Analysis of Securities Class Actions by ESG Risks

Over the past decade, Directors and Officers (D&O) underwriters have observed the evolution of loss causes leading to securities class actions (SCA). While in early 2010 almost all SCA settlements were caused by activities related to core corporate governance, recent SCA settlements are indicative of a variety of loss causes with a significant presence of environmental, social, and governance (ESG) risks as underlying factors. Our review of the SCA settlements recorded between 2020 and 2022 suggests that 64% of settlements correspond to environmental and social risks, while the remaining 36% are related
to governance risks.

ESG-related regulatory requirements are on the rise in the U.S. and globally. The United States Securities and Exchange Commission (SEC) has proposed rules to enhance and standardize climate-related disclosures for investors requiring all public companies to disclose any potential climate-related risks and their greenhouse gas emissions.² It is anticipated that SEC rules will go into effect in 2024. Globally, the European Union has been leading efforts in more stringent regulatory requirements to mitigate ESG
risks. The new German Supply Chain Due Diligence Act,³ which went into effect on January 1st, 2023, requires that any German-based company with over 3000 employees report any Human-rights and Environmental related risks in their supply chains.

With the increasing importance of ESG risks, underwriters are facing three key challenges managing the impact of such risks on their book of business:

1. Scalability: The process of extracting relevant ESG signals from the large body of reports and articles, also referred to as unstructured data sources, is costly and labor-intensive.
2. Repeatability: With the continuous evolution of ESG risks and the corresponding
   regulatory requirements, underwriters need access to a repeatable insight extraction
   process that can be updated according to the latest definitions and regulatory
   requirements.
3. Reliability: ESG insights have not been integrated into predictive analytics used by
   underwriters due to the above two limitations as well as the need to adequately
   calibrate such analytics and demonstrate that the changes are transparent, explainable, and consistent across policies and portfolios.

Consequently, in conversations with underwriters during recent Professional Liability Underwriting Society (PLUS)⁴ conferences, we see that underwriters generally investigate and analyze ESG risks on a case-by-case basis.⁵

In this article, we explain an analysis that offers practical ways to resolve the above pain points enabling underwriters to consistently extract verifiable and scalable business values from relevant ESG insights and in line with their long-term business growth strategy.

Scalability
Our analysis of ESG risks for publicly traded companies suggests that commercially available ESG scores often lack conformity and transparency.⁶ In further looking into this issue, we believe that reliable ESG insights primarily reside in reports, news articles, and credible research studies, collectively referred to as unstructured data sources, which are often not fully integrated into ESG scores. Processing unstructured data sources manually is time-consuming and expensive. With recent advancements in Artificial Intelligence (AI) capabilities in Natural Language Processing (NLP), unstructured data sources
can quickly be processed and relevant ESG insights extracted at scale and low cost. The key to extracting high-quality ESG insights is to:

A. Ingest a diverse set of unstructured data sources.
B. Combine general and financial domain-centric Large Language Models (LLM).
C. Develop comprehensive taxonomies.
D. Extensively calibrate the NLP capability.

Repeatability
The Underwriting community has highlighted the need for more concise definitions of ESG risks. The definition of these risks has been evolving over the past few years and we anticipate further updates and refinements in the coming years. Consequently, underwriters need a solution that can be updated in line with changes in the scope of ESG risks. In our analysis we adopted the following definition for ESG risks: Specific actions taken by a company that can clearly lead to a reduction or increase of these risks.
We used a company’s balance sheet to define specificity and clarity in our definition. The table below shows a few examples of how our analysis considers different sentences extracted from our unstructured database for the companies we analyzed.

The solution architecture is designed in a way that the model can be updated without the need to update the code and the outputs can be regenerated based on the updates made to the definition and taxonomy.

 

Table. Examples of Sub-Text identified by the model as relevant to ESG Risks as well as model forecast in terms of contribution to ESG Risks (Positive, Negative, Neutral)

Identified sub-text	Model Output
The clinical trial of a cancer drug rejected by the Food and Drug Administration last week was marked by thousands of violations of study rules, damning investigator misconduct, and worrying signs of toxicity the company did not publicly disclose.	Relevant, Negative
A Potentially Responsible Party (PRP) has joint and several liabilities under existing U.S. environmental laws. Where we have been designated a PRP by the Environmental Protection Agency or a state environmental agency, we are potentially liable to the government or third parties for the full cost of remediating contamination at our facilities or former facilities or at third party sites.	Relevant, Neutral
We have evaluated the benefits of relying on other exemptions and reduced reporting requirements under the JOBS Act.	Relevant, Positive
Our sales to the U.S. government are subject to extensive procurement regulations, and changes to those regulations could increase our costs. New procurement regulations, or changes to existing requirements, could increase our compliance costs or otherwise have a material impact on the operating margins	Relevant, Negative
We have faced and will continue to face claims relating to content that is published or made available through our products and services or third-party products or services. [From a social media company]	Relevant, Negative

Source:  Capgemini Analysis

Reliability
In a recent article published on dandodiray.com entitled Analyzing Securities Class Actions by Size⁷, the author shows that the probability of a public company experiencing a SCA is correlated with its industry sector and market cap. Using publicly available SCA court filings from 2011 through 2020, the authors statistical analysis suggests that the size of a company is positively correlated with the probability of experiencing SCA. In other words, the larger a company is, the more likely they are to be named in a
class action lawsuit. Further, the author shows that in addition to the statistically significant trend for size, the same probability is also positively correlated company’s industry sector. For example, given a similar market cap, it is more likely that a company in pharmaceutical industry experiences SCA than a manufacturing company.

