The recent Sustainable Finance Disclosure Regulation (SFDR) introduced by the EU presents ILS fund managers looking to build a green reputation with “significant challenges” and tough questions, notes Joel Smith, Associate Partner at Synpulse Management Consulting.
But for those who do this effectively, they also provide an opportunity to “be a first mover and market maker for shaping norms and standards for how the SFDR applies to ILS,” he added.
The SFDR came into effect on March 10, 2021 with the aim of promoting transparency in the fast-growing area of environmental, social and governance (ESG) financial products.
The idea is that financial product providers can clearly indicate to investors which of their products promote sustainable investment, and at least three ILS fund managers have already stated that funds fall within the greenest classifications of these standards.
However, Smith notes that the SFDR was not specifically written with ILS in mind and therefore requires interpretation and also flexibility to accommodate future regulatory changes.
For example, a common theme behind the most sustainable classifications (Articles 8 or 9) revolves around how insurance creates social value. But while insurance policies may have inherent ESG properties, this alone is not a sufficient condition to comply with the guidelines.
As part of the classification, ILS fund managers must also define and disclose the fund’s sustainable objective, sustainability indicators, binding selection criteria and other components, depending on the circumstances.
“While these public disclosures for the Articles 8 and 9 classifications provide an opportunity to attract ESG-focused investments, they raise important questions under the hood,” Smith noted.
“They require ILS fund managers to reassess key aspects of their business model to answer new questions such as, ‘What additional data do I need to assess the ESG nature of an incoming transaction? What ESG impact will the incoming transaction have on my overall fund or portfolio? And how does my SFDR rating change my process for reviewing that transaction?’”
In addition, the loose fit of regulation on ILS transactions poses problems when it comes to features such as “see-through requirements,” Smith added, including assessing the ESG qualities of not only the sponsor, but also the underlying policies.
This raises further questions about data availability, and fund managers’ answers will depend not only on their interpretation of the SFDR, but also on their ESG philosophy and even the feasibility of the requirements.
“Whether an ILS fund manager wants to be a market maker, a box ticker, acting on the most immediate expectations of stakeholders, or a barrel scraper, doing only what the law requires them to do, there has to be a solid business mode. ‘ said Smith. “Such a business model should be able to support the promises made to investors, regulators and other stakeholders.”