ESG AND CAPTIVES: HOW THEY RELATE

For decades, captives have represented an integral tool for controlled risk transfer that satisfies the needs of the owner/members. Captives represent companies and members involved in a wide variety of industries and professional practices. US-domiciled single parent captives represent a broad range of industries, ranging from auto manufacturers to pharmaceuticals to banks. Group captives and risk retention groups (RRGs) run the gamut from soil engineers to physicians to auto warranty writers.

Regardless of the sector or the professions they serve, the influence of environmental, social and corporate governance (ESG) principles may extend to captives and corporations as these principles evolve. The impact of ESG, however, will vary depending on the risk and business profiles of the captive insurers and their owners.

An evolving concept

ESG is a key topic of interest among stakeholders in the insurance industry, but there is some uncertainty as to what it actually entails, and what actions or disclosures are expected. This is particularly true for US-based companies, as was evident in the results of an October 2021 AM Best Special Report, “US Insurers’ Perceptions of ESG”. Most re/insurers generally responded that more clarity is needed from regulators about how to identify, measure and report ESG factors.

Given the wide variety of regulatory, government and international organizations promoting ESG, it is not surprising that the focus and definitions may diverge. The US Securities and Exchange Commission (SEC), state insurance commissioners, the Prudential Regulatory Authority in the UK, the European Insurance and Occupational Pensions Authority (EIOPA), and regulators in Bermuda and Guernsey, have been interested in and are taking steps to incorporate aspects of ESG frameworks in regulatory considerations.

ESG in ratings opinions

AM Best believes that the insurance industry plays an important role in supporting sustainable economic and social development, and that management of ESG efforts will strengthen the insurance industry’s contribution to building a resilient, inclusive and sustainable society. However, the influence of ESG on financial strength may vary depending on the risk profile and business profile of the insurer.

ESG is a broad umbrella that includes individual factors.

What’s important to note is that ESG is global and covers a cross-section of industries. ESG is not specific to US insurers alone

Environmental factors generally pertain to the natural world and encompass climate risk, resource use, energy use, pollution and waste management. Social factors are those that affect human lives and relate to how a company interacts with the communities in which it operates, its suppliers, employees and broader stakeholders. Corporate governance factors relate to procedures and processes according to how a company is directed and controlled.

Consideration of ESG factors can help companies and investors identify qualitative risks and opportunities not otherwise captured by conventional objective financial metrics, to enhance long-term returns.

Accepted ESG standards are still a work in progress. Implementing and disclosing ESG practices is often challenging for insurers and will vary by company and by industry. Even in re/insurance, when assessing financial strength, the relevant ESG factors vary depending on the company’s business profile, the level of risk transfer, and the operating environment.

Factors that influence insurers include:

• Environmental: Climate risks; carbon emissions; natural resources use, pollution, and waste
• Social: Data privacy; human capital; product liability; stakeholder opposition; health and safety, social/judicial inflation
• Corporate governance: Governance, behavior; transparency; board composition; business ethics; diversity, equity, and inclusion (DEI)

AM Best realizes that the impact of ESG risks and opportunities on financial strength over the short and long terms is likely to vary depending on the nature of the company. We anticipate that factors related to climate risk and governance will have the greatest impact on financial strength for property and casualty insurers over the near term; asset-related risks would challenge life insurers; health equity for health insurers; and social inflation for casualty/liability insurers over time.

Most re/insurers already consider ESG factors in their day-to-day decision-making. Management of climate risk, social inflation, cybersecurity, DEI, governance, management of demographic changes, and financial transparency all fall under the ESG umbrella. Monitoring ESG factors helps insurers identify and develop new insurance products to meet the changing needs of their owners/members.

Pressure from regulators and other stakeholders to improve transparency on ESG-related disclosures is likely to increase, so understanding and measuring ESG risks will likely become more relevant to all re/insurers.

