29 October 2019
Investors are increasingly considering the environmental, social and governance (ESG) properties of their portfolios, say John Seo and Joanna Syroka of Fermat Capital Management. They believe insurance-linked securities (ILS) are aligned with positive ESG attributes which could help protect and enhance portfolio returns.
As specialists in insurance-linked securities (ILS) we are often asked about the ESG attributes of this unique asset class and how these translate into responsible investment policies.
ESG considerations, as we see it, are crucial to the long-term performance of any investment. We believe the ILS asset class – which offers capital market investors a mechanism to provide new capital to the global re/insurance sector1 – is naturally aligned with ESG principles, as we outline below. Our view is that continued adherence to high ESG investment standards will not only accelerate ILS market growth, but should also ensure the long-term sustainability and attractiveness of the asset class for investors going forward.
The ILS market was born in the late 1990s after two events in the US – Hurricane Andrew in 1992 in suburban Miami and the Northridge Earthquake in 1994 in suburban Los Angeles – caused a near collapse of the insurance markets in Florida and California. These disasters created an opportunity for capital market investors to provide new capital to the re/insurance sector and since then ILS have had an increasingly important role in helping stabilise insurance markets by broadening the mutual sharing of risks across a larger and deeper capital pool.
By their very nature, environmental considerations, the E of ESG, are closely linked with ILS. One of the main risks underpinning investments in the re/insurance sector is weather. This means the ILS market – like the insurance and reinsurance markets it supports – is at the forefront of monitoring changes in weather extremes and their impact on economies. Every US hurricane catastrophe bond – the most well-known type of ILS instrument – indicates the risk of the bond both with and without the impact of factors such as elevated sea surface temperature (SST) to assess the possible impact of climate change on hurricane activity2.
Unlike long-duration investments like equities, long-term bonds and real estate, ILS are more short-term in nature (maturities typically range from one to five years) and can therefore reprice their returns in the relative near term as new information about the frequency and severity of weather events becomes available. In this way capital market investors are provided with a forward-looking, market-based indication of the costs of weather risks and consequently climate change. In return for providing capital to set against these risks, investors stand a greater chance of being adequately compensated for them.
However, re/insurance losses are also driven by other environmental factors such as the underlying insured exposure in harm’s way. In hurricane-prone areas, for example, ILS provide a market-based indication of the long-term costs to society of coastal property development as well as the hurricane hazard. Better managed communities and infrastructure, all things being equal, should be rewarded with more competitively priced re/insurance risk capital than poorly managed developments, which are more prone to larger insurance losses. The same principle applies to urban development in seismic zones. This market-based pricing mechanism provides an important signal of the relative benefits of environmental risk mitigation and adaptation measures to communities and creates a powerful feedback loop that aligns incentives for better risk management in the long run. Re/insurance and ILS markets are uniquely placed to provide this essential price discovery function to society.
As an illustrative example, let us consider Florida, one of the largest buyers of property catastrophe insurance coverage in the world. The current industry estimate of the 1-in-200 year insured loss from a hurricane hitting a major city such as Miami is USD 250 billion3. At the same time, the total capital base of the traditional reinsurance industry is estimated at approximately USD 350 billion4. Although the reinsurance capital base is not all exposed to this single event, a 1-in-200 year event would throw the global re/insurance market into disarray with significant impacts on not only the population affected locally, but on the entire cost of insurance worldwide.
We estimate that in aggregate, the entire global traditional reinsurance market covers only USD 40 billion of single-event loss in Florida5. ILS, in recent years, have grown to the point that they provide an estimated USD 50 billion of additional hurricane coverage to insurance companies and reinsurers active in the state6. Therefore, ILS have significantly helped spread hurricane risk outside of the Florida insurance market, helping to reduce the potential economic impact of a major hurricane on the citizens of Florida. Moreover, by helping to better manage Florida's risk, ILS have contributed to the stabilisation of re/insurance markets globally so they can better support sustainable economic activity worldwide.
