PART 1: REALLOCATING PORTFOLIOS TO INCREASE ALTERNATIVES EXPOSURE

Diversification remains a cornerstone of effective portfolio management, particularly for insurers who must navigate the complexities of market volatility and economic fluctuations to deliver financial security, competitive pricing, long-term guarantees, innovative products, effective risk management, and potential dividends for policyholders.

Greater diversification and portfolio stability

Traditional insurance portfolios, heavily weighted towards fixed income, have faced challenges in recent years, with the low interest rate environment hitting bond returns, while periods of market volatility have caused equity/bond correlations to spike, eliminating many of the diversification benefits of traditional balanced portfolios.

In this environment, insurers have increasingly sought higher yielding investments that are also characterised by higher levels of illiquidity. These alternative assets, including private credit, infrastructure and real estate, provide exposure to different risk factors and return drivers that can enhance portfolio resilience across the market cycle, helping to mitigate the overall impact of adverse market conditions on portfolios. For insurers, the ability to diversify into alternatives can help them to reduce their reliance on equities and bonds alone, and maintain financial stability to meet policyholder obligations.

Enhanced return potential in a challenging interest rate environment

The prolonged ultra-low interest rate environment between 2010 to 2022, and the subsequent sharp rise in rates, has posed significant challenges for the insurance sector. As interest rates have risen in the last two to three years, unrealised losses on fixed income allocations have led insurers to focus more on their liquid assets, specifically the management of their fixed income holdings. Nevertheless, demand for alternatives has remained stable across European insurers’ allocations.

One factor supporting demand for alternatives is the pressure to offer attractive yields to policyholders, which means insurers need return-seeking assets to play an ever more important role in their portfolios. Alternative investments are attractive thanks to their diversification benefits amid rising market volatility, as well as their ability to provide a hedge against inflation risk and protect against rising claims in the non-life space.

Private credit, for example, can offer yields that are often superior to those of traditional fixed income assets while also being less sensitive to changes in interest rates. Infrastructure and real estate also offer attractive return potential, as well as predictable income streams that can increase in line with inflation.

Regulatory changes and long-term equity treatment

The move to reallocate portfolio surpluses to alternatives is further supported by recent regulatory changes, such as the introduction of a long-term equity investment (LTEI) category to the Solvency II directive by the European Commission. This new category, which replaces the existing duration-based equity model, applies to both listed and unlisted OECD equity holdings, including alternative investment funds (rather than only equity portfolios), and reduces the capital charge to 22% (from a 39% market risk solvency ratio for public equity, and a 49% charge for private equity). Insurers also need to have a commitment to hold assets for a period in excess of five years on average, compared to the minimum 12 years holding period under the old requirement.

The draft delegated acts to the Solvency Directive, published in July 2025, specifies that ELTIFs as well as closed-end, unlevered alternative investment funds are eligible for the LTEI framework. It further clarifies the balance sheet tests that will be required as part of an insurers’ Own Risk and Solvency Assessment (ORSA). Our return-on-capital analysis shown in Exhibit 1 highlights how the new LTEI category may impact the relative attractiveness of alternatives in insurers’ portfolios. While return-on-capital is dominated by private credit assets under the standard formula, when the long-term equity investment calculation is applied, private equity and transportation assets move high up in the charts, with similarly strong moves in return-on-capital from public equity. It is worth noting that some private credit strategies that are unlevered and accessed through closed-end funds will also benefit from the LTEI category.

Portfolio risk-return analysis

While it’s clear that alternatives can help diversify insurers’ portfolios, finding the optimal allocation can be difficult. Our analysis (see Exhibit 2) plots the impact of reallocating the average European insurers’ portfolio to alternatives, with the intersection of the X and Y axis representing the current average portfolio allocation across Europe, and every dot along each asset class line representing a 1% incremental reallocation to that particular asset class. A 5% reallocation to private credit secondaries, for example, will be expected to lead to an increased portfolio volatility of about 35 basis points and an increase in expected annual return of about 42 basis points.

Our analysis suggests that gradually increasing allocations to some alternatives, such as real assets, can reduce volatility and increase return in the average insurers’ portfolio. An insurer that is focused on reducing portfolio volatility may therefore look at boosting exposure to timberland, transportation and infrastructure. However, an insurer that is seeking to increase potential returns could look at adding to private credit secondaries, which our analysis suggests would be expected to increase return potential with less impact on expected volatility than other return-seeking assets.

Creating a framework for optimal alternatives allocations

To translate this risk-return analysis into insurers’ portfolios, we’ve developed an asset allocation framework that takes into account typical liability profiles to optimise insurers’ portfolios.

In this case study, exposure to liability-backing fixed income assets is maintained at a constant level throughout the optimisation exercise. We focus on reallocating the surplus portfolio, which typically constitutes around 20% of insurers’ portfolios.

Our optimisation framework incorporates parameter uncertainty. We draw a thousand simulations from the distribution of expected returns, volatility and correlations, and subsequently run a thousand efficient frontiers. The average across the efficient frontiers is the robust frontier. The optimised asset allocation in the more conservative portfolio includes commercial mortgage loans, infrastructure and transportation, which are the assets already identified as being the most diversifying. The optimised higher return portfolio incorporates more exposure to private credit and private equity.

These simulations suggest that optimising allocations using our framework can help reduce surplus portfolio volatility and enhance expected returns, aligning with insurers' long-term financial objectives.

