ESG in credit risk: Workshop with insurance companies

Governance is considered by investors and CRAs as the most important ESG pillar in the insurance sector, with the key credit relevant areas covering organisational structure, board independence, management credibility, financial strategy, risk management and track record. The better the company’s governance performance, the lower the risk of controversies, regulatory fines, and reputational damage.

Furthermore, strong governance credentials are especially important in managing the risks that are central to an insurer’s business: protecting people and businesses from environmental and social risks. CRAs and investors mentioned several factors to consider when analysing insurance companies:

• Integration of environmental and social issues in executive committees and throughout the governance structure
• Top management commitment and accountability
• Regulatory compliance
• Appropriate implementation and supervision of an ESG strategy
• Top management remuneration linked to ESG Key Performance Indicators (KPIs)
• Performance against ESG targets and track record

“We seek evidence of how governance structures are working and limiting the company’s exposure to environmental and social risks.”

– CRA

A representative from one insurer stated that the remuneration of both senior and executive level employees is linked to ESG performance in relation to the company’s sustainability goals. The company has created a steering committee for sustainability to integrate and monitor the implementation of ESG issues in the company’s governance structure and strategy.

“From a financial perspective, before looking into sustainability-related solutions, we spent a fair amount of time focusing on how our decision-making process affected environmental and social issues, and ensuring these issues were well governed.”

– Corporate borrower

As in other industries, cyber-attacks are a growing concern. As a result, insurance companies are devoting more time to running scenarios on these sources of risk across all lines of business to identify risk mitigation solutions. As one issuer pointed out, cybersecurity is also a business opportunity for insurers that should be further explored.

Investors and CRAs also mentioned the size of insurance companies as a factor affecting the quality of governance and ESG performance and reporting, due to limited resources for smaller organisations. In addition, the latter can have less diversified portfolios and business models, which could imply a larger exposure to certain ESG risks.

On the asset management side, the participating insurance companies are engaging with investees to support them in their energy transition, with divestment as a last resort if progress is not made. Although there is a significant lack of data available on corporates’ environmental indicators and transition plans, participants see increasing mandatory requirements for climate-related reporting as a useful tool for improving the quality and availability of corporate data. In the UK, for example, a range of entities face compulsory disclosure under the Task Force on Climate-related Financial Disclosures (TCFD).

For CRAs and investors, investment policies, carbon neutrality strategies (including scope 3 emissions) and scenario analysis are crucial components in credit risk assessments. This is particularly the case in the European market, where litigation risk could arise from binding EU emission reduction targets. However, different perspectives were expressed on when these climate related issues might become relevant in terms of default risk for insurance companies. While some investors are sceptical about the impact of these risks on credit defaults near term, others expressed concern that regulators could increase capital requirements for companies that are more exposed to climate change, as this increase could affect bond valuations.

“If an insurer suddenly needs to hold much more capital because it is overly exposed to climate change transition or physical risks, this could have an impact on bonds.”

– Investor

Moving on to underwriting, investors and CRAs see climate risk as relevant for credit analysis, particularly for non-life insurance and reinsurance companies. They expect insurers to assess the likelihood and the magnitude of accepted insurable climate related risks. However, there are too many uncertainties regarding the time horizon of these risks, making some investors and CRAs wary of the implications for credit risk assessments.

“There are three things you want to know about risk: likelihood, timing, and scale. We know the likelihood of several climate risks is high, but we don’t know the timing and scale. That is why we are doing scenario analysis. The question is, when will we be comfortable incorporating horizon uncertainty into credit risk assessments?”

– Investor

There is even more uncertainty on the underwriting side for life insurers because of the added complexity stemming from health risks associated with different climate scenarios. However, insurance companies shared that these aspects are being gradually incorporated into their underwriting risk analysis.

All participants agreed that increasing regulatory-driven climate disclosure, specifically to the EU Taxonomy and TCFD, will become increasingly important as part of risk assessment in the future, with limitations related to consistency, comparability and transparency expected to decrease.

“Having formalised frameworks (under TCFD) helps us be more forward-looking and have discussions about where the risks lie.”

– CRA

Both investors and CRAs expressed concerns about the social and economic costs of divesting from high greenhouse gas emitting industries and ceasing to finance specific economic activities (e.g. new oil sites) or geographical areas (e.g. wildfire-prone regions).

Even though insurance companies are divesting as a last resort to reduce their exposure to increasing physical risks, some investors fear that the overall strategy and risk pricing process are not always clear.

“If we believe divesting will result in better investment performance then it’s the most logical thing to do.”

– Corporate borrower

While CRAs agree that lowering exposure to climate risks is critical, they argue that corporates’ size and portfolio diversity are important factors to consider. For example, abandoning wildfire insurance may have a greater impact on smaller insurance businesses, since their business models are typically less diverse.

It remains unclear how these exclusionary practices affect credit risk. However, some participants mentioned that failing to protect people and businesses can result in reputational damage, a risk that could become financially material.

“Some insurance companies are starting to exclude oil companies in underwriting, but this may create bigger economic problems.”

– CRA

According to CRA participants, companies that demonstrate the ability to capitalise on the opportunities presented by this challenge, such as developing new products or deploying innovative risk management strategies, will stand out to credit analysts for their risk management agility.

“Innovating products are needed to address the challenges of this transition.”

– CRA

Risk-reduction solutions, such as insurance-linked securities and risk-sharing mechanisms, which are common among reinsurance companies, may become more relevant for the broader insurance sector, as a means of reducing its vulnerability to social challenges related to the energy transition.