Sustainable investments, ESG criteria, climate change, and ratings – many private and institutional investors focus on these topics. Markus Hill spoke with Roland Kölsch, Qualitätssicherungsgesellschaft Nachhaltiger Geldanlagen (QNG), about this range of topics and the special features and challenges of the rating process for CAT bonds (insurance-linked securities). The conversation will focus on the special features of the asset class catastrophe bonds, the connection to topics such as sustainability criteria (SDGs), “impact investing” and also the advantages and disadvantages of this special market segment. The recent issuance of CAT Bonds (“Red Cross & Volcanoes”) and the current search of investors for alternative investment opportunities in the low-interest phase underlines the topicality of the subject.
Hill: Mr. Kölsch, you are now in your fifth year as the person responsible for the quality standard for sustainable investments, the FNG seal. Could you explain what this is all about?
Kölsch: Motivated by the need to steer the growing proliferation of sustainable investments in a certain direction, various stakeholders got together in 2012 to work out criteria for classifying the quality of sustainable financial products in a three-year development project. With the participation of financial advisors, asset owners, rating agencies, academia, the church, asset managers, and NGOs, the quality mark was launched in 2015.
The result is a multi-layered methodology that attempts to evaluate the different building blocks used in the various investment paths to (more) sustainability and express them in a multi-level label. The holistic methodology is based on a minimum standard. These include transparency criteria and consideration of labor & human rights, environmental protection, and anti-corruption as summarized in the globally recognized UN Global Compact. All companies in the respective fund must also be analyzed in full for sustainability criteria. Investments in nuclear power, coal mining, significant coal-fired power generation, fracking, oil sands as well as weapons and armaments are taboo. High-quality sustainability funds that excel in the areas of “institutional credibility,” “product standards,” and “portfolio focus” (security selection, commitment, and KPIs) receive up to three stars.
The FNG seal goes far beyond a pure portfolio assessment and includes quantitative and qualitative elements. With over 80 questions, for example, the sustainability investment style, the associated investment process, the associated ESG research capacities, and any accompanying engagement process are analyzed and evaluated. Besides, elements such as reporting, controversy monitoring, an external sustainability advisory board, and the fund company as such play an important role.
The more multi-layered and intensive a fund’s activities are at the various levels, the higher its sustainability quality and the potential to ultimately achieve indirect and direct impact.
Hill: Now it sounds as if only the usual equity, bond, or mixed funds are evaluated here.
Kölsch: Since the majority of the products on the market come from these asset classes, the majority of the financial products that apply are from these classic investment forms. However, among the investment funds we award, you will find more and more investment concepts that are not quite so common, such as convertible bonds, high yield, emerging markets, capital preservation, and subordination concepts. Microfinance is currently on the horizon and in real estate, the transparency foundation is being laid. Things got exotic in 2018 when, after more than a year of preliminary work, we tested the first Cat Bonds fund for its sustainability quality.
Hill: Why exotic?
Kölsch: What sounds very simple is anything but trivial. Because a cat bond is ultimately about a bond, but this is in turn divided into a multi-part structure. A cat bond is a construct with various components and players.
It is not the insurance company that issues the cat bonds, but a special purpose vehicle set up for this purpose that stands between the investor and the insurance company. Unlike ABS, the purpose of the latter is to conclude a reinsurance contract with the insurance company as the so-called sponsor/cedent. The potential obligations arising from this contract are financed by the issue of a bond in which the investor: then invests.
Another component is the insurance premium. It is firmly negotiated at the time of issue and must adequately compensate for the risks assumed via the reinsurance contract. The premium is paid by the sponsor, i.e. the insurer, and then paid out to the investor together with the money market component in the form of a coupon. In summary, the investor receives a variable part from the money market component and fixed compensation for the insurance risk.
Hill: What makes such an exotic asset class as cat bonds so attractive in principle?
