Embracing ESG Initiatives to Become a More Attractive D&O Insurance Risk

Failing to develop strong ESG initiatives may result in limited access to capital and lost business opportunities.

In recent years, corporations have started investing more heavily in environmental, social, and corporate governance (ESG) initiatives and have become increasingly focused on employing ESG standards in their operations.

ESG efforts align with the modern trend of corporate boards adopting a philosophy of “corporate responsibility,” in which they consider the long-term impact of their operations and strive to advance the interests of a wider variety of stakeholders. Though often associated with preventing climate change and reducing carbon emissions, corporate ESG concerns actually are broader in scope and include focus on sustainability, diversity, equality, employee welfare, and cybersecurity protocol.

Companies are investing in ESG initiatives not only to strengthen their public image and respond to stakeholder priorities, but also because a demonstrated commitment to ESG initiatives is becoming a critical element of doing business in the modern age. For example, many lending firms and institutional investors are shifting their investments toward companies that meet their ESG standards, and financiers may even withhold financing for certain projects that fail to meet those standards. As a result, failing to develop strong ESG initiatives may result in limited access to capital and lost business opportunities.

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Given the competitive advantages available to companies that take ESG issues seriously, some companies have resorted to exaggeration or making representations about their ESG efforts to investors and potential business partners that have no credible basis or cannot be supported by concrete evidence. This phenomenon has been coined “greenwashing,” and it is starting to attract the attention of government regulators and the plaintiffs’ bar.

As a result of the above dynamics, ESG has taken a prominent role in the directors and officers (D&O) insurance underwriting process. Insurers are carefully scrutinizing companies that do not have concrete and well-defined ESG initiatives. Likewise, insurance underwriters are taking second and third looks at companies that appear to be “overselling” themselves on ESG-related issues. The risk profile associated with regulatory action and large-scale litigation is growing. Companies must be well-prepared and responsive to insurer inquiries on this topic so that they can be perceived as an attractive risk that is worthy of competitive premium pricing and manageable self-insured retentions.

The Regulatory Landscape

In recent years, regulators—and, most prominently, the U.S. Securities and Exchange Commission (SEC)—have expressed an interest in identifying companies that  fail to meaningfully identify material issues related to ESG, in an effort to make ESG issues a corporate priority. Regulators are also starting to vet the challenges posed by corporate greenwashing and are therefore seeking to control what types of ESG information are considered material and must be disclosed to the public.

For example, the SEC recently proposed a rule that would require companies to disclose specific climate-related information in their financial filings. The proposed rule would require the company to discuss any climate-related commitments it has made, as well as its plan for satisfying those commitments. The company would also need to determine and disclose the amount of greenhouse gas emissions involved in its operations, which include not only emissions from its own activities, but also the emissions produced by other entities in its supply chain. This proposed regulation could mark a trend in which other regulators try to enact similar regulations governing ESG efforts, which would likely expand to consider factors other than climate change.

ESG Efforts Bring New Risks

Increased regulatory scrutiny of companies’ ESG efforts, as well as shareholder concerns over these efforts, pose various risks to companies. New regulations may present significant compliance challenges, and shareholders and regulators may be poised to bring actions based on novel theories of liability.

For one, the ESG issues and metrics utilized in new regulations may be different from the ESG factors and metrics companies have implemented to measure and report their ESG efforts on their own good-faith initiatives. Moreover, attempting to calculate information such as the carbon emissions of other entities involved in a company’s supply chain may prove extremely difficult, considering companies may not have complete and reliable access to that information.

In addition, developing and implementing strategies to collect and report the information that regulators require will take time to perfect. All of these obstacles could lead to inaccurate or inconsistent ESG-related disclosures, despite a company’s good faith efforts to comply. These inaccurate or inconsistent disclosures will surely attract the attention of regulators, who may feel pressured to bring actions related to alleged ESG failures to demonstrate their commitment to these laws.

Companies may also face the risk of shareholder litigation alleging ESG failures. In recent years, securities lawsuits have expanded from traditional, accounting-based theories of liability to include more event-driven theories of liability. Shareholders may allege, for example, that a company failed to properly handle or prevent some adverse event like a cyber breach or failed to implement policies to prevent widespread discrimination, and then failed to disclose the material risks of those adverse events occurring to the company’s shareholders.

