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The Mexican Insurance Industry is Prepared to Face the Costs of Recent Catastrophic Events

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The Mexican Insurance Industry is Prepared to Face the Costs of Recent Catastrophic Events

A chain of catastrophic events struck Mexico over the past two weeks. Hurricane Katia and two earthquakes of historical significance for their magnitude and destructive power caused heavy damage across much of the country. Mexico City was hit particularly hard by the 7.1 magnitude earthquake, as were the neighboring states of Morelos and Puebla. The earthquake occurred less than two weeks after an 8.2 magnitude quake along the country's Pacific coast struck the states of Oaxaca and Chiapas on Sept. 7, 2017.

S&P Global Ratings believes, however, that in the wake of these natural disasters, Mexico's insurers will show resilience. We believe that insurers' adequate catastrophe risk management, reinsurance protection, and a prudent regulatory environment that requires high levels of equalization reserves will help to balance insured losses.

Overview
  • A string of natural disasters have taken place Mexico in the past two weeks, causing catastrophic damage to the country's infrastructure and major loss of life. The highest insurance losses will come from the earthquake that hit the neighboring regions of Mexico City.
  • Nevertheless, we believe that Mexico's insurers' adequate risk management practices and reinsurance protection, combined with the country's prudent regulatory environment, have left the industry in a good position to balance the costs of these natural disasters.
  • Ultimately, we don't expect these events to materially impact the solvency of rated Mexican insurers, which are generally well-protected by both reinsurance coverage and prudent reserve levels. However, if insurers were to consume their natural catastrophe reserves to absorb claims, their capital and earnings could flag, potentially weakening the ratings on a number of companies.

Damage Assessment Will Take Time

We expect the earthquake that hit the neighboring regions of Mexico City to lead to greater insurance losses because of the area's dense population and strong infrastructure development relative to the southern regions and the Gulf Coast. It's still early to assess the economic impact of those events in exact terms, and it isn't currently clear whether insurance losses will be greater in infrastructure, residential property, or commercial property. However, we expect that the Mexican government will primarily shoulder the costs of reconstruction. Given non-life insurance's low penetration in the sector in Mexico (a mere 1.25% of GDP), we expect insured losses to represent only a very small fraction of the overall cost.

Still, Mexico has very high exposure to catastrophic events, including earthquakes, floods, hurricanes, and other meteorological events such as the El Niño phenomenon. The sheer scale of these exposures poses high product risk for the property and casualty (P&C) insurance industry that, in our view, has been well managed up to this point. Our evaluation of enterprise risk management is adequate for Mexican insurers on average, and the sophistication of risk management across the sector has been increasing, particularly after the implementation of a Solvency II-like framework in the country.

The current regulatory framework requires insurers to conduct solvency tests periodically that evaluate several stress scenarios, including a simulated default of the insurer's largest reinsurer and its potential impact on its solvency position. Moreover, the regulator requires admitted reinsurers to have a minimum rating level to operate in the country, and reinsurers with higher ratings represent lower asset risk charges against the required level of solvency capital, which incentivizes insurers to cede business to reinsurers of high credit quality. Those regulatory requirements are particularly important to Mexican insurers, given that they generally take out substantial reinsurance protection against property catastrophe risk, which significantly reduces the impact of such events on their net combined ratios. Proportional reinsurance for natural events is high; retention for these risks has averaged around 17% over the past 10 years, while non-proportional reinsurance is also widely used to limit their maximum exposure. Industry reinsurance protection has been tried and proven, following hurricanes Ingrid and Manuel in 2013, which caused $5.7 billion in economic losses, and hurricane Odile in 2014, which cause $1.2 billion in economic losses. The overall industry presented little volatility in technical results and no consumption of equalization (natural catastrophe) reserves (see table 1).

A Conservative Regulatory Framework Protects Insurers The regulatory framework in Mexico also takes into account highly conservative prudential measures related to catastrophic risks. It requires companies to hold equalization reserves calculated on the basis of a conservative 1,500 year return period for its probable maximum loss (PML). Those catastrophic reserves are the last layer of protection for Mexican insurers' capitalization and can be used if excess-of-loss reinsurance isn't enough to cover losses. Among Mexican P&C insurers, equalization reserves amounted to around $2 billion as of March 2017.

Although equalization reserves are not included within the capitalization required by the Mexican regulator, S&P generally factors them into our total adjusted capital (TAC) calculation. The consumption of those reserves to absorb catastrophe claims could lower their TAC, eventually weakening their stand-alone credit profiles and, ultimately, our ratings on them.

Solvency Is Well-Protected

We will continue to assess the impact of recent events on domestic insurers' capital and earnings as insurance losses become clearer. However, we do not expect these natural disasters to materially impact the solvency of rated Mexican insurers, which are in general well protected by reinsurance coverage and prudent reserve levels. Potential rating actions will depend upon Mexican insurers' capital buffers, their earnings power over the next two years, and managerial intentions to replenish lost capital.