12 minute read 16 Sep 2021
High angle view of bridge over section of lake

Short-term steps for long-term value: the impact of ESG ratings on TSR

Authors
Penney Frohling

EY-Parthenon Partner, Financial Services Strategy, Ernst & Young LLP

Financial services strategy practitioner. Helps clients navigate financial crises, new regulations, transformative customer, technology, geopolitical and environmental trends.

Simon Woods

EY EMEIA Financial Services Insurance Strategy Leader, EY Global Financial Services IBOR Lead

Senior advisor to board-level executives in financial services. Business leader. Industry thought leader. Passionate about having the courage to challenge conventions and foster innovation.

Contributors
12 minute read 16 Sep 2021

As its financial implications become clearer, ESG will remain high on the strategic agenda for insurers.

In brief
  • There is clear and growing evidence that environmental, social and governance (ESG) issues will have a meaningful impact on insurers’ stock prices.
  • ESG scores have been adopted by more rating organizations and are increasingly used to determine inclusion in ESG indices and funds.
  • Insurers need to shape clear narratives about their ESG efforts to share with investors and analysts, and identify appropriate metrics to track progress.

Environmental, social and governance (ESG) principles have risen with astonishing speed to the top of the strategic agendas for senior leaders and boards in insurance. Approaches to adoption vary considerably across the industry, however, and range from pure regulatory compliance to new, purpose-led corporate strategies driven by the United Nations’ sustainable development goals (SDGs).

Further, there is uncertainty about the best ways to track the impact of ESG and insurers’ progress toward their goals over the near, mid and longer terms and its potential impacts on value creation and value destruction. Communicating that progress to stakeholders is an additional challenge.

In a previous article, we suggested four top-line metrics that can act as leading indicators of the efficacy of ESG strategies, and help manage perceptual issues that threaten insurers’ value during the next three to 18 months. 

  1. Total shareholder return (TSR)
  2. Brand value
  3. Economic net worth (ENW)
  4. Return on capital

This article will closely examine ESG ratings and their potential impact on insurers’ stock prices. Specifically, we will explore a few core issues:

  • How insurers are rated and the varying approaches used by rating organizations.
  • Differences in ratings across the sector.
  • How these ratings determine inclusion in ESG indices and the different approaches used to build ESG-tagged ETFs (Exchange-traded funds) and index tracker funds.
  • The increased investment flows into these funds and the inevitable impact on trading volumes, volatility and share price.

To drive our analysis, we created a database of the top 100 insurers by market cap, covering ESG scores and rankings data decomposed by sub-sector and their inclusion into five key ESG indices:

  1. MSCI World SRI Index
  2. MSCI ACWI ESG Universal Index
  3. MSCI World ESG Leaders Index
  4. S&P 500 ESG Index
  5. S&P DJSI World Enlarged Index ex. Alcohol, Tobacco, Gambling, Armaments, Firearms and Adult Entertainment

We have selected these five indices based on the broad acceptance of MSCI, S&P and Dow Jones ratings and their indices as benchmarks, as well as the scale of flows into funds that track these indices. We intend to conduct further analysis to see how insurers’ inclusion and relative weights in key indices change over time and to define the implications in terms of the impact on shareholder returns and access to capital. 

For C-suite leaders and boards, the most critical question is likely to be – what to do about these ratings? We believe that the following actions are critical, and plan to explore them in more detail in future articles in this series.

  • Become fully educated on the rating criteria applied by major agencies, including MSCI, S&P and Moody’s, and how these criteria evolve, as they inevitably will.
  • Understand index construction for the major agencies and how your equity or bond could be included or excluded.
  • Identify the “must-have” indices for your company.
  • Assess your ratings relative to your peer group, how these are decomposed by “E” vs. “S” vs. “G”, and the relative weightings among these three lenses.
  • Create a cohesive communication strategy, including a clear storyline and meaningful KPIs, that can be easily shared with and understood by the investor and analyst community.

Because ratings are largely a function of ESG strategies, it’s critical that board directors and senior leaders ensure their organizations have a cohesive and well-documented strategy in place and are rigorously executing it.

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Chapter 1

Preparing for the impact of ESG ratings

Insurers are at risk of being excluded from key ESG indices.

In our discussions with senior executives across the industry, we hear increasing concern about ESG ratings and the potential impact on investor appetite and share price. Our analysis indicates that these concerns – particularly those about being left out of key indices – are well-founded:

  • 50 out of 66 insurers in the MSCI World are excluded from MSCI World SRI due to low ratings. The 16 carriers that have made the cut benefit from a 4.5x weight adjustment (5.19% representation instead of 1.16%), which will enable them to capture a greater share of investment into their shares.
  • Eight out of 23 insurers in the S&P 500 are excluded from S&P 500 ESG due to an average ESG score of 18. The 15 that made the cut have an average score of 38 and benefit from a 1.3x weight adjustment (1.97% representation instead of 1.47%).
  • The Dow Jones SI World Enlarged index only allows 2.8% from the insurance sector, with a minimum ESG score of 75.8, well above the market average.
Inclusion, exclusion of insurers across three key ESG indices

It is still too early to draw a direct correlation between ESG ratings and total shareholder returns. However, precedent indicates that index participation has a profound impact on share price over time; therefore, lack of inclusion in ESG index funds will have a measurable impact on trading volume, volatility and, ultimately, TSR. 

