It is generally accepted that the insurance business revolves around the aggregation, management, and transference of risk. This is true whether we are thinking about the risk aggregation and transference inherent in the diversifying characteristics of a pool of insured individuals or if we are viewing a block of ceded reinsurance business in isolation.
Of course, there are other types of risk that insurers also encounter. Pricing risk is a function of product design failing to achieve ROE targets. Mortality risk is encountered when an insured passes away too soon. Then there are a host of risks found on the asset side of the balance sheet. Examples here include market risk, investment risk, and counterparty risk, and yes, it gets infinitely more granular!
But there are other risks that insurers implicitly onboard when they are trying to align assets and liabilities through the investment management process. These include environmental risks like issuers in the general account being rampant polluters and incurring unanticipated material costs to clean up or comply with regulations. They also include social risks like involvement in potentially unsavoury activities like tobacco, gambling, or weapons manufacturing. Lastly, they include governance risks such as accounting scandals or issues around board composition.
ESG risks abound in the insurance space. Whether they are intentional or accidental, if ignored they can have an outsized impact on a general account at the least opportune time. The application of an ESG program or even simply integration of ESG into the investment management process can help to mitigate investment risk by uncovering material factors missed during credit analysis or private placement due diligence. Given the low turnover of (and tax treatment seen) in general accounts, ESG screening can assist in risk avoidance or the potential of forced selling due to a credit event or compliance violation. That’s not to mention the positive goodwill and brand impact generated across a prospective client base when doing good becomes good business.
There are several considerations that an insurer should consider before deciding to jump into the deep end of the ESG pool. First, how involved does the insurer want to be? Is integration of a third-party data source enough to provide additional visibility of specific asset risks, or does the firm want to begin engaging with issuers with the mindset of producing positive change? Second, how does the insurer anticipate leveraging either proprietary or third-party data to complement their existing research process. Finally, what are common examples of use cases that a firm could reference when implementing an ESG process? We will look to address each of these in turn.
Level of Involvement
How “Green” do you want to be? This is a question that, while simple, requires a lot of thought up front. A primary implication is the desired end state. On one end of the spectrum, awareness and understanding the impact on security selection can be accomplished easily by positive or negative screening for specific ratings, business activity, or threshold scores. Independent research can be consolidated with in house credit analysis to display the robustness of the overall process.
On the other end of the spectrum, undertaking engagement is usually seen in firms with dedicated stewardship teams. Think of it as like monitoring covenants on a regular basis with a specific goal in mind in addition to repayment of an obligation. The layers of support, data and technology required may be intimidating initially.
The Data Conundrum
Much like answering the initial question of greenness above, another key ingredient is determining what data to use and how to actually connect it with general account or sub portfolio holdings. There are well over 100 ESG providers in the market today. Some are larger global market data providers that are a mile wide and an inch deep. Others may have more of a niche focus on a region, ESG pillar, or methodology. Others still may be open source.
Consuming and distributing this type of data also poses challenges like delivery mechanism and support, linking holdings to the data, and visualization, whether using a portfolio analysis tool, BI utility, and/or client-facing portal.
A compounding factor introduced at firms that decide to leverage their existing research processes in addition to third party data is the concept of materiality. Not all factors are going to be as meaningful for every firm. For example, emissions are going to be critical for transportation issuers but largely irrelevant for technology issuers. Where this becomes a unique challenge is that agreement on what constitutes materiality can still be thought of subjectively. Further, as firms incorporate their research processes with market data, disclosure quality and completeness will vary across issuers and markets.
Putting the Data to Work
Now for the fun part! Examples of use cases abound in the ESG space. We already hit on some aspects like portfolio construction and slicing and dicing by factor exposures. Other popular ways to incorporate this type of data including time series analysis (to see how ratings, scores, and factors evolve over time), controversy monitoring, performance attribution, and risk modelling are shown throughout the post.
This type of data is typically utilized across the firm. It is not uncommon to see sales and distribution showcasing their environmental or social focus, compliance touting the effectiveness of their stewardship, or credit analysts or risk managers talking about the value of their process or risks avoided due to it.
The use cases are flexible enough to fit most investment management processes.
In summary, ESG has seen tremendous adoption since the United Nations introduced the Principals for Responsible Investing in 2006. The types of risks identified by third party providers or sussed out from internal processes is synonymous with proper risk management in a low turnover, buy and hold segment of the market. While there are many risks that insurers must be aware of, integrating ESG can be a true value add for the space, not merely lip service or a marketing ploy.
Pat Reilly has 15 years of experience within the investment management industry focusing on fixed income. Prior to joining FactSet, Pat started his professional path as a Credit Manager at Wells Fargo and then as an Investment Services Analyst at Pacific Life. He earned a Bachelor of Science, Finance from the Eller College of Management at the University of Arizona and a Master of Business Administration from the Marshall School of Business at the University of Southern California.