ARTICLE December 2015 For professional investors

Article | 1

Johan van der Lugt

Equity Analyst Banks and

Insurers

Global Equity

Our ambition

is to identify

the stored

value on the

basis of a

company’s

‘traditional’

and ESG profile

Using ESG to assess the quality of Return on Equity

We firmly believe that ESG analysis, combined with traditional financial analysis, can offer

investors powerful insights. It helps us in identifying attractively valued and better

managed companies. More importantly, many academic studies have shown that

incorporating ESG factors improves downside protection while potentially improving the

upside as well. With our proprietary Sustainable ROE Analyzer, we use ESG information to

assess the quality and sustainability of Returns on Equity (ROEs) of property & casualty

insurance companies.

Investing in material sustainability issues can enhance value for shareholders

Investments in material (i.e. financially relevant) sustainability issues can enhance value

for shareholders while investments in immaterial sustainability issues have little or

negative value implications. This is an important outcome of a paper published in mid-

2015 by Kan et al. from Harvard Business School.2 Their main finding is that firms with

good performance on material sustainability issues significantly outperform (in terms of

stock market performance) firms with poor performance.

We ask ourselves that important question: how can we strengthen our conviction by

incorporating ESG factors? In our analysis, we assess those factors that are likely to have a

material impact on the long-term sustainability of a company's business model and its

share price. How can we identify companies that focus their sustainability investments on

material issues rather than immaterial issues and deliver good performance?

Some value is not yet visible: identifying ‘stored value’

We find the Resource-Based View of the Firm (RBV) the most suitable framework for

understanding a company’s financial and non-financial value drivers. A firm’s competitive

position is defined by a bundle of unique, heterogeneous resources and relationships.

1 This article is an abstract of a comprehensive white paper ‘Value Creation Opportunities in Global P&C Insurance – A Deep Dive Into ESG Upside’, Johan Van der Lugt, Robeco, December 2015 2 Khan, M., G. Serafeim, A. Yoon (2015), Corporate Sustainability: First Evidence on Materiality, Harvard Business School, working paper (http://www.hbs.edu/faculty/Publication%20Files/15-073_8a7e13e5-68c5-4cc3-a9a0-a132bbef3bc7.pdf)

• ESG analysis helps to assess the quality of Return on Equity • We introduce our Sustainable ROE Analyzer

• We apply this to property & casualty insurance companies.1

Article | 2

It is the task of a firm’s management to adjust and renew these resources and

relationships as time, competition, and change erode their value.3 This last point is also

made by the International Integrated Reporting Council in their thinking around the

different forms of capital and ‘stored value’.4 This last concept refers to ‘the value

generated through actions that have yet to be reflected in an increase in financial capital

via the income statement and balance sheet.’ Think of the growth of brand value or

employee satisfaction that can have lasting long-term value, yet may deplete earnings and

equity in the short term.

Our agenda as long-term oriented investors is to identify the stored value on the basis of a

company’s ‘traditional’ and ESG profile. In this paper, we take a first step by introducing a

framework that draws on the RBV theory and puts ESG factors into a value-creation

perspective.

We focus on determining a company’s earnings power: will it be able to continue its record

of earnings? What is the quality of the generated earnings? Are they based on growth

opportunities, efficiencies and/ or balance sheet optimization? What is this company's

proprietary or sustainable competitive advantage? Essentially, it comes down to

identifying firms with an enduring capability to create value and sustain competitive

advantage based on strong ESG performance with a focus on material issues.

Putting the property & casualty insurance sector under the microscope

We focus our analysis on property & casualty (P&C) insurers for a number of reasons:

• The P&C insurance industry is exposed to important secular trends such as climate

change, population growth and an emerging middle class, autonomous driving, big

data and usage-based insurance, and cyber risk.

• There is room for improvement in their ESG scores versus the broader insurance

sector.

• They have favorable industry characteristics (e.g., Canada, Australia, Japan and the

Nordics are typical markets with higher concentration ratios) and sensible regulators.