ILS enable insurers and government entities to manage systemic catastrophe risks with an efficient, pre-event approach – rather than an inefficient, post-event approach to disaster response. A key governance benefit of pre-event preparation for disaster response is a considerable increase in transparency and accountability of disaster relief funds; an unspoken dynamic of traditional post-event disaster aid is that the situation often must get worse before relief funds are mobilised. Even then, the amounts and conditions under which relief funds will be received are uncertain, making fund implementation plans difficult and inefficient to use in practice. However, pre-arranged financing with transparent triggers for funding flows can greatly increase the efficacy of disaster financing and planning.
Guided by these pre-event financing principles, the World Bank Treasury, as part of a larger spectrum of risk financing services offered by the World Bank Group, has been enabling client countries to manage their natural catastrophe risks with catastrophe bonds that use so-called parametric loss triggers. These triggers are based upon transparent and objective parameters of an event, such as magnitude and location of an earthquake, central pressure of a hurricane or even the number of lives lost due to a specified disease. Through its ILS platform, the MultiCat Program, the World Bank has been facilitating the issuance of hurricane and earthquake catastrophe bonds for the government of Mexico since 2009. And since 2014, it has been directly issuing catastrophe bonds for the benefit of client countries through its Capital-at-Risk Notes Program, including the 16 country members of the Caribbean Catastrophe Risk Insurance Facility, the Pacific Alliance member countries (Mexico, Chile, Colombia, Peru) and low income World Bank country members facing pandemic risks.
These issuances are embedded in broader national disaster risk management programmes aimed at reducing the impact of disasters on economies and include contingency planning for a faster, more predictable and more effective response to vulnerable communities, as well as ex-ante risk mitigation measures. In our view this increasing trend of sovereign policies and actions for de-risking public balance sheets will form a significant piece of sustainable market growth in the future and a source of recurring risk transfer to the ILS space.
ESG Ratings for ILS
As illustrated by the examples above, we believe ESG factors are critical to the long-term investment proposition and performance in the ILS asset class. They should create opportunities that enable the market’s future growth, while providing incentives to ensure investments are adequately and sustainably priced.
By reviewing all ILS when they are announced, ESG considerations can be taken into account. This can include assigning an ESG rating with respect to their overall structure, rationale and quantitative elements. A simple example, that would ensure consistent usage and ease of implementation, is illustrated below:
- POSITIVE – represents positive accord with one or more ESG principles
- NEUTRAL – implies overall neutral accord with regard to all ESG principles
- NEGATIVE – works against one or more ESG principles
As an example, a positive rating would be given to the catastrophe bonds issued by the World Bank as part of their Capital-at-Risk Notes series, which strongly reinforce all three ESG elements. A negative rating would be given to an ILS issued by an entity that stands against such principles, for example a corporation or even a government that is listed on an investor exclusions list or that is attempting to subvert transparency standards in its risk disclosures. As well as being a clear governance concern under an established ESG framework, the latter would also rate negatively against general underwriting standards. Therefore, it is rare for us to encounter ILS that might warrant such an ESG rating, as other assessments would have already eliminated them early on in our investment screening process. This example serves to illustrate how intertwined ESG principles for investing are with traditional underwriting of ILS.
Moreover, adherence to these principles in traditional ILS underwriting more broadly should help to ensure these ESG standards are maintained and improved further. Looking through the lens of governance again, for example, transparency is emphasised in how loss triggers, loss modelling and risk factors are defined and disclosed in ILS submissions. The quality of this material has a great deal to do with the quality and transparency of reporting by the re/insurance company sponsoring the ILS issue. Avoiding investments with bad risk disclosure practices and bad loss trigger designs sends a strong message to companies seeking to access the ILS market as to the corporate governance standards that are required by investors.
ILS play an important and growing role in managing some of the world’s most pressing risks. The attractive risk-adjusted returns of the asset class reflect this valuable contribution to the security, stability and growth of the global re/insurance market and therefore the benefits it can bring to economies and societies worldwide. As such we believe the natural and continued alignment of ILS with positive ESG attributes could further protect and enhance portfolio returns for investors as the asset class grows in the years ahead.
The information in this document is given for information purposes only and does not qualify as investment advice. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.