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

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.

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. 

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. 

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. 

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.

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 DJSI^3,4 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.

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.

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.

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.

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.