united kingdomen
Using ESG to assess the quality of Return on Equity

Using ESG to assess the quality of Return on Equity

06-01-2016 | Insight

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.

Stay informed on Sustainability Investing with monthly mail updates
Stay informed on Sustainability Investing with monthly mail updates
Subscribe

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.

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree