An ESG metric no one talks about

There’s rarely a day when (re)insurers are not reminded of the ESG spotlight trained upon them – with the E being very much the focal point.

This week, for example, we had Extinction Rebellion disrupting the Baden-Baden conference – something that would never be allowed at Monte Carlo – while last week activist group Insure Our Future published its annual ESG league table which criticised perceived laggards, such as Berkshire Hathaway and Lloyd’s.  

(Re)insurers are listening. In recent weeks, for instance, the industry’s largest reinsurer Munich Re committed to not insuring new fossil fuel projects from next year while also exiting all traditional energy insurance coverage via its Syndicate 457. Next month, it’s fair to assume, there will be more initiatives unveiled when the United Nations Climate Change Conference – more commonly referred to as COP27 – opens in Sharm El Sheikh, Egypt 

Against this backdrop, it’s not surprising there are a plethora of initiatives to measure the industry’s ESG performance. Most come at it from an investor perspective but more recently there has been emphasis on measuring the E (and, to an extent, the S and G) from the perspective of underwriting, not least by ESG Insurer itself. 

These typically focus on underwriting strategies and company guidelines – what risks are being insured and what measures are being put in place to measure carbon underwriting footprints. These are valuable metrics but perhaps there is one yardstick that the industry frequently uses but never in the context of ESG. 

The protection gap.

Let us explain. Insurers regularly congratulate themselves that the service they provide is a social good (as well as a profitable enterprise). John Neal, the CEO of Lloyd’s, was making this point at the weekend in an interview with The Sunday Times. “Insurance, on its good days, has a societal benefit. What we do really does matter,” he exclaimed. 

There is merit in this position. After all, the very raison d’être of insurance is to step in after a disaster and compensate for the loss: to help people and businesses get back on two feet. The losses of the few paid for by the premiums of the many, as the maxim goes. 

But the protection gap is a reminder that there are many disaster victims who do not benefit from insurance’s societal good. In 2021, for example, Aon estimates insurers paid out around $130bn in claims yet the total economic loss was $343bn. In other words, only a third of the damage caused by storms, floods, earthquakes and drought was covered.

And those who don’t benefit are typically the poorest and most in need of help. 

Take flooding, for example. Swiss Re recently estimated that of all the major global flood disasters from 2011-2021, only 18 percent of losses were insured. That statistic will be even lower in Pakistan where nearly 1,800 people were killed and ten of thousands displaced by the August floods.  

What if insurance bore a larger share of these economic losses? Say, two-thirds, or roughly $229bn, using Aon’s estimates. Around the world, homes would have been rebuilt and livelihoods restored far faster than actually happened. Families and communities would have recovered far faster from events that, without insurance, would have taken months or even years to put behind them.  

It is a question Conning’s director of insurance research William Pitt raised earlier this year in a thought-provoking article examining the industry’s cost base.  

He pointed out there that are multiple factors why the protection gap exists but the cost of insurance is certainly one of them. And if insurance is a social good, as we like to think, then the most socially valuable thing insurers can do is to sell more insurance at lower prices. 

But the problem is its cost base. 

In the first half of 2021, US P&C insurers only paid out 59.6 cents in claims for every dollar of premium they earned, constrained by expense ratios that have not budged in more than four decades. P&C insurers’ expenses accounted for 25.8 percent of premiums in 1978 and 27.3 percent in 2020. 

In other markets, expenses are even higher. At Lloyd’s, which accounts for more than half the premiums written in London and a large share of natural catastrophe insurance and reinsurance business around the world, the expense ratio was 35.5 percent in 2021. When he became CEO four years ago Neal made it clear that expenses were far too high. The good news is the expense ratio has fallen from above 40 percent in 2017 but much of this is likely to be down to revenue expanding higher than static costs and reduced intermediary commissions (in a hardening market).

Reducing expense ratios is arguably the biggest thing insurers could do to increase their social value. Of course, it is hard to do. As Pitt points out, insurance is a complex and highly regulated business, pushing administrative expenses up. Customers need to be educated in risk to buy it, which is why commissions to brokers are so high. Insurers that avoid using brokers usually find they have to spend lavishly on advertising. 

But savings are clearly possible. Technology can transform processes, create efficiencies and revolutionise distribution, for example. Frictional costs in accessing capital or in the retail-wholesale chain could be reduced. New methods of marketing – embedded insurance via trusted, non-insurance brands, for example – may transform the retail model in the future.

Keen students of the P&C industry will be sceptical, of course. The sector has shown a remarkable ability to survive without revolution when it comes to costs, distribution and the value chain. But if the industry is to really convince policymakers, regulators, customers and the watching world that it is a force for good then narrowing the protection gap would be a good way to do it. And that depends in part on its cost base.

So, perhaps it’s time expense ratios and a commitment to lowering costs became regarded as an intrinsic ESG metric in the same way as fossil fuel underwriting or diversity of workforce…