Kate Miller is a partner and head of institutional at London and Capital & Shadrack Kwasa is an executive director at London and Capital
16 October 2019

Why ESG investing is good for captives

Investors often find discussing environmental, social and corporate governance (ESG) factors confusing, and implementing these principles in a portfolio is an even greater challenge. This article is intended to clarify what is meant by ESG and socially responsible investing (SRI), while describing the impact they can have on a captive’s business.
There is little consensus around what people mean when they talk about ESG: the same terminology can mean different things to different people. In general, ESG refers to an approach to investing which focuses on addressing:

  • E: environmental issues such as carbon emissions, water scarcity, environmental pollution.
  • S: social issues such as discrimination, gender issues, equal pay, wealth distribution.
  • G: governance issues such as executive pay, corporate responsibility, regulatory intervention.

From an investment perspective, ESG means structuring investment decisions to directly, or indirectly, take these considerations into account. ESG is often referred to as responsible investing, sustainable investing, ethical investing or green investing—all of which can be used to refer to some, or all elements of ESG investing. Therefore, when discussing ESG and SRI it is essential that people clarify the terms they are using.

All this is important for captives, which can be particularly sensitive to ESG issues—arguably more so than other institutional investors and insurers. ESG events tend to have an impact on insurance assets and liabilities.
Table 1 illustrates the potential impact of ESG on an insurer’s balance sheet.

Certain lines of business and industries expose captives to more ESG risk than others, but this is an issue that all captives should be aware of, because:

  • ESG risks may not be immediately obvious.
  • ESG risks can materialise and damage a captive’s balance sheet very rapidly.
  • ESG investment risks can be mitigated substantially by making simple changes to an investment portfolio.

Benefits of ESG-aware investing
Clients often express concern about whether their expected return profile will change once they commit to ESG-aware investing. It is a common misconception that ESG investing must be done at the expense of investment returns. When done correctly, ESG investing should enhance the long-term return profile of a captive investment portfolio, for several reasons:

  • Holding securities that are exposed to negative ESG events will likely result in losses in the long-run as these risks materialise.
  • Socioeconomic and regulatory trends mean that early adopters of ESG-aware investments will benefit as ESG becomes increasingly popular, driving up the price of ESG-aware securities, and down the price of securities with negative ESG associations (consider the growing popularity of electric vehicles and the increased regulation limiting diesel engines).
  • Where ESG correlations exist for captives between assets and liabilities, there is a meaningful risk of unexpectedly large losses as a result of ESG events. Investing with those correlations in mind provides for a more diversified risk profile across the business.

A good example of this from a social and governance perspective was the diesel emissions scandal. For a captive underwriting directors and officers risk for a diesel car manufacturer while simultaneously being invested in securities issued by car manufacturers, this presented a concentration of risk, as it had to pay out on large claims while suffering investment losses on securities linked to affected manufacturers and related companies.

In a world where climate change leads to higher frequency and impact of cat events, the business may keep in mind the correlation between the liabilities (insurance losses resulting from a large cat event) and the assets (investment losses resulting from generally more cat events). By limiting exposure to investments that may suffer if natural catastrophes increase, the captive is diversifying its risk exposure.

Hence the captive can diversify risk across the business by limiting exposure to car manufacturers and related businesses on the asset side and replacing these with uncorrelated exposures.

Large, commercial insurers are already incorporating these ideas and practices into their businesses. For captives, the risks around ESG issues may not be as obvious, which may leave them in a vulnerable position as these risks emerge. Captives which have not systematically evaluated ESG exposures may find that unexpected ESG events could have an outsized, adverse impact on their viability and their owners’ businesses.

Captives that have not developed a way to systematically evaluate ESG risks should start with the questions in Table 2.

London and Capital has plenty of experience in helping captives understand how ESG risks impact their business and positioning their investment portfolios to capitalise on, and reduce, risks. ESG risk is an area that many captives have historically overlooked, but which could become significant as the world and the insurance industry evolves.
ESG may be a hidden risk for many insurance players and we would encourage companies to explore what ESG means for their business.

Kate Miller is a partner and head of institutional at London and Capital & Shadrack Kwasa is an executive director at London and Capital.
They can be contacted at:  charlotte.wilkins@londonandcapital.com