ESG considerations for with-profits funds

ESG is a growing focus for the life insurance industry. While the direct impact on with-profits funds has typically been relatively small, the relative discretion over with-profits investment strategy and continued focus on ensuring good outcomes for customers mean there are a number of key ESG considerations for with-profits funds.

Investment strategy

Climate risk remains an emerging risk, with rapidly evolving scientific research and data, leading to uncertainty over the size and timing of potential market impacts. The speed of transition to net zero and the impact on investment markets globally will be heavily influenced by government policy and actions of regulatory bodies, which may be subject to sudden change, recently illustrated by the UK government's changing stance on phasing out petrol cars and old boilers. This inherent uncertainty creates a huge challenge for firms in understanding possible impacts on their investment strategy. At a company level, many firms are assessing their exposure by sector to ensure that as different sectors of the economy transition at different speeds they are not left with stranded assets, for example, as a result of changes in government policy. For many insurers, the with-profits fund may not be sufficiently material to feature specifically in firmwide analysis, so understanding the transition risk to policyholders and the estate may need to be considered separately. While the considerations will differ depending on the fund’s run-off plan and the remaining duration of the book, understanding the exposure of the fund’s assets to transition risk will be key to ensuring the risk is sufficiently understood to ensure it can be managed in line with the fund’s objectives and risk appetite.

One of the key challenges to introducing an ESG-focused investment strategy is whether that is consistent with optimising investment returns. Traditionally optimising returns has often been focused on maximising them, as the return achieved will ultimately determine customer payouts. Typically, ESG-aligned investment funds (including unit-linked funds) demonstrated higher returns during the COVID-19 pandemic. Still, conversely, the energy crisis resulting from the Russia-Ukraine war led to missed returns from non-renewable energy during 2022. This volatility, combined with balancing the needs of different cohorts of policyholders with differing investment time horizons, means that many funds have made limited adjustments for climate risk and ESG considerations to date. However, over the long term, we might expect ESG-focused funds to be more protected from the impacts of climate change, in which case adopting an ESG-focused investment strategy could lead to lower volatility.

The recent launch of the Transition Plan Taskforce’s disclosure framework has brought transition planning to the fore for insurers. Input from with-profits management teams will be important to balance both ambitions around portfolio decarbonisation and responding to climate risks, with the needs of with-profits customers, to ensure that any impact on the with-profits fund is timed and implemented in a way that minimises downside risk to the fund.

Wider risk exposure

It is not only transition risk that firms need to consider. The majority of with-profits funds have an allocation to physical assets, including property, which are also exposed to the physical impacts of climate change, such as increased flooding or windstorms. In combination, the physical and transition impacts of climate change could lead to previously highly liquid assets becoming suddenly illiquid, e.g. new research or reputational damage driving down a share price or a natural catastrophe destroying a physical asset. This might be of particular concern to funds in run-off, where liquidity management is a high priority.

Litigation risk should also be assessed by with-profits funds, given the insurer retains responsibility for the investment choices of the fund. In the case of with-profit funds, litigation risk would likely refer to the risk of a claim being brought against an insurer due to the mismanagement of climate risk, breach of fiduciary duties or misrepresenting their current or future exposures to climate risk. While physical and transition risks are likely to reduce with action, this is not necessarily the case for litigation risk. There is a risk that funds transition their portfolios ahead of the market and this results in poorer returns, leading to lower bonuses and ultimately a worse outcome for the policyholder. Conversely, funds are at risk of not doing enough which could lead to missed returns, stranded assets, reputational damage or possibly hindering their chances of meeting portfolio decarbonisation commitments. In both cases, it is important for firms to be able to communicate and justify their decisions to policyholders, in a way that is fair, clear and not misleading. While litigation risk applies to all types of investment business, it is particularly important for with-profits funds given the insurer retains responsibility for investment choices.

Customer engagement

We commissioned a survey of 1,500 consumers earlier this year, which found that 93% of participants considered climate change to be an important issue for savers in the UK, with the majority expecting that the responsibility of ensuring investments are climate-friendly should lie with either government or the broader financial services industry. Many with-profits funds have begun to educate their customers by making explicit references to ESG in their PPFM, but this is an area where there is more to do, both in terms of sharing information with customers and in understanding their preferences for sustainable investment.

Our survey found that more than 60% of participants would move to a new climate friendly investment that had clear long-term benefits for the climate, but also a lower return than current investments. However, attitudes vary between cohorts, with older participants more likely to disagree with these statements, which may prove to be a barrier to explicitly green investment strategies for funds in run-off. For open funds, there is potentially an opportunity to engage with new customers by offering a climate friendly investment option, as well as contributing to a wider societal purpose in supporting the overall transition to net zero of the UK economy.

How Hymans Robertson can support you?

If you are interested in a conversation on ESG considerations for your with-profits fund, please get in touch.

This blog is based upon our understanding of events as at 13 October 2023. It is a general summary of topical matters and should not be regarded as financial advice. It should not be considered a substitute for professional advice on specific circumstances and objectives. Where this blog refers to legal matters please note that Hymans Robertson LLP is not qualified to provide legal opinion and therefore you may wish to obtain independent legal advice to consider any relevant law and/or regulation. Please read our Terms of Use.