Investors are increasingly considering the environmental, social and governance (ESG) properties of their portfolios. As specialists in insurance-linked securities (ILS), we are often asked about the ESG attributes of this unique asset class and how these translate into responsible investment policies. Here we outline why positive-ESG alignment is fundamental to ILS investing and how we implement our ESG policy at Fermat.
ESG considerations, as we see it, are crucial to the long-term performance of any investment. We believe the ILS asset class – which offers capital market investors a mechanism to provide new capital to the global re/insurance sector – naturally aligns with ESG principles, as we outline below. Our view is that continued adherence to high ESG investment standards will not only accelerate ILS market growth but will also ensure the long-term sustainability and attractiveness of the asset class for investors going forward.
The ILS market was born in the late 1990s after two events in the US – Hurricane Andrew in 1992 in suburban Miami and the Northridge Earthquake in 1994 in suburban Los Angeles – caused a near-collapse of the insurance markets in Florida and California. These disasters created an opportunity for capital market investors to provide new capital to the re/insurance sector. Since then, ILS have had an increasingly important role in helping stabilize insurance markets by broadening the mutual sharing of risks across a broader and deeper capital pool.
By their very nature, sustainable environmental considerations, the E of ESG, are closely linked with ILS. One of the main risks underpinning investments in the re/insurance sector is weather risk. This means the ILS market – like the insurance and reinsurance markets it supports – is at the forefront of monitoring changes in weather extremes and their impact on economies. For example, every US hurricane catastrophe bond – the most well-known type of ILS instrument – indicates the numerical probability of loss to the bond both with and without the impact of factors such as elevated sea surface temperature (SST) to allow consideration of the possible effects of climate change on hurricane activity. These types of climate change impact analyses allow investors to evaluate the sensitivity of ILS transactions to potential climate-related changes. Identifying and quantifying physical climate-related risks to ILS is a core component of the ILS underwriting and investment process. Leading managers in this market continually monitor events and check their models and benchmarks for any potential changes in activity, seeking to detect, quantify and integrate emerging climate trends into their underwriting and investment processes.
Unlike long-duration investments like equities, long-term bonds and real estate, ILS are more short-term in nature (maturities at issuance typically range from one to five years; a typical catastrophe bond portfolio has one and a half to two years of average duration) and can, therefore, reprice their returns in the relative near term as new information about the frequency and severity of weather events becomes available. In this way, capital market investors and ILS sponsors alike are provided with a forward-looking, market-based indication of the costs of weather risks and consequently, climate change. In return for providing capital to set explicitly and openly against these risks, investors are better able to be compensated adequately for climate risks.
Re/insurance losses are also driven by other environmental factors such as the underlying insured exposure in harm’s way. In hurricane-prone areas, for example, ILS provide a market-based indication of the long-term costs to society of coastal property development, not just the costs of the hurricane hazard alone. Better managed communities and infrastructure, all things being equal, should be rewarded with more competitively priced re/insurance risk capital than poorly managed developments, which are more prone to more substantial insurance losses. The same principle applies to urban development in seismic zones. This market-based pricing mechanism provides an essential price signal for the benefits of environmental risk mitigation and adaptation measures and creates a powerful feedback loop that aligns incentives for better and sustainable risk management in the long run. Re/insurance and ILS markets are uniquely placed to provide this essential function to society.
The essential and multi-faceted role of insurance in inclusive economic development and growth has long been acknowledged. Insurance enables trade and commerce, makes economic activity more efficient, promotes financial sector stability and growth, facilitates investment and innovation, and improves access to credit and financing for individuals and businesses. It also supports poverty reduction by helping households manage risks to their lives and livelihoods, to build financial resilience and to advance economically. The empirical evidence confirms that a nation’s insurance market development is closely related to economic development and that insurance is integral to supporting and sustaining inclusive economic growth for societies worldwide.
As an illustrative example of how the S of ESG is fundamental to the ILS asset class, let us consider Florida, one of the largest buyers of property catastrophe insurance coverage in the world. The current industry estimate of the insured loss from a Category 5 hurricane hitting a major city such as Miami is USD 250 billion. At the same time, the total capital base of the traditional reinsurance industry is estimated to be under USD 400 billion. Although the reinsurance capital base is not all exposed to this single event, such an event would throw the global re/insurance market into disarray with material impacts on the cost and availability of insurance worldwide.
