed to promoting sustainability, and a quarter was even willing to pay a higher premium to do so. As only 4% of Germans currently have policies with such insurers, this represents a significant opportunity for insurers as market sentiment shifts.

However, at the same time the UK Prudential Regulatory Authority (PRA) has warned that there is more for the market to do to understand and manage exposure to climate risks. Similarly, the German regulator BaFin has noted that a 2021 survey on sustainability in the insurance industry revealed a discrepancy between the widespread awareness of the importance of climate-related risks, and insufficient analysis of these risks shown by the small numbers of stress tests carried out by insurers.

A rising litigation risk

The higher the regulatory bar is set as regards ESG, the more likely litigation becomes for companies that fail to meet it, all of which translates to a developing risk landscape for the insurance sector. As the regulatory landscape changes and ESG reporting becomes more established, this too leads to increased claims risks, particularly for D&O lines where the push for greater transparency in relation to sustainability seems set to create significant opportunities for legal claims. In this regard, the landmark decision against a global energy company by a Dutch civil court based on the European Convention on Human Rights ordering the company to reduce its carbon emissions throughout its entire value chain, and the lawsuit against a French retailer for an alleged violation of French Due Diligence law with regard to sourcing of beef from suppliers engaged in deforestation, would seem to be signs of things to come.

Additionally, there are an increasing number of activist investors and other stakeholders bringing legal challenges for a variety of ESG-related claims. Much of this activity has been in the U.S. or Europe, but the expectation in the London market is that similar developments will be seen in the UK and that developing lines of climate litigation in particular represent significant potential exposures for the London market. 

There is some expectation that new climate-related exclusions will be developed in response, and that these may become commonplace additions in certain lines. 

Similar to the ‘silent cyber’ threat some years ago, policyholders and insurers alike will want to assess existing cover to see whether coverage for ESG-related risks is (whether accidentally, or by design) ‘baked-in’ or whether, for example, standard pollution exclusions might bite for climate-related claims. Certainly, the rapidly developing ESG risk landscape is likely to lead to wordings developments, particularly in certain business lines.

Greenwashing risks and trends are also something for the market to watch closely in the near future, particularly as the regulatory regime develops. 

A change in terminology?

As a final thought, with ESG now routinely topping the corporate agenda, it is also fair to ask whether this term remains fit for purpose as the sustainability agenda develops in the EU and UK markets and beyond. The phrase ‘ESG’ is a broad church and can, depending on audience or intent, mean almost any number of things – and not all consistent. For example, certain nuclear and gas activities are, for the time being, declared to be in line with EU climate and environmental objectives covered by the EU taxonomy, but Austria and Luxembourg have already indicated that they will turn to the European Court of Justice to prevent this classification. And the conflict in Ukraine has triggered a discussion with regard to the EU Social Taxonomy whether weapon production should continue to be considered a ‘socially harmful’ activity.

What constitutes a ‘sustainable’ investment or activity? To insurers, whether on the investment or underwriting side, these are questions worth considering closely.

U.S.

A patchwork of ESG policies across states

In the U.S., insurance commissioners in certain large states, such as California, continue to expand climate-related disclosure requirements by insurance companies and take action regarding potential bias in insurers’ use of big data.

For example, in June 2022, a group of state insurance regulators, led by Insurance Commissioners Ricardo Lara of California and David Altmaier of Florida, adopted a new standard for insurance companies to report their climate-related risks, in alignment with the international Task Force on Climate-Related Financial Disclosures (TCFD). This development is a product of the Climate & Resiliency task force within the National Association of Insurance Commissioners (NAIC). As a result, for certain insurers in the fifteen states using the NAIC Climate Risk Disclosure Survey (e.g., California, New York, and Washington), compliance with TCFD reporting will be due by November 2022. In an example of how such disclosures could be repackaged and distributed by regulators, Commissioner Lara announced in April 2022 a new report and webpage detailing insurance companies’ investments in fossil fuels. The webpage shows, among other things, an insurance company’s percentage of assets under management that are fossil fuel-related.

