Mid-Year Outlook: A global rewiring (full report) 

• Changes in the macro environment have complicated risk management and regulatory alignment for insurers, demanding a reappraisal of strategies. 
• Insurers are adapting by diversifying, such as adopting a barbell approach to optimise yield while managing risk, rebalancing portfolios in response to inflationary risks, and seeking stability through diversification into Asia's corporate and quasi-sovereign bonds. 
• The increasing importance of private markets, including private equity and direct real estate, presents opportunities for insurers to achieve capital efficiency and resilience amidst market uncertainties. An era of relatively modest inflation, a predictable interest rate environment, and stable geopolitics has given way to geopolitical and macroeconomic fragmentation, through events such as the US-China tariff disputes, the Russia-Ukraine war, and broader realignments of alliances.

As a consequence, risk management and regulatory alignment have become more complex. Specifically, we identify four challenges insurers face, each of which requires its own set of responses.

Challenge 1: Volatility is now structural

Elevated uncertainty leads to higher volatility, making diversification even more necessary. In addition, the current investment landscape means the way insurers diversify also needs to evolve. 

Insurers typically split their investment strategy into two parts. The first is a liability-driven portfolio and the other a surplus portfolio. In the liability-driven portfolio, particularly for life insurers with longer time horizons, asset classes such as high-quality government and investment grade bonds dominate.  

Under current market conditions, a more nuanced approach to calibrating risk within both portfolios is needed. For example, the lower end of investment grade, particularly BBB-rated issues, is increasingly viewed with caution as regions like the UK or certain parts of Europe risk downgrades. Insurers therefore need to assess whether they’re being appropriately compensated for the risk taken, which potentially includes not only higher losses but also higher capital charges.

How insurers can respond

Some are shifting to a barbell strategy, combining safer government bonds with high-yield credit, particularly with issuers that are more likely to be upgraded. European high yield, for example, may offer more rising stars than their counterparts in the US, where fallen angels have recently dominated. This approach can offer a way for insurers to optimise yield while managing risk with more predictability.

In surplus portfolios, multi-asset, equity income, and equity market-neutral strategies are able to serve more of a core role in portfolio construction. These strategies have built-in capabilities to reduce downside risk and improve the potential for cash flow stability, helping to mitigate portfolio volatility. Importantly, in a more uncertain environment, active risk management can respond more quickly to market disruptions.  

Challenge 2: A resurgence of inflationary risk

Inflation is another concern for insurers. Here, the baseline macroeconomic reality in the US is one of entrenched inflation. With fiscal policy remaining expansionary, we do not expect any rate cuts from the Federal Reserve this year. In Europe, inflation has been stabilising. However, investors should not be complacent; inflation can be imported from the US through energy prices and supply chain pressures among other channels. That may lead to hesitation by the European Central Bank and the Bank of England on further cuts in rates, even if growth stalls.

How insurers can respond

Some insurers previously extended duration in expectation of more US rate cuts, and may now be exposed. They will need to rebalance their portfolios to align with liabilities, maintain cash buffers, and refocus on shorter-duration, higher-quality credit. The takeaway is that duration is a tool, not a trade in this environment. Prudence is required.

Challenge 3: The reappraisal of sovereign credit

Since sovereign bonds are no longer viewed as the safe havens they once were, insurers are re-evaluating their role in portfolio construction. Some, including those in the UK and France, are diversifying away from domestic government bonds where high debt burdens are raising questions about long-term sustainability. 

As spreads widen in riskier developed market government bonds, the implications for capital charges become more significant. Interestingly, Portugal, Greece and Italy - once sidelined at the riskier fringes of sovereign debt - now appear more stable, a dramatic reversal underscoring how relative risk is being reinterpreted in the new investment regime.

How insurers can respond

Asia offers diversification. In comparison to the more indebted countries in Europe and North America, many in Asia are relatively insulated from fiscal excess. For example, Japan, India, and other Asean economies are viewed as more stable from a credit perspective. Building exposure to Asia’s corporate and quasi-sovereign bonds, with their attractive spreads and solid fundamentals, could help build portfolio resilience. 

Challenge 4: The shift away from public markets is intensifying

This one is perhaps less of a challenge and more of an opportunity. One of the most notable trends in insurance portfolios is the role of private markets. Asset classes such as private equity, private credit, and direct real estate are increasingly foundational. 

How insurers can respond

Direct lending, which supports private equity, offers contractual yields with lower mark-to-market sensitivity than publicly traded credit along with higher resilience to interest rate uncertainty. And because direct lending is unrated, it’s more capital efficient if structured correctly to reduce volatility-based capital charges.

In Europe, real estate is gaining traction following a reset in valuations. However, investors exploring this asset class must look beyond pricing to the environmental and regulatory implications of their investments. Tenants are demanding ever higher environmental standards. Therefore, assets that support the low carbon transition such as sustainable logistics and office retrofits may offer higher risk-adjusted return opportunities. 

Adding ballast to portfolios

Insurers are adapting to the new investment regime by sharpening their asset-liability management discipline, embracing active risk management, and reassessing exposures not just by asset class, but also by sector, liquidity premium, complexity premium, geography, capital efficiency, and volatility sensitivity. 

Adding exposure to Asia, global equity, quality credit, and private markets can all help build ballast in portfolios that are increasingly tested by real-world complexity.