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AM BEST'S MONTHLY INSURANCE MAGAZINE



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ESG and Insurance Credit Ratings: Frequently Asked Questions

AM Best believes that communicating how it views environmental, social and governance factors in the context of insurance credit ratings will provide greater transparency to the market. This frequently asked questions document was developed to provide additional background and context.
  • January 2022
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Editor's Note: The following is an excerpt from Best's Commentary: ESG and Insurance Credit Ratings: Frequently Asked Questions. Go to www.ambest.com to access the full report.

 

ESG and Credit Ratings

Why is ESG important to a (re)insurer's financial strength?

AM Best's view is that ESG factors, when material and relevant, play an important role in the financial strength of a (re)insurance company. As our perspective is forward looking, AM Best seeks to understand all the risks and opportunities that could impact the (re)insurer's financial strength and creditworthiness. AM Best's analysis includes identifying the impact of credit factors that are related to ESG on a (re)insurer's credit ratings. Certain ESG factors may not impact a (re)insurer's financial strength today but may do so in the future or may become more relevant. ESG factors have the potential to affect positively or negatively any of the building blocks considered in AM Best's analysis: Balance Sheet Strength, Operating Performance, Business Profile, or Enterprise Risk Management.

Related: AM Best Issues FAQ on ESG and Insurance Credit Ratings, Announces Inclusion of ESG Section in Best’s Credit Reports

Property and Casualty (Re)Insurers

For most P/C (re)insurers, environmental factors such as climate risk (the changing frequency and severity of weather-related events) may pose a severe threat to the balance sheet, as they may result in material, rapid, and unexpected consequences on capitalization, as well as elevated operating performance volatility. AM Best has always considered environmental risks a key part of its analysis and conducts stress testing to see how a (re)insurer's capital position can withstand shock events. Moreover, the ability to model weather-related events can vary greatly by company, peril, and market, so an understanding of gross and net exposures, as well as the management of these risks, is important to ensure that climate-related risks are captured appropriately. For some P/C (re)insurers, other ESG factors may be more important, such as environmental litigation (pollution and contamination) or social inflation for casualty insurers.

Life and Health (Re)Insurers

Environmental factors may also be relevant to L/H (re)insurers, particularly those that may have exposures to stranded assets owing to longer-duration investment portfolios and are thus more susceptible to transition risk. Furthermore, L/H (re)insurers that take into account changing demographics, which could affect longevity, mortality, and morbidity assumptions, would be viewed as prudent.

Governance

Governance is relevant for all (re)insurers and is captured under AM Best's Enterprise Risk Management building block. Governance, which can impact financial strength, has always been an important consideration in AM Best's ERM framework evaluation. Solid corporate governance is essential for establishing a company's risk culture as well as implementing the structures, processes, and policies by which a (re)insurer abides by. The governance aspect of ESG takes into account financial and non-financial risks, including insurance activities, financial irregularities, management or board disputes, regulatory intervention or solvency breaches, and fraud monitoring. The severity of incidents is important to credit quality.

Will ESG impact my rating?

AM Best considers numerous credit factors, including those that fall under the E, S and G, when they are material and relevant to the financial strength of a (re)insurer. In our rating analysis, we consider a rating factor (including ESG factors) relevant only if we believe it will have an impact on financial strength within our time horizon (typically 36 months). The impact of ESG factors on financial strength can vary based on the type of company, the company's balance sheet exposure on both the asset and liability sides, the level of risk transfer, and the markets in which the (re)insurer operates. ESG factors may become more important to financial strength over the longer term.

If a (re)insurer is a good environmental steward will that improve its rating?

Not necessarily. Credit rating factors and ESG factors may not always intersect, and positive (or negative) ESG factors may have no impact on credit quality. Although good internal practices such as recycling programs and internal sustainability targets may improve a company's image, they may not impact financial strength.

Will ESG-related questions be added to the Supplemental Ratings Questionnaire (SRQ)?

AM Best already requests information pertaining to exposure management and stress testing in its SRQ but does not anticipate adding new ESG-specific items to it at this time. However, we reserve the right to obtain additional information on ESG or any topic we feel is relevant to the evaluation of the credit rating.

How has climate risk been factored into the assessment of financial strength?

AM Best's approach to assessing climate risks and opportunities includes assessment of a company's climate exposures, its strategic business plans, and how these exposures can affect creditworthiness over the rating time horizon. For climate risks, AM Best considers the impact of physical, transition, and climate-related liability risks.

Weather-related events are considered a severe threat to insurers' balance sheet strength because of the often significant, rapid, and unexpected impact of such losses. AM Best expects (re)insurers accepting climate-related risks to be able to demonstrate that they can effectively manage these risks, including consideration of the increased severity and frequency of weather-related events, and that they have the financial wherewithal to withstand potential losses.

Related: Best’s Market Segment Report: Realistic Optimism in the Current Reinsurance Market

When calculating overall risk exposure, (re)insurers may want to consider both their investing and underwriting operations, and include investments that may be affected by climate risk, such as coastal properties at risk of flooding due to rising sea levels.

The financial impact of climate risks will vary depending on a company's mix of business and geographic exposures. Its business profile and the level of reinsurance protection will dictate underlying volatility in financial metrics and the ability to generate profitable returns.

Risk management plays an important role in a company's ability to effectively model weather-related events and factor climate risk into the pricing and modeling of risks. A key area for consideration is the availability of appropriate data and analytical tools to accurately model weather-related events. Overexposure, inadequate modeling, or insufficient protection arising from an event are concerns if losses fall outside of AM Best's or the company's expectations. For life insurers, climate risk can change the pattern and resistance to infectious disease, which could affect future mortality and morbidity rates.



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