Non-life insurers must do more with ESG when setting premiums

Five-step plan for successful ESG transition

ESG (Environmental, Social and Governance) plays an increasingly important role in our day-to-day activities and companies are increasingly placed under a social magnifying glass. While they strive to increase transparency about ESG, ESG is more than reporting and governance. For insurers, the actuary's role is crucial to the implementation of their ESG philosophy. A five-step approach paves the way to a successful ESG transition of the actuarial processes.

Societal pressure and long-term value

For insurers, ESG becomes more and more important for the operational management of insurers. Societal developments, such as climate change, scarcity, diversity and inclusion, data security and transparency, mean that both clients and investors increasingly value ESG considerations in their decision-making.

‘Like other companies, insurers recognize that the ESG transition offers opportunities for long-term value creation’, say PwC risk modeling specialists Lars Janssen, Juliska Tel and Raquel Humphris. ‘On the one hand, customers are often willing to pay more for green and socially sound products. On the other hand, regulators play a role in the requirements of ESG activities. De Nederlandsche Bank, for example, recently announced that it expects insurers to demonstrate that they can act adequately on the consequences of climate and environmental risks. This puts the role of the actuary in the spotlight.’

Crucial role actuary

Mapping out ESG risks not only provides a better insight into the insurer's portfolio, but can also serve as a catalyst for social developments. ‘The actuary plays a key role in this and must take into account financial, commercial and ESG considerations’, Janssen continues. ‘Finding this balance is complex and subject to change. Pricing and product development are among the most important steering mechanisms of the insurer. But they must be used effectively to maintain support and trust in society.’

‘A successful ESG transition requires an integrated and coherent approach’, Tel adds. ‘Due to the increasing availability of data and data analysis techniques, insurers have to modernize and think more concretely about themes such as actuarial modernization and the actuary of the future. To help insurers with this, we have established a five-step approach that supports them in preparation and execution. This five-step plan focuses on the insurer's continuous pricing process.'

Five-step approach for pricing risk

In order to align with the insurer's ESG objective, ESG needs to be part of both the technical and commercial premium. Based on its objectives, an insurer may decide that the final commercial premium differs from the technical premium. This decision has a direct effect on the characteristics of the portfolio and causes inflows, outflows and/or changes in policyholder behavior.

ESG adds an extra dimension to the premium setting process. Using the commercial premium to create an incentive can be beneficial for the environment, but it can also have unwanted side effects. Because an insurer can drive ESG transformation in customers through pricing, it is important that an insurer assesses its models using five steps.

Step 1: Portfolio analysis
Step 2: Product development
Step 3: data inventory
Step 4: technical premium
Step 5: commercial premium and ESG philosophy

Step 1: Portfolio analysis

An insurer must first of all gain insight into the ESG risks of the portfolio: the ESG-related developments from which damage claims may arise. The insurer obtains this insight by carrying out a portfolio analysis. The insurer determines the potential ESG risk for each individual product. This step requires dedicated attention and a close collaboration between the commercial and actuarial departments. It is preferable to form a multidisciplinary team.

Step 2: Product development

In order to mitigate the ESG risks as much as possible, an insurer needs to make decisions about existing products, products to be expanded and new products based on the established ESG risks and customer profiles. This offers opportunities for both redesigning existing products and developing new products that are more in line with current social developments.

Step 3: data inventory

One of the major challenges for an insurer is the availability of suitable data to price products. This is where the need for ESG indicators comes into being. The insurer needs to gain insight into the amount of data available. In doing so, he must take into account accessibility and storage so that he can use the data efficiently in the price model.

Step 4: technical premium

To determine a technical premium, the insurer combines the insights gained from the previous phases. He assesses and translates the available data so that it is suitable for use as ESG variables. The challenge here is not only in suitability, but also in decision making. It is up to the actuary to assess all information in a way that may be different from the established pricing model. He must form an opinion on the current price model and the method used. This can lead to conclusions about the granularity of the model, the applicability of the identified ESG risks in the model and the quality of the results. Depending on the current pricing model, the impact could range from limited adjustments to the development and implementation of new pricing models.

Step 5: commercial premium and ESG philosophy

The insurer determines the commercial premium based on the technical premium and taking into account the goals of the company and the ESG philosophy. The insurer identifies and weighs the impact of the ESG risks on the technical premium against the ESG targets. It is important to have insight into the ESG risks that he may or may not include in determining the commercial premium. Here too, there is a challenge for the insurer. Extra attention is needed to identify ESG goals that fit in with the insurer's philosophy. What incentives or disincentives does the insurer want to create based on this? And what possible desirable and undesirable consequences does this have for its position in the market and within society?

Example five step approach: transition to an electrified fleet

An example where an insurer can apply the five-step approach is the transition to an electrified fleet based on ESG objectives and legislation and regulations. The electrification of the fleet creates new opportunities for insurers. They can encourage the market to drive in a more environmentally friendly way by setting premiums.

Understanding the dynamics of an electrifying fleet is key to understanding and pricing the associated risks and opportunities. When determining the commercial premium, the insurer faces a challenge. Reducing this premium compared to the technical premium can stimulate electric driving. At the same time, indirect social exclusion exists because the purchase of an electric vehicle can be costly and part of society cannot benefit from this incentive.

To facilitate this discussion, PwC investigated the impact of the electric fleet on the level and frequency of claims. ‘We see, for example, that the frequency of claims for electric cars is comparable to fuel cars and that electric vehicles have a different risk profile. As a result, the claims are on average higher compared to fuel cars, which translates into a rising technical premium. The commercial bonus can be used to stimulate socially desirable behavior in the purchase of electric cars. This research shows that despite data limitations, it is feasible to make data-driven decisions with regard to including ESG components in pricing. Insurers can carry out the same research to gain insight into the ESG effects within the market.’, Janssen concludes.