We estimate that in aggregate, the entire global traditional reinsurance market covers USD 40 billion of single-event loss in Florida. In recent years, ILS have grown to the point that they provide an estimated USD 50 billion of additional hurricane coverage to insurance companies and reinsurers active in the state. Therefore, ILS have significantly helped spread hurricane risk outside of the Florida insurance market, helping to reduce the potential economic impact of a major hurricane on the citizens of Florida. Moreover, by helping to manage Florida’s risk better, ILS have contributed to the stabilization of re/insurance markets globally so they can better support sustainable economic activity and growth worldwide.
ILS are also helping close insurance protection gaps. In 2019, Swiss Re estimated that the global gap between insurance need and insurance availability – the ‘protection gap’ – stood at a staggering USD 1.2 trillion across the three main lines of insurance business: property, health and life. Of this, they estimated a global protection gap for natural catastrophes of USD 222 billion, noting that only 33% of the total global economic losses from natural catastrophes over the previous decade were borne by re/insurance on average.
The protection gap is more pronounced in emerging economies and countries with under-developed insurance markets. For example, in Latin America and the Caribbean only an estimated 17% of the economic losses from natural catastrophes were covered by re/insurance over a ten-year period. Without adequate insurance mechanisms to absorb such shocks, governments experience enormous pressure to divert funds toward disaster recovery, aid to citizens, and the rebuilding of lost infrastructure. The negative impact on domestic GDP can be significant and long-lasting. For example, in the aftermath of the Haiti earthquake in 2010, Haiti’s GDP growth fell from +3.1% to -5.1%. The earthquake caused total economic damages equal to 120% of the country’s GDP. A similar sized earthquake that hit New Zealand in 2010-11 caused only the loss of 18% of GDP. These two events bring into sharp contrast the impact a natural catastrophe can have on a country with and without insurance coverage and how insurance has a public policy role in managing the direct and indirect costs of natural disasters at the household, enterprise, and sovereign levels.
For these reasons, in recent decades, development organizations have made significant investments to build and expand insurance mechanisms in developing and emerging economies. These insurance building efforts include the tapping of the ILS market for catastrophic natural disaster risks that can overwhelm local insurance systems and shock economies. With technical assistance from the World Bank, the Turkish government established the Turkish Catastrophe Insurance Pool to significantly reduce the government’s fiscal exposure to earthquake risk by providing affordable catastrophe risk insurance for lower-income, urban Turkish homeowners. A key element to achieve affordability was the management of reinsurance costs, which involved the use of catastrophe bonds. More economically developed nations are also increasingly considering ILS, including the US Federal government, which launched a catastrophe bond program in 2018 for the National Flood Insurance Program. In these ways, ILS are supporting progress on globally agreed commitments on disaster risk management and insurance made by governments through the Sustainable Development Goals (SDGs) and Sendai Framework for Disaster Risk Reduction. By providing a structural capital solution to the re/insurance industry, ILS help close protection gaps by expanding and supporting the efficient functioning of the global re/insurance marketplace, helping it deliver on the promise of insurance for societies across the globe.
Finally, in recent years, World Bank bonds have been increasingly used as a collateral solution for catastrophe bonds. As of 2019, more than 60 catastrophe bonds with an aggregate amount of approximately USD 13 billion have used World Bank bonds as collateral. These World Bank bonds are issued off the same global debt issuance program that the World Bank uses to issue roughly USD 50 billion annually to fund its sustainable development activities. The proceeds from every single issue contribute to the World Bank’s mission to alleviate poverty and boost shared prosperity in its member countries. When ILS sponsors choose these World Bank bonds as a collateral solution, therefore, the positive social impact of an ILS investment is further enhanced.
