Beyond just a regulatory requirement, ESG factors have become crucial in understanding an insurance company’s investment risk and credit profile, say Messrs Scott Hawkins and Matt Daly of Conning.
ESG (environmental, social and governance) concepts are of interest among a wide variety of investors. Part of that awareness stems from the recognition that ESG investments now represent a significant pool of assets.
For instance, the Global Sustainable Investment Alliance reported in 2018 that sustainable investments, which includes ESG investing, represented more than $30tn of assets, a 34% increase since 2016. Japan had become the largest centre for sustainable investing after Europe and the US.
Over that period, Japan saw an increase from just 3% of total professionally managed assets to 18%.
Not surprisingly, there is a growing awareness among insurers and their asset managers of better developed frameworks to incorporate ESG factors into investment decisions. As a result, insurers and their asset managers need to understand the challenges of integrating ESG into fixed-income investment management. The firms that master those challenges may find themselves in a stronger position to ensure ESG factors are fully captured during investment analysis, reduce investment risk, and be a positive catalyst for investment returns.
A growing global movement
As a term, ESG made its first appearance in 2005’s Who Cares Wins study. That same year, the UNEP/Fi (United Nations Environment Programme – Finance Initiative) published the so-called Freshfield’s Report which showed that ESG issues are relevant for financial valuation. These publications led to the launch of the PRI (Principles for Responsible Investing) and the SSE (Sustainable Stock Exchange Initiative).
While European insurers and asset managers are further along in integrating ESG into investment decision making, North American and Asian firms are rapidly catching up. Regulation is clearly playing a role in driving that growth. In May 2018, the European Commission proposed regulation that would also require insurers, asset managers, and pension funds to report on the procedures they have in place to integrate ESG risks into their investment and advisory processes and list how those risks could impact financial returns. In the US, the SEC was petitioned in October 2018 by a group of institutional investors and stakeholder groups to require the disclosure of ESG criteria for publicly traded companies. Asian regulators are developing similar disclosure requirements. These regulatory developments are likely to continue, accelerating the adoption and integration of ESG factors into investment management.
The importance of ESG-investment integration for insurers
Beyond regulatory requirements, why is ESG crucial for insurers? The answer is that ESG factors are crucial in understanding investment risk.
Asset managers and the insurers they work with, have a fiduciary duty to generate solid and risk adjusted investment returns for their clients and policyholders. Successfully executing that duty also requires a deep understanding of the investment risk their clients face when making a recommendation.
The integration of ESG factors enables a more robust analysis of a potential investment risk. This might include the possible exposure to the financial impact caused by climate change, supply chain mis-management, poor worker protection, and inadequate governance. Beyond the financial risk, negative press caused by overlooked ESG factors can create a mismatch between security valuations and the underlying financial reality. As a result, the use of ESG factors are an increasingly important part of an analyst’s fundamental assessment of credit profiles and influence security valuation.
The investment integration challenge
As insurers and asset managers integrate ESG into their investment processes, they will need to be aware of several challenges. One challenge is developing an organisation structure to support the integration efforts. Understanding what ESG factors are most important, and how they differ, is crucial to successful integration with investment risk management. That understanding is complicated by the non-standardisation of ESG reporting. Non-standard ESG reporting hampers the ability of an analyst to identify the material ESG risks to the valuations they develop.
Senior leadership and support are crucial for the successful adoption and integration of ESG into investment management. High-level support demonstrates that ESG is a key differentiator for the organisation and not a public relations exercise.
For example, Conning created an ESG steering committee, which includes senior level leadership across the US., Europe and Asia, to provide strategic guidance and help evaluate and evolve firmwide ESG initiatives and responsible investment practices. The ESG steering committee also supports the chief risk officer, who is responsible for oversight and compliance with respect to client guidelines related to ESG issues.
Because insurers are primarily invested in fixed-income securities, ESG integration can be a crucial part of the credit research function. Credit research analysts need to integrate ESG factors into their target rating and outlook for each credit issuer. This information should be communicated to portfolio managers and risk management so that both groups have a deeper understanding of the investment risk the firm is assuming for its clients.
Developing this understanding requires the analyst to filter the noise surrounding ESG factors. Many ESG factors can be immaterial to a specific company’s credit profile, because those factors speak to different stakeholder groups or industries. For example, environmental issues are more impactful in the credit analysis of utilities and energy than financials.
Because ESG factors differ among industries, analysts also need to identify and develop solutions to enable cross-industry comparisons. Cross-industry comparisons are important to allocate investments among sectors. One solution can be to create a consistent framework that assigns an ESG factor based on industry.
The improving ESG data challenge
For investment analysts looking to integrate ESG factors further into their analysis, a major challenge is the non-standardisation of ESG reporting by companies. That challenge can be partially addressed if insurers and asset managers have experienced analysts with years of insights into key drivers of industries and management teams. However, even those analysts need to understand that effectively using ESG factors to evaluate developed market debt is more than plugging data into a quant model. It requires them to also have a deep understanding of the qualitative factors that influence the credit assessment.
Analysts seeking to further integrate ESG factors into their valuations can use third-party providers that assign ESG ratings. They will also benefit from continuing efforts to develop globally recognised reporting standard.
In January 2019, Fitch Ratings launched its new integrated scoring system that shows how ESG factors impact individual credit rating decisions. The new ESG Relevance Scores are sector-based and entity-specific. Similarly, the MSCI ESG rating enables analysts to positively or negatively screen for MSCI ESG ratings for unique client portfolio requirements.
Corporate disclosure on ESG issues has steadily improved since the launch of the Global Reporting Initiative in 2000. More recently, the International Integrated Reporting Initiative and the US-based Sustainability Accounting Standard Board have advanced industry sector-specific reporting and its relevance for investors.
Looking ahead for the insurance industry
What does the medium-term future look like for ESG and insurers and their asset managers? Increased disclosure, integration, and refinement.
Given the continued development of ESG disclosure regulation, management teams can expect ongoing pressure to produce ESG reports on the company’s own ESG footprint as well as how it integrates ESG into its investment process. That pressure to integrate ESG into investment analysis reflects the reality that insurers and reinsurers are major investors as well as providers of coverage for other industries that may be perceived as having a negative societal impact. A prime example of that is investment in and coverage for fossil fuel industries, specifically coal.
The further integration of ESG into investment decision processes by insurers and asset managers will lead to the eventual standardisation of ESG reporting across corporate sectors. At the same time, as analysts continue to refine their ESG analytical methods there will likely be a growing number of ESG support firms providing a range of services from data and ratings to advice and technology. Insurers and asset managers will have a choice to make between developing these support systems in house or acquiring them from third-party providers.
Looking ahead, one thing is certain, for insurers and their asset managers, the integration and use of ESG factors is more important than just public relations or products. Successfully integrating ESG into investment analysis and management will increasingly be a competitive differentiator in attracting clients and their assets. A
Mr Scott Hawkins is director, insurance research and Mr Matt Daly is managing director and head of credit research at Conning.