Understanding SFDR and IDD

Key Takeaways 

• SFDR (Sustainable Finance Disclosure Regulation) sets consistent ESG disclosure standards for financial market participants and financial products. It includes principal adverse impacts (PAI). 
• The insurance distribution directive (IDD) update requires advisers to capture sustainability preferences and reflect them in each investment decision, especially for insurance based investment products (IBIPs). 
• The EU Taxonomy makes sustainability claims easier to compare by separating Taxonomy Eligible from Taxonomy Aligned. 
• Compliance is practical: align factfinding, suitability wording, and website/Terms of Business disclosures with finance disclosure regulation SFDR Level 2 requirements. 
• This article endeavours to explain the regulations and what advisers must do to meet the regulations. 

What are the ESG Regulations?  

ESG – Environmental, Social and Governance – helping improve ethical behaviour in how companies operate, and working towards improving climate change. The European Commission’s Action Plan on Sustainable Finance is aimed at putting financial pressure on companies throughout the world to improve conditions for workers and to reduce their carbon emissions. In practice, these rules also help create a level playing field for financial market participants, including asset managers, by setting clearer expectations on sustainability disclosures. They are closely linked to the Sustainable Finance Disclosure Regulation (SFDR) and the Insurance Distribution Directive (IDD), which influence how financial products, including insurance based investment products (IBIPs), are discussed and recommended. 

How does ESG connect to SFDR? 

ESG is the broader framework for assessing how sustainable and responsible a company or investment is, while the Sustainable Finance Disclosure Regulation (SFDR) sets out how financial market participants (including asset managers) must disclose ESG-related information for their financial products. In other words, ESG is the “what” (the factors being assessed), and SFDR is the “how” (the disclosure rules that explain how those factors are considered in an investment decision). This helps create a level playing field by making sustainability claims more comparable and transparent across the market. 

SFDR Regulations: Effective from 10 March 2021 

SFDR is mainly aimed at providers to supply sufficient information on their funds so that they can be classified under Article 6, 8 or 9 (See Table 1 Definitions on page 4). It requires asset managers to provide standardised disclosure on how ESG factors are integrated into their funds and products. Further legislation – SFDR Level 2 RTS – will take effect from 1st January 2023 and will introduce more detailed requirements relating to disclosures in the periodic reports of ESG-focused products. 

What is the Insurance Distribution Directive (IDD) update from 02.08.22?  

The IDD update is designed to help retail investors make more sustainable choices and support the shift to a low‑carbon, more sustainable, resource‑efficient and circular economy, in line with the Sustainable Development Goals. If a customer has sustainability preferences, advisers need to recommend Insurance‑Based Investment Products (IBIPs) that match those preferences. This means advisers must update their advice process to reflect a customer’s sustainability preferences for both new business and for reviews where clients already have money invested in funds. 

What is the EU Taxonomy and why does it matter? 

This is a classification system for business activities assessed under six environmental objectives – companies can be Taxonomy Non-Eligible / Taxonomy Eligible and/or Taxonomy Aligned or a combination. In simple terms, it provides a shared EU “rulebook” for describing which activities can be considered environmentally sustainable.  

It helps bring more consistency to sustainability claims and

makes it easier to compare disclosures across different companies and sectors. Taxonomy Eligible does not automatically mean an activity is Taxonomy Aligned - alignment is a higher bar and relates to meeting the detailed criteria set out under the framework. 

Understanding 

The key terms in the legislation need to be understood by advisers so that they can clearly explain to clients why certain funds are recommended and others aren’t. Once a client declares a preference for ESG funds, learn what level of sustainability preference the client has and then make appropriate recommendations. This approach supports the Sustainable Finance Disclosure Regulation (SFDR) and the Insurance Distribution Directive (IDD) in practice, and helps avoid greenwashing, where some financial market participants present financial products as sustainable when they are not to determine clients’ preferences, the adviser needs to have a clear understanding of the three different sustainability preference categories outlined in the IDD section of the table below. 

Under the IDD update that came into effect from 2nd August 2022, advisers have to gather the customer sustainability preferences when advising on insurance-based investments – There is no Opt-Out to this requirement. 

What should you disclose in your Terms of Business and on your website? 

