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From the diesel emissions scandal to the perceived exploitation of zero-hour contracts, there have been many examples in recent years of how failures in the way companies are run can have a harmful impact on the environment, society and investor returns. More than ever, insurers need to be aware of the risk these failures can present to their invested capital.
At the World Economic Forum earlier this year, AXA chief executive Thomas Buberl argued that unmitigated climate change could result in an uninsurable world. Extreme weather events are likely to inflate insurance companies' claims to such an extent that some physical assets may just be too risky to underwrite. Analysis from Standard & Poor's showed that if the frequency and impact of recent weather events were considered to be the 'new normal', current catastrophe losses could be undervalued by reinsurers as much as 50%. This presents a serious danger for (non-life) insurers who may be exposed to environmental, social and governance (ESG) risks on both sides of their balance sheets.
On the other hand, the assets invested by the insurers could be building the very future they cannot afford. In order to align the return expectation to that of their societal impact, it requires awareness that environmental, social and governance (ESG) information is essential to navigating the transitions over time.
At LGIM, we manage assets on behalf of a spectrum of institutional and retail clients, including insurance companies. We believe that integrating ESG themes into investment processes has the potential to lead to better financial outcomes, mitigate overall portfolio risk and meet clients' growing appetite for investments that better reflect their values.
Beyond the balance sheet
At the simplest level, ESG is about good management. Companies with strong governance oversight are less likely to provide investors with unpleasant surprises; equally, companies that are aware of their impact on wider stakeholders are less likely to face political or regulatory pressure.
Such companies are also better positioned to withstand – and even benefit from – shifts in the market environment. Examples of the challenges that ESG can help to address include the impact of climate change on energy markets; the interplay between the growing digital economy and security; and the rise of the 'conscious consumer.'
In order to assess the true strength of a company's governance, we believe it is important to ask questions about stakeholders and timeframes that conventional analysis and traditional investment solutions might overlook. Some risks faced by companies will not be obvious, given the vast amount of information that lies outside of the balance sheet, as detailed in Figure 1.
In order to make a formal assessment of these risks – and opportunities – investors can compare and contrast different companies' performance on key ESG metrics.
This need not ultimately involve the blanket exclusion of certain sectors and stocks; for example, tobacco or defence companies. Such action forms a subset of responsible investing known as 'ethical' strategies, which we will not address in this article.
Preventable surprises
We believe incorporating ESG themes into investment processes can play an important role in mitigating risks, whose crystallisation, can take a toll on stock performance.
Even though some events can be labelled 'black swans', many surprises will be preventable: a 2016 study by Bank of America Merrill Lynch suggested that exposure to 15 out of 17 US bankruptcies since 2008 could have been avoided through the integration of ESG within conventional analysis.
Importantly for insurance portfolios, which are predominantly allocated towards fixed income, a 2016 report from Barclays showed that bonds with high ESG ratings had lower spreads and higher credit quality than other securities in the Bloomberg Barclays US Corporate investment grade index. Furthermore, it found that introducing ESG themes into the investment process of a corporate bond portfolio generated a 'small but steady performance benefit.'
Better potential outcomes
Of the 2,250 peer-reviewed studies published on this topic between 1970 and 2014, the majority identified a positive link between high ESG scores and corporate performance, according to a review conducted by Deutsche Bank and Hamburg University.
While most of the studies published have focused on equities, there has been promising research on other asset classes. According to the Deutsche Bank / Hamburg University meta-study, of those published before 2014, high ESG scores were linked positively to the performance of bonds in 63% of studies, and positively with the performance of real estate in 71% of studies. Unlike in equities, the review found no studies showing a negative correlation between ESG scores and performance for these two asset classes. It is important to note, however, that these benefits to performance are by no means guaranteed; past performance is not indicative of future results.
ESG for index investors
ESG integration can be done across the different types of assets that insurers own; from fixed income and equities to real assets. For actively managed assets, a fundamental investment process can incorporate material ESG aspects. For index funds, there are three main ways in which ESG criteria can be implemented:
• Tilts: This means constructing an index of a broad universe of companies (such as the FTSE All World) that overweights and underweights companies according to their performance on specific criteria. The main advantage of this strategy is that it retains a similar return profile and offers diversification, but can also reduce exposure to certain ESG risks and capture ESG opportunities.
• Engagement: By engaging with companies, investors are able to communicate their interests and expectations, in order to find grounds for mutual benefit. This entails meeting with company boards and other stakeholders, and voting at shareholder meetings.
• Exclusion: While blanket divestment from companies and sectors can be a risky strategy, since it results in a more concentrated portfolio, limited exclusion – and the threat of it – is still a potent tool.
LGIM's approach
At LGIM, we can combine the benefits of the ESG tools at the disposal of index investors to provide portfolios with risk/return profiles that are similar to the broader indices, while aiming to make a significant ESG impact.
Even though we have a large in-house engagement team, it is impossible to apply the same methodologies of ESG standards across thousands of securities. Our use of tilts within certain index portfolios allows us to create a consistent approach with the right incentive structures.
It is essential that companies understand how they are being incentivised or penalised. Accordingly, we seek to disclose the methodology that tilts exposures, allowing for open communication with investee companies.
To further strengthen the ESG impact, LGIM has implemented its Climate Impact Pledge, a targeted engagement process where we work directly with the companies in which we invest to bring about positive change.
We are launching index strategies which take this one step further, so that a failed engagement could ultimately lead to divestment, where stocks can be excluded within a tightly controlled tracking error margin. As a result, the impact on returns is expected to be minimal while the message to the companies is magnified.
Insurers have historically been at the forefront in managing and mitigating risk. But the scale of some issues like climate change means we are, to some degree, in uncharted territory. Fortunately, ESG integration is an essential tool to help insurers understand the growing concern. While there are no investment guarantees, we strongly believe that our approach can help us to deliver sustainable value for investors over the long term.
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