Portfolio resilience through sustainability

Meaghan Muldoon |Sep 23, 2019

Insurers are increasingly focused on integrating sustainability, but the perceived trade-off between sustainability and other goals remains an area of concern. We explore how insurers can enhance their resilience to climate change from both a physical and transition risk perspective, with data and scenario analysis as the common thread.

Moving from avoid to advance

The findings of the 2019 Global Insurance Survey suggest insurers are making steady progress on their sustainability journey. Yet this progress may be hampered by a continued belief that integrating ESG considerations into a portfolio involves compromising financial (income, alpha) or risk management (diversification) goals.

On the surface, this suggests insurers remain wedded to a view that sustainable or ESG investing, is about ‘values’ rather than ‘value’. A more nuanced reading, however, may be that insurers seek sustainable outcomes alongside their traditional financial objectives. This is reflected in the significant role green bonds play – the second highest allocation intention within fixed income portfolios and the face-to-face interviews.

Figure 1: Climate related risks insurers face

Climate related risks faced by insurers.

Sources: BlackRock June 2019. Adapted from the International Association of Insurance Supervisors (IAIS)/ Sustainable Insurance Forum (SIF), July 2018: ‘Issues paper on climate change risks to the insurance sector’ available on Figure 1 summarizes the main climate change-related risks that are relevant for insurers, both on the underwriting and on the investment side. It does not represent an exhaustive analysis and is for illustrative purposes only.

This echoes conversations we have with many of our clients around the world, whether it is about reconciling sustainability with their index-based approach through optimization or preparing for climate change, while keeping mainstream exposures. Our research suggests that investors do not need to choose between the pursuit of returns or the pursuit of ESG objectives. Enhanced data and insights make it possible to create sustainable portfolios without compromising financial goals. We find ESG has much in common with existing quality metrics such as strong balance sheets, suggesting ESG-friendly portfolios could be more resilient in downturns. While ESG-focused indices are young and performance histories include back-tested data, the evidence is promising and becomes even more compelling over longer time horizons as ESG-related risks tend to compound.

As with other financial goals, such as diversification, there may be a trade-off between shorter-term return potential and mitigating longer-term risk. Ultimately, however, the integration of ESG considerations could lead to greater resilience. Sustainable portfolios tend to have a quality bias, meaning they may underperform in ‘risk-on’ periods, but provide greater downside protection in ‘risk-off’ scenarios. The pay-for operational excellence and reduced vulnerability to sustainability risks such as climate change is likely to increase over time and may be increased further through active management.

Building resilience

The role of ESG in building greater resilience is probably the most obvious in the context of climate change. Preparedness for climate change transition also highlights the challenges associated with finding a balance between different goals. Figure 1 summarizes the main challenges insurers face on both the underwriting and the investment side. From an investment perspective, we focus on two primary sources:

  1. Physical risk, which captures the impact of environmental change on financial performance.
  2. Transition risk, which captures the risks (and potential opportunities) arising from the move towards a decarbonized economy.

Physical risk

The cost of climate change-related events is mounting rapidly, as Figure 2 illustrates, a fact we believe investors have not fully priced into their portfolios. The BlackRock Investment Institute recently published a paper that maps the potential physical impact for a range of asset classes today and in a variety of forward-looking scenarios, including a ‘no action’ case. It underscores the importance of scenario analysis to understand these climate-specific risks and opportunities, and position portfolios accordingly.

Figure 1: Mounting costs

Mounting costs of climate change

Source: BlackRock Investment Institute, with data from NOAA National Center for Environmental Information (NCEI), October 2018. Notes: The line shows the number of climate events with losses exceeding US$1bn. The data includes droughts, flooding, severe storms, tropical cyclones, wildfires, winter storms and freezes. The bars show the total cost. The data has been adjusted for inflation using the 2018 US dollar rate.

Transition risks

We see the global transition to a lower carbon economy accelerate over a 5- to 7-year time horizon. Currently, most investment approaches to transition risk focus on pure divestment policies or risk mitigation through ‘low carbon’ indices, which measure absolute carbon emissions. Investors increasingly complement these with impact strategies across both public (e.g. green bonds) and private markets (e.g. renewables infrastructure). However, we think there are further steps investors can take.

  1. Mapping transition readiness: As the transition gains momentum, we think there is growing merit in systematically assessing companies’ transition readiness. Our sustainable research group has developed a proprietary framework that not only maps and compares companies’ transition risk, but also how well a company is positioned for success in a low-carbon economy. Figure 2 depicts the key pillars of the BlackRock low carbon transition framework.
  2. Mapping regulatory transition risk: Over the last decade, climate change-related regulation has moved to the top of the regulatory agenda, with the number of regulations across the 50 largest economies by GDP increasing from 10 in 1998 to over 400 in 2018 according to the UN-supported Principles for Responsible Investing (PRI) network – and that momentum is only likely to speed up. Ensuring portfolio resilience from a climate transition perspective, therefore, also entails being able to simulate the potential impact of such regulations. We expect carbon-intensive companies in particular to face regulatory pressure. Being able, for instance, to map carbon pricing across various jurisdictions will help investors to manage those risks better and build resilience across their portfolios.

Figure 3: Transition ready

Core business involvement and natural resources management.

Sources: BlackRock Sustainable Investing and BlackRock Investment Institute, December 2018. Note: The table is for illustrative purposes only.

Meaghan Muldoon
EMEA Head of Sustainable Investing
Meaghan Muldoon, Managing Director, is EMEA Head of Sustainable Investing at BlackRock.
Read biography
Global Insurance Report 2019:
Re-engineering portfolio resilience
BlackRock’s eighth annual global insurance survey provides perspectives on markets and portfolio construction from 360 senior insurance executives, plus client interviews and insights from BlackRock’s experts.
Global Insurance Report 2019: Re-engineering portfolio resilience