ESG and insurance-linked securities (ILS): Q&A with PCS’s Tom Johansmeyer

Insurance-linked securities (ILS) market participants, as well as wider insurance and reinsurance related interests, are increasingly focused on environmental, social and governance (ESG) issues and embracing positive ESG principles and processes within their business models.

At the same time, the institutional investor community is focused on sourcing ESG compatible risks and in some cases major ESG allocators are going to start to direct their funds towards investment opportunities that fit their ESG mandates.

As a result, ESG is set to create a lot of change and also opportunity across the reinsurance and ILS market.

So we spoke with Tom Johansmeyer, Head of PCS (a Verisk business), to get his view on the importance of ESG and what needs to happen to ensure the industry is responding to ESG positively, on both the risk and investment sides of the market.

Q: The ILS market is starting to take a closer look at environmental, social, and governance (ESG) risks. What’s changing in the market?

A: ESG has certainly become a much more important consideration in the ILS market recently, and it seems as though that trend could continue to gain momentum. What’s changing now appears to be specificity. For a while, it was easy to tick the ESG box by drawing a straight line from catastrophe risk to climate change. The notion that investing in catastrophe risk focused on weather is enough to show an ESG commitment seems to be waning. And I’ve heard from more than a few ILS market players that they’re getting tired of the ‘everything is ESG’ argument.

Q: What are some of the more interesting ideas you’ve heard?

A: I’m starting to get feedback about the ability to identify ESG components within a catastrophe event. It’s very interesting, but still difficult to do. Whether on an industry-wide basis (via PCS) or even on a deal-by-deal basis for traditional business, you could do some blunt-force work to identify components of a catastrophe loss that aren’t consistent with ESG. With Hurricane Laura, for example, there was a post-event onshore oil spill in Louisiana that contributed somewhat significantly to the loss.

Isolating large onshore risk losses in catastrophe events is only of tactical utility, though. What you see as potentially problematic in the Gulf of Mexico (particularly in places like Galveston, Texas) aren’t the same as what you might encounter in New York, New Jersey, or Massachusetts. And the same issues arise as you move inland.

Further, you’d need to take a look at what types of risk loss matter and why. Along the coast of the Gulf of Mexico, the presence of the oil industry makes the connection to the fossil fuel sector reasonably straightforward. If you’re committed to ESG principles, though, there are a lot of other sectors that could be relevant. A tornado event in 2020 – not in a coastal state – resulted in an estimated US$300 million insured loss to a transportation and logistics facility, a loss severity that rivals those of oceanfront condos affected by hurricanes. It’s not unusual to see hotels and resorts sustain significant damage from tropical storms. Those sectors may not be directly engaged in the mining/extracting, refining, production, or transportation of fossil fuel inputs and products, but they’d still need to be evaluated on the basis of consumption, not to mention other potentially environmentally unfriendly practices (ranging from improper disposal of plastics to human rights violations).

Q: And side from large risk losses? What could be done in personal lines?

A: That gets a bit more challenging. You could do some blunt analysis on auto losses and net them out of the ESG-favourable component of a catastrophe loss estimate. You could probably run an analytic based on electric vehicle adoption or the sale of gasoline in the retail market to further refine your understanding of the affected vehicles, but this isn’t much more than an easy first step. There are similar steps you could take with  households – both standalone and within commercial habitational structures. The big question I’d ask (and I’m not equipped to answer it) is whether you’d find enough differentiation to make the effort worth it right now.

Q: So, you’d see this more as a large risk loss issue for now.

A: Yes, but only because that’s the easiest way to get started. And I think there’s a certain value in just getting started. In the ESG space, lack of data seems to be one of the most cited impediments to progress, and at least as far as PCS is concerned, we have the large risk loss data to do some initial analysis – and help our clients do the same.

Q: What have you noticed in the data?

A: The PCS team took a look at large onshore risk losses going back around thirty years and large offshore losses going back almost that far. More than half of the combined historical losses are from companies directly involved in the fossil fuel industry. That’s mining and extraction, various value-added manufacturing stages, and the transportation of materials and products. We’ve excluded sectors that might be seen as non-ESG through consumption behaviour just to keep the analysis as clean as possible. Remember, this is a first step, and the team and I will find ways to enhance and revisit both our data sets and how we look at them in the coming months.

The fossil fuel players have generated disproportionately high aggregate insured losses relative to frequency … keeping in mind that they account for more than half the list by number of events. Roughly two thirds of industry-wide insured losses from the cohort we’re watching came from companies directly engaged in the fossil fuel sector.

Q: And by country:

A: The United States and Canada accounted for nearly 30 per cent of the total number of events identified. There are two ways to view this. You could go on the assumption that developed markets have greater insurance and reinsurance penetration, potentially larger accumulations of large risk (each of which could be affected), and presumably greater transparency in the event of a loss. Or, you could be surprised, because developing markets are believed to be a bit behind in terms of ESG, and even though insurance penetration tends to be lower in such markets, the large multinationals that would lead to large losses tend to have programmes that cover their developing market facilities. In the end, the increased presence of risk in developed markets appears to have been the greater factor. The next three onshore markets most affected after the United States and Canada, according to our analysis, are Australia, Germany, and Japan.

Q: What’s the opportunity for the ILS market in the near term?

A: I’m glad we’re specifying ‘near term’ here. Long-term, the sky’s the limit, but sometimes, near-term action is harder to kick off. As an industry, there’s always a fair amount of chatter about resistance to change, but I’m not ready to make that call with ESG right now. At least, not with the usual volume. I think the more important issue is prioritization.

Q: How so?

A: What’s become clear since 2017 is that reinsurance and ILS are caught in a tough spot when it comes to innovation and new market entry. Prior to 2017, softer market conditions made investments in new markets difficult to attain. Nobody was ready to take risk without reasonably clear visibility to attendant returns. Our efforts on cyber are my ‘go to’ for this. We pushed hard, and eventually, at the beginning of the summer of 2017, we’d made traction.

Then, Hurricane Harvey hit. Then Irma and Maria. And then the wildfires. And 2018 brought further challenges.

During this period of heightened activity, ILS funds necessarily spent most of their time on the basic blocking and tackling needed to manage their operations and their capital. They focused on natural catastrophe, worked to understand their losses, addressed issues around claims, and took the necessary steps to raise capital again. It’s hard to invest time in new markets when your core purpose demands more attention than usual – and when you’re staring down significant losses.

Of course, hardening market conditions tend to point ILS funds back to their usual collection of risks, which may pay better than those that aren’t as well understood. It makes a lot of sense. When the pricing works, you usually go with what you know.

Q: How does the ILS industry overcome that?

A: New ideas and new risks need to be easily understood, quick to digest, and accessible on a test basis at first. Rather than try to get a syndicated nine-figure ESG cat bond done, a small bilateral ILW might make more sense, particularly if the relevant data is easy to obtain and understand. Specifying a basket of risks for the ILW could bring even more clarity to the process, which should make it easier to understand the risk, validate how consistent it is with ESG principles, and complete a transaction. Sometimes it’s easier to start with a toe in the water than to dive right in.

Read more of our coverage of ESG in the insurance-linked securities (ILS) market.