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