Rui Wang provides a primer for how general insurance firms should approach ESG investment and risk management
As environmental, social and governance (ESG) topics advance in public discourse, insurance executives are increasingly being asked to address these issues directly. Questions are being raised about insurance companies’ own ESG activities, as well as how they pay attention to those of their clients and investee entities.
In particular, general insurance firms are regarded as having material exposure to the negative impacts of climate change, primarily through underwriting and also via invested assets. How these firms manage the associated risks therefore becomes a vital aspect of their ESG practice.
Regulators and legislators are also becoming active in this area. As may be expected, climate change concerns have so far dominated the regulatory activities, which tend to be exploratory exercises.
Incorporating ESG into a risk management framework
Most firms have opted to incorporate ESG risks into existing risk management frameworks, rather than revamping frameworks around ESG. Where warranted, specific ESG items are captured in the risk register, then managed and monitored from there, with the focus on underwriting risk (in relation to climate change) and investment risk (in relation to investee entities’ exposure to ESG issues).
When evaluating ESG risks, three challenges come to mind. The first is performing this evaluation in the context of any pricing impact. For example, climate change risk and people’s awareness of it may have pushed up (re)insurance pricing. The question becomes one of ‘pricing adequacy’, which is more difficult to address than ascertaining whether climate change or extreme weather has impacted the underlying risk.
The second challenge is anticipating any ESG tail risk. For example, an insurer may retain equity investments in a company with questionable employment practices, on the basis that such issues are already priced in and it is well compensated by higher expected return. The investment may end up causing financial losses due to the investee being abandoned by investors and customers, or negatively impacted by government policies on relevant ESG issues. A case in point is the Boohoo supplier scandal that surfaced in 2020.
Finally, data availability and quality is a major issue in all areas related to ESG. Through efforts from the likes of the Task Force on Climate-related Financial Disclosures and the UN Global Compact, progress is being made on both fronts.
Enhancing enterprise risk management
Insurers are exploring how to manage risks more holistically on both sides of the balance sheet. For example, an insurer may have concentrated exposure to extreme weather in certain geographic locations, while issuers of its municipal bond investments may be exposed to the same set of risks. While the correlation may not materialise in significant financial losses, it is potentially a source of added volatility. It could be meaningful for insurers to better understand this and take actions to reduce the risk exposure and correlation. Similarly, insurers that underwrite director and officer risk or workers’ compensation risk are looking to apply relevant underwriting insights to help guide investment activities from governance and social aspects, respectively.
Set the right framing for ESG risks
As pressure from stakeholders intensifies, it is tempting to take the plunge and start signing up to various ESG initiatives. However, given the nuances involved in addressing ESG risks, the unknown or incomplete plans from governments, and the uncertain business and financial consequences, it would be wise for insurers to take cautious steps and adopt logical decisions.
For example, major scientific and technological breakthroughs are necessary to achieve global decarbonisation, with equity funding regarded as the best way to unlock these developments. At the same time, evidence is yet to emerge on the benefit of ‘bond portfolio decarbonisation’ (divestment from bonds issued by oil companies, power generators, and so on). A firm that is serious about climate change should prioritise equity investment on science and technology, and be cautious about making major changes to its bond portfolio.
One way to manage the situation is to bring ESG into a ‘goal hierarchy’ for specific topics. A clear articulation of where ESG specifics fit in helps to create logical and proportional action plans, and ensures that these are viewed within the appropriate context.
For example, some insurers have stated that the core purpose of their investment portfolios is to pay policyholders’ claims, which itself has substantial social implications. Within this context, the insurers discuss the conservative nature of these investments (with a large allocation to high grade fixed-income assets) and the need to maintain liquidity for paying claims. This, in turn, sets up a discussion on how best to manage the credit risk in the portfolio.
The many facets of ESG investing
Many people use the terms ‘responsible investment’ and ‘ESG investing’ interchangeably. The Principles of Responsible Investment (PRI) is an investor initiative working in partnership with two UN initiatives, and a leading proponent of responsible investment globally; it defines responsible investment as a strategy and practice to incorporate ESG factors into investment decisions and active ownership. The PRI has dispelled three popular misconceptions on responsible investment and ESG investing:
- Responsible investment can be implemented without asset owners (such as general insurance firms) putting funds into a specific investment strategy or product. It is fundamentally about involving ESG considerations in investment decisions and operations.
- Instead of having to accept lower investment returns, asset owners should be able to obtain better risk-adjusted returns by using ESG data and taking advantage of ESG and ESG investing trends.
- If an asset owner wants to focus solely on investment performance, it can do so while embracing responsible investment. The PRI acknowledges that there are alternative approaches that are more narrowly defined, such as ‘impact investing’ and ‘ethical investing’.
What is the investment performance impact?
The recent meta study ‘ESG and Financial Performance:
Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015–2020’ covered peer-reviewed academic papers published from 2015 to 2020. It showed that among 54 studies on equity investments, 33% found that an ESG investing approach delivered better risk-adjusted investment outcome than the conventional approach, 54% found results neutral or mixed, and 14% found that the ESG approach performed worse. Among 11 studies on fixed-income investments, 19% found results in favour of ESG investing, 56% neutral or mixed results, and 25% negative results.
When interpreting this, it is worth bearing in mind the following considerations:
- Past performance is not an indicator of future results. The financial market is quite ruthless in eliminating significant outperformance. In other words, the better risk-adjusted investment outcome from certain ESG strategies is unlikely to persist into the future. Some also argue that long-term persistent ‘outperformance’ is typically associated with higher tail risk, which had existed a priori but did not (fully) materialise – for example, tobacco stocks.
- It is important to understand the mechanism through which a company’s poor/good ESG practices translate into negative/positive financial performance relative to a benchmark group. Otherwise,it is difficult to know whether a study has revealed a correlative relationship or a causal one.
- Companies with strong balance sheets and good profitability, such as technology companies and luxury brands, seem to be leading the charge on ESG issues so far. In many cases, it is their strong fundamentals that are driving better investment outcomes (such as lower debt default rates), rather than their ESG practices.
“A clear articulation of where ESG specifics fit in helps to create logical and proportional action plans”
Preparing for the future
At such an early stage of ESG investment and ESG risk management, it is constructive to focus on three things:
- Monitoring improvements in ESG data disclosure, which has been evolving fast. When you have better and fuller data, better decisions can be made.
- The valuation that is being paid on ‘ESG-friendly’ investments, relative to those with similar fundamentals. For fixed-income assets, this means the book yield obtained at the point of purchase; for equity investments, it means the valuation multiples (such as price/earning ratio). Asset managers are also charging higher fees for managing such investments. Additional expense and excessive valuation eventually serve as a drag on investment performance.
- Monitoring and engaging with governmental, legislative and regulatory developments. ESG topics are too large for single firms or industries to handle, and it’s important that general insurance firms participate in policymaking and provide risk expertise in the process.
The opinions expressed in this article are those of the author and not necessarily those of his employer.
Rui Wang is an enterprise capital strategist at New England Asset Management Limited
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