However, strategic asset allocation is not a one-time exercise but an ongoing process. As market conditions evolve and new opportunities arise, insurers must continuously reassess their portfolios and make adjustments as needed. A dynamic approach to asset allocation allows insurers to remain agile and responsive to changing market dynamics, maximising their potential for success.

PART 2: THE OUTLOOK FOR PRIVATE CREDIT AND REAL ASSETS

Based on our risk-return analysis, return-on-capital calculations and investment framework, the long-term strategic case for insurers to allocate more to alternatives appears strong. At the same time, the market outlook for the most attractive alternative asset classes highlighted in our analysis – private credit, transportation, and infrastructure – also looks compelling.

Private credit: Resilience and yield

Private credit has grown rapidly over the last decade and a half. Assets under management have expanded more than five-fold since the global financial crisis, as regulatory reform constrained bank lending and institutional investors stepped in to provide capital. This structural shift has created a durable opportunity set that continues to scale.

Performance has been strong. Direct lending has outperformed broadly syndicated loans and high yield bonds over the last 10 years (Exhibit 4), delivering a superior return profile with meaningfully lower volatility. The illiquidity premium remains intact, with spreads over leveraged loans and high yield bonds remaining elevated relative to history.

For insurers, the combination of robust returns and relatively muted drawdowns makes private credit an attractive diversifier to traditional public credit exposures.

The characteristics of the asset class reinforce its appeal. Direct lending loans are typically floating rate, which means their coupons reset in line with policy rates, resulting in very low duration risk. This insulates valuations from the impact of rising or volatile interest rates, in contrast to public fixed income markets. At the same time, wide credit spreads provide a cushion that should keep all-in yields attractive even as base rates gradually normalise. Coupled with senior-secured structures and strong covenants, this combination has allowed the asset class to deliver high and stable income through the cycle.

Defaults have remained low by historical standards, and while selective defaults have increased, they are often resolved through arrangements such as PIK (payment-in-kind) toggles, amend-and-extend agreements, or restructurings that preserve value and prevent outright default. This flexibility stands in contrast to the more binary outcomes often seen in public markets.

Looking ahead, the key risks often cited — excess dry powder and increased competition for deals — have so far failed to materially compress spreads, which have remained stable against broadly syndicated loans and high yield bonds over the past year.

That said, private credit is not immune to an economic slowdown. While its senior secured nature and higher recovery rates relative to public credit provide some downside protection, private credit typically is used to finance companies with lower-quality fundamentals, resulting in higher default risk. It is therefore critical for private credit portfolios to be diversified across managers, vintages and sectors to ensure resilience through the economic cycle.

Transportation and infrastructure: Stable income and returns

Transportation is another area within alternatives that offers insurers access to elevated yields. The opportunity set typically spans shipping, aircraft leasing and railcar leasing, with shipping the dominant segment. Assets are generally leased on long-term charters to investment-grade counterparties, providing predictable cash flows with limited default risk. Importantly, the sector has demonstrated resilience across multiple stress events in recent years — from Covid-19 disruption to the Suez Canal blockage and geopolitical tensions around the Strait of Hormuz. Robust underlying demand, coupled with a historically muted new-build order book, has kept supply in check and sustained high utilisation rates. This backdrop has translated into attractive, stable yields that have compared favourably with other high-income real asset sectors.

Structural trends should continue to support the return profile. The continued increase in per-ton mile distances, coupled with the re-routing of supply chains and growth in passenger travel underpin demand, while regulatory pressure for newer, more fuel-efficient, and ESG-compliant fleets will constrain effective supply by accelerating the obsolescence of older vessels and aircraft. Lease structures often transfer residual value risk to counterparties, further insulating investors from volatility in asset prices. As such, we expect transportation to remain a source of resilient, high-quality income with risk-adjusted returns that compare favourably to both traditional credit and other real asset opportunities.

Infrastructure investments, on the other hand, are driven by mega themes, such as energy demand, energy security, and the need for infrastructure modernisation. Infrastructure assets have delivered stable income streams and resilient returns over the last five years, with the need for private capital to bridge infrastructure funding gaps supporting yields (Exhibit 5).

The strategic importance of infrastructure investments is underscored by the growing need for modernisation and infrastructure development across the globe. As governments face fiscal constraints, the role of private capital in funding infrastructure upgrades has become increasingly critical. For insurers, infrastructure investments offer the potential for stable, long-term returns, while also contributing to the development of essential public assets.

Additionally, the long-term nature of infrastructure investments aligns well with the liability profiles of insurers. Infrastructure projects often have extended timelines, with income streams that can last for decades. This long-term horizon matches the long-term liabilities that insurers must manage, making infrastructure a natural fit for their investment portfolios.

CONCLUSION: ALTERNATIVES CAN PLAY AN ESSENTIAL ROLE IN INSURERS’ PORTFOLIOS

As insurers continue to adapt to changing market dynamics and regulatory landscapes, the strategic inclusion of alternatives in portfolios can provide a competitive edge. By embracing private credit, transportation, infrastructure, and other alternative asset classes, insurers can target enhanced portfolio returns, mitigate risks, and meet policyholder expectations in terms of claims, premiums, and returns.

Insurers must remain agile and forward-thinking, leveraging the unique attributes of alternative assets to achieve their investment objectives and deliver value to policyholders. However, by embracing alternatives, insurers can not only enhance their financial performance but also contribute to economic development and stability in markets around the world. As the industry continues to evolve, the role of alternatives will only grow in importance, making them an essential component of any forward-thinking insurer's investment strategy.