ESG in Insurance Portfolios: Less Talk, More Action

The global insurance industry appears to have reached an inflection point on the topic of ESG. In years past, insurance companies had difficulty measuring the ESG exposure in their portfolios. As the tools and data improve, however, and as insurance companies incorporate ESG into their investment decisions, the challenges have moved from measuring ESG to implementing ESG. European insurers are generally ahead of American insurers, but some companies are further along than others in every region. What further challenges lay head for companies who have started to implement ESG? What can insurers early in the process learn from the pioneers? S&P Global Market Intelligence hosted a webinar on March 31, 2022 with industry practitioners to discuss these issues. This article summarizes some of the highlights of the session.

The Market Landscape

• New regulations and reporting standards will continue to demand more credible corporate disclosures. Regulators are exercising greater scrutiny, calling out what they perceive as greenwashing with companies using disclosures and sustainability-related labels as a marketing tool to appear to be proactive on these issues. Recent proposed regulations by the U.S. SEC for more disclosure by publicly traded domestic firms will drive further transparency on climate risk, with companies needing to report greenhouse gas emissions for Scope 1 and Scope 2.
• The sustainable debt market reached a record high in 2021. The year saw total sustainable debt issuance (including green, social and sustainability-linked bonds) increase by more than 50% to approximately USD1tr. As this growth continues, a key challenge will be to manage it in a way that preserves the legitimacy of these financing instruments.
• There is growing recognition that ESG climate risks are financial risks. Exposure to climate-related physical risks is a concern as the severity and frequency of weather-related events increases. Transition risks are a growing concern, as well, in particular with the likely rise in carbon prices, which S&P Global Sustainable1 says could increase by more than seven-fold by 2030 to achieve the goals of Paris Agreement.
• Three ESG topics are likely drive the conversation in 2022. This includes assessing natural capital biodiversity risk, enhancing the ESG skills of corporate boards and government leaders and turning net zero into action. There is also a clear trend to measure the financial impact of physical climate risks. This will combine climate models that look at flooding, heat waves, wildfires and more and their impact on vulnerable assets to put a dollar value on climate-related risks.

Applying Sustainability Insights to the Investment Process

• Sustainability issues are new for insurance companies. These factors have always been considered on the liability side, but are also increasingly important for investments. This can be particularly true for longer-term investment strategies with lower turnover, like book-yield oriented strategies or buy-and-hold strategies, which insurance companies often apply.
• Climate-related insights can help with risk mitigation. The majority of insurance companies' investments are in fixed income and credit or credit-like instruments, where the emphasis is on downside risk considerations given the asymmetric payoff profile of the asset class.
• ESG factors can also be a very important lens to identify investment opportunities. Companies with good sustainability credentials often exhibit operational excellence and generally have more stable businesses. Those with a strong transition plan typically have solid growth prospects over the coming years, and investments in these companies could offer attractive asset return opportunities.
• ESG integration is needed when applying sustainability insights to the investment process. ESG integration involves more than just looking at a score, similar to credit analysis being more than just looking at a rating. Combining sustainability insights with credit and business analysis could uncover unique investment opportunities.
• Investing in European utilities underscores the importance of integration. Companies that are leading operators of renewables could be attractive, but the climate in Europe is actually becoming hotter and drier. This can create risks for some parts of the renewable business, such as the hydro generation business that depends on rain.
• ESG integration means considering E, S and G at all stages of the investment process. On the fundamental side, it is important to consider the nature and magnitude of a company’s decarbonization process to see if the capital expenditures and products are aligned with a lower-carbon economy. Similarly, technicals involve identifying climate risk on the supply and demand of a bond. For sustainability-linked bonds, for example, there is a need to assess the strength of the structure, covenants that are offered and the robustness of the key performance indicators (KPIs). When it comes to valuation, it is important to look at climate risk-adjusted yield to see if there is enough compensation for the risk being taken.
• It is essential to view the measures that companies are taking to adapt their businesses to climate risks. For physical risks, assets should be mapped to climate hotspots and those in vulnerable areas assessed further to see if they have sufficient insurance and are taking measures to strengthen the infrastructure. For transition risks, it is important to evaluate the impact of decarbonization of economic activity on a company’s business model and the risks of stranded assets, higher costs and higher financing needs.
• Scenario analysis can help evaluate business and economic outcomes. It is possible to look at forecasts of energy demand, for example, and how it is going to develop in line with transitioning to a net zero economy to be more precise and targeted in managing risks.
• Transition risk could be managed through engagement. Collaborating with companies that are part of a portfolio could encourage them to set net zero goals and align their capital expenditures and products with a less carbon-intensive business. This could be better than divestment, as it can guide companies to a greener future, while keeping a portfolio well diversified.  

