D&O Insurers as ESG Monitors

Amelia Miazad is a Professor at the UC Davis School of Law. This post is based on her recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver to All Stakeholders? (discussed on the Forum here) both by Lucian A. Bebchuk and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr; and Stakeholder Capitalism in the Time of Covid (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.

Companies must reduce environmental and social harms to remain profitable over the long-term. In response to increasing investor and stakeholder demands, companies have ramped up their ESG commitments, from achieving “Net Zero” to closing the gender and racial pay gap. To protect investors and consumers from companies that make bold commitments, but lack the intention or ability to meet them, global regulators, including the SEC, are focused on “greenwashing”. At the same time, though, there is a proliferation of voluntary and mandatory ESG reporting obligations. And in March 2022, the SEC proposed rule amendments that would require public companies to disclose certain climate-related financial data. Notably, the SEC’s proposed rule encompasses disclosure of how boards are overseeing climate change risks.

Just as many corporate boards were beginning to align their risk oversight and decision-making with this new normal, an intensifying ESG backlash is complicating matters even more. A growing number of federal and state Republican lawmakers are directing  their ire at ESG and vowing to stop “elite progressives” from usurping “free markets”. Paradoxically, these free market champions are proposing–and enacting–sweeping legislation to constrain boards and investors from considering environmental and social risks.

As these discordant ESG demands play out in the public arena, board decision-making is more fraught with legal and regulatory risk than ever. We are already witnessing an increase in ESG-related shareholder litigation and SEC investigations. And a bevy of law firm memos warn that the proliferation of both pro and anti-ESG legislation increases legal risk for directors.

But directors do not, for the most part, bear the financial burden of their missteps. Rather, Director and Officer (D&O) liability insurers step in to defend, settle, and pay claims. The fact that D&O insurers bear the financial risk of the board’s ESG lapses suggests that they are motivated to monitor how boards are addressing ESG risks. But corporate law scholars have long given up on D&O insurers as effective corporate governance monitors. A series of qualitative studies have concluded that D&O insurers lack the incentives and ability to monitor corporate directors, or at least in ways that would meaningfully improve corporate governance. As a result, scholars have concluded that D&O insurance worsens corporate governance because it reduces the deterrent effect of corporate and securities litigation.

My paper, D&O Insurers as ESG Monitors, challenges this conventional view as it applies to ESG risks. I argue that ESG risks are distinct from traditional corporate governance risks in ways that are increasing both the incentives and ability of D&O insurers to monitor their insureds. Through qualitative interviews with experts in the D&O insurance industry, the paper offers the first descriptive account of how D&O insurers are incorporating ESG into their underwriting process, and thus evolving from passive to active monitors of their insured’s ESG risks. The underwriting process has two phases–insurers first gather information; then, they use that information to decide whether to cover the risk, limit coverage, or increase premiums. The paper demonstrates that D&O insurers are starting to gather more information about ESG risks than traditional corporate governance risk. Their methods for gathering this information are evolving too, as D&O insurers are creating their own proprietary ESG data analytics, as well as relying on increasingly sophisticated external ESG data providers. While this is a new and emerging practice, D&O insurers are also starting to use ESG information to make coverage decisions, from refusing to offer policies to offering premium discounts for companies with “good ESG”.

The paper builds on this descriptive account to theorize that insurers are likely to increase their focus on ESG, for reasons that are both obvious and unexpected. The business model underlying the insurance industry helps reveal why ESG risks, and climate change in particular, are uniquely problematic for insurers. Insurers collect premiums and promise to pay for losses arising out of covered claims. As climate-related disasters increase, it increases insurers’ liabilities. This is the “liabilities” side of the insurers’ balance sheet, and where the scholarly attention has been focused. On the other side of the balance sheet, insurers are some of the largest and most diversified investors in the world. While scholars and policy makers have focused on large diversified investors and “universal owners” such as “the big Three”, the role that insurers play as investors is largely unexplored. My paper fills this gap, and demonstrates that ESG risks, and climate change in particular, threatens both sides of the insurers’ balance sheet.

Insurance regulators have recognized that ESG risks pose unique threats to the viability of the insurance industry because they impact both sides of the insurers’ balance sheet. For example, in April of 2022, a bipartisan group of state insurance regulators adopted a new standard for insurance companies to report their climate-related risks, which aligns with the international Task Force on Climate-Related Financial Disclosures (TCFD). As a result of the rule, which applies to both public and private insurance companies, 80% of companies in the US insurance market must now disclose how they are incorporating climate risk into both their underwriting and investment decisions.

While this is a remarkable shift, and insurance regulators are recognizing that insurers play a unique role in minimizing ESG harms, there is almost no focus on the role of D&O insurers in particular. Through their ability to gather and analyze vast amounts of ESG information, and use that information to exclude or limit insurance for corporate directors, D&O insurers are uniquely positioned to encourage companies to reduce their environmental externalities and minimize ESG risks. After illuminating D&O insurers’ unique abilities, the paper ends with a normative argument, and invites regulators, lawmakers, and the insurance industry to recognize and foster the promise of D&O insurers as effective board monitors.

The complete paper is available for download here.

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