In sum, there appear to be a variety of ways in which regulators and shareholders can seek to hold corporate boards responsible for alleged ESG-related failures, especially now that regulatory agencies are beginning to formally recognize the inherent materiality of certain ESG risks. These actions, regardless of whether they will ultimately prove successful on the merits, are very expensive to defend against and pose a threat even to companies making strong ESG efforts.

One way to protect against these risks is to secure strong management liability insurance, which should provide coverage for these types of risks.

ESG and Insurance

Insurers are seriously considering companies’ ESG efforts when evaluating new business opportunities and renewals for existing management liability insurance programs. Insurers are seeking to align their businesses with companies that have implemented ESG standards into their operations, as they likely view these companies as good risks that will be able to avoid many types of liabilities in the long run.

Insurers also have become more selective when selling management liability insurance, in light of the increasing number of ways in which company boards may face liability associated with alleged ESG failures. Therefore, companies can expect a more intensive D&O/management liability underwriting process during which insurers will ask pointed questions about the company’s strategies for managing ESG risks and specific plans for complying with any new regulations requiring ESG-related disclosures. Insurers may also ask companies to provide information that supports the ESG-related representations they make in SEC filings and investor communications, as unfounded representations could lead to allegations of greenwashing and even securities fraud.

Insurers may also try to combat losses from ESG-based claims by issuing policies with higher premiums and retentions, and by modifying policy language to limit coverage for certain claims that a policyholder company might typically expect to be covered under a comprehensive management liability policy. Insurers could even try to deny coverage for ESG-based claims by arguing that the policyholder company made material misrepresentations about its ESG initiatives during the underwriting process because it either knew them to be false or failed to engage in appropriate diligence before making the representations.

Best Practices for Policyholders

Obtaining strong management liability coverage is critical to reducing the risks associated with ESG-based regulatory actions and lawsuits. Companies should consider the following when preparing to enter an increasingly competitive market for D&O/management liability insurance:

1. As a preliminary matter, even before entering the insurance market, companies should be transparent and realistic when publicly discussing their ESG initiatives, including their long-term goals and progress in achieving them. This approach will help to avoid unfounded allegations of greenwashing and fraud, and will mitigate litigation risks associated with those representations. Insurers, like companies in other industries, will demand information about a company’s ESG efforts and will expect to see well-documented and measurable initiatives that support public statements about ESG commitments.

2. When engaging insurers, companies should be prepared for what is sure to be a challenging underwriting process. Companies should familiarize themselves with their current management liability policies and know the limits and exclusions, and how terms may apply to limit coverage. Companies should also identify their most likely exposures to regulatory actions and litigation based on their unique ESG risk factors so that they can focus on securing favorable coverage terms to protect against those risks.

3. During the underwriting call, not only should the company be prepared to explain its ESG strategies and back up its ESG-related representations with concrete evidence, but the company’s executive team should lead the conversation, making it clear immediately that the company takes ESG issues seriously and plans to devote substantial resources to addressing those issues in the long run.

4. Companies should also try to differentiate themselves from industry competitors when presenting their ESG efforts to insurers. For example, certain insurance brokers have devoted time, effort, and resources to develop tools that enable their clients to submit to an independent examination of ESG efforts and then receive an individualized “risk rating” based on various ESG metrics and benchmarks. Companies can utilize tools like this to help “back check” their ESG efforts and demonstrate that they are a strong risk in their industry class.

5. Finally, companies should not overlook the obvious when it comes to interacting with D&O underwriters. The composition of the board itself can reveal a lot about whether the company is truly committed to its ESG initiatives. The board should embody diversity in every way—gender, race, ethnicity, industry experience, and corporate discipline.

As ESG initiatives continue to gain traction and notoriety, companies face more exposure than ever to make sure they follow through on those commitments. Companies will be well-advised to embrace ESG efforts so that they can access strong insurance coverage to minimize risks and take advantage of the competitive advantages that are likely to become available as a result of being a good corporate citizen.

Lynda Bennett is the chair of the insurance recovery group at Lowenstein Sandler. She also counsels clients with respect to contractual insurance requirements, new insurance products (such as cyber insurance), innovative risk management tools, and insurance program assessment. 

Michael Scales is an associate in the group. His practice focuses on representing policyholders in disputes against insurance companies in matters involving D&O liability, professional liability, employment practices liability, and commercial liability.

From: Corporate Counsel

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