Property/casualty insurance companies are confronted with a conundrum: continuing to confine investments to high-quality, extremely liquid instruments such as bonds, while earning enough income to stave off the effects of inflation.

Solving this daunting problem has been confounding. But the industry is not sitting still. Many insurers are tinkering with their investment portfolios, slightly altering bond classes and durations, dabbling a bit in equities, and making tentative forays into more esoteric gambles such as real estate and private equity.

Who can blame them?

“Never before has any insurer management team faced the interest rate environment of the moment,” said Robert Hartwig, president of the New York-based Insurance Information Institute Inc. “The problems are not just U.S. but global in nature, affecting insurers and reinsurers the world over.”

With interest rates running in the very low single digits, safer bets like bonds—the industry's traditional investment vehicle—are akin to stuffing cash under the mattress. According to the III, about 70% of insurers' invested assets are held in bonds, which are interest-rate sensitive, of course. To inch up returns, insurers are readjusting their bond portfolios, carefully and slightly shifting from municipal bonds to higher-yield corporate bonds, among other offerings.

“There is only so much insurers can do because of regulatory restraints to keep investments liquid and of high quality,” Mr. Hartwig said. “But, there is definitely some action out there, with many insurers chasing (better) yields, where they can find them.”

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Right now, they're less apt to find these yields in municipal bonds. While munis accounted for 52% of U.S. property/casualty insurers' aggregate bond portfolio at year-end 2007, they accounted for 44% at year-end 2011, according to the III. Higher-yield corporate bonds picked up the slack, increasing from 30% to 37% over the duration.

The migration to corporates is driven by factors besides improved yields. “There are a lot of conservative views (of municipal bonds) now that two or three municipalities have gone under and several more are threatened,” said Herbert E. Goodfriend, senior vice president at New York-based insurance broker and financial advisory firm Gill & Roeser Inc.

Additionally, the superior tax treatment of municipal bonds vs. corporate bonds (municipal bonds are exempt from federal taxation of interest income) loses its luster when the yields are so low, Mr. Hartwig said. As he put it, “There's just not much of a tax benefit left.”

Despite the migration from munis to corporates, the industry still confronts meager portfolio returns. As Karen Wells, co-head of the insurance investment advisory group at Towers Watson Investment Services in New York, said, “Regulations are written requiring insurers to hold a preponderance of fixed income bonds, which are really one of the riskiest classes out there, given that yields are effectively lower than the rate of inflation,” she said.

“We're asking clients to take off the traditional insurance investment blinders and explore the wider universe,” Ms. Wells said.

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This wider universe comprises other asset classes such as equities and real estate, and different approaches to fixed income maturity. “Durations are shortening across the board, and are now at about 6.5 years,” said Stephan Christiansen, managing director of insurance research at Hartford, Conn.-based research firm Conning & Co.

Mr. Hartwig provided III statistics on maturities indicating that at year-end 2007, 8% of insurers' bond portfolios had a maturity of 20 years or longer. At year-end 2011, this percentage fell to 6%. Thirteen percent of insurers' bond portfolios at year-end 2007 contained bonds maturing in a 10- to 20-year timeframe, whereas only 10% at year-end 2011 held bonds of this duration. Similarly, five- to 10-year duration bonds also fell to 27% of holdings from 34% over the period. Meanwhile, bonds with a one- to five-year duration saw increases to 41% of portfolio holdings from 30%.

The upshot?

“Obviously, fewer companies are locking into longer-term bonds due to the low yields and the effects of inflation,” Mr. Hartwig said. “When you invest at 1.5% for 10 or more years, you are locking into something that will likely be below the rate of inflation, guaranteeing a loss.”

Another shift in investing philosophy appears to be toward more sector-diverse corporate bonds. “We're seeing a move away from purely A-rated or better corporate (bond) exposures to more diverse issuer exposure in the BBB marketplace,” Ms. Wells said. “We believe insurers with stronger exposure to BBB corporates will have better diversification than those that stick with an A or better mentality. As long as they do proper credit research, there remains a very low probability that these (bonds) will default—they're still investment-graded fixed income assets.”

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Mr. Christiansen agreed that there is more interest in BBB and BB bonds, and in equities to boot. “Some companies are looking to increase yield by allocating more of their investments into lower-quality bonds,” he said. “Others are shifting a bit into equities, particularly those sectors that produce decent dividends and are priced relatively low. It's not impossible to see a 3% yield on equities with dividends, which is double the return on a one-year Treasury (bond) these days.”

James Amen, partner and insurance company specialist at Philo Smith & Co., a Stamford, Conn.-based independent investment banking firm, estimates that 1% of insurer portfolios are invested in preferred stocks and 15% in common stocks, much of it dividend-bearing. “If a company is underleveraged and able to generate close to an underwriting profit, they are more likely to be more heavily exposed in equities as well as alternative investments such as private equity, real estate and sector-specific funds,” he said. “Still, these are slight movements—nothing dramatic.”

Mr. Hartwig added another relatively nontraditional investment to the list—privately placed bonds, which represented around 3.5% of insurer bond investments at year-end 2007 and 8% at the conclusion of last year, he said.

Ms. Wells echoed these and other diversifications, including bank loans (a loan made to a corporation, with the investor taking on the issuer risk); master limited partnerships, typically energy-related; and real estate. The latter comprises traditional real estate investment trusts spinning off cash flow and moves by some insurers to buy company buildings, as opposed to leasing these facilities. “There are lots of options out there,” she said.

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While there may be options to lift investment income, the outlook nonetheless remains grim.

“The impact of poor investment earnings has clear ramifications,” said Howard Mills, chief adviser to the insurance industry group at New York-based Deloitte. “The focus must be on underwriting and expenses. Insurers are making greater use of data to increase underwriting gains, while cutting costs wherever they can. The days of relying on investment income to smooth over underwriting losses are over, at least for the foreseeable future.”

Mr. Hartwig said: “Insurers can tweak their portfolios, but where the rubber meets the road is pricing.”