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Insurers face energy exposure risks from climate change in their investment portfolios

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      By Brendan McCarthyESG Research Analyst, Calvert Research and Management

      Washington - Investments that are heavily dependent on fossil fuels face the greatest uncertainty from the energy transition to renewable sources. While individual fossil fuels' demand (i.e., coal vs. oil) is projected to diverge, the overall sector trend shows a reduction in long-term demand growth and the erosion of economic advantage over renewable alternatives.

      Insurers are exposed to fossil fuels and nuclear energy companies in two ways: policy coverage and investment portfolios. Insurers who underwrite policies to companies exposed to the energy transition face a dwindling customer and revenue base. This exposure is largely concentrated among property and casualty (P&C) insurers who write policies covering property damage, business interruption and other impacts. Many of these polices are short term, allowing those insurers to transition their customer focus beyond companies reliant on these energy sources over time.

      The greater risk to insurers comes from their exposure to these companies through the insurer's investment portfolio. Insurance companies collect regular premiums and must invest them prudently to ensure they exceed expected policy claim payouts. Furthermore, they must be able to maintain this asset-liability parity over the long run to remain solvent and to generate profits. Portfolio exposure to fossil fuels and nuclear energy companies adds unmitigated risk, which could negatively impact the asset-liability parity over time, hurting the insurer's profitability.

      Investment portfolio drivers and exposure

      Analyzing 175,000 unique investment holdings from the largest publicly traded insurers in the US, it becomes clear that subsector focus, not firm size or market cap, drives investment goals and allocations.

      Life and health (L&H) insurers are long-term investors. These insurers need to match the long-term payouts with long-term investments paying steady income, like long-term bonds. L&H insurance companies have the greatest overall exposure to fossil fuels and nuclear energy. In contrast, P&C insurers write shorter-term policies (1-3 years) and thus have a greater focus on investing in liquid assets with short-term horizons, like common stock. P&C insurers have the least overall exposure to fossil fuels and nuclear energy. Reinsurers, which insure P&C and L&H firms against tail-end and other risks, generally have exposure somewhere between P&C and L&H.

      Also consider where insurers invest in the capital stack. Stockholders absorb company losses before debtholders, making common stock a riskier investment. Given the different investment horizons, it is perhaps not surprising that P&C firms have more common stock exposure to fossil fuel and nuclear energy companies than L&H firms, making the P&C portfolios riskier than they initially seem. While the difference is small (the majority of every insurer's portfolio is in long-term bonds), it is material in an industry with trillions of dollars of invested assets.

      Renewable energy exposure

      To mitigate exposure to the energy transition, insurers can invest in companies engaged in renewable energy generation. This can maintain a portfolio allocation to the energy sector while investing in areas of growing opportunity like solar and wind power. Once dependent on subsidies, these sources have now become price-competitive with coal even as they wean off of the subsidies.

      Insurers overall have negligible exposure to renewable energy generation, partially due to the small universe of investable companies in this burgeoning space and partially due to growing recognition among investment officers of the energy transition and its implications.

      Bottom line: Insurance companies depend on their investment portfolios for long-term profitability. Fossil fuel and nuclear energy investments present long-term material risk to those portfolios. While insurers vary on their exposure based on business models and individual ESG integration, there is still significant risk mitigation and long-term opportunity in shifting those investments into renewable energy.