• The short duration of their book of business makes them good candidates for change.

• Management tends to be conservative, which has benefits and drawbacks. There is a

long learning curve. Tenured management teams have lived with the fallout of their

mistakes, which helps them to be disciplined and properly underwrite insurance.

The P&C insurance industry has some cyclicality in terms of natural catastrophes, industry

capacity and pricing. When premiums are low, capital is abundant and competition is high,

the industry is said to be in a soft period of the cycle with underwriting standards falling.

The subsequent phase is precipitated by a catastrophe or similar significant loss. With less

stable players driven out of the market, some capacity (and capital) leaves which

decreases competition (hard period of the insurance cycle). Consequently, premiums

increase, with underwriters less likely to take on risks and exhibiting pricing power. What

separates outperformers from underperformers is management quality. In other words,

how disciplined is an insurer in terms of walking away from underpriced business and

pushing for rate increases in a competitive environment?

3 Rumelt, R.P. (1984), ‘Toward a Strategic Theory of the Firm’. In: R. Lamb (ed.), Competitive Strategic Management, New York, Prentice Hall, pp. 556-570. 4 International Integrated Reporting Council (2015), ‘Applying the Integrated Reporting concept of ‘capitals’ in the banking industry’, <IR> Banking Network, August 2015 (http://integratedreporting.org/wp-content/uploads/2015/08/IR-Banking-Network-Publication.pdf)

Article | 3

Several mega trends are impacting the P&C insurance industry as illustrated by the exhibit

below from the Integrated Reporting (IR) Insurance Network. The pace of change implies

that insurers will be dealing with significant business model evolutions impacting their

value chain and profitability. With many macro trends unfolding the P&C industry will look

different ten years from now. We see it as the role of insurance companies and their

management teams to anticipate risks and opportunities related to these mega trends.

Mega trends affecting the insurance industry

Source: Integrated Reporting Insurance Network, Value Creation in the Insurance and Reinsurance

Industry, February 2015

Digital technology does offer many opportunities to improve claims management. This has

been the focus of many insurers, particularly around telematics. Big data also offers

opportunities to enhance client interaction through personalized products and

individualized risk assessments. This is an area, we would say, where P&C insurance

companies have much more work to do. It is our belief, that most P&C insurance

companies have been slow to recognize the significance of disruptive technologies and the

potential changes to their distribution strategy and client proposition.

As argued in the introduction, it is important to focus on those factors that are material

from an earnings and capital perspective.

Article | 4

For the insurance sector, risk management and corporate governance stand out as the two

dominant material themes. Central to our thinking is thus how these material factors

impact a P&C insurer’s profitability.

Introducing our Sustainable ROE Analyzer

In line with the saying ’not all earnings are equal’ we would add that not all returns on

equity (ROEs) are equal either. To further investigate this we introduce a proprietary

framework, the Sustainable ROE Analyzer, which takes return on equity as the central

profitability metric and links it to industry-specific and ESG/ secular themes. Combining this

with a ROE decomposition analysis we are able to better assess the quality and

sustainability of a company’s ROE, both in absolute terms and relative to peers. Linking

material sustainability factors with ROE drivers for the P&C insurance industry, we

distinguish the following important drivers of ROEs:

1. Financial drivers: risk management and corporate governance

2. Growth and efficiency drivers: link between sustainability strategy and corporate

strategy (data analytics/ big data, cyber insurance, climate change, changing

weather patterns)

3. Efficiency driver: human capital management (employee turnover)

Source: Robeco

Our framework establishes a direct relationship between industry metrics such as customer

retention rates, claims ratio, expense ratio and reserve releases on the one hand and ESG

and long-term themes such as customer satisfaction, climate change and changing

weather patterns, population growth, data analytics/ big data and risk management on

the other hand. This enables us to better assess the quality and sustainability of the ROE.

Do higher ranked ESG names have higher ROEs?

