In this era of structurally low yields and stricter regulatory oversight, earning investment income is tough—and it’s probably going to stay that way. Insurance CIOs realize that the traditional investing strategies they’ve relied on in the past are unlikely to meet their future needs (Display below).

These challenges are encouraging insurers to think creatively about a wider range of investments. For most, however, the quest for higher returns means moving out on the risk curve. The big question is: Just how far off the beaten path can insurers go?

There are no easy answers. Like many investors with long-term horizons, insurance companies need their capital to go the distance— and with as little volatility as possible. How they "spend" their risk budget involves tricky trade-offs, hinging on how much liquidity they need to operate their businesses and their tolerance for realized losses, and potentially large unrealized losses, relative to their liability streams and excess capital. While the recent market turbulence has opened up attractive entry points across many riskier asset classes, it has also magnified the risks involved in capturing these opportunities.

As they start investing in these nonconventional strategies, insurers must also secure the necessary expertise to evaluate how these asset classes behave under various market conditions and how they are likely to affect the specific regulatory, accounting and ongoing business challenges insurers face.

It’s a complex balancing act, requiring new ideas and new solutions. After evaluating the full spectrum of investment options, we suggest three paths insurers can take to improve their return profiles while staying within a capital-efficient framework.

New fixed-income "core" strategies offer insurers attractive ways to add income and diversification.

 

Path 1: Embracing the New Core in Fixed Income

New fixed-income "core" strategies offer insurers attractive ways to add income and diversification. These include strategies that provide global bond exposure and those designed to capture the upside of the high-yield market with much less downside. As part of a holistic approach, these solutions can help improve the risk/return characteristics of an insurer’s total portfolio.

Focus on: Emerging-Market Investment-Grade Debt

By providing access to a large and growing share of the global economy, investments in emerging markets, via hard currency, have an important role to play in a well-diversified portfolio.

Emerging-debt markets are broadly riskier than developed-world debt markets. Corporate governance in emerging markets tends to be weaker (with fewer protections for creditors and shareholders), politicians and policymakers are more unpredictable, and currency fluctuations are more frequent. These risks are also why investors in emerging markets can collect a premium relative to the comparably rated securities of companies in developed economies.

Emerging-market (EM) risk can lurk in a wide variety of individual bonds, and it often doesn’t matter whether the borrower hails from Shanghai, São Paulo or Seattle. What’s more, the market often misprices this risk. A broad, top-down approach that groups credits into developed-market (DM) and EM buckets, and assumes that the latter are always more risky, may not pick up on this distinction.

Investors who focus on ratings and on how a bond is trading might conclude that the risk isn’t worth the reward. But those who drill down more deeply may find that they’re getting paid more than they should be, since the market tends to gauge a firm’s level of risk based on its country of origin, not its business profile.