When practitioners apply climate considerations into strategic models such as strategic asset allocation (SAA), they tend to apply climate-impact adjustments at the security level after the portfolio optimization is complete.
Neuberger Berman has developed a proprietary framework to estimate the potential impact of climate change at the asset-class level, which can then be used to generate climate-adjusted capital market assumptions to serve as inputs in an SAA. We believe there are considerable advantages to this ex-ante adjustment for climate-related effects because SAA determines a meaningful portion of the variation of portfolio returns over time. Substantial variation exists in our estimated climate effects for asset classes, sectors and regions, suggesting the availability of abundant “climate asset-allocation alpha.”
In previous work, we showed that this “Climate SAA” process could “recover” some of the estimated return “lost” when climate-related effects are applied ex post.
In this paper, we apply the same Climate SAA framework with constraints and objectives, such as solvency capital requirements and asset-liability matching, designed to reflect those of European insurance investors.
Executive Summary
- We use a proprietary framework that incorporates “Climate Value at Risk” (Climate VaR) and an equivalent proprietary sovereign bonds model to estimate the potential impact of climate change on the present value of assets and securities, which we then aggregate up to the benchmark index level to use as inputs into the strategic asset allocation (SAA) process.
- Under a 2°C warming scenario, we subject the optimized asset allocations of a typical UK general insurer and Continental European life insurer to these climate-related adjustments to estimated returns: these ex-post adjustments lower the portfolios’ estimated returns, revealing them to be sub-optimal.
- We run an optimization for each insurer that integrates climate-related effects into the SAA by subjecting the portfolio constituents to climate-cost adjustments ex ante.
- This “Climate SAA” process “recovers” a large portion of the estimated return “lost” to the ex-post adjustment for climate adjustments.
- The process also lowers the solvency capital requirements (SCR) of the portfolios on the efficient frontier, as it results in allocations away from equities and extended fixed income and toward core fixed income. - Climate SAA also lowers the financed emissions of the portfolios; introducing financed emissions as a constraint in the Climate SAA optimization can lower them even further, with minimal effect on estimated return and volatility (but with some sacrifice of solvency-capital efficiency).
CLIMATE EFFECTS CAN BE MITIGATED BY INTEGRATING THEM INTO AN SAA
Standard and Climate SAA efficient frontiers for a typical UK general insurer
Source: Bloomberg, MSCI, JP Morgan, S&P Global, Neuberger Berman. Data as of April 2023. Indices used: Bloomberg-Barclays Indices for Government/Agency Debt, Corporate Bonds, and US Equities; MSCI Indices for UK Equity and Global Equity; JPM EMBI for Emerging Markets Sovereign Debt; JPM CEMBI for Emerging Markets Corporate Bonds; MSCI and S&P Global Indices for Real Estate. Past performance is no guarantee of future results. Please note that estimated returns data is based on NB’s capital markets assumptions and are provided for information purposes only. There is no guarantee that estimated returns will be realized or achieved nor that an investment strategy will be successful, and may be significantly different than shown here. Investors should keep in mind that the securities markets are volatile and unpredictable. There are no guarantees that historical performance of an investment, portfolio, or asset class will have a direct correlation with its future performance. Net returns will be lower.
