The right metrics can accurately gauge the impact of ESG strategies and progress toward goals, writes Penney Frohling, EY-Parthenon partner and EMEIA financial services strategy leader
As insurers navigate a period of immense change in response to ESG and the need to serve a broader set of stakeholders, our EY insurance team believes the following four metrics will represent the most accurate and holistic barometers of exposure to climate-related risks and perceptual issues that threaten insurers’ value during the next three to 18 months.
Total shareholder return (TSR)
This metric incorporates time horizons from minutes to decades and is comprehensive in incorporating the long-term growth prospects of a company, its resilience and reputation, commitment to innovation, ability to address consumer, societal and environmental issues and meet governmental regulatory requirements.
As more investors introduce ESG criteria into portfolio management, demand and supply will drive up share prices of the firms that meet the criteria. So, it is highly likely over the short and medium terms that share price performance will become a good measure of how well individual insurers present their ESG credentials and tell their ESG stories.
One of the most pressing issues for the C-suite currently is the ESG rating that a company is given by equity analysts. There are significant concerns associated with the inconsistencies in how these ratings are conferred.
These concerns are justified due to the potential impact of these ratings on share price and investor appetite – institutional investors may decline to invest due to new ESG investment policies. Many senior insurance leaders fear that poor or even mediocre ESG ratings will make them look bad relative to their peers and lead to stock price depreciation.
ESG ratings are a critical path for ESG index inclusion, such as the Dow Jones Sustainability Indices and MSCI’s ESG ratings.
Over the past 12 months, flows into “green” funds and sustainable exchange-traded funds have increased fivefold in the UK and other markets. Inclusion in these types of funds typically leads to higher stock prices and missing out could result in underperformance relative to peers.
Over the long term, it is our conviction that firms that make choices to enhance long-term value will also deliver superior returns to investors. While TSR is a good overall indicator, the challenges of decomposing it into sub-metrics are well known. The following three metrics offer some correlation to TSR and are more readily broken down into underlying drivers.
Intangible but measurable, brand value may be the ultimate long-term value metric, with direct positive correlation to shareholder value.
In the insurance sector, brands have typically emphasised perceptions of financial strength, stability and longevity. ESG principles, including transparency and accountability, that are geared toward a sustainable, long-term perspective can be excellent complements to traditional positioning.
Conversely, brands that don’t credibly demonstrate a commitment to a greener economy, diverse workforces, ethical business practices and a more equitable society may face backlash in public opinion and increased regulatory scrutiny.
Decreases in favourability ratings and, ultimately, financial value would likely follow. In other words, damaged brands can make stock prices fall.
Brands are financially valuable to firms precisely because of their value to other stakeholders, including customers, employees, suppliers and partners. While these are often considered “soft” metrics, they are nevertheless measurable and will become more important to tracking value in the age of ESG.
Economic net worth (ENW)
The time horizon of the insurance sector is, by default, long-term, due to the nature of the risks it covers in its policies. Because of the short-term focus of past accounting standards, insurers have for some time been disclosing various non-GAAP measures, including market consistent embedded value and Solvency II own funds, to show shareholders their ENW and ability to create long-term value.
With the introduction of IFRS 17 in 2023, investors will also be able to infer a GAAP measure of ENW.
We are seeing important changes in the risk and return profile on both the asset and liability sides as a result of ESG considerations and expect the approach to ENW evaluation will further evolve.
For both assets and liabilities, firms should take stock of the way they measure their current values to reflect the fact that risk profiles and future expectations are changing in response to climate action. They can use this insight to communicate a robust assessment of their current ENW. They should also look to quickly embed new data, assumptions and valuation techniques related to green assets and liabilities into their ENW frameworks as increasingly useful differentiators relative to long-term value creation.
Return on capital (ROC)
ROC measures the ability to underwrite, price and manage risk effectively to generate positive returns.
The capital-intensive nature of the insurance business stems from the need for large reserves against the broad variety of underwritten risks, including longevity, mortality, morbidity and climate-related risks, covering a broad spectrum of time horizons.
Many insurers already have sophisticated risk modelling, often mandated by regulatory capital standards, and perform stress tests against key risk factors to ensure they remain adequately capitalised.
Risk-based capital requirements are a good indicator of exposure to “tail risks” and the firms able to generate a positive ROC are often the ones best able to price for these risks in their underwriting.
There is growing momentum in the industry to include climate risks, including both physical and transition risks, in insurers’ internal capital models.
There are also regulatory moves toward climate scenario testing. We expect to see significant evolution as data on climate impacts and exposures evolves, and also expect ROC to become an increasingly important indicator of an insurer’s success in managing its exposure.
Development of hybrid ESG metrics requires more time
Why do we believe that these are the most sensible metrics to gauge stakeholder views of the industry’s approach to ESG in the near term? Primarily because they are:
Pragmatic and practicable
Already tracked and reported by some insurers
Often signed off in standard audit procedures
They are also easily decomposed into sub-metrics to enable root-and-branch analyses, support mapping to non-financial metrics and provide line of sight to different stakeholder groups. Plus, they accommodate multiple time horizons and diverse stakeholder interests, as well as near-term measures of both value destruction and protection.
Because financial metrics will remain the dominant way of communicating to stakeholders, they will be more easily adoptable.
The development of more sophisticated “hybrid” metrics to accurately and credibly correlate ESG to financial performance requires more time. Such metrics will be of limited relevance to insurers, which will be net users of data to make investment and underwriting decisions once standards have been established. This is an iterative process involving many industries.
Tomorrow’s market-leading insurers will be those that do the necessary and deep strategic thinking and take the right measured actions today, and our EY insurance team believes these are the most sensible metrics to gauge stakeholder views of the industry’s approach to ESG in the near term.