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Chapter 2

Getting rated: insurers’ rating against key ESG criteria

Globally, insurers have below average ESG ratings.

Multiple agencies, research and analytics firms are issuing ratings and scores to evaluate companies’ exposure to ESG-related risks and readiness to handle ESG issues. These ratings and scores are all based on bottom-up evaluations of multiple factors and unique methodologies that align to investors’ long-term performance analytics. There are legitimate concerns about inconsistencies in how these ratings are conferred, their reliance on self-reporting2 and the proliferation of different ratings that companies need to subscribe to and monitor. Analysts, institutional investors and industry bodies are putting increasing weight on ESG scores despite these inherent flaws. We expect ratings to evolve rapidly and to coalesce around the well-established agencies. We also anticipate that ESG ratings, heretofore more skewed to “G” than “E” or “S,” will become more holistic and balanced.

So, how does the insurance sector fare relative to the average in the indices we tracked? Overall, the insurance industry performs slightly below the average across all industry sectors in terms of MSCI ratings (3-10% lower share among “leaders”) and S&P ESG (49% score vs. the total S&P average of 62%), as shown in Figure 2.

Average MSCI ESG ratings

European insurers are ahead of the curve in formulating and executing ESG strategies and have a greater proportion of leaders in the MSCI ESG index, as shown in Figures 3 and 4. 

MSCI ESG ratings and S&P ESG scores for insurers by region
MSCI ratings and S&P ESG scores by sub-sector

Our database of the ESG scores of the world’s top insurers shows that the highest proportion of consistent outperformers are multi-line carriers based in Europe (e.g., Allianz, AXA, Swiss Re, Zurich Insurance, Generali), with American and Chinese insurers lagging behind. There are exceptions, of course; for instance, Ping An is the first insurance company from mainland China to be selected into the Dow Jones SI Index family and improved both its MSCI rating and S&P score (BB to A and 26 to 68 respectively, from 2016 to 2020), demonstrating that a concerted focus on ratings yields results. 

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Chapter 3

ESG index inclusion and impacts

Index inclusions offers near-term benefits, while exclusion has long-term effects.

While causality between ESG commitments and financial performance is difficult to define, those insurers with clear ESG strategies and strong ratings will benefit from index inclusion and potentially better share price performance resulting from bigger capital flows. 

There is an abundance of ESG funds, including both index-tracking and actively managed funds, with various criteria for what constitutes ESG. As shown in Figure 5, our analysis focuses on a selection of ETFs that track a few of the largest indices, with a good rating by MSCI or high score from S&P indicating inclusion. 

Overview of type and construction methodology of ESG indices

Our research indicates that the announcement of inclusion in flagship indices will trigger a one-off share price increase, though the benefit is relatively short-lived. However, in the case of ESG funds, studies show that index inclusion is expected to produce multiple types of, and longer-lasting, benefits. For example, studies of the S&P DJSI3,4 show increased investor appetite, including greater interest from institutional investors, leading to above-average fund flows into index-tracking funds and stock price increases. Firms that were included in indices also saw increased analyst attention and coverage.

Index exclusion, on the other hand, is expected to have long-lasting impacts that may be difficult to recover from. Thus, maintaining good ratings and scores will be critical to remaining in ESG indices and sustaining the benefits of inclusion.

What does this mean for the insurance sector? While certain industries may be perceived as “greener” than others, the majority of the key ESG indices are developed with the aim to track the benchmark index closely in terms of maintaining sector weights – representation of the insurance sector as a whole will match the benchmark. A few indices outright exclude poor ESG performers; in others, companies with strong ratings (that reflect credible ESG policies and actions) enjoy above average weights. More details can be seen in Figure 6.

Selected insights on results of index inclusion analysis
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Chapter 4

Why ratings matter: the tidal wave of flows into ESG funds

As ESG funds attract more assets, inclusion becomes more important.

While the history of ESG funds goes back to the early 2000s, ESG investing has gone mainstream over the past three years. No longer primarily a concern of individual investors, ESG now sits atop the agenda of the largest institutional investors, private equity funds and asset managers.

