As regulators introduce more robust environmental, social and governance (ESG) frameworks for the fund management sector, Executive Director, Sherman Taylor explains how ILS managers active in Europe will need to be conscious of their dealings with service providers and take steps to show their ESG processes at work. *
The European Supervisory Authority (ESA) developed the EU's Sustainable Finance Disclosure Regulations (SFDR) which became effective on 10 March, 2021, imposing requirements on European fund managers, financial advisors and certain other EU firms to disclose information to potential investors related to their environmental, social and governance (ESG) frameworks.
Geared towards promoting sustainable investing practices and combatting "greenwashing" by introducing transparency obligations, it is still uncertain what the full impact of the SFDR will be on the insurance-linked securities (ILS) market. The immediate impact will largely depend on the extent to which new ILS capital is sourced from the EU, with EU-based ILS funds likely to have to incorporate ESG processes within their investment activities. ILS fund managers from outside the EU who market their funds to investors within the EU will also need to be mindful of the SFDR's disclosure requirements.
SFDR is the first significant attempt by a regulator to codify ESG disclosure requirements and it's reasonable to assume that regulators in other regions will follow suit using ESA's framework. Responsible investing considerations already form a significant part of the decision-making process within global capital markets, and ILS funds will need to align their activities accordingly.
The ILS sector is well placed to accommodate this shift. It has long recognised the necessity of incorporating ESG into its activities in order to continue to access fresh capital. Other sectors have not been as proactive, and we have already seen the capital markets divest from companies that fail to meet investors' ESG standards. This presents an opportunity for the ILS sector, as capital divested from companies with poor ESG frameworks can be redeployed into ILS funds exhibiting positive ESG ratings.
However, the ILS sector brings together the insurance and capital markets and creates a complex securitised product. There are numerous variables and service providers involved across the value chain of ILS funds - a typical ILS deal can involve as many as 25 different service providers each with their own ESG framework - which means it's difficult to ensure uniform ESG standards are being met. A cautionary note is that companies in other sectors have suffered ESG rating downgrades not because of their own direct action, but because of the actions of their outsourced service providers. The lesson that Ocorian, as a provider of administrative and fiduciary services to the ILS sector, can postulate is that in this new investment era, ILS funds must consider their ESG frameworks to be equally weighted with their balance sheet performance.
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