Promoting Environmental, Social and Governance (ESG) performance has become a top priority of corporate executives and boards everywhere, including in property and casualty insurance.
Executive SummaryWhile there is the notable absence of emerging risk content in many investor ESG measures, general liability underwriters are constantly scanning the horizon for the next asbestos, and D&O underwriters are watching out for the next Enron, note Praedicat executives David Loughran and Robert Reville. Here, they also describe two additional shortcomings of investor-oriented ESG measures, contrasting the virtues of casualty insurance underwriting in moving the promises of a better world forward.
However, promoting ESG performance requires measuring it, and nearly 18 years since the term ESG was first coined in a 2004 UN-sponsored report, and decades since “socially-responsible” investing came into vogue, there is little agreement in how to measure ESG performance.
A 2019 study by researchers at MIT and the University of Zurich examines the six most prominent ESG measures used by investors today and reports that the correlation among them averages just 0.54. The correlation in credit scores issued by the major credit-rating agencies, by contrast, exceeds 0.95. It should come as no surprise then that while credit scores are highly predictive of future financial performance, ESG scores seem to have little predictive power, financial or otherwise. ESG-branded equity funds, for example, might perform slightly better than the universe of all funds (and maybe only because they tend to be tech-heavy), but analyses suggest they perform no better on objective measures of sustainability and social responsibility.
As P/C insurers look to embed ESG throughout their operations, they might first consult their own internal underwriting expertise in anticipating how commercial activity can harm the environment and the health of workers and consumers. Commercial casualty underwriting avoids three significant issues with investor-oriented ESG measures:
- Investor ESG measures value future commitments more than current action.
- Investor ESG measures tend to value how the environment impacts companies more than how companies impact the environment.
- Investor ESG measures fail to capture the full range of emerging risks to human health and well-being.
Adjusting or enhancing ESG analytics available in the investor market to circumvent these issues will result in measures that better align with underwriter best practice, correlate with insurance claims and align with the sustainability goals of insurers themselves.
The first observation that investor ESG measures rely too heavily on future commitments was recently forcefully expressed in a lengthy essay published by former BlackRock Chief Investment Officer Tariq Fancy. He essentially accuses the entire ESG complex of being complicit in corporate greenwashing. Companies that are transparent in the challenges their business models pose to human health, social justice and the environment, and appear organized to tackle those challenges, tend to receive relatively high ESG scores regardless of their historical ESG performance and whether they meet future ESG commitments.
Fancy concludes that ESG has accomplished little and only governmental action will move the needle on pressing ESG issues. Promises are nice, but they have little meaning unless ESG holds companies accountable for what they actually do.
Casualty underwriters, of course, have long understood that a company’s promises do not by themselves protect against future claims. That’s why underwriters scrutinize what a company produces today and what it has produced in the past, and then evaluate that production against our collective understanding of the hazards they could pose now and in the future.
The argument that investor ESG measures tend to focus more on impacts to companies than impacts to the environment was made recently in Bloomberg Businessweek by Cam Simpson, Akshat Rathi and Saijel Kishan. The authors focus on the ESG ratings published by MSCI, the largest ESG rating company. MSCI recently gave McDonald’s Inc. a ratings upgrade even though the significant greenhouse gas emissions from its meat-based supply chain continue to grow. The authors write that MSCI’s ratings upgrade came “after dropping carbon emissions from any consideration in the calculation of McDonald’s rating. Why? Because MSCI determined that climate change neither poses a risk nor offers ‘opportunities’ to the company’s bottom line.”
The authors continue, “MSCI was looking only at whether environmental issues had the potential to harm the company. Any mitigation of risks to the planet was incidental.”
For casualty underwriters, it is standard practice to consider the potential for the supply chain of a company to cause harm and embroil it in litigation.
Finally, there is the notable absence of emerging risk content in many investor ESG measures. One would think, for example, that the production and downstream use of chemicals of concern to scientists would weigh heavily in the E component of ESG. But environmental contaminants that have triggered mass litigation in the United States, such as per- and polyfluoroalkyl substances (PFAS), are not accounted for in the typical ESG score. Nor is an emerging contaminant of great concern like microplastic (by our count, more than 2,500 studies were published on microplastic in 2021 alone).
Instead, users might find electromagnetic fields and genetically modified organisms, two phenomenon that perhaps deserve to be monitored but are hardly top-of-mind among toxicologists and epidemiologists today who are far more concerned about, say, the havoc wrought by myriad endocrine disrupting chemicals in our environment.
Meanwhile, general liability underwriters are constantly scanning the horizon for the next asbestos and D&O underwriters for the next Enron. Casualty insurance by necessity spans what matters in the E, S and G. The issues that drive ESG are the issues that ultimately drive liability in society.
The liability perspective of casualty underwriting is essential to developing ESG scores that are meaningfully correlated with a company’s future financial performance, claims activity and, most importantly, transition to sustainable operations. Liability, after all, is how society holds corporations accountable for actions that governments may be too late in regulating.
Companies that are slow to substitute away from employing dangerous chemicals in their production processes or reluctant to remove products from the market that harm workers and consumers or lag in facilitating a more diverse, equitable and inclusive workplace could find themselves playing defense in the court of law regardless of how compliant they are with government regulation or what they promise to do in the future.
ESG can shape meaningful change, but it must have a foundation in emerging risk, deep knowledge of how companies act rather than what they promise, and an unwavering focus on accountability and liability. In short, ESG needs casualty underwriting as much as casualty underwriting needs ESG.