This analysis validates current industry best practices in which D&O pricing models rely on market capitalization and industry sector, among other variables, to price D&O policies. In other words, these variables are deemed reliable to be used at scale for pricing purposes.

It is desirable for underwriters to access reliable analytics related to ESG given its increasing impact on D&O losses. With existing ESG scores not generated based on a commonly accepted methodology, in our analysis we developed and trained a predictive model that relies on the output of the NLP capability presented earlier. In the next section we present the details of our analysis as well as its results validating that the model can help underwriters increase their pricing and risk selection. Further, we show that the generated segmentation is in addition to what underwriters currently use in their processes, e.g., size and industry sector.

Approach
For a combination of public companies with and without SCA settlement losses, we analyzed a range of publicly available documents using our NLP model. The purpose of the analysis was to (a) assess if text extractions deemed as relevant to ESG risks are predictive, and (b) whether the predictive power of ESG is above and beyond segmentation power underwriters get from variables such as company size and industry sector.

To evaluate the predictive power of ESG insights, for companies with SCA settlement losses, we analyzed unstructured data from those companies published prior to the plaintiffs filing an SCA. We opted to perform our analysis on SCA settlements as the most relevant source of underwriting losses for D&O policies. To compare the results of our analysis to those presented in the article entitled Analyzing Securities Class Actions by Size we converted the results of that analysis, which was based on the probability of an SCA, to the probability of an SCA settlement using the below equation:

P(SCAS) = P(SCA) x P(SCAS|SCA)

Where P(SCA) is the probability of experiencing securities class action (SCA) and P(SCAS|SCA) is the probability of experiencing SCAS conditioned on a company being subjected to SCA. The graph below shows the variations of probability for a SCAS by company market capitalization followed by the table listing P(SCAS) by industry and market cap.

 

 

Table. Probability of a SCAS by size and industry, 2015-2019

industry	Small Cap	Mid Cap	Large Cap
Manufacturing	0.95%	1.63%	2.36%
Retail	1.09%	1.85%	2.64%
Information	1.17%	1.96%	2.79%
Finance and Insurance	1.19%	2.00%	2.83%
Professional, Scientific and Technical Services	1.22%	2.04%	2.89%
Education and Healthcare	1.68%	2.70%	3.72%
Pharmaceutical	1.68%	2.70%	3.73%
All other industries	0.84%	1.45%	2.13%

Source:  Capgemini Analysis

 

As part of our analysis, we generate an index called, _ESG, which is weighted and aggregated based on the ESG insights extracted by our NLP engine. The _ESG index segments our sample to companies with high ESG risks and low ESG risks. Our analysis shows that _ESG is highly predictive and can predict companies with more likelihood of experiencing a SCAS as well as those that are less likely irrespective of their market capitalization. As shown on each graph, companies identified as High ESG Risk are significantly more likely to experience a SCAS when compared to the case where ESG Risk is unknown,
the solid lines vs. the dashed line. Similarly, companies identified as Low ESG Risk are significantly less likely to experience a SCAS when compared to an unknown case.

With respect to forecasting P(SCAS) by industry sector, we see that our ESG indicator can forecast companies with a high and low likelihood of SCAS as shown in the table below.

To assess if the ESG predictive power of our index is in addition to the predictive power from company market cap and industry sector, we conducted two correlation analyses. The first correlation analysis was between our ESG index, _ESG, and market cap of the companies considered. As shown in the below graph by R2 metric, there is no correlation between _ESG and market capitalization.

 

In the second correlation analysis, we looked at the correlation between _ESG and industry sector for small, medium, and large market caps. As shown in the graphs below, the R2 metric is low, indicating there is no correlation between our ESG index and industry sector.

 

Conclusions
With ongoing discussions around ESG risks and their impact on D&O underwriting, we believe transparent analytical capabilities can help underwriters and insurance companies to incorporate ESG insights in their decision-making process in line with their long-term business strategies. Our analysis suggests that investing in extracting verifiable ESG insights at scale is valuable.

The suggested analysis is also repeatable at low cost by design positioning the underwriting community to rely on it as a powerful tool aligned with evolving definitions of ESG Risks.

 

References

1 Corresponding author: hesaam.aslani@capgemini.com

2 https://www.sec.gov/news/press-release/2022-46

3 https://www.loc.gov/item/global-legal-monitor/2021-08-17/germany-new-law-obligates-companies-to-establishdue-diligence-procedures-in-global-supply-chains-to-safeguard-human-rights-and-the-environment

4 https://plusweb.org/

5 https://www.businessinsurance.com/article/00010101/NEWS06/912347452/ESG-considerations-increasinglyfactor-into-D&O-underwriting

6 Aggregate Confusion: The Divergence of ESG Ratings, Review of Finance, Volume 26, Issue 6, November 2022, Pages 13151344, https://doi.org/10.1093/rof/rfac033

7 Analyzing class actions by size and industry sector https://www.dandodiary.com/2021/06/articles/securities-litigation/guest-post-analyzing-securities-class-actions-by-size/

 

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