In our two previous articles for insurers, we talked about setting targets on the road to net zero and using climate scenario analysis to help with route-planning. But as vital as this journey is, insurers can’t lose sight of the importance of yield, solvency efficiency and asset and liability management (ALM).

One finding from our recent ESG Insurance Survey highlights this point. We found that 76% of insurers still see environmental, social and governance (ESG) factors as secondary drivers of their investment strategies (see Figure 1).

ESG analysis and strategic asset allocation

ESG remains a secondary concern, in part, because the focus is often on security selection rather than asset allocation. While it makes sense to take account of ESG risks when evaluating a company, we don’t think that’s enough. ESG factors can have a material impact on the long-term returns of various asset classes; therefore, analysis of ESG factors needs to be incorporated at the strategic asset allocation (SAA) level.

Although the tools and techniques to apply ESG factors at the SAA level exist, they are not yet mainstream. But here at abrdn, we wanted to take the lead. We’ve made several changes to our SAA process to incorporate climate and other ESG objectives (for further details of these changes, please refer to our recent white paper, Strategic Asset Allocation: ESG’s New Frontier).

Establishing the impact of climate change on long-term expected returns

We consider the impact of the climate transition on our long-term expected returns as part of our SAA.

Our general approach to forecasting asset-class returns is based on developing a range of economic scenarios. In each scenario, we make different assumptions about prevailing GDP growth, inflation rates and central-bank interest rates. We then form views on the probability of each scenario and generate probability-weighted mean ‘expected’ returns.

It is therefore very natural for us to turn to a scenario approach when considering the possible long-term impact of climate change on investment portfolios. We do this by combining the probability-weighted mean expected return of our standard economic scenarios with the mean impairments from our climate-scenario analysis for each asset class. Assessing the impact of climate on returns across a range of different scenarios is crucial. And we regularly retest return assumptions as market prices and climate policies shift.

As a result, our views on the financial effects of climate change are embedded in our long-term expected returns.

Portfolio optimisation – adding climate impact to the efficient frontier of risk and return

We make an important additional adjustment to the SAA process. We add a third ‘climate opportunity’ dimension to the standard two-dimensional efficient frontier of risk and return. In modern portfolio theory, the efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a given level of expected return.

The standard portfolio optimisation process tests combinations of asset class weights to find the one with the optimal position on the efficient risk-return frontier. In standard optimisation tests, there are typically several portfolios with similar risk-return characteristics, if uncertainty is taken into account. What we do is add a second stage to the optimisation process, choosing the most efficient portfolios for a certain risk-return profile that also have the greatest capital allocation to energy-transition-linked activities. This multi-objective optimisation approach, in effect, adds a third dimension, as we can see in Figure 2.

Figure 2: Adding climate impact to the efficient frontier

The many uses of climate scenario analysis

In our previous article, A forward-looking view: helping insurers plan for decarbonisation, we discussed climate-scenario analysis and commented on its importance to insurers when considering net-zero targets and plans, and evolving regulatory developments. In this article, we have demonstrated an additional use for climate scenarios; incorporating the effects of climate change into long-term expected returns. Our work suggests that these factors are among the most important drivers of long-term risk-adjusted returns and therefore deserve to be incorporated into the SAA process.

In conclusion

In time, we think enhanced SAA approaches will become more common as a means of further embedding climate considerations into strategic decision-making.

SAA analysis that integrates ESG effectively should deliver better risk-adjusted returns than SAA that does not.

If you’re looking to increase your allocation to climate solutions without losing sight of traditional risk and return objectives, we believe a disciplined SAA process can help you channel your capital to investments that make a real-world impact.

Further reading

Many of our insurance clients are benefiting from our enhanced SAA process. An example of this is brought to life in a joint whitepaper between the Phoenix Group and abrdn, which you can read here.

For more about our SAA approach see our recent white paper, Strategic Asset Allocation: ESG’s New Frontier.

In the final instalment of our four-part series on insurance investing and sustainability, we will be discussing the barriers to sustainable investing that still exist.