Linking ESG scores (from RobecoSAM) with expected ROEs (Bloomberg consensus) we find

that a high ESG score does not automatically imply a high level of relative profitability.

Article | 5

In other words, more factors explain a high profitability other than just ESG related topics.

• What matters in our view, is the quality and sustainability of the ROE. If a high level of

profitability is supplemented with a high ESG score, it implies lower ESG risk and

therefore in general a greater quality and sustainability of the underlying profitability.

• Most interesting from an investment perspective are the companies with a low ESG

score and low forward ROE expectation. How can they achieve value creation by

improving both their ROE outlook and their ESG score? What is structural and what

can be improved?

ESG score and ROE

Source: Robeco, RobecoSAM, Bloomberg

Does an improved ESG score translate into multiple expansion?

In our next exhibit we show the percentage improvement in the ESG score from 2009 to

2015 (from Sustainalytics) on the x-axis and the price/book multiple expansion on the y-

axis. Our conclusion is that an improvement in the ESG score can result in multiple

expansion, but of course it is not the only relevant variable.

ESG improvement and multiple expansion, 2009-2015

Source: Robeco, Sustainalytics, Bloomberg

It is important to note that multiple expansion (or contraction) is often the result of an

interplay of many different factors: an improved earnings outlook, changes in the macro

environment, changes in the industry structure, changes in the level of competition and

regulation, an improved balance sheet/ capital position, higher dividend/ capital return

initiatives, management change, etc. ESG topics and an improvement in ESG scores may

Article | 6

further contribute. We believe that multiple expansion combined with an improvement in

the ESG score can be more sustainable than one that bears a weaker relationship with ESG

improvements.

Learning from the leaders

Based on our ESG-ROE screen we identify Insurance Australia Group (IAG) as top

performer5. What insights do we get from analyzing IAG’s profitability and ESG

performance?

• Management quality and governance: IAG has a high-quality management team (with

a clear alignment with shareholder interests and a focus on execution), a consistent

strategy, strong risk management and corporate governance, is ahead of peers in

integrating ESG metrics into incentive plans, and has a culture of conservative

financial settings.

• Franchise quality: focus on personal lines and SME and mid-size commercial lines (not

the top-end where most of the cyclicality manifests itself), strong underwriting culture

and discipline, cost-efficient distribution (high share of direct distribution), and an

integrated value chain.

• Market structure: operating in a consolidated marketplace with rational listed players,

automatic renewal of insurance policies.

Where are opportunities for improvement?

For the broader group of P&C insurers we see the following areas of improvement:

• Resilience: responsiveness to secular themes, disruptive technologies, and changing

client preferences (presenting risks, but also opportunities).

• Materiality: reporting on material issues, how they affect different stakeholders and

the company (also in terms of earnings and capital) and providing a demonstrable

link with financial targets and incentive plans.

• Targets and incentives: formulating the ‘right’ key-performance indicators in incentive

plans (ROE, capital strength, employee engagement and client satisfaction), and

preferably abstain from absolute profit targets. Greater emphasis on non-financial

KPIs in incentive plans. KPIs incentive plan should be in line with company targets.

• Governance: more relevant industry experience and technology knowledge required

at board level, independent board with an independent chair, more frequent dialogue

between board and investors.

Our Sustainable ROE Analyzer is a useful tool to focus on those profitability drivers that

determine both the quality and the sustainability of a company’s ROE. We see it as a

practical solution to looking at materiality and how this translates into financial value

creation for shareholders.

Important information

This publication is intended for professional investors. Robeco Institutional Asset

Management B.V. has a license as manager of UCITS and AIFs from the Netherlands

Authority for the Financial Markets in Amsterdam. This document is intended to provide

general information on Robeco’s specific capabilities, but does not constitute a

recommendation or an advice to buy or sell certain securities or investment products. The

prospectus and the Key Investor Information Document for the Robeco Funds can all be

obtained free of charge at www.robeco.com.

5 Investment decisions depend on various factors, such as valuation and risk profiles. This should therefore not be construed as an investment advice.