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Using ESG to assess the quality of Return on Equity

Using ESG to assess the quality of Return on Equity

06-01-2016 | Visione

We firmly believe that ESG analysis, combined with traditional financial analysis, can offer investors powerful insights. With our proprietary Sustainable ROE Analyzer, we use ESG information to assess the quality and sustainability of Returns on Equity (ROEs) of property & casualty insurance companies.

  • Johan  van der Lugt
    Johan
    van der Lugt
    Investment Analyst Global Equities

Speed read

  • ESG analysis helps to assess the quality of Return on Equity
  • We introduce our Sustainable ROE Analyzer
  • We apply this to property & casualty insurance companies

Investments in material (i.e. financially relevant) sustainability issues can enhance value for shareholders while investments in immaterial sustainability issues have little or negative value implications. This is an important outcome of a paper published in mid-2015 by Kan et al. from Harvard Business School. Their main finding is that firms with good performance on material sustainability issues significantly outperform (in terms of stock market performance) firms with poor performance.

In our analysis, we assess those factors that are likely to have a material impact on the long-term sustainability of a company's business model and its share price. We focus on determining a company’s earnings power: will it be able to continue its record of earnings? What is the quality of the generated earnings? Are they based on growth opportunities, efficiencies or balance sheet optimization? What is this company's sustainable competitive advantage? We want firms to have an enduring capability to create value and sustain a competitive advantage based on strong ESG performance on material issues.

Scopri gli ultimi approfondimenti in tema di sostenibilità
Scopri gli ultimi approfondimenti in tema di sostenibilità
Abbonati

Putting the property & casualty insurance sector under the microscope

We focus our analysis on property & casualty (P&C) insurers for a number of reasons:

  • The P&C insurance industry is exposed to important long-term trends such as climate change, population growth, autonomous driving, big data and cyber risk.
  • There is room for improvement in their ESG scores versus the broader insurance sector.
  • They have favorable industry characteristics and sensible regulators.
  • The short duration of their book of business makes them good candidates for change. 
  • Management tends to be conservative, which has benefits and drawbacks. Tenured management teams have lived with the fallout of their mistakes, which helps them to be disciplined.

Several mega trends are impacting the P&C insurance industry. Examples are global aging, economic uncertainty, digitization and regulations. Insurers will be dealing with significant business model evolutions impacting their value chain and profitability. With many macro trends unfolding the P&C industry will look different ten years from now.  We see it as the role of insurance companies and their management teams to anticipate the resulting risks and opportunities.

For the insurance sector, risk management and corporate governance stand out as the two dominant material themes. Central to our thinking is how these factors impact a P&C insurer’s profitability.

Introducing our Sustainable ROE Analyzer

Not all returns on equity (ROEs) are equal. To investigate the quality and sustainability of a company’s ROE, we use a proprietary framework, the Sustainable ROE Analyzer, which links return on equity to industry-specific and ESG/ long-term themes. It establishes a direct relationship between industry metrics such as customer retention rates, claims ratio, expense ratio and reserve releases on the one hand and ESG and long-term themes such as customer satisfaction, changing weather patterns, data analytics/ big data and risk management on the other hand. For the P&C insurance industry, we come up with the following important drivers of ROEs:

  1. Financial drivers: risk management and corporate governance
  2. Growth and efficiency drivers: link between sustainability strategy and corporate strategy (data analytics/ big data, cyber insurance, climate change)
  3. Efficiency driver: human capital management (employee turnover)

Do higher ranked ESG names have higher ROEs?

Linking ESG scores (from RobecoSAM) with expected ROEs (Bloomberg consensus) we find that a high ESG score does not automatically imply a high level of relative profitability.

In other words, more factors explain a high profitability other than just ESG related topics.

  • What matters in our view, is the quality and sustainability of the ROE. If a high level of profitability is supplemented with a high ESG score, it implies lower ESG risk and therefore in general a greater quality and sustainability of the underlying profitability.
  • Most interesting from an investment perspective are the companies with a low ESG score and low forward ROE expectation. How can they achieve value creation by improving both their ROE outlook and their ESG score? What is structural and what can be improved?

Our Sustainable ROE Analyzer is a useful tool to focus on those profitability drivers that determine both the quality and the sustainability of a company’s ROE. We see it as a practical solution to looking at materiality and how this translates into financial value creation for shareholders.