The actuarial profession needs to pay more attention to social risk, says Chris Sutton
My first exposure to sustainability issues in actuarial practice came in the early 1990s from clients who refused to invest in tobacco products or in companies linked to South Africa. In one way, these were simple exclusion rules, devised before we knew about environmental, social and governance (ESG), factor tilts or risk dashboards. In essence, though, these were asset owners who saw a business model that relied on a harmful addiction, and companies that were content to operate in an apartheid society. Perhaps these clients were onto something; they certainly left an impression on one young actuary.
Social risk is important for actuaries today for two reasons:
- Our ESG approaches are becoming unbalanced. We talk a lot about ‘E’ – especially climate risk and, increasingly, biodiversity – and we have always been involved in ‘G’. However, we need to talk more about ‘S’.
- We prefer it when ESG practice looks outward rather than inward. When we are considering ESG solutions, we tend to look first at third-party assets and their management, rather than at our own working practices.
How can we begin to think about social risks and actuarial practice? First, we need to raise awareness of social risk – and the social section of an established ESG framework can be a helpful place to start. Having just celebrated 20 years since its inception as the FTSE4good index series, the FTSE Russell ESG framework is a good tool: it is thoroughly tested in practice and has evolved over time to meet developments in the sustainability agenda.
The FTSE Russell ESG approach collects data across five different themes under its Social pillar: labour standards, human rights, health and safety, customer responsibility, and supply chain. There are implications for actuarial practice in each of these themes; to highlight the range of issues, let’s focus on human rights.
The foundation for most modern interpretations of human rights is the UN General Assembly’s Universal Declaration of Human Rights, adopted in 1948. Two years later, the European Convention on Human Rights was drafted by the Council of Europe and subsequently ratified by 47 member states, including the establishment of the European Court of Human Rights. Since then, many countries have adopted human rights in their constitutions, into legislation or via supreme court precedent.
ESG investors are most often concerned with human rights in high-impact industries (such as mining operations affecting the rights of indigenous peoples, or textile supply chains and the risk of modern slavery within them), or in countries lacking freedom of association. These are important, but there is also plenty of actuarial work in which human rights should be considered. Let’s look at examples from life, non-life and pensions.
Risk classification in whose interest?
At one level, life insurance underwriting is all about discrimination: which risks to exclude, which premiums to load, to whom cover will be offered, and so on. It is not hard to envisage a conflict between underwriting practice and an individual’s economic, social and healthcare rights.
Risk classification presents perhaps the most pressing human rights consideration for life assurance actuaries, and this subject has been covered in Guy Thomas’s book Loss Coverage: Why insurance works better with some adverse selection. In the book, Thomas argues for a more sophisticated treatment of adverse selection than is traditionally found in actuarial literature and practice. He advocates for more focus on loss coverage, “the expected losses compensated by insurance” and the benefits to society that flow from increasing coverage contrary to typical life assurance underwriting policies. This approach would have implications for what insurers can ask of prospective policyholders and for the use of disability as a risk variable.
Data, data everywhere
Differential pricing in general insurance also raises issues. The EU Non-discrimination regulations’ impact on motor premiums in 2012 was one controversial development in this area. However, with the increasing use of data science and products that co-exist with ongoing data collection from policyholders, the risk of biases (intended or otherwise) in premium calculations is now present across a wide range of products. Great care is needed in both data collection and the construction of algorithms.
The socially acceptable boundaries of innovation are being tested in the field of health insurance, where there are potential conflicts with rights to privacy, healthcare and social protection. As insurers gain the ability to slice claims-related risks more finely, they may introduce large social risks into the business model. This is not a call for Luddism, but a suggestion that human rights should be explicitly considered while technological capability evolves, not afterwards.
The price of complexity
Whether businesses act responsibly in relation to their customers has been the source of several high-profile ESG controversies in recent years, including diesel vehicle emissions data, opioid marketing and the mis-selling of financial services. As well as being unethical, these practices can cut across several human rights.
How to behave responsibly becomes even more important in situations where there is asymmetry of information and expertise. This is often the situation that pensions actuaries find themselves in when they are consulted by clients. Modern pensions and investment systems are complex, which makes actuarial advice valuable but also places social risk with the adviser. The consulting business model sees complexity as its friend: more complex problems can generate more consulting fees. However, with the asymmetry of information, who in the consultant–board–member triumvirate is qualified to adjudicate on how complex a solution is in different parties’ interests?
There are other social risks in the pensions space that actuaries should be aware of, and more questions we could ask ourselves. To what extent should modern labour standards embrace sustainable pension provision for all workers? How do contribution rates into new defined contribution arrangements tally with this under reasonable long-term return assumptions?
ESG risk interactions
The danger of viewing social risks in pre-defined ‘E’, ‘S’ and ‘G’ themes is that we might miss interactions between those themes. For example, climate risks and social risks are becoming increasingly intertwined, with the need for a just transition to net zero having been highlighted by several commentators. Even the examples covered in this article take on new dimensions when we include the climate change factor. ‘Who pays?’ questions illustrate the point:
- As human-induced climate change (mainly caused by industrialised nations) leads to increased mortality rates in parts of the Global South, who should pay for higher life insurance protection premiums?
- If the expectation of future lifetime falls because of climate change, should life assurers be able to profit if they have large pensions annuity businesses that invested in fossil fuel companies?
- Should there be river or sea-level trackers, rainfall gauges and air-quality monitors that transmit data back to property insurers? Should that data also be shared with those who organise relief for those affected by extreme weather events?
- Say an investment consultant charged fees for implementing an investment strategy that included oil and gas investments, and then a change in benchmark index, and then the introduction of a risk dashboard that included climate risk, and then selection of a shareholder engagement service – can they also charge fees for advising on the disinvestment strategy?
Social risk has many and increasing implications for actuarial practice. Yesterday’s high-impact industries for human rights-conscious investors were engaged in extraction and manufacturing. Tomorrow’s might well be in finance and data.
Chris Sutton is senior lecturer in actuarial science at Queen Mary University of London and a member of the FTSE Russell ESG Advisory Committee