These should clearly disclose whether the firm considers or does not consider the adverse impact of investment decision  on sustainability, including any principal adverse impacts (PAI). Under the Sustainable Finance Disclosure Regulation (SFDR) (often referred to as the finance disclosure regulation SFDR), further Level 2 requirements came into force from January 2023, adding more detailed disclosure expectations for financial market participants and advisers. The recently published Brokers Ireland Climate Guide has a good example of the wording required. 

Practical Application for Advisers 

The European Insurance and Occupational Pensions Authority (EIOPA) has published guidance to help intermediaries to integrate the new requirements on customers’ sustainability preferences in the suitability test required under IDD.  

The guidance provides a roadmap for firms, including 6 key actions to ensure that their operational framework and due diligence process, and more specifically the so-called ‘suitability test’, are in line with the regulatory requirements for sustainability preferences. 

Include an explanation of ‘sustainability preferences’ in the interview with the customer – The adviser should be able to explain the three sustainability preference choices. 

Redesign your suitability test – The customer’s sustainability preferences must be recorded by the adviser. The only exception to this principle is when the client clearly states their preferences at the beginning of the meeting. 

1. Include questions on sustainability preferences in your suitability test – Assess the client’s interest in sustainability and whether these should be considered in selecting suitable products/funds. If the client has no interest, then they are classed as ‘sustainability neutral’ and this should be recorded on the Factfind/ Questionnaire and in the Suitability Letter. If the customer is interested in making a sustainability preference choice, the adviser will have to gather further information, based on the three sustainability aspects that an IBIP can have, broadly – (1) Taxonomy Aligned? (2) Sustainable Investment as per SFDR? Or (3) Consider PAIs? The client may choose one of these or a combination of two or all three and needs to decide minimum percentages or specific PAIs. 2.

2. Detail the client’s sustainability preferences in the suitability statement – Based on the client’s sustainability preferences, the adviser may be able to select a suitable product or funds that match these. However, in some cases (e.g. where a client wants 100% Taxonomy-Aligned funds and none are available) this may not be possible and you have to ask the client if they want to adjust their preferences to widen the scope of available funds. This may mean revisiting the Sustainability Questions and discussing alternative responses which increase investment choices. 

As of 1st January 2023, when the Commission Delegated Regulation (EU) 2022/1288 (8) will come into force, the adviser will have to ensure that the customer’s sustainability preferences correspond to the precontractual information provided to them through the ESG standardised information document and the specific product information on the distributor’s website. In this respect, particular attention should be paid to the possible choice of minimum proportions of each category provided by the client. Ideally, the adviser should have a matrix to classify all the products it distributes according to the various sustainability aspects included in its suitability assessment questionnaire. 

Adapted Due Diligence Process 

1. Include questions on sustainability preferences in the Annual Review – Annual reviews have to take account of a client’s sustainability preferences and any changes need to be recorded and, if necessary, the fund selection process should be reviewed to ensure that the client’s investments are in accordance with their updated preference and recorded in a suitability statement.  

2. Train your Staff – ensure the relevant employees (i.e. including persons in contact with the public and persons responsible for distribution) of intermediary distributing IBIPs (whether or not they are of a sustainable nature) are provided with basic knowledge and skills about sustainability preferences in their ongoing training. 

Sustainability Preferences – Questionnaire 

This set of questions can be integrated into your Risk Questionnaire, Factfind or as a separate ESG Questionnaire.  

You need to ask: 

1. if the client is interested in ESG investing (if not, this still needs to be recorded!)  

2. if so, then which of the three categories or a combination of the three does the client prefer and  

3. what minimum percentage is required/specific PAIs. 

Suitability Statement 

Depending on the client’s responses, you will need to add wording to the Suitability Statement to cover the client’s sustainability preferences. 

Conclusion: 

SFDR and the insurance distribution directive (IDD) update are designed to make sustainable finance more consistent and transparent - so clients can understand how ESG factors, the EU Taxonomy, and principal adverse impacts (PAI) are reflected in financial products. For advisers, the priority is practical: gather and document sustainability preferences, match them to suitable funds and insurance based investment products (IBIPs), and ensure disclosures (including Terms of Business and website statements) align with finance disclosure regulation SFDR requirements. Ultimately, this supports clearer client conversations, more robust suitability evidence, and helps reduce greenwashing while supporting sustainable investments.

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