Mexico is vulnerable to hurricanes on both coasts and flooding as far inland as the capital city. As Ana Paula Nacif discovers, catastrophe modelling in the country is progressing – and bringing with it a better understanding of the country’s exposures.

With a unique geography and specific hazards, Mexico presents a challenging environment for the insurance industry. Last year’s near misses (two category 5 hurricanes made landfall but in sparsely populated parts of the country) and hurricane Wilma, which hit the country’s coast back in 2005 causing losses in the region of $2bn, brought home to reinsurers the need to assess risks and quantify exposure in a more accurate manner.

Mexico’s geographical position means it is vulnerable to storms from both the Pacific and Atlantic oceans. According to AIR Worldwide, Mexico experiences an average of almost two hurricane landfalls per year and, while the northeast Pacific is more active overall, both basins produce a similar number of major hurricane landfalls.

But landfall risk is not Mexico’s only concern. The orientation of the country’s coastline, combined with dominant storm track patterns, means that Mexico also experiences a significant number of bypassing hurricanes, which can bring damaging winds and heavy precipitation to coastal exposures. In addition, flooding from tropical cyclones can extend hundreds of kilometres inland and persist several days after landfall, which can result in significant losses.

High hurricane activity remains a concern for the industry. “Hurricanes in the region are topical at the moment and there has been a lot of investment and investigations to provide a hurricane model,” says Christof Reinert, Munich Re’s manager of property treaty underwriting for Latin America and the Caribbean.

New modelling

Back in April, AIR Worldwide released a commercial tropical cyclone model for Mexico and another commercial model, being developed by RMS, is expected to enter the market at the end of next year. “After Wilma in 2005, there has been a tremendous concern, also from the government side; people want to deal with the exposure properly and be better prepared,” Reinert explains.

Whereas in the past one of the challenges for the industry in Mexico was to get hold of good-quality data, the landscape has changed over the past few years. “Unfortunately it does take a big event such as Wilma to raise awareness but the quality of information coming from Mexico has improved markedly,” says Milan Simic, managing director of AIR Worldwide.

AIR’s model estimates insured losses from wind and flood to buildings, contents and business interruption. It includes a catalogue of more than 50,000 loss-causing events, both bypassing and landfalling. According to the modelling firm, the largest concentrations of exposure along Mexico’s coastline are the resort towns of Cabo St Lucas and Acapulco on the Pacific Coast, and Puerto Vallarta, Tampico and Cancun on the Atlantic. And although well inland, Mexico City – with its $1.5trn of insured exposure – is also at significant risk from precipitation-induced flooding.

“The vast majority of insured risk in Mexico comes from commercial and industrial risks, as residential insurance penetration is still relatively small

The vast majority of insured risk in Mexico comes from commercial and industrial risks, as residential insurance penetration is still relatively small in the country. “There is also a variation in building standards and materials throughout the region, which can vary greatly between say Mexico City and Yucatan,” explains Simic. “The costs have been going up steadily, between 2% and 5% per annum for labour and materials, and, in terms of underwriting risks, property valuation is critical.”

But insured values have remained more or less the same. When facultative renewals come around, prices are going up only at inflation rate (about 4% in Mexico), according to Hugh Powell, CEO of Guy Carpenter for Latin America and the Caribbean. “Some of our placements see values increased as a result of acquisitions or moderate investments in the hotels business, but obviously this is not a true increase for that segment in the Mexican market, but rather some activity with regard to changing names.”

According to Simic, although the market hasn’t seen a significant trend in terms of insured values, there has been a correction in the market, especially in Yucatan. “Some companies cancelled their contracts while others took them on. And rates went up following Wilma, as it is always the case after a major event. But we are hoping that our model will provide a tool for all participants in the market to help the dialogue between the parties to avoid overreaction following a major event. With the model, underwriters can back up their decisions with accurate calculations.”

Increasing exposures

Having more accurate methods of calculating exposure may prove crucial for the industry as the country’s insurance market grows. Mexico’s growing economy and the federal government’s significant infrastructure investment have already had an impact on insurance demand, which is likely to rise even more. As Reinert explains: “The construction industry is expanding, which means that we have seen more insurance demand, especially in some technical lines of business.”

He also points out that, with such growth, risk management will become even more of a focus for the industry. “The main challenge for reinsurers and insurers in the country is risk management and encouraging companies to have proper risk management and control. The construction quality, for example, is still an issue.”

Exposure, risks and losses may well be high, but insurance penetration in Mexico is still low, approximately 2% of GDP in comparison with a global average of 7.5%. And the Mexican Insurance Association is aiming to more than double insurance penetration by the year 2015.

“This low level of insurance stands in stark contrast to the vulnerability of Mexico to natural disasters,” says Richard Schneider, head of Swiss Re’s Mexico office. He adds that, after large catastrophes such as the floods in Tabasco last year, the burden to help the population and to alleviate an economic setback lies heavily with the government.

“In May 2006 a cat bond was launched on behalf of the Mexican government

That’s why in May 2006 a cat bond was launched on behalf of the Mexican government. The government is indemnified in the event of an earthquake exceeding a certain level of severity, defined by magnitude, depth and location. And there is no threshold for losses, which is a more common structure for cat bonds issued by insurers and reinsurers.

The deal was structured by Swiss Re and placed in the capital markets through a parametric cat bond and the remainder was reinsured. “The Mexican Government is aware that this is only the first step towards a more adequate catastrophe risk management regime and is analysing similar solutions for other catastrophic exposures, such as hurricanes,” Schneider says.

Bottom-up approach best

As for the insurance industry itself, reinsurance capacity is widely available and therefore capital market solutions are not as attractive. “We have not yet seen any insurer subscribing to a cat bond,” says Powell. “The demand is still low given the high pricing of such vehicles when compared to traditional reinsurance. There are also regulatory issues.”

He adds: “We have seen local insurers approaching quota share underwriters seeking relief for their statutory cat reserves for quake and hydrometeorological perils (winds and flood) on a pro rata treaty basis. Capacity here is abundant and viable compared to other financial means of capital relief.”

Another trend in the Mexican market is microinsurance, a bottom-up approach to insurance, which has attracted insurers and reinsurers alike. “Insurers and reinsurers have a twofold motivation for being engaged in this segment,” explains Schneider. “The first is pursuing a double bottom line by being active in developing markets and generating additional returns. The second is gaining social benefits by helping low-income people gain access to insurance products, thus providing them with an additional financial tool that helps them overcome the negative impact of individual catastrophes.”

As Mexico’s renewal season approaches, it seems that the industry is working on new solutions to deal not only with the exposure coming from high hurricane activity in the region, but also with a market where there is an insurance gap to be filled. As Schneider explains: “Innovative approaches, such as microinsurance and simpler and affordable products, are needed to bolster the use of insurance so that it serves the low income population. The ultimate goal is to close the gap between economic and insured losses.”

It remains to be seen how the pace of change