Kölsch: Cat bonds are bonds used to cover insurance losses from rare natural catastrophes. Catastrophe bonds usually relate to hurricanes, floods, earthquakes, and pandemics and are therefore well suited to diversifying larger portfolios, since natural catastrophes have nothing to do with the stock market and different catastrophes are in turn hardly correlated with each other. The value of a cat bond hardly fluctuates as long as the defined loss event does not occur, because the money is parked in safe, short-dated bonds. Counterparty and interest rate risk are low, and a fixed interest rate above money market levels is paid. The bonds are issued at nominal value and repaid at 100% at maturity. In a pre-defined event of a “catastrophe”, so-called trigger events (usually during a fixed period of three to five years), the entire amount or at least part of the paid-in capital is transferred to the issuer of the bond. The risk is therefore that investors will lose money when such catastrophes occur. The probability of loss is compensated with higher interest rates. Especially in times of zero and even minus interest rates, cat bonds thus offer a not uninteresting yield pickup and allow (qualified) investors to improve their risk-return profile.
Securitizing catastrophe risks on the financial market creates an additional insurance opportunity, which often makes it possible to insure (peak) risks in the first place that no individual insurer would otherwise take on the books.
For example, the Danish Red Cross recently placed a cat bond that covers volcanic risks in developing countries and is intended to finance relief measures.
So when a (natural) catastrophe occurs, it is always a question of concrete use of proceeds.
Hill: That would be entirely in line with the SDGs of the global community.
Kölsch: The 17 Sustainable Development Goals (SDGs) with their 169 sub-goals represent an easily understandable framework of summarized challenges facing the global community, for which solutions are needed by 2030. From the capital market too. In the EU, the action plan for financing sustainable growth, the so-called Sustainable Finance Regulatory Framework, is being implemented in a highly topical manner.
However, the makers of the laws in Brussels have not taken the ILS market into account in their considerations, i.e. cat bonds are “out of scope” of the regulation. Therefore, there is a risk that this asset class, which demonstrably has a direct impact, will not be taken into account at all in a future regulated market for sustainable investments. It would nip in the bud an asset class that is in itself very attractive from a sustainability perspective, depending on its design, given the foreseeable high level of investor interest in sustainable investments. In principle, this investment opportunity even meets the strict requirements of Article 9 of the Disclosure Regulation and can be easily linked to the economic activities of the taxonomy, which are still to be completed and defined as sustainable.
Hill: What are the challenges of this asset class, which initially sounds confusing by name, which is not infrequently misunderstood in the sense that investors also profit from disasters?
Kölsch: You addressed an important perception problem of catastrophe bonds. Investors do not benefit from catastrophes. On the contrary, the money parked in the cat bond comes to (partial) payout and provides capital for those affected by natural disasters or pandemics.
When it comes to assessing the sustainability of this not-so-trivial form of investment, transparency is the first step. At the outset, one must look at the various building blocks of any financial product and ultimately try to trace the path of the money flow. Ultimately, an investor wants to achieve an impact with their investment in sustainable investment. This can be direct or indirect. Channels of impact are usually indirect and cannot always be represented in causal terms.
Hill: And how do you proceed with cat bonds in concrete cases?
Kölsch: The core of sustainability considerations in financial investments is to determine what ultimately supports an investment or not. Ideally, this should be done with concrete, verifiable effects, or impact. The impact tools of sustainable investors are “promoting,” “demanding,” and “preventing.
Since the key element in Cat Bonds is the application of funds in the event of a loss occurring, we focused mainly on this as a first step. So that’s a different approach compared to a conventional sustainability fund, which is usually about the ESG analysis of the particular companies that the fund invests in. So here you would look at a Munich Re or Swiss Re as a whole from a sustainability perspective. With cat bonds, it doesn’t make much sense to look in detail at the violators such as insurers or reinsurers. That would be insufficient because insurers have multiple balance sheet items with large amounts of assets and liabilities. Nor is the intermediary vehicle the focus of the analysis. The activities that are financed should money flow for reconstruction in the event of a disaster, for example. Cat bonds or cat bond funds have a more specific focus. They, therefore, require more detailed analysis, just as is the case with green bonds.
That is why we developed our own more detailed approach in our SRI quality standard, which was intended to provide transparency in the first place. Based on a first cat bond fund, this fund had to prove that money flows of its invested bonds in the case of so-called trigger events at least do not lead to the minimum exclusion criteria of the FNG seal. For example, no payments were allowed to be made to companies involved in activities such as arms manufacturing, fracking, and coal mining.
So identifying payment flows is essential. This alone was a major challenge because even the fund manager did not know exactly where the money would go in the event of a trigger event.
