A Win-Win: Why Insurance Companies Rely on ESG Strategy
You turn on the news to another natural disaster striking; the reality of the climate crisis is becoming increasingly difficult to deny. While some companies/industries are notorious for greenwashing, others try to do their part to contribute to positive change. Regardless, companies far and wide have set ESG (Environmental, Social, and Governance) targets to decrease their negative environmental impact, often driven by shareholder and stakeholder pressure.
Specific industries have additional motivation to reduce negative environmental impact, as their bottom line depends on a balanced climate. Uniquely, the Insurance industry has no choice but to drive environmental sustainability, as profitably is dependent on tackling the global climate crisis.
Industry Overview
The P&C (Property & Casualty) insurance industry is based on the concept of risk management, where policyholders pay for the assurance that, in the case of an unprecedented event, they have coverage to rebuild what has been lost. As this business model is based on hypothetical future events, forecasting is key. To accurately predict the company's costs for the upcoming fiscal year, actuaries conduct statistical analysis to prepare for insurance claims, though the current frequency of natural disasters amplifies the uncertainty of this process. Historically, we have seen the catastrophic damage created by climate-related natural disasters, specifically the 2016 Fort McMurray fires, leading to $5.96 billion in insurance losses and unquantifiable losses for those personally affected. As mentioned, this model is all based on risk, indicating that a policy with greater risk for a claim would incur a higher premium. Individuals living in “high-risk” areas are left in a vulnerable position, as gaining access to an affordable insurance policy is a rarity. This reality is a growing concern as our environment continues to deteriorate and we see correlated financial outcomes. For example, nine of the ten most costly years for insurance payouts have been since 2011. To preserve the accessibility of P&C insurance policies, environmental risk must be effectively managed.
To calculate the cost of your insurance policy, statistical models leverage key metrics to determine your potential cost to the business—for example, the value of your asset, the location, and the likelihood of a claim. The average home insurance policy in Ontario is $1,250 per year, though this number varies drastically. Due to its high exposure to flooding, LaSalle, Ontario residents pay the highest property insurance rates. As climate-related disasters occur, the cost of insurance policies will inevitably increase to ensure the company can aid those affected. On average, home insurance policies in Ontario have increased a bold 10 percent since Fall 2021, an additional challenge to home ownership in our current economy.
Insurance acts as a backbone of developed economies, by using their float (net premium) to invest in bond markets, encouraging business development, providing job opportunities, and relieving disaster recovery. As insurance premiums become unmanageable for individuals to afford, the business model cannot be sustained, and the economic support from the insurance sector will weaken. Thus, an action-based climate strategy is needed to balance premiums, reduce the impact of natural disasters, and sustain the positive economic spillover effects of the industry.
ESG; The Reality of the Insurance Sector
After analyzing the laundry list of reasons insurance companies must create positive environmental action, are they doing enough? To be blunt, the answer is no, as there is always more that could be done to preserve our environment.
There are multiple ways that environmental sustainability could be considered through the P&C insurance business model, the first being through sustainable investing. As insurance companies accumulate large sums of money through monthly payments, this capital is invested as companies await claims. In both private and public markets, renewable energy is a key area to invest in to ensure progress is being achieved toward a sustainable future. Sustainable investing was a hot topic amongst European insurers as early as five years ago, though now, in the present time, we witness the challenges and opportunities for North American markets. To ensure the topic of sustainable investing is digestible for insurance companies, most use the United Nations Sustainable Development Goals as a guiding framework, with topics including climate action and affordable and clean energy. These focus areas help create a sustainable investment strategy alongside other popular methods such as investing in green bonds and green infrastructure.
With such streamlined frameworks and strong guiding principles for sustainable investing, one may wonder why there is still a lack of North American action? Here we find a very nuanced and complex answer, as insurance companies are highly regulated, often under a legal magnifying glass. As many sustainable assets are new to market, there is less historical data to rely on, creating a riskier investment opportunity for the company. As we know, insurance companies operate on the foundation of risk management. Thus, sustainable investing is less favourable in this context. Additionally, the risk of greenwashing is high, and insurance companies may need more experience to responsibly invest in sustainable initiatives. Ironically, one may believe that a lack of climate-related action is the biggest risk of all. While this may be true through a long-term lens, we cannot deny the significance of short/medium-term financial returns.
Aside from investment opportunities, companies could consider ESG goals in underwriting processes and new product development. EY states that only 60 percent of insurance companies are integrating ESG into underwriting and development, creating a key area for improvement. To tackle the targets of the United Nations, 43 percent of global insurance companies have committed to achieving net zero by 2050. However, this number is alarming for North America, as it would be accurate to assume the European insurance industry is leading this area, and 43 percent leaves vast room for improvement. While this statistic demonstrates an area of growth, it also sheds light on how insurance companies are progressing faster than other industries within financial services. The same study indicates that only 31 percent of global institutional investors have made this same net-zero commitment in the suggested timeframe.
As we see temperatures rise and natural disasters more frequent than ever before, it is evident that action is needed from all parties. As consumer preferences change, we must see action from companies in a proactive manner rather than a reactive approach. The P&C insurance industry must be a leader in adopting sustainable strategies to ensure the longevity of affordable and accessible policies as well as continually stimulate our economy, capital markets, and business development. If anything, our climate depends on it.