As shown in Figure 7, the increase of assets flowing into ESG funds has been dramatic. As of December 2020, passive funds constituted roughly 22% of the European sustainable fund universe by assets under management (AuM). While open-ended funds dominate passive strategies in terms of total assets, the growth in the size and breadth of the offerings in ETFs is impressive. Assets in ESG ETFs closed the year at EUR 82.5b, up from EUR 32.1b in 2019, an increase of 156%. Such ETFs are becoming an effective tool for investors seeking to benefit from the trend of governments, companies and asset managers committing to achieve net-zero targets by 2050.

Development of ESG funds

Bloomberg estimates that cumulative global inflows to ESG ETFs will reach an estimated US$1 trillion over the next five years.5 While Europe has dominated the ESG ETF market historically, as seen in Figure 8, Bloomberg expects the US market to fuel the next wave of organic expansion. The US ESG ETF market rose more than 318% in the first nine months of 2020 and has experienced the largest ever ESG ETF launch, the BlackRock US Carbon Transition Readiness fund, which raised US$1.25 billion from institutional investors. A sister fund targeting non-US stocks was also launched, attracting a further US$475 million from investors. These ETFs are not pure index trackers; rather, they assign portfolio weightings that reflect a carbon transitional readiness score to an underlying equity index.

European sustainable fund strategies

Assets in sustainable investment products are expected to grow exponentially over the next five years and could potentially exceed assets in conventional funds, redirecting capital significantly.6 One of the major barriers to investment in ethical funds – perceived underperformance – appears to be coming down. There is growing evidence that ESG funds and indices outperform, or at least perform on par with, benchmarks (see accordion).

More growth will come from rising investor focus on risks stemming from sustainability issues in the wake of the COVID-19 pandemic and growing evidence that ESG risk management boosts returns. The EU’s green financing rules will provide further impetus. It is important to note that there is a downside to the explosive growth in these types of funds, with many leading investment professionals warning of a potential bubble being created due to excess demand for a limited number of equities. In circumstances such as these, investors, particularly individual investors, can be subject to wide swings in asset values and must be prepared to take a long-term view.

  • How do ESG funds perform?

    The most significant research that’s been released to date: 

    • Morningstar examined the long-term performance of nearly 4,900 European funds, including 745 sustainable open-end and exchange-traded funds. It found that average returns and success rates for sustainable funds across seven Morningstar Categories showed no performance trade-off associated with sustainable funds. A majority of sustainable funds outperformed their traditional peers over multiple time horizons.7
    • Research from MSCI showed that top-tercile ESG performers in its flagship ACWI funds had approximately 12% higher earnings than poor performers in the bottom tercile. The study also examined whether ESG investing sentiment has led to a price bubble; however, decomposition of overperformance did not show increasing valuation levels for top ESG performers.8
    • Analysis from State Street found that, over the first half of 2020, ESG index strategies have been a source of excess return compared to the S&P 500 Index. The analysis focused on the performance of four US equity ESG indices, created by four different providers. Although the magnitude of the outperformance varied, each index beat the benchmark over time and has done so consistently, regardless of ESG methodology or ESG data provider.9
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Chapter 5

The bottom line: ESG ratings will drive share price and TSR

Our analysis, as well as market activity, confirm the importance of ESG ratings.

Our ongoing engagement with the market around ESG issues and opportunities, as well as our analysis of the available data, lead us to conclude that there is a correlation between ratings, inclusion in ESG indices, the ESG funds that are based on these indices and, ultimately, insurers’ stock prices. The ratings process is still evolving and is characterized by inconsistencies among the major ratings agencies, requiring choice and active management of the investor community.

Still, firms that fall behind – or are perceived to be falling behind – are likely to be punished by the market, with their pool of available investors shrinking over time. That means ESG ratings and index inclusion need to be critical near-term topics for the C-suite and boards, which must craft a cohesive ESG strategy, develop the right KPIs and share a clear storyline about their achievements to different stakeholders, including analysts, rating agencies and investors. 

Special thanks to EY’s Krisztina Bakor, Noshin Suleman, Teresa Schrezenmaier and Matt Latham for contributing to this article.

Summary

The potential impact of ESG ratings and scores on the stock price has captured the attention of boards and senior executives across the insurance industry. With more assets flowing into ESG funds, inclusion in the right indices may determine future access to capital. Even as rating methodologies evolve, C-level leaders and board directors must craft a cohesive ESG strategy, develop the right KPIs to measure progress, and share a clear storyline about their achievements to different stakeholders, including analysts, rating agencies, and investors. 

About this article

Authors
Penney Frohling

EY-Parthenon Partner, Financial Services Strategy, Ernst & Young LLP

Financial services strategy practitioner. Helps clients navigate financial crises, new regulations, transformative customer, technology, geopolitical and environmental trends.

Simon Woods

EY EMEIA Financial Services Insurance Strategy Leader, EY Global Financial Services IBOR Lead

Senior advisor to board-level executives in financial services. Business leader. Industry thought leader. Passionate about having the courage to challenge conventions and foster innovation.

Contributors