Regulatory developments

Two noteworthy recent announcements speak to the increased attention being paid to ESG. On November 15, 2021, the New York State Department of Financial Services (DFS) issued final guidance for insurers to manage the financial risks associated with climate change. After issuing a proposed version of the guidance in March 2021, DFS received comments from a broad range of stakeholders, including insurers, trade groups, consumer advocates, climate experts, rating agencies and other financial regulators.

The guidance defines the DFS’s expectations for all New York insurers. This includes integrating the consideration of the financial risks from climate change into governance frameworks, business strategies, risk management processes, and scenario analysis, and developing their approach to climate-related financial disclosure.

Already in 2022, the Bermuda Monetary Authority (BMA) has announced that it will integrate ESG factors into its regulation of the insurance industry. The BMA plans to provide insurers with “comprehensive guidance on the governance aspects of climate change” including expectations for boards, risk management, insurer self-solvency assessments considering climate-related risks such as the transition to a low carbon environment, and physical risks.

It will also assess the insurance and investment fund sectors’ frameworks for opportunities and adjustments needed in the context of “green” finance.

Most single parent captives are part of larger publicly traded parent organizations governed and regulated by the SEC. While the SEC has yet to put out formal guidance on ESG, many publicly traded companies have already disclosed their ESG efforts by releasing sustainability reports, as formal adoption by the SEC appears almost certain. In March 2021, Acting SEC Chair Allison Lee announced the opening of a comment period regarding climate change disclosures. These submissions will likely be used to develop future ESG guidance.

The SEC has expressed its support for Biden administration ESG initiatives. Even as insurers await additional guidance from the SEC, many publicly traded companies are already displaying their awareness of ESG issues. Thus far, the measured approach of the SEC has not yet been formally adopted or incorporated into a standardized disclosure framework for ESG information.

Since most privately held US-based, single parent captives and group captives come under the auspices of the National Association of Insurance Commissioners (NAIC), all eyes are on the NAIC to see what “next steps” are underway.

To date, the NAIC has been neutral but there appears to be some interest in ESG factors, resulting in the formation of the Climate and Resiliency Task Force (which includes five separate workstreams, including the Climate Risk Disclosure Workstream).

ESG and captive ratings

Many of the single parent owners are household names with significant resources that have broadened their governance over time to address new issues in risk management and brand protection. AM Best monitors this routinely as part of our interactive rating process and has generally found these companies to be dedicated to ESG both holistically and, specifically, when any of the components is directly pertinent to their industries.

Group captives and RRGs are member-driven with narrower profiles and size/scope, and may not be as heavily impacted by all components of ESG, except through investments. Additionally, natural catastrophe is generally not a significant risk for those captives where the lines of business tip toward general liability, professional liability, workers’ compensation and commercial multiple peril.

The nature of an organization’s business has put some captive owners under more scrutiny than others. Each owner has its own particular set of circumstances, depending on its scope of operations. Because of the heightened concern for environmental issues, the oil and gas and energy sectors are under the microscope, with many of the environmental headlines specifically aimed at this sector.

For example, in May 2021, Chevron was challenged by environmentally active shareholders pushing for lower emissions. Around the same time, a Dutch court ordered Royal Dutch Shell to reduce emissions at a faster pace. ESG investing is a significant issue in this space as momentum has risen behind efforts to promote renewable energy, sustainability and the transition of energy sources.

ESG pressures are being felt throughout the oil and gas sector, with the upstream segment scrutinized on environmental impact and the midstream for governance and social impact.

While AM Best does not rate the parent companies of the rated captives, their credit profiles and financial wherewithal are closely monitored. In Best’s Credit Rating Methodology, the impact of the non-insurance parent is evaluated by providing rating lift or drag in the published rating.

AM Best incorporates its views of the parent’s enterprise risk management in the captive’s risk management and the amount of lift/drag to apply to the rated companies.

Dan Teclaw is an associate director of AM Best. He can be contacted at: dan.teclaw@ambest.com

John Andre is managing director of AM Best. He can be contacted at: john.andre@ambest.com