What Insurance ESG Pioneers Have Done Well

• A common set of themes sets the early movers apart. The insurance pioneers tend to have a top-down and consistent approach across business functions. ESG tends to also be a focus of senior management, and expectations are usually set within every discipline, as was done with the enterprise risk management rollout a decade or so before.
• They understand that ESG is more than just an investment issue. It is a distribution, underwriting and human resource issue, as well. Many of the largest players have made public financial commitments to reflect their priorities, ranging from establishing targets for sustainable or green bond purchases to pledging funds for specific themes, such as diversity. It has also included divestment of certain exposures.
• They provide annual updates as part of their robust disclosure. This allows for a transparent progress report for the capital markets community. In addition, they often have dedicated ESG resources, versus making it a part-time job.
• These players look to innovate across the balance sheet. This could include developing insurance products for underserved communities, investing in fintech or insurtech that can help ESG causes or creating a product that can be harnessed in the underwriting process.
• They target specific outcomes and track progress against robust KPIs. Metrics may include a specific decline in a carbon footprint, alignment of portfolio companies to science-based targets and more.
• The pioneers have shown a willingness to rethink historical norms. When considering ESG factors, companies are less anchored to the past, which requires an overhaul in capital market risk and return assumptions.  
• There is a material shift in asset classes that will need to be accounted for moving forward. Adapting the potential investable universe is also a critical step. The use of ESG scores alone could result in suboptimal portfolios given the backward nature of many of the scoring methods. Investment grade will tend to score better than high yield on average, or governments tend to score better than credit on average. This could be adjusted in several ways, such as bifurcating emerging markets into subsections, instead of thinking of it as a broad asset class, or expanding the illiquid asset universe, as private companies could be best positioned to offer ESG solutions.
• Understanding a company’s current footprint is critical. A best efforts basis is a great start, knowing that there may be limitations in what market data offers, such as the lack of consistent carbon reporting for municipal bonds. Spending time on the asset classes that are most impacted is a good start.
• Using an if-then decision tree framework as opposed to a yes-no construct can be helpful. This could provide a larger investable asset universe for a portfolio managers, while creating some guardrails around what positions could be held in terms of specific sectors or investments. It also could avoid taking funds away from an entity that has a strong transition plan.
• Insurance companies can have considerable influence on S and G. This can take place through corporate-level initiatives, underwriting practices and commitments. Employing thematic approaches to target specific outcomes could help, and tracking KPIs could be the proof statement that the desired goals are being met.
• S and G will require a shift in how the manager universe is considered. These funds likely will not have a performance history, and many will have newer portfolio management teams. Companies will need to have a conviction in the philosophy and process of the managers, coupled with agreed-upon KPIs.  Achieving social benefits and strong investment returns are not mutually exclusive, so evaluating investments against traditional benchmarks can be appropriate.
• ESG is just another component of strong fundamental research. Favoring engagement over divestment should make sense for most business functions. Instead of a blanket action of divestment, rewarding those with a credible transition plan could help ensure that they meet their goals.
• Insurers could benefit from becoming signatories or members of insurance-specific ESG initiatives. These initiatives establish group-wide commitments and help develop taxonomies. They also agree on a dataset and how to measure exposures, and offer a unified voice for action. Implementing a net zero or carbon reduction commitment has also become commonplace in the last few years.
• Commitments have been pulled forward from the 2050s to mid-2030s by some of the larger players. More aggressive actions will be seen in the coming years. There should be a feedback loop between those investments and an organization’s philosophy around ESG and a KPI dashboard that provides details beyond year-to-date returns.
• ESG is likely a fertile ground for alpha opportunities and future growth. Some larger companies are using the financial commitments in things like renewables, low-carbon industries or sustainable investments as a way to offset some of their existing portfolio companies that have a longer transition timeline. Exclusionary practices will likely be adjusted, as well, to bring revenue thresholds down for carbon-intensive industries.

Contributors:

Tim Antonelli, CFA, FRM, SCR
Insurance Multi-Asset Strategist, Wellington Management

Mahmoud El-Shaer, CFA
Fixed Income Portfolio Manager, Wellington Management

Thomas Yagel
Chief Product Officer, S&P Global Sustainable1

For more information, listen to the webinar here.