In addition, insurance companies continue to face challenges to their use of big data, as regulators and state legislatures grow increasingly concerned about bias and discrimination issues. For example, in 2021, Colorado passed a law that will require insurers to demonstrate that their use of external data and algorithms does not discriminate on the basis of certain classes. In June 2022, California’s insurance commissioner issued a Bulletin that specifically identified the use of artificial intelligence and machine-learning by insurers that could be “prone to human bias when identifying trends of particular groups based on certain characteristics”. Of course, there may be practical difficulties with compliance when some insurers use data obtained from external sources that could be subject to intellectual property protections. We expect this to continue to be an area of heightened priority for regulators as insurers implement increasingly the use of big data in underwriting and other areas of their businesses.

While some states such as California and New York have prioritized ESG issues as they are more commonly understood in the UK and Continental Europe, other states have taken very different approaches on such issues, showcasing the regulatory variance across jurisdictions in the U.S. For example, Texas recently passed a law preventing government agencies and municipalities from doing business with entities that ‘boycott’ energy companies that invest in, or assist in, the “exploration, production, utilization, transportation, sale, or manufacturing of fossil fuel-based energy”. In connection with enforcement of this law, the Texas State Comptroller has probed 19 financial institutions that he suspects are boycotting fossil fuel companies, requesting clarification of their investment policies and procedures. This year in Oklahoma, the state passed a similar bill called the ‘Energy Discrimination Elimination Act’ and the trend seems poised to take hold in other states. The treasurers of fifteen states - West Virginia, Alabama, Arizona, Arkansas, Idaho, Kentucky, Mississippi, Missouri, Nebraska, North Dakota, Ohio, Oklahoma, Pennsylvania, South Carolina, and South Dakota - wrote a joint letter decrying efforts to pressure U.S. banks and financial institutions from lending, to or investing in, coal, oil, and natural gas companies, which they note are “vital to our nation’s economy”. Meanwhile, Arizona’s Attorney General has taken a different tack against ESG policies, arguing that “coordinated efforts to choke off investment in energy” may constitute violations of antitrust law.

New SEC Rules relating to climate disclosures and ESG 

Given the state-specific regulation of insurance in the U.S. market, we would not normally highlight developments in federal regulations. However, this year, the SEC is expected to finalize rules relating to new mandatory climate-related disclosures for public companies that will likely change the disclosure landscape for many insurers and investment funds. Even if the new rules do not directly impact some insurers straightaway, state insurance regulators likely will take note of the rules’ sweeping scope and subsequent implementation. The proposed rules would create categories of disclosure that include: 

• quantitative accounting of direct and indirect greenhouse gas emissions;
• a new section in annual reports and registration statements that identifies the company’s climate-related strategies; and
• climate-related metrics disclosed in a company’s audited financial statements.

The breadth of the rules, proposed in March 2022, has prompted a wide range of reactions from industry observers, including an unprecedented volume of letters submitted to the SEC by the end of the June 2022 comment period. Supporters of the rules laud the SEC for promoting informed investor choices and environmental protection. Opponents of the rules argue, among other things, that the SEC does not have the legal authority to issue such rules and that the rules will bring about extreme costs for companies, investors, and the economy more broadly. As one SEC Commissioner put it, she believes the proposed rules “turn the disclosure regime on its head”. It is likely that the rules will be subject to legal challenges in the coming years.

On 25 May, 2022, the SEC further issued proposed rules to require ESG-related disclosures by investment funds, which would require environmentally-focused funds to disclose greenhouse gas emissions of their portfolio investments.

Mexico

The Mexican legal framework has not included ESG-specific regulations. However, ESG criteria have been gaining strength as a ‘soft law’ instrument in Mexico. Leading global companies have developed corporate rules and published voluntary commitments related to ESG issues, which has caused small and medium-sized companies to join these ESG efforts in order to continue participating as part of the leading global companies’ supply chain. Also, in the summer of 2022, Mexico announced that it is planning to sell up to the equivalent of $147 million in ESG bonds, with the proceeds to be used to finance investments in highways, public works, healthcare, and transportation. 

Authored by Jordan Teti, Lydia Savill, Birgit Reese, Niclas Höhle, Carlos Miranda Ramos, and Karino Galicia.