Governance benefits and significance
ILS enable re/insurers and government entities to manage systemic catastrophe risks with an efficient, pre-event approach – rather than an inefficient, post-event approach to disaster response. A key governance benefit of pre-event preparation for disaster response at the governmental level is a considerable increase in transparency and accountability of disaster relief funds; an unspoken dynamic of traditional post-event disaster aid is that the situation often must worsen before relief funds are mobilized. Even then, the amounts and conditions under which relief funds will be received are uncertain, making fund implementation plans difficult and inefficient to use in practice. In contrast, pre-arranged financing with transparent triggers for funding flows can significantly increase the efficacy of disaster financing and planning.
Guided by these pre-event financing principles, the World Bank Treasury, as part of a broader spectrum of risk financing services offered by the World Bank Group, has been enabling client countries to manage their natural catastrophe risks with catastrophe bonds that use so-called parametric loss triggers. These triggers are based upon transparent and objective parameters of an event, such as the magnitude and location of an earthquake, the central pressure of a hurricane or even the number of lives lost due to a specified disease. Through its ILS platform, the MultiCat Program, the World Bank has been facilitating the issuance of hurricane and earthquake catastrophe bonds for the government of Mexico since 2009. Moreover, since 2014, the World Bank has been directly issuing catastrophe bonds for the benefit of client countries through its Capital-at-Risk Notes Program, including the 16 country members of the Caribbean Catastrophe Risk Insurance Facility, the Pacific Alliance member countries (Mexico, Chile, Colombia, Peru), the Philippines and lower-income World Bank country members facing pandemic risks.
These issuances are embedded in broader national disaster risk management programs aimed at reducing the impact of disasters on economies and include contingency planning for a faster, more predictable, more transparent and more effective response to vulnerable communities, as well as ex-ante risk mitigation measures. In our view this increasing trend of sovereign policies and actions for de-risking public balance sheets will form a significant piece of sustainable market growth in the future and a source of recurring risk transfer to the ILS space.
However, governance factors are not just relevant to ILS issued by public and international organizations. They are also critical when assessing ILS issued by re/insurance companies and other corporate entities. Risk disclosures in ILS submissions have a great deal to do with the quality and transparency of reporting by the company sponsoring the ILS issue. Therefore, we believe, the G in ESG is as important as the other two elements when it comes to assessing and underwriting ILS investments and to supporting sustainability in the context of our asset class.
In our view, good governance in the context of an ILS is reflected in the transparency of the risk disclosures with a particular focus on the structure of the ILS, which should have a clear loss trigger mechanism and provide sufficient details on the contingent release of funds, and essential data and risk modeling to enable reasonably robust risk estimation. Transparency on these fronts is an especially important pre-requisite for deploying capital to areas where it has not been applied before. Disclosures on how a company governs its risk are also critical. At Fermat we value company sponsors that can demonstrate that they are good risk managers and strive to constantly improve their risk governance. Just as with sovereign sponsors noted above, managing systemic catastrophe risks with an efficient, prepared approach also enables companies to quickly estimate, respond to and reduce ultimate losses. For example, an insurance company that has invested in data, technology, systems and protocols for responding to and managing claims should be able to assist policyholders more quickly, make more timely and trusted reserve estimations and deliver superior results after loss events, as evidenced by their track records and reserve development history. Another example is a utility company that continues to invest in cutting edge modeling and technology to mitigate their wildfire risk. Such a company is not only better positioned to reduce wildfire risk for the communities they serve but, by sharing their knowledge and data, is more likely to build confidence with investors and attract ILS capital to better manage catastrophic wildfire risks.
This inherent alignment of traditional ILS underwriting with important G elements, we believe, will ensure that ILS have the intended positive impact on sponsor companies and the clients they serve. In our view, this will be key to maintaining the relevance and sustainable growth of the asset class while protecting returns for investors.
Fermat ESG ratings
As illustrated by the examples above, we believe ESG factors are critical to the long-term investment proposition and performance in the ILS asset class. They should create opportunities that enable the market’s future growth while providing incentives to ensure that investments are adequately and sustainably priced, with onward benefits for ILS sponsors and the initiatives ILS support.
