All supervisors have considered the impact of the Environmental, Societal and Governance (ESG) framework on the firms they supervise.  However, the maturity of the approach adopted varies markedly.

In this article Jonathan Hall, Legal & Regulatory Executive at AILO, explores some of the current trends and explains what it means for regulators, advisers, consumers and businesses in the life sector.

Research

One of the three pillars of AILO’s mission is advocacy. In order to champion the interests of the cross-border life assurance and wealth management industry it is important to identify what is coming down the tracks, to be aware of what the various supervisors and supervisors’ bodies are planning.

It is no surprise that one of the common themes from a review of the strategies of IAIS, EIOPA and a number of the regulators supervising AILO members is the need to address ESG. However, the supervisors are at different stages on the evolution path described below.

Research headlines and major factors driving these trends

The first point to note is that there is little explicit reference to either the societal or the governance elements of the framework.

It would be fair to argue that the regulators already address the governance aspect. All supervisors must ensure that the licensed institutions coming under their wing demonstrate fitness and propriety. Any financial institution which fails to establish an effective system of internal controls can expect rapid regulatory sanction.

Similarly, the societal element is now a hygiene factor.  How many financial institutions do not have policies which address diversity and inclusion issues, or which ensure that employment practices in its supply chain recognise human rights? The supervisors, of course, are looking to protect possibly the most important stakeholders.  There is a continued raising of the bar to ensure customers can make informed decisions and their interests are paramount at all stages of the product life cycle. 

Some regulators are internally focused.  They know they must get their own house in order before they can supervise effectively.  This applies not only to their structures and funding models but also operational efficiencies and their carbon footprint. This is the foundation of a supervisor’s ESG strategy.

Many regulators have addressed the impact of ESG on the operations and risk profile of financial institutions. Firms are expected to identify the risks associated with climate change when completing their ORSA. This will include identifying the cost of transitioning to a new working environment. It will also include the impact of climate change on mortality and morbidity risk.  In the Property & Casualty arena it means evaluating the additional risks associated with weather events which are more frequent and more severe.

EIOPA and the FCA have moved beyond this. Their actions are driven at least in part by political demands, which may currently be absent in smaller jurisdictions. Increasingly consumers want to know the ESG credentials of the products they are buying.  This applies to foodstuffs in the supermarket, but it applies equally to investors. The focus of the regulators is therefore to ensure that the directors of underlying investments disclose how they are meeting their ESG obligations. The financial institutions are seen as the gatekeepers of this transparency.

And finally, the larger supervisors, again probably driven by political expectation, are looking to the financial institutions to exert their powers as significant holders of shares and units to ensure the desired behaviours area adopted in the subject investments.

Benefits of this research to AILO and the industry

Many AILO members will already be ahead of their local supervisor’s requirements, encouraged by group expectations and best practice. An effective D&I policy is hardly contentious and makes the firm more attractive rather than less.  Firms will already reflect climate change in their ORSAs.

It will however be interesting to see how firms respond to the more advanced requirements of the supervisors. Monitoring the behaviours of underlying investments is onerous and expensive particularly when it requires a decision to walk away from sales. The share price of Peabody Energy, the largest coal producer in the US, is three times higher than it was a year ago.  Investors are opportunistic. Clearly there are still plenty of investors for whom profit is more important than principle. Turning these investors away will cost AILO members, in the short term at least.

Conclusion

Anyone who thinks the impact of the ESG framework is transitory or superficial should think again. It is clear that the supervisors envisage that the framework will impact its own and firms’ operations, how they conduct themselves and the evaluation of risk and solvency.  Increasingly financial institutions are expected to ensure that investors have reliable information which demonstrates the ESG credentials of investment targets and allows for comparison. The apex of the pyramid is that, as shareholders, financial institutions should use their investing power to demand the right behaviours in board rooms. Not all regulators have reached this point yet but clearly, it is the direction of travel.

About the author

Jonathan Hall is a solicitor (non-practising). He has a Masters degree in European Union Law and over thirty years’ experience working in financial services – principally in the areas of Legal, Compliance and Risk.

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