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 – is naturally aligned 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, 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 risk of the bond both with and without the impact of factors such as elevated sea surface temperature (SST) to assess the possible effects of climate change on hurricane activity. These different views allow investors to evaluate the sensitivity of specific ILS transactions and their portfolios to potential climate-related changes to hurricane activity. 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 typically range from one to five years) 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 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 against these risks, investors stand a higher chance of being adequately compensated for them.
However, 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 as well as the hurricane hazard. 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 important signal of the relative benefits of environmental risk mitigation and adaptation measures to communities and creates a powerful feedback loop that aligns incentives for better risk management in the long run. Re/insurance and ILS markets are uniquely placed to provide this essential price discovery function to society.
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 1-in-200 year insured loss from a 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 at approximately USD 350 billion. Although the reinsurance capital base is not all exposed to this single event, a 1-in-200 year event would throw the global re/insurance market into disarray with significant impacts on not only the population affected locally but on the entire cost of insurance worldwide.
We estimate that in aggregate, the entire global traditional reinsurance market covers USD 40 billion of single-event loss in Florida. ILS, in recent years, 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 worldwide.
In addition, 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 get worse 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. However, 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 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. And since 2014, it 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) and low-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 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, the G in ESG is as important as the other two elements when it comes to assessing and underwriting ILS investments.
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.
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. Fermat’s Investment Committee reviews all ILS 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 and all potential primary investments are rated with respect to their overall structure, rationale and quantitative elements. To ensure consistent usage and ease of implementation, we decided to keep our rating system simple as follows:
1. POSITIVE – is in positive accord with one or more ESG principles
2. NEUTRAL – is overall neutral with respect to all ESG principles
3. NEGATIVE – works against one or more ESG principles
This rating is documented by Fermat’s Chief Compliance Officer as part of Fermat’s approval process, with notes indicating potential ESG issues and a stated future criterion for if and when the identified ESG issues might lead us to seek to liquidate the holding or abstain from a similar investment in the future. We conduct a quarterly review of those investments with a negative ESG rating to determine if we believe that those positions should be reduced or liquidated entirely. It should be noted that many potential ILS investments do not make it to this ESG rating phase, having been excluded from investment earlier in the screening and underwriting process.
As an example, a positive rating would be given to the catastrophe bonds issued by the World Bank as part of their Capital-at-Risk Notes series, which strongly reinforce all three ESG elements. A neutral rating, for example, could be assigned to an ILS sponsored by a small insurance company that does not have the same systems, reporting, response and claims handling capabilities as other, larger insurance company peers active in the catastrophe bond issuing market. The rating signals that such a smaller company does not meet the higher corporate governance standards and risk disclosures that large national insurance companies with longer track records and larger balance sheets can afford. 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 listed on an investor exclusions list or 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. Therefore, it is rare for us to encounter ILS that might warrant such an ESG rating, as other assessments would have already eliminated them early on in our investment screening process.
We believe adherence to these principles in traditional ILS underwriting more broadly will ensure these 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. The quality of this material has a great deal to do with the quality and transparency of reporting by the re/insurance company sponsoring the ILS issue. Avoiding investments with poor risk disclosure practices and bad loss trigger designs, therefore, sends a strong message to companies seeking to access the ILS market as to the corporate governance standards that are required by investors. 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 ESG-positive rated ILS investments.
ILS play an important and growing role in managing the world’s most pressing 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 and therefore the benefits it brings to economies and societies worldwide. As such, we believe that the natural and continued alignment of ILS with positive ESG attributes could further protect and enhance portfolio returns for investors as the asset class grows in the years ahead.
 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).
 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: Reinsurance: Will Investor Losses Lead to a Rising Tide for Pricing? by A.M. Best, 2019. Available online at: http://www3.ambest.com/bestweekpdfs/sr705410119549full.pdf
 Source: Fermat Capital Research
 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/