More than a buzzword

The acronym ESG, when it first emerged, often made people scratch their heads more than a little. What did the letters mean?

However, environmental, social and corporate governance issues, to give ESG its full name, is now an area that is increasingly becoming more and more high profile due to the wide range of issues that it covers, with increased pressure from investors, governments, regulators and consumers on many aspects of it.

Environmental issues have long been present in global headlines, as the climate crisis steadily becomes worse. As global climate change continues to contribute to increasingly high temperatures and fuels severe flooding, more and more people are demanding action.

The November 2022 COP27 event in Egypt heard a series of appeals from countries that are at risk from a wide range of effects from global warming, from wildfires to rises in sea levels.

With public opinion watching this issue closely, there have also been a string of protests over insurance companies that insure coal-related projects, specifically coal mines, with protestors calling on insurers to cease coverage. Many have now done so, making it almost impossible for a number of coal mines to get insurance of any kind. Similarly, there have been protests over companies that invest in coal projects.

Social issues can include anything from human rights to equal opportunity management appointments, and corporate governance can straddle a wide range of issues, as well as both of the above.

ESG is most certainly not something that can be taken lightly by anyone. The 2021 Marsh report pointed out that ESG is becoming an increasingly important topic for the captive insurance market as a whole.

Marsh pointed out that fully realising upcoming business opportunities means transforming along with an evolving world. Many organisations are putting more attention to ESG issues in their day-to-day operations.

By developing and deploying short and long-term strategies to manage and mitigate ESG risk, companies can distinguish their operations with key stakeholders, protect their brand, and deliver commercial and competitive advantages, said Marsh. Many investors are paying attention to ESG risks and company performance. The global insurance industry, too, has been focusing on how ESG influences risk profiles.

According to Marsh, captives will be playing a role in this transformation, helping facilitate and enhance an organisation’s approach to ESG. Many captives buy reinsurance, for example, and some commercial reinsurers are now requiring ceding insurers to have ESG policies in place.

Carbon credits

“ESG is the new buzzword,” Marcus Schmalbach, chief executive of Ryskex, told Captive International. “We started seeing it a couple of years ago when it was then called corporate social responsibility and now, we’ve split it a bit into three separate silos as environmental, social and governance.”

According to Schmalbach ESG could be linked to, for example, making investments from the captive—where are they investing, such as into sustainable solutions which are increasingly being offered by investment banks and so on. As another example, under the governance part could be cyber issues, which address the possibility that a company has to focus on cyber attacks, where the captive itself could be a potential partner for the headquarters themselves to secure cyber risk, taking attacks and other cyber-related issues.

ESG is a broad field, Schmalbach pointed out. This broad field mainly means that the companies are assessing and calculating their corporate social responsibilities, with any captive they have being a very interesting vehicle for the headquarters to address ESG issues and use the captive either as an investment tool in sustainable solutions, or to somehow cover things like carbon credits, which are a big use case at the moment. Some carbon credits could also be transferred to a captive and some could be secured by the captive itself.

Looking at carbon credits, Schmalbach warned that if looked at in a negative way they could be seen as creating the next potential investment bubble as people buy them up.

However, looking at the positive side, Schmalbach said that he’s really interested to see what happens here, as there’s a lot going on in the carbon credit market under the headline of ESG-linked investments.

“I think this can also be linked to the climate change risks which every single company has, so the carbon credit could also be from my perspective very much linked to climate change risks. Carbon credits could be, for example, something where the captive can invest their premiums in to help out the company itself.

“It would also be an ESG committed investment. There are a lot of things coming up and I think the captive market would be a very strong partner in this carbon credit link with climate change investments.”

Schmalbach can see that market growing and said that he has already had some conversations with captives who are currently turning their head around how they can use this new field of carbon credit to possibly make ESG committed investments.

He hypothesised that could be a circle, with the parent companies transferring their climate risks into the captive itself and on the other hand the captive invests in ESG committed products, such as buying carbon credits.

“So, you invest in the captive and the captive gives the premium somehow back to the to the parent company or invests in investment banker products,” Schmalbach explained. “I see a holistic circle coming up, the captive market could be one of the big investors into carbon credits in the near future due to the fact that the parent will spend more money on covering climate change risk within the captive so I think this makes the circle complete.”

Risk management too

An additional area that ESG could help captives to manage is risk management, according to Aon. In its latest report on this area, published in November 2022, Aon highlighted the United Nations Environment Programme Principles for Sustainable Insurance (PSI). Endorsed by the UN secretary-general and leading insurance industry chief executive officers, the PSI serve as a global framework for the insurance industry to address ESG risks and opportunities and is a global initiative to strengthen the insurance industry’s contribution to building resilient, inclusive and sustainable communities and economies.

According to Aon, studies have highlighted how organisations that prioritise ESG and related sustainability initiatives achieve, on average, better corporate results.

“This is not surprising as the evidence shows that organisations with better managed risk achieve stronger outcomes than those that do not,” said the Aon report. “Similarly, organisations that more proactively manage ESG will, on average, have a more developed sense of the risk/reward dynamic associated with ESG metrics than those that do not.

“Captives can play a crucial role through establishing a framework to assess and measure the inherent risks that ESG introduces to the parent. Although some of the risks associated with ESG are currently uninsurable, the risks typically present characteristics that would facilitate insurability, for example elements of the transition pathway could be de-risked, however without sufficient data, it is unlikely that insurers will offer coverage until sufficient experience is amassed. This is not uncommon for emerging risks.”

Aon said that ESG represents a combination of existing risks with new characteristics and new and novel risks in some cases. However, it added that embedding ESG in the captive strategy in some cases involves incorporation of new metrics and measurement techniques for existing risks. It is reasonable that the captive, as an expert underwriter for the parent organisation, should take a leading role in the inclusion of relevant new metrics in the risk assessment processes and apportion risk capital to these risks.

By using the captive as a means to apply underwriting discipline on the risks, the parent organisation can typically develop a better understanding of the underlying characteristics of the risk and begin the process of building a means to manage the inherent volatility through the application of insurance accounting principles, while also improving risk management and reporting practices.

“The captive has the potential to play an important role as an agent for behaviour change within the parent company and in some cases help accelerate much-needed transition pathways through the ability to apply risk management techniques,” the report said.