ESG and Captive Insurance: Navigating Risks and Opportunities

Environmental, social, and governance (ESG) risk is now firmly on the agenda of most captive insurance company boards of directors. The rise of ESG has been exacerbated by the COVID-19 pandemic and a surge in climate change, geopolitical risk, and shareholder activism in recent years.

ESG is a double-edged sword for captive insurers. On the one hand, it poses a host of new challenges captive owners and managers have never faced before. On the other, it has opened up a multitude of opportunities on which captive insurance companies can capitalize.

"We are living in a decade of cascading global risks, which can greatly impact coverage capacity and increase insurance rates in the traditional risk transfer market," said Adriana Scherzinger, head of captives sales and execution for Zurich North America. "Given those cascading risks and the harder market for many types of risks, we are seeing more risk managers adding or expanding the use of captives."

The primary challenge of ESG is the ever-increasing pressure from regulators, investors, and clients to adhere to new green, ethical, and corporate social responsibility standards and obligations and to prove their credentials. A prime example is the European Union's ESG Regulatory Regime, which provides a framework for companies to follow.

An added problem is that the ESG rules and standards within each country can vary greatly. This makes it difficult for companies operating in different jurisdictions to adhere to them.

Rising Claims

Another issue is that ESG has exposed captive insurers to a raft of new claims for failing to meet their targets or making inaccurate or misleading disclosures or statements. These claims can range from regulatory investigations and civil and governmental litigation to event-driven litigation and shareholder activism claims.

"In the United States, certainly, we are starting to see a big increase in claims and litigation, whether that's from the environmental, social, or governance side," said Jordan Mosher, vice president at Huntington National Bank and director of Huntington Captive Insurance Co. "It's a different situation altogether in Europe, where there's more of a focus on legislation and regulation, albeit there has been some movement in that regard in states such as Tennessee and Florida, for example."

Captive insurance companies also have to ensure that they only invest their funds in organizations that share the same values as their parent company. When it comes to ESG investments, these investments have been proven to perform as well as, if not better than, the general equity market, particularly exchange-traded funds, which captive insurers frequently invest in.

"It would be contradictory for a parent company to have strong investment principles when it comes to ESG, as it wants social and environmental change, but then turn its back on all those with respect to its captive," said Michael Maglaras, principal of Michael Maglaras & Company. "Rather, it needs to be consistent in everything it does."

Another key challenge for captive owners and managers is knowing the correct way to address ESG risks, according to Alex Gedge, senior captive consultant at Hylant. That requires ensuring they are properly educated in how to do so, she said.

"ESG needs to be deployed as part of board meetings and building those considerations into the captive as standard practice," said Ms. Gedge. "But oftentimes, you will get a chief financial officer who is so involved in the day-to-day workings of the captive that they don't have the time or headspace to piece together everything that they need to be doing in terms of ESG."

In terms of opportunities, captives can be used to help companies better manage their ESG risks and achieve their goals through making more informed strategic decisions. For example, using the captive to take a closer look at how environmental factors may increase risks for property or operations by analyzing historical data, thus enabling an organization to plan ahead to protect their interests from a weather event.

ESG covers a wide range of risks, from the traditional governance exposures to new and emerging ones that are becoming increasingly more prevalent, such as extreme weather caused by climate change and pandemics. That requires that captive insurance companies fully understand the risks they are writing.

"A captive can be used to insure almost any of its parent's insurable exposures, from traditional property and casualty coverages to employee benefit programs," said Ms. Scherzinger. "I'm seeing property, product liability, and international employee benefits being put into single-parent captives. And lately, there's increased interest in putting cyber, medical stop loss, D&O, and several other coverages into captives."

Flexible Coverage

Using a captive insurer affords a company the flexibility to cover such an exposure directly by transferring the risk to the reinsurance markets, using an alternative risk management solution such as parametric coverage, which is triggered by measurable factors like rainfall or wind speed. As well as covering governance risks such as D&O liability and environmental exposures like natural catastrophes, they can also be used for emerging risks such as renewable technologies, where there may be limited loss history data, and it's hard to secure traditional coverage.

"There has been a big increase in legal defense cover, with larger limits outside of commercial policies that may be included from a crime or EPLI perspective," said Mr. Mosher. "So the company might decide not to directly indemnify this in ESG cover but use a broad-based legal defense cover that can fill out their ESG umbrella."

He added, "With all the emerging risks that are coming out of ESG, it's a great opportunity for captives to step in for the commercial market."

Captives can also be used to support companies' policies for governance and social change. For instance, captives might be used to protect their risks in respect to diversity, equity, and inclusion (DEI) and invest in entities that support DEI.

"Governance for captives is always a critical piece," said Ms. Gedge. "This is one of the great opportunities for captives because they are typically well governed and managed and can deploy the experts they already have to make sure that everyone is being ethical, efficient and regulatory compliant."

She continued, "Having a captive also ensures that you have got robust risk management in place to deal with environmental issues. It will respond quickly as changes in these areas or emerging risks come to the fore—that's where a captive proves its true value."

However, in order to be truly effective in terms of ESG, Mr. Maglaras said that captive owners need to consider the impact of their actions. That requires, he said, putting in place a way of measuring their effectiveness.

"As a board of directors, it's always key to know what the impact of your actions are, particularly as it relates to ESG," said Mr. Maglaras. "That means looking at how your returns benchmark against the industry average and how well the captive is performing in terms of the ESG strategy and values of its parent company.

"In this way, you need to have vigorous boardroom discussions about how the portfolio is performing and its faring against other similar captives. You also need to look at the difference you're making in the community as a result."

He added, "Believe it or not, it's possible to have a captive insurance company that invests in ESG principles and still operates as a business that is motivated by profit—the two aren't mutually exclusive. It's possible to be a good corporate citizen and a successful business person at the same time."