As environmental, social, and governance (ESG) issues have gained significant traction, companies face increased pressure to act as conscientious investors, environmental stewards, and
responsible corporate citizens.
Neither the insurance nor reinsurance industries are immune to these pressures. In fact, ESG stakes may be even higher for insurers and reinsurers, given their unique position as risk carriers,
asset managers, and institutional investors.
Industry players recognize this and are making strides to incorporate practices into their investment and underwriting decision-making processes. In an AM Best survey of 100 insurers and reinsurers domiciled in Europe and the Asia-Pacific region, 77% of respondents said proper understanding and integration of ESG factors is critical to the long-term viability of their business.
At AM Best, ESG risks that are relevant and material to credit quality have always been implicitly covered in our credit rating analysis. We have long captured environmental and governance issues in our ratings opinions through catastrophe stress tests, asbestos and environmental tests, and enterprise risk management.
However, in December 2018, AM Best began including a section within Best’s Credit Rating Methodology (BCRM) making explicit reference to the role that ESG factors play within each of the credit rating analysis building blocks. This was not a change in methodology. Rather, AM Best’s intention was to provide greater transparency around our methodology.
ESG in building blocks
The BCRM consists of four key building blocks. AM Best evaluates the balance sheet strength, operating performance, business profile, and enterprise risk management of insurance and reinsurance organizations to arrive at a credit rating. ESG factors possess the potential to impact one or more of these four building blocks of the rating methodology.
For example, environmental factors are critical to the analysis of balance sheet strength and operating performance. Environmental factors, particularly climate risk, can pose a severe threat to the balance sheet strength of a company. This is especially true for property and casualty insurers. Therefore, we expect insurers that accept weather-related catastrophe risk to be able to demonstrate they can effectively manage that risk and have the financial wherewithal to absorb any potential losses. The inability to do so could lead to a negative rating action.
Asset risk is another key component of balance sheet strength, and stranded assets have the potential to negatively affect the balance sheet. The main area where insurers and reinsurers are addressing ESG is in their investment decisions. More than half of respondents to AM Best’s survey of European and Asia-Pacific insurers and reinsurers stated they already incorporate ESG factors into their investment strategies, and an additional 15% expect to begin doing so by the end of this year.
The most common incorporation strategy is negative screening—the process of excluding companies or sectors from an investment portfolio based on specific ESG criteria. This is a means of reducing exposure to certain industries, such as coal mining, nuclear energy, or tobacco production.
Despite negative screening, the risk of stranded assets remains. Stranded assets are assets that have suffered from unanticipated or premature write-down or devaluation from external factors such as significant policy, legal, technologic, or market changes. For example, as alternative
energy assets gain traction, coal burning power plants may be at risk of becoming stranded assets. One concern over the medium-to-long term is exposure to stranded assets and a company’s ability to transition its asset portfolio to ensure that there are limited write-downs
due to those assets.
Why is this important? Because a stranded asset can reduce the size of the company’s balance sheet structure, and it can also impact operating performance. This is particularly relevant with the United States rejoining the Paris Agreement in 2021, which AM Best expects will usher in greater focus on climate risk for U.S. insurers and reinsurers.
In terms of operating performance, ESG factors can make a positive or negative impact. For
example, a company might improve its operating performance through the integration of ESG risks being considered in the underwriting process leading to better risk selection and, therefore, better operating results. Conversely, ESG-related litigation and fines, which could be elevated as a result of social inflation, may negatively affect an insurer’s earnings and financial results.
AM Best defines social inflation as the rise in the cost of current and future claims caused by higher court awards and legislative rises in claims payments—changes driven by a shift in societal behavior. For medical professional liability (MPL) insurers, social inflation is a key risk.
The business profile of an insurer speaks to, among a number of other factors, the competitive market position of an organization in relation to its peers. Reputational risk is hugely important in the insurance sector. It’s a highly competitive sector, and certain organizations have the ability to retain customers and policyholders largely based on their reputation. Something like a data breach could materially damage the reputation of an organization and erode policyholder trust, not to mention result in material fines. That type of ESG-related scandal could negatively impact the business profile assessment.
Enterprise risk management ties directly to governance. Having very strong risk modeling capabilities and risk management can enhance the credit quality of an organization. Conversely, a governance failure or a breakdown around that risk modeling capability could lead to negative movement in the credit rating.
AM Best expects that insurers and reinsurers that exhibit strong corporate governance practices will likely be better positioned to manage risks and opportunities. They are also more likely to experience less volatility over the longer term.
It is worth noting that since March 2020, when AM Best began disclosing whether ESG factors were key rating drivers, roughly 10% of rating movements have been a result of ESG factors. Environmental and governance factors have been the most frequent drivers of these rating movements.
Social inflation risk in MPL
Social inflation, which is an ESG factor, affects all MPL writers. Runaway juries, nuclear verdicts, and soaring defense costs have the potential to negatively impact a company’s balance sheet strength and operating performance. The compensation awarded by juries often reflects public sentiment, which frequently outpaces the actual damage.
Tort reform in many states has curtailed this a bit. However, the constitutionality of caps on noneconomic damages is constantly being tested in the courts. And in many instances, caps have been found unconstitutional, on the grounds that they deny plaintiffs the right to a jury trial.
Additionally, economic damage awards are increasingly high. The MPL Association continues
to lobby for "certificates of merit" and a process to weed out meritless claims that can often result in nuclear verdicts. Due to significant loss-control methods, training, risk selection, better claims management, and other measures in recent years, the frequency of MPL claims has been low or flat. However, the frequency of these high-severity claims has been growing.
As a result, many MPL carriers are employing innovative approaches and utilizing the rapidly growing area of legal data analytics, which provides insight into the behavior of courts, judges, and juries.
In the face of COVID-19 and the different statewide executive orders, it will be essential for defense attorneys to understand and apply the appropriate standard of care in each jurisdiction, which seems to be conforming or adapting to changes in the delivery of healthcare with each passing day of the pandemic.
The pandemic was a driver in making healthcare more accessible through the use of diagnostic tools developed for home use and the increased use of telemedicine. But with those advances come the potential for misdiagnosis, under-diagnosed conditions, and the increased potential for high-severity claims.
Good Samaritan laws and states’ immunities may help to shield medical professionals from liability in the short term, but waves of litigation are expected in the long term. Lawsuits against physicians arising from the pandemic for neglecting the standards of care may be difficult
to defend as the definition changed many times throughout 2020. Defense of these cases will certainly be costly.
The MPL segment has been well capitalized for a number of years, and preventing reserving deficiencies is paramount. Investments in technology and data analytics is expected to increase as the segment continues to battle the impact of social inflation.
From an operating performance perspective, social inflation is not new but it is very hard to predict, which makes underwriting and pricing a challenge. For this reason, tort reform trends are very important. Carriers are reducing capacity and increasing pricing to return to the profitability the MPL segment has enjoyed historically.
Data analytics and information gathering in recent years and throughout the pandemic will be key to educating claims handlers and defense attorneys going forward. The material benefits of these investments are projected to be realized in the coming years.
AM Best is closely monitoring carriers to assess their enterprise risk management strategies and innovative approaches, as well as investments deployed on analytics, to mitigate the risk
of social inflation on results.