Unfortunately, this turned out to be a blind spot in a generally transparent data situation for cat bonds, as many special-purpose entities were unwilling or unable to provide information on the sustainability character of their insured customers. Incidentally, this was the starting point for a parallel engagement approach by the fund provider, which is now also insisting with other product providers on the need to systematically record sustainability characteristics to meet the ESG requirements of end investors and also of the regulatory authorities.
Since our audit team and a supporting ESG agency received hardly any feedback from the cat bond special purpose vehicles themselves and there was also no willingness to commit to the exclusion criteria of the FNG seal using declarations of commitment, we proceeded inductively; put the cart before the horse, so to speak.
Alternative approximation criteria were identified as proxies based on the different contract types of the respective cat bonds. Thus, based on clusters such as “Residential”, “Commercial”, “Industrial” and “Pandemic”, the universe of remaining Cat Bonds to be analyzed further can be narrowed down. Lot sizes of individual insured sums provide indications of eligible large projects, individual objects such as nuclear power plants, or business partners of a private, commercial or industrial nature. Further data could be derived from the volume of payments. For example, experts confirmed that small contracts would almost certainly not involve excluded activities. Pandemic or mortality bonds, which payout based on deaths and illnesses, are by definition not related to the required exclusion criteria. Nor would payments to cover residential or commercial losses be associated with them. Depending on the composition of GDP and the geographic distribution of insurance, further conclusions can be drawn. By definition, it is obvious that the first and third sectors of an economy have nothing to do with the industry. Expert work by an insurance and risk management department of a university-provided further clarification. In the end, such methods proved that almost 100% of the portfolio could not be assigned to the excluded activities.
Overarching basic checks were carried out at the level of the sponsor concerning binding sustainability guidelines, such as signing the Principles for Sustainable Insurance or compliance with the ten principles of the UN Global Compact. What was neglected in this first step was a close look at the security assets parked.
Hill: But then there is still a lot to be done before we can speak of a real standard.
Kölsch: The award of the FNG seal to a cat bond fund for the first time confirms that the product in question is about more than the mere assumption of (additional) insurance risks by the capital market. Serious damage caused by natural disasters is thus repaired and, with the reconstruction of the destroyed infrastructure, the living conditions of those affected are systematically improved, which, among other things, preserves the stability of society. Today, this form of securing the future is mainly used for highly developed regions. However, the targeted coverage of natural disaster losses in less developed regions is starting to become an essential component of supranational engagement. CAT Bonds are emerging as a good tool against the consequences of pandemics, earthquakes, and major storms in the circle of the World Bank, WHO, and governments.
It is time to take the sustainability efforts of this attractive asset class to level 2.0. For example, through our work, it came to light that even the major reinsurers do not know the details of exactly what goes through their books when, for example, a trigger event triggers corresponding payment outflows. This is a potential reputational risk for any top management that announces general group-wide exclusions to the media. If you like, we have done some pioneering work with the FNG seal to lay the foundations for transparency and to create a framework that makes it possible for the first time to identify “DNSH” (the “do not cause significant harm” rule that is so important in the EU context for sustainable finance).
However, this can only be a first step, which must be followed by others. It is reassuring to know that certain business activities are prevented. But more promising for the future and very more important in terms of ecological and social challenges are deliberate promotions of desired sustainable developments. It is where positive criteria and targeted themes come into play as attractive investment opportunities. Besides, the respective backup assets for parking must meet the ESG minimum requirements, as it must be considered just like a portfolio of a sustainability fund.
The entire SRI industry must work to ensure that the ILS industry and the insurers and reinsurers behind it move forward in terms of transparency. Also against the background that so far one can only analyze the insurance assets according to ESG criteria, but not the so-called “underwriting”. So it’s about the asset AND liability side.
Hill: Thank you very much for the interview.
Roland Kölsch is a managing director of the Qualitätssicherungsgesellschaft Nachhaltiger Geldanlagen (QNG) responsible for the FNG seal, the German-language SRI quality standard, among other things. He has been active in the field of sustainable investments since 2005: as a fund manager at one of the major SRI pioneers in Brussels, product specialist for sustainable investments at a private bank in Switzerland, and head of asset management at Alternative Bank Switzerland.
Qualitätssicherungsgesellschaft Nachhaltiger Geldanlagen (QNG): https://qng-online.de