Insurance organizations worldwide are becoming increasingly aware of environmental, social, and governance (ESG) risk factors and their potential impacts on their investment portfolios and lending policies.
According to DBRS Morningstar, the world’s fourth largest credit ratings agency, large institutions, in particular, are facing greater pressure from external shareholders to better manage their exposures to environmental risks. This has become more important than ever for property & casualty (P&C) insurers after several years of heightened natural catastrophe losses.
Global losses from natural disasters in 2020 were US$210 billion, according to Munich Re, of which only US$82 billion was insured. Both overall losses and insured losses were significantly higher than in 2019, which saw a total loss of US$166 billion, of which US$57 billion was insured.
North America suffered the highest losses in 2020 after a record-setting North Atlantic hurricane season, severe thunderstorms in the American Midwest, and yet another series of large wildfires in the western US, fueled by drought conditions. In Asia, losses from natural disasters were lower than in the previous year, but floods and cyclones were the dominant perils. Meanwhile, in Europe, the natural disaster figures for 2020 were “relatively benign” and characterized by some localized extreme losses, mainly flash flooding.
One thing is clear, which is that climate change will play an increasing role in all of these hazards, putting more onus on P&C insurers to manage their environmental exposures appropriately.
“The assessment of environmental risks is a major component of DBRS Morningstar’s analysis for the property and casualty (P&C) insurance business,” the firm explained. “This includes the impact of insured catastrophes on an insurance company’s financial strength, as well as considerations regarding claims predictability, frequency, and severity.”
Social risk factors can also have a significant impact on an insurance organization’s customer and employee base, as well as its financial strength. In general, financial institutions with retail-oriented operations, are closely scrutinized by regulators to manage social risk factors fairly. If they fall short of expectations – for example, via a data breach, or mis-selling products – insurers could be subject to fines and penalties. They could also face irreparable damages to their reputation, which in turn, could have a negative impact on their investment capabilities.
“Weak corporate governance, as well as inadequate business ethics, can have a detrimental impact on a financial institution, potentially resulting in fines, impaired financial performance, or even the withdrawal of an operating license,” DBRS Morningstar added.
DBRS Morningstar recently announced it is taking a more formal approach to incorporating ESG factors into its rating process across all rating groups worldwide, including financial institutions (which includes insurance companies). The firm has identified 17 significant ESG factors – five environmental, seven social, and five governance - that analysts will now consider when rating organizations.
“In large part, these [factors] are already incorporated into the ratings process,” said Gordon Kerr, DBRS Morningstar’s head of global structured finance research, based in London. “What we’re doing now is we’re bringing these ESG factors forward and out so that they’re identified and discussed [formally] in that ratings process. Where we find that one of these factors is involved and influential in determining our ratings, we will then be identifying that and detailing that in our press releases and ratings reports.
“Not all of the 17 factors are applicable to every ratings group. For example, land impact on biodiversity is really applicable for governments and corporate finance, but less so for financial institutions and structured finance. On the other hand, business ethics is more applicable for financial institutions … but not necessarily as relevant for governments. Where the 17 ESG factors are applicable, we’re taking a global approach across the ratings groups.”
Being a credit rating agency, DBRS Morningstar is looking at how ESG factors impact the overall credit position and financial position of an insurance organization.
“It’s important to note that we are not looking at this from the viewpoint of sustainability,” said Andrew Lin, managing director, global corporates, DBRS Morningstar, based in Toronto. “It’s really from the viewpoint of such items like [an organization’s] revenue line, expenses, cash flows, [or] perhaps it affects the asset value or the ability to refinance. We’ve always been considering these ESG factors. The idea here, with these criteria, is to make it more transparent and more explicit, as opposed to implicit. We’re not introducing new factors; this is a process for us to better disclose what we’ve been doing.”