At Fermat, ESG principles for investing are intertwined with our ILS underwriting process and are critical to the composition and ultimately, we believe, to the growth and performance of our portfolio. Adherence to these principles in traditional ILS underwriting more broadly should also ensure these standards are maintained and improved further in the marketplace. Fermat’s Investment Committee reviews all Rule 144A catastrophe bonds when they are announced to determine if they would be appropriate investments for Fermat’s clients. Part of this review includes assigning an ESG rating. With respect to their overall structure, rationale and quantitative elements, all 144A catastrophe bonds brought to market, as well as all non-144A positions in our portfolios, are ESG rated as follows:
1. POSITIVE – is in positive accord with more than one ESG principle
2. NEUTRAL – is overall neutral with respect to all ESG principles
3. NEGATIVE – works against one or more ESG principles
An ILS that receives a negative rating is not eligible for investment in our portfolios. In addition, an ILS from a sponsor that meets any of our sustainability exclusion criteria also receives a negative rating and is not an eligible investment for Fermat portfolios. To ensure ratings are applied consistently, a scoring system is used. An investment's rating, and associated scoring and commentary, is documented by Fermat’s Chief Compliance Officer (COO) as part of Fermat’s approval process.
As an example, a positive rating would be given to the catastrophe bonds issued on behalf of a government by the World Bank as part of their Capital-at-Risk Notes series, which strongly reinforce all three ESG elements. A positive score would also be given to an insurance company that reaches the highest standards in catastrophe bond risk disclosures, by providing detailed information regarding the subject business underlying the ILS issue, granular data on current and projected insured exposures, clear and replicable risk modeling information and that demonstrates a strong track record in making timely and accurate loss and reserve estimations after loss events. A neutral score, for example, could be assigned to an ILS sponsored by an insurance company that does not have the same systems, reporting, response and claims handling capabilities as other peers active in the catastrophe bond issuing market. The score signals that such a company does not meet the higher corporate governance standards and risk disclosures or has yet to demonstrate that they can govern their risk as well as other companies in the market. However, with time and experience, ESG ratings for bonds issued by such sponsors could improve.
A negative rating would be given to an ILS issued by an entity that stands against such principles, for example, a corporation or even a government that is attempting to subvert transparency standards in their risk disclosures. As well as being a clear governance concern under our established ESG framework, the latter would also rate negatively against our underwriting standards.
We conduct a quarterly review of the ratings of all investments in our portfolios and in the Rule 144A catastrophe bond universe and re-rate investments, as necessary, in light of any new public information or change in condition of the ILS itself. This review is conducted by the Investment Committee and documented by the CCO. Should the review result in the change of an ESG rating to negative, the Investment Committee will determine how best to liquidate the position if appropriate or, where applicable, take action to remediate the situation through active engagement with the sponsor. We will abstain from similar investments until the identified ESG issue(s) is resolved.
As noted above, we believe adherence to ESG principles in traditional ILS underwriting more broadly will ensure that ESG standards are maintained and improved further. Looking through the governance (G) lens again, for example, transparency is emphasized in how loss triggers, loss modeling and risk factors are defined and disclosed in ILS submissions. Avoiding investments with poor risk disclosure practices and bad structural or loss trigger designs, therefore, sends a strong message to companies seeking to access the ILS market as to the corporate governance standards required by investors. We believe it is also crucial to the long-term performance of our ILS investment strategies and the sustainability of the ILS marketplace.
As Fermat’s underwriting process emphasizes analysis of the risk disclosures in ILS submissions, there is a strong tendency for Fermat portfolios to hold a very high number of overall ESG-positive rated ILS investments. In fact, it is rare for us to encounter ILS that might warrant a negative ESG rating, as most Rule 144A bonds in our investment universe are rated as either neutral or positive, and preliminary assessments of private ILS submissions eliminate potentially negatively rated investments very early on in our investment screening process before ESG ratings are even assigned.
Engagement and stewardship
At Fermat we support engagement and stewardship, but engagement and stewardship as it pertains to our unique asset class. The ESG powers and responsibilities of an ILS investor are unique when compared to other classes of investments. A traditional shareholder may find that the best use of its powers resides in advocacy and shareholder activism. By contrast, ILS investors do not have the ownership rights of shareholders and the associated standing to directly influence the management of businesses. Nevertheless, ILS investors play a critical strategic role in providing risk capital to re/insurance companies and other sponsors, which ultimately can support households, businesses, and governments in managing their catastrophe risks and accessing insurance coverage that might not otherwise have been available or possibly only at a higher cost. ILS investors create the market where diversified capital supplies protection for catastrophes and where climate issues are at the forefront. While the ESG principles involved are clear and universal, the practices must inevitably differ between investors in ILS securities and investors in businesses. This realism in our ESG stance, we believe, will lead to the greatest, positive impact on societal functioning in a world that is becoming more risk and sustainability aware.
