ESG: Tick-box exercise or a true risk differentiator?

Opinion by Alicia Goosen, Chief Broking Officer and Angela Jack, Business Unit Head - Financial Services Group at Aon South Africa

Although not new, Environmental, Social and Governance (ESG) issues have become a key focus in the last 18-24 months, in part driven by growing awareness of environmental and equity and inclusion issues, as well as the health and wellness impacts of COVID-19. The events of 2020 highlighted how ESG issues can become financial risks overnight.

In a nutshell, ESG is the consideration of material environmental, social and governance risks and opportunities alongside traditional financial factors. It is increasingly a major factor used to assess the long-term viability, resilience and financial prospects of an organisation, and is also increasingly influencing the capital and insurance markets.

What does ESG mean from an insurance and risk management perspective?

ESG is gaining increasing focus in the underwriting community with many carriers having signed up to the Paris accords. Initiatives to become carbon-neutral means ESG is increasingly focused on. Generally, insurers have made much progress in understanding the physical risk implications of climate change and broader climate and ESG issues, but the gap between how the road to net zero will be enabled by underwriting activities remains to be closed.

The underwriting considerations are so much wider as insurers need to review risk across a corporation’s entire ESG stance - the potential for huge reputational risks emanating from a significant environmental or social disaster are top of mind here – consider for example the Brumadinho tailings dam disaster in Brazil a few years ago. Brazil's worst industrial accident sent millions of tons of toxic waste gushing into the surrounding area, destroying the rural village of Córrego do Feijão, in the state of Minas Gerais in south-eastern Brazil, killing 270 people and devastating agriculture in the region.

Today, reinsurers, like Munich Re as one example, have environmentalists on their board of directors. Several companies have investors who actively ensure that the companies they invest in are proactive and robust in their ESG stance.

Environmental Component

The environmental component encompasses the impact that a company has on the environment - both positively and negatively. The most common considerations here are climate change and greenhouse emissions. From a South African standpoint, the complexity of the Environmental element of ESG is best articulated in our coal environment.

In 2015 the insurance market first became impacted by thermal coal policies when most of the European insurers signed up to the Paris Agreement. This triggered a harsh decline in capacity as most global insurers were swift to exit the coal sector, with 30% plus revenue coming from thermal coal. More recently, the American and Australian carriers issued their own thermal coal policies. 

With the rapid and large decrease in capacity, premiums and rates have increased exponentially, with those insurers still able to deploy capacity acutely aware that this capacity comes at a big premium. In addition, it also has the ability to impact Insurers’ own ESG profile.  As a result, what was initially anticipated to be a gradual withdrawal from the sector, in fact turned into an immediate disruption with more than 50% of local capacity lost in the past 12 months alone. The loss of capacity is not limited to just one line of insurance but is also impacting multiple lines including property damage and most liability insurance classes.

Eric Anderson, Aon’s President, presenting on this issue recently in Bermuda, articulated it best when he said that carbon-intensive businesses need support from the insurance sector to transition, rather than being abandoned.

“In order to decarbonise, we need massive investments in new technology and new resources, both public and private. That capital will require protection, so walking away from carbon-intensive businesses in the short term, with no plan to transition, will leave a power generation void, particularly in developing countries. It will also strand that workforce and leave them without family-sustaining wages.”

Andersen explained that none of the private, public and social sectors can get to net-zero without the help of the others. He identified a need to collectively create the conditions that leverage the talent and creativity of the best scientists, engineers, technologists and inventors, and which provide the opportunity to create a financial return. “This combination will require a market to measure, price and transfer risk.”

Aon’s experience in the market is that carbon-intensive clients need to conduct separate and comprehensive presentations on their ESG initiatives to ensure that their efforts are properly recognised by carriers. Fundamentally, these presentations have the ability to change an Insurer’s viewpoint if they move away from tick-box approaches and demonstrate real value from an underwriting perspective. For example: 

• Detailed long-term strategies to lower carbon emissions.
• Environmental improvement projects such as solar and other renewable endeavours, green buildings, reforestation and so on.
• Detailed rehabilitation plans in the mining sector.

Social Component

While environmental and governance issues are easier to define, the ‘social’ component of ESG is imminently more challenging to encapsulate, covering a litany of issues from socially ethical business practices; workforce policies, supplier relationships, and the extent to which they invest in their local community. Social issues that have translated to actual reported claims in the Directors & Officers Liability space include:

• Diversity and Inclusion
• Human Rights
• Working Conditions
• Corporate Social Investment

Could ‘social’ ultimately be the element that stems the withdrawal by Insurers from risk on the basis of a poor ‘environment’ score if it is in turn balanced by a strong social position? Does a lack of insurability for these sectors then translate into a negative social score for insurers?

When looking at developing countries and their dependencies not only on coal from a power generation perspective, but also from a wider mining industry viewpoint, one cannot ignore the huge role that they play in community outreach, public schooling, local medical services and social development. It is notable to mention that while mining risks generally score poorly on the environmental aspect of ESG, if we look at the South African context of “S” there has been no other industry sector more proactive and effective in the vaccination drive against COVID-19 than the mining industry, not only for their own employees, but for the broader communities in which they operate. 

So, could this mean that a negative ‘E’ score is offset by a positive ‘S’ score where the impact is so profound?

Governance Component

The governance component relates back to the strength of the board of directors and supervision of the company, as well as how close it is to its stakeholders versus a management-only focus on company direction. 

Looking at what Insurers are extracting from an ESG review, governance is probably the best understood. While it has traditionally been regarded as only of concern to the D&O liability line of business, there is now increasingly calls from multiple lines of insurance business, including cyber and general liability, to demonstrate strong leadership and governance practices.

ESG reporting as a true risk differentiator

Just as we want Insurers to look at the concept of ESG holistically and not allow a single component to render a client risk uninsurable, it’s equally important that business leaders do not treat the important issues of ESG as a mere tick-box exercise. There are numerous examples of forward-thinking companies that have published their ESG reports as independent documents or supplements within their annual reports. They recognise that for these statements to have a meaningful impact on an insurer’s willingness to provide capacity, their ESG reporting needs to stand up to intense scrutiny.

Reporting on ESG policies, practices and metrics communicates how well, or how poorly, a company is managing ESG risks and opportunities, demonstrates commitment to the environment and society, and manages shareholder expectations. When executed well, a company’s ESG strategy should highlight an interdependent value chain among stakeholders.

When one looks in the context of mergers and acquisitions, there is no doubt that ESG and financial due diligence now carries equal weight and goes far beyond box-ticking. At the same time, ESG risks are undeniably difficult to measure and quantify amidst ever-changing goalposts in the context of climate action and constant market shifts.

Meredith Jones, Aon’s Global Head of ESG, explained it best when she said that a first step to gaining clarity is to start thinking about ESG in terms of materiality: that is, the impact those practices have on the company’s financial condition. “There are many corporates that still confuse ESG with ‘being nice’, when they should think of it more from the standpoint of enterprise risk management and potential value creation.”