Nov 2019

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Think Tank: The Geneva Association - Are insurance balance sheets carbon-neutral?

Source: Asia Insurance Review | Nov 2019

Due to its enormous size and capital base, the insurance industry has the potential to play an important role in countering climate change. To this end, the major capital flows associated with its investment and underwriting businesses would need to be redirected towards carbon-neutral activities. Alexander Braun from the Institute of Insurance Economics, University of St. Gallen, Sebastian Utz from the School of Finance, University of St. Gallen and Jiahua Xu from the Ecole polytechnique fédérale de Lausanne suggest an asset-pricing approach to detect carbon-intensive positions on their balance sheets in a research paper published by Geneva Assocation and Springer.
Climate change is one of the greatest challenges for humanity. According to recent estimates, the global average temperature has already risen by 1 °C compared to pre-industrial levels. The dominant cause for this development are anthropogenic greenhouse gas (GHG) emissions, which create temperature anomalies for many millennia. Should the trend persist, the earth will be faced with catastrophic and irreversible consequences such as ocean acidification, permafrost thawing, desertification, extreme weather, coastal flooding and the extinction of many species. 
Recent disasters such as hurricanes Harvey, Irma and Maria in 2017 could be harbingers of this development and, alarmingly, research consistently predicts more severe meteorological and hydrological events in the future. The impact of climate change on societies is expected to be devastating, ranging from famines and droughts to the uninhabitability of whole geographic regions.
What the industry can do
On the positive side, serious efforts to stabilise carbon emissions are emerging. Since the ratification of the United Nations Framework Convention on Climate Change (UNFCCC) in 1994, 24 Conferences of the Parties (COP) have been held. During the most recent summit of 2018 in Katowice, almost 200 nations agreed on binding rules for the implementation of the 2015 Paris Agreement.
The major shift in energy generation and industrial practices associated with the long-term temperature goal of 2 °C will require a significant redirection of global capital flows towards carbon-neutral infrastructure projects and technologies.
Thus, the insurance industry, as a big contributor to the world’s GDP, bears a great responsibility. Recognising their potential to counter climate change, many insurers have committed themselves to a comprehensive, enterprise-wide plan of action.
While these are encouraging developments, the actual effectiveness of many of these activities remains unclear. In some cases, companies might merely pursue showcase projects such as investments in emission reduction technologies or environmentally focused funds on a smaller scale, simply because mentioning sustainable business practices resonates well with the public. For a real impact to materialise, however, insurance firms must consistently pursue green policies in their core investment and underwriting portfolios. The potential is enormous: estimates for the global insurance sector indicate around $25tn in assets under management and almost $5tn in non-life premium volume.
A reallocation of just a fraction of these capital flows to low-carbon sectors of the economy could be a substantial catalyst for the achievement of climate goals. However, since existing frameworks are not binding, and it is costly for stakeholders to scrutinise the industry, insurers might not be strongly incentivised to extend the green paradigm to their entire balance sheet.
Sustainability in insurance
The global insurance industry is home to some of the world’s largest institutional investors. With about $25tn in assets under management, it commands more than 15 times the estimated annual gap ($1.6tn) that needs to be closed by the private sector to achieve all 17 sustainable development goals (SDGs) by 2030.
Given their long-term investment horizon as well as buy-and-hold strategy, insurers are well positioned to support the transition to the low-carbon economy by funding sustainable projects, particularly related to infrastructure. Due to its stable cash flows and long-term nature, infrastructure is a promising asset class that many insurers have begun to consider in the low interest rate environment of the last decade.
Despite its overwhelming potential to combat climate change, the global insurance industry has been adopting the sustainability paradigm at a modest speed. Merely 129 insurers worldwide undertook notable measures against global warming between 1995 and 2009, indicating that the majority remained on the sidelines.
In addition, it is unknown how many of those companies that do pursue green policies actually work with effective levers. More specifically, insurers may pursue several activities against climate change and its consequences, such as science projects, loss prevention, technology investments and new product development‚ without consistently keeping their core investment and underwriting portfolios carbon-neutral. Reported green investments comprise $23bn in emission reduction technologies and $5bn in environmentally focused funds.
This is a drop in the bucket compared to the industry’s overall assets under management. Hence, for some insurers, green projects may be a fig leaf rather than a real effort to combat global warming.
Being carbon-neutral
Owing to its enormous size and capital base, the insurance industry should occupy a key role in the achievement of the UNFCCC climate goals. If only a fraction of the sector’s investments worldwide could be directed away from carbon-intensive assets, this would constitute a substantial contribution to the efforts against global warming. It is doubtful, however, whether voluntary initiatives will be enough to genuinely implant the sustainability paradigm in the industry DNA.
Since insurance companies can be viewed as large portfolios consisting of financial risks (asset side) and underwriting risks (liability side), we suggest an asset pricing approach to detect carbon-intensive positions on their balance sheets.
Our model extends the insurance-specific five-factor framework of Ben Ammar et al. by the excess returns on GHG allowances. Owing to the long (short) position in the price of CO2 implied by their business fundamentals, green (polluter) firms can be expected to exhibit a positive (negative) carbon factor beta. 
As these effects feed through to the portfolio level, they should be measurable in the excess return time series of the insurers’ stocks. We empirically implement the model based on rolling regressions and illustrate the evolution of the carbon footprint of 35 European insurance companies over the past few years.
Further analyses are required to tackle the limitations of our work. First, the suspected link between the carbon price and stock returns needs to be better understood. Similarly, more research is needed regarding the relationship with bond returns. The question is to what extent our model picks up non-green fixed income positions in investment portfolios. This is a key issue‚ since the asset allocation of insurance companies comprises around 60% to 70% of government and corporate debt.
Second, one should not forget the liability side of the balance sheet. The market value of insurance contracts only reacts to shifts in risk fundamentals but not to changes in the price of CO2. Thus our model cannot detect GHG exposures in the insurers’ underwriting business. This may result in a situation in which firms appear to be climate compliant‚ because they run a low-carbon asset portfolio while they still write coverage for coal plants. 
The introduction of an ESG label for insurance companies only makes sense if it also covers their liability side. Although there are no straightforward solutions to these issues, considering the high stakes associated with climate change, their further consideration will be well worth the effort. A 
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