The investment income earned from collected premiums is fundamental to insurers’ business models. Indeed, in some of the most competitive business lines, it’s frequently been the difference between profits and losses.
About this series
Over the course of 2021 we will be examining a range of salient issues under an umbrella theme of ‘Powering growth; strengthening resilience - Helping insurers innovate, transform and thrive’. Under three key pillars, we will share a range of articles, podcasts, research and videos that address:
In other words, the purpose of insurers’ asset management strategies has been pretty clear: to maximise returns and reduce risk. The value created from those investments has generally accrued to the company, its shareholders and maybe, in a financial sense at least, to its employees and the communities in which they operate.
But the goalposts have moved and are moving further, irreversibly. Beyond purely financial returns, regulation and a societal shift towards the need for sustainability and rejuvenation of our planet are refocusing minds around ESG (Environment, Social, Governance) principles and achieving carbon neutrality justly and in an acceptable timeframe. Going forward, insurers’ investments will have to consider impact alongside risk and return.
This will have major implications for insurers’ asset management strategies over the coming decades, both in terms of supporting business growth and becoming more resilient to the risks that are emerging and will emerge from a society and (global) economy in transition.
At the root of the changes taking place is a fundamental shift in the relationship between companies and society; the unwritten social contract. Whereas previously, profit maximisation was accepted (by a majority at least) as the dominant purpose of a business, increasingly profit is now being regarded as an outcome of a company’s broader purpose. Academics and researchers, such as Porter and Kramer, have discussed the need of all investors to create ‘shared value’1, arguing that the competitiveness of a company and the health of the community around it are mutually dependent.
Others, such as Robert Eccles2 have tackled similar ideas by noting that companies have two basic objectives: to survive and to thrive. Eccles argued that shareholder value should not be the objective of a company but the outcome of the company’s activities. Rather than profit being the purpose, profit comes from pursuing a purpose that benefits society.
In effect then, we are witnessing a redefinition of investment purpose and how an organisation is seen and expected to create system value, placing the emphasis on the need for all companies (insurers included) to align with the broad church of their stakeholders’ interests and concerns.
To understand how an insurer creates system value, one has to look no further than how it designs its business strategy and executes its operations to benefit stakeholders, using its various sources of capital (financial, human, social, intellectual and natural).
Insurers will need to consider whether to draw a value boundary around just customers, or whether to include their families, their communities, the local ecosystem, or take a whole of planet, whole of humanity stance. The logic of the value creation boundary is that the more tightly it’s drawn, the larger the domain – what are defined in economics as ‘externalities’ - over which companies are potentially having a negative impact.
Where insurers choose to draw the value creation boundary will clearly have implications for subsequent actions. It will determine which business is appropriate to be in the portfolio. It will influence decisions over the provision of new capital. It will colour the approach to stewardship (voting and engagement) of assets held. Other effects could include new thinking over the structure of incentive arrangements – and many more besides.
Bringing this back specifically to asset strategy, investment, as I said already, has historically been viewed in the context of solving a two-dimensional problem: maximising return and minimising risk. In an age where legitimacy is a key issue, this is no longer sufficient.
Looking forward, insurers won’t be able to consider investments independently from either society or the environment and so will need to include a third dimension: impact. That is, the effect investments have on clients, on stakeholders, on wider society and the planet. Impact lies at the core of societal purpose and its potential for value creation – it therefore follows that insurers’ continuing license to operate will substantially rest on taking responsibility for and managing that impact.
Probably the most objective current reference point for measuring that impact and a clear statement of what societal wealth and wellbeing includes, is the United Nations’ Sustainable Development Goals (SDGs). They cover a broad range of social and economic development issues expected to frame government agendas and political policies until at least 2030 (Figure 2). With goals such as ending poverty and hunger, achieving gender equality and improving access to clean water and sanitation, the SDGs point to a common language which the great majority of economies (and hence industries and organisations) seem committed to rallying around.
Willis Towers Watson, in conjunction with insurers and third-parties, has developed the Climate Transition Pathways (CTP) accreditation framework. The aim of CTP is to change the narrative around insurance and insurance working as a force for good to help accelerate the move to a low carbon economy.
The belief behind CTP is that enabling the transition to occur in an effective and orderly way gets us to a net-zero economy faster and/or more safely than would withdrawing insurance and financing from high-carbon operations. The danger is that through this engagement approach, CTP supports emissions from these operations longer than necessary if they were to be excluded.
Therefore, CTP has been designed to enable insurers and financial institutions to identify and support organisations committed to robust transition plans, using a consistent approach and independent assessment. It provides a perfect case study of what we believe will be the new normal – navigating the complex decision making required when trying to satisfy return, risk and impact goals.
What may all this mean for an insurer’s investment portfolio in roughly 20 years’ time? I’m currently serving on the World Economic Forum’s Global Future Council for Investment, in which we’ve been assembling thoughts on the likely macro landscape that will exist in 2040 within which investment portfolios will need to be built. The first driving factor – and no surprise here – is climate change. The current scientific consensus is that the global economy needs to be emitting no more than 13.5 billion tonnes of carbon dioxide equivalent in 2040, compared to the current 54 billion tonnes3. Think about that in terms of the transition needed, the demand for renewable energy infrastructure and the likely effects of that supply/demand equation for system value and investment returns.
But the amount of carbon in the atmosphere is just one of nine planetary boundaries identified by Johan Rockstrom4. Essentially, our linear economic system (take-make-use-throw) isn’t sustainable on a finite planet. Ultimately, we need to move to a more circular economy. While there are big question marks about the speed at which this transition may take place, the implications appear more predictable. By definition, a circular economy is about disrupting or replacing the linear economy, meaning the throughput of consumer goods should considerably reduce. The logical conclusion is that the opportunity set for investors will change, perhaps substantially.
Another factor to consider alongside these trends is the potential change in emphasis between financial and natural capital, and how this affects value and returns. Historically, financial capital was scarce while natural capital was abundant. Now the reverse is largely true, exemplified by Government bonds being issued at negative yields. It seems that Mark Twain was ahead of his time when he said: “buy land, they’re not making it anymore” – given that by 2040 the world will need to feed an additional 1.4 billion people and land will be needed for solar and wind farms to provide renewable energy.
As the aphorism goes, the best way to predict the future is to help create it. That is exactly what investment does – it allocates money now in the expectation of some benefit, and in doing so helps shape the future.
What we have to recognise is that society’s expectations of what those benefits look like, their reasonableness in the broader environment context, and the boundaries of who stands to gain are changing.
As major investors, insurers have an opportunity and a growing number of stakeholders would say, a duty, to reimagine investment purpose and strongly influence how the future unfolds.
1 https://hbr.org/2011/01/the-big-idea-creating-shared-value (Harvard Business Review, 2011)
2 https://sloanreview.mit.edu/article/why-boards-must-look-beyond-shareholders/ (MIT Sloan Management Review, 2015)
3 exponentialroadmap.org (March 2020)
4 A safe operating space for humanity, Johan Rockström et al, Nature 2009