Catastrophe Bonds, Solvency, and the Asset Management of Insurance Companies

The insurance sector has been subject to several major trends throughout the last decade. Two of them set the stage for this research proposal: the maturing of the market for catastrophe (cat) bonds, as well as the regulatory reforms in Europe aimed at the introduction of new risk-based solvency standards. Since both of these developments are likely to shape the insurance industry for years to come, they naturally lend themselves to the derivation of highly relevant research questions.

The cat bond market which emerged in the mid-1990s has become an important means of additional risk bearing capacity for the insurance industry. The success of this instrument is based on its popularity as an alternative risk transfer technique for insurance and reinsurance companies as well as the appeal of its risk-return and correlation profile for investors. Although the cat bond asset class has withstood the major dislocations in the global markets during the recent financial crisis fairly well, issuance volume declined sharply in 2008. In the meantime, however, the size of the primary market has returned to pre-crisis levels and all signs indicate that it is entering a prolonged period of steady growth.

Solvency II, the EU's flagship project to modernize European insurance supervision, has entered its final development phase and is expected to come into force in 2013. The design of this framework has substantial consequences for policyholders and taxpayers, since inadequate solvency capital requirements could either cause inefficient reductions in investment or lead to excessive risk taking, thus endangering the stability of the financial system as a whole. Due to harmonization efforts and the close integration of the Swiss and European economies, particularly through the capital and insurance markets, potential issues associated with Solvency II are also highly relevant for the Swiss Financial Markets Supervisory Authority (FINMA) as well as the Swiss insurance industry.

Interestingly, however, the importance of both of these topics is not yet mirrored by the amount of academic research that has been conducted on them to date. The pricing process of cat bonds, e.g., is still not sufficiently well understood and a commonly accepted valuation model has not yet emerged. This impedes the quick expansion of the instrument's investor base. Furthermore, although Solvency II is viewed to be one of the most innovative regulatory frameworks currently available, several important aspects with regard to the adopted risk modeling and risk measurement approaches have not been subject to scientific scrutiny yet. In the light of heavy lobbying efforts by industry sources, independent academic research constitutes a focal element in the ongoing discussion with regard to the adequacy of the new standards. Consequently, within this project, we intend to address at least three aspects of the cat bond market and Solvency II that are highly relevant for the asset management of insurance companies. In addition, our results will also be interesting for risk managers and policymakers. Due to the recent rebound of the cat bond market and the upcoming introduction of Solvency II, we believe that this research project is very timely. The suggested project design aims to maximize synergy effects between the sub-topics, particularly with regard to specific research questions, key preconditions, and employed methodologies. The main goal is to write at least three quality research papers with the potential for publication in the leading journals of the field of risk management and insurance.