In summary, ILS play an important and growing role in managing the world’s most pressing insurable risks. The attractive risk-adjusted returns of the asset class reflect this valuable contribution to the security, stability and growth of the global re/insurance market. In our view, the inherent and continued alignment of ILS underwriting with positive ESG attributes will further protect and enhance portfolio returns for investors as the asset class grows in the years ahead, while enabling the sustainable positive impact that ILS, and the systems they support, can have on economies and societies worldwide.
 In this note we use the term re/insurance to refer collectively to insurance companies and reinsurance companies, the latter of which provides insurance to insurance companies.
 The IPCC’s most recent AR5 report states it is very likely that anthropogenic forcings have made a substantial contribution to increases in global upper ocean heat content, and hence SSTs, observed since the 1970s (Source: IPCC AR5 2014).
 For a comprehensive literature review on the theoretical and empirical underpinnings on insurance’s central function in inclusive economic growth see Lester, R., “Insurance and Inclusive Growth”, June 2014, World Bank, Washington DC. Available online at https://documents.worldbank.org/en/publication/documents-reports/documentdetail/826921468148789534/insurance-and-inclusive-growth
 Source: KCC White Paper, June 2014, “The 100 Year Hurricane, Karen Clark & Company”. Available online at: http://www.karenclarkandco.com/news/publications/p...
 Source for dedicated traditional reinsurance capital: "Leading Up to January 2021 Reinsurance Renewal", January 2021, Guy Carpenter. Available online at: https://www.guycarp.com/insights/jan-reinsurance-r...
 Source: Fermat Capital Research
 Source: Sigma Report No. 5, “Indexing resilience: A primer for insurance markets and economies”, September 2019, Swiss Re Institute, Zurich. Available online at: https://www.swissre.com/institute/research/sigma-research/sigma-2019-05.html
 Source: https://files.swissre.com/natcat-protection-gap-map/index.html. Accessed July 2020.
 Source: “Closing the protection gap. Disaster risk financing: Smart solutions for the public sector”, 2018, Swiss Re, Zurich. Available online at: https://www.swissre.com/dam/jcr:61067508-f362-442c-9795-095862b2ee48/Closign_the_protection_gap.pdf
 Sources: https://www.gfdrr.org/sites/gfdrr/files/publication/Earthquake%20Insurance%20in%20Turkey%20History%20of%20the%20Turkish%20Catastrophe%20Insurance%20Pool.pdf and https://www.gccapitalideas.com/2013/04/29/gc-securities-completes-catastrophe-bond-bosphorus-1-re-ltd-series-2013-1-notes-for-the-turkish-catastrophe-insurance-pool/
 These resolutions by the UN Member States note the importance of insurance and call for reducing vulnerability and increasing resilience to disasters as key goals and priorities. See UN General Assembly Resolution A/RES/69/283 Sendai Framework for Disaster Risk Reduction 2015-2030, 23 June 2015, Priority 3: Investing in disaster risk reduction for resilience, 30.(b) p14/24. And see UN General Assembly Resolution A/RES/70/1 Transforming our world: the 2030 Agenda for Sustainable Development, 25 September 2015, [a]: Goal 1., 1.5, p15/35; [b]: Goal 2., 2.4 p15/35; [c]: Goal 3., 3.d p17/35; [d]: Goal 8., 8.10 p20/35; [e]: Goal 11., 11.5 p22/35; [f]: Goal 13., 13.1 p23/35.
 Source: World Bank, 2019. “World Bank sustainable development bonds as collateral solutions for the catastrophe bond market” by Michael Bennett and Akinchan Jain, The International Debt Capital Markets Handbook 2020, World Bank. Found online at: https://www.capital-markets-intelligence.com/books/featured/international-debt-capital-markets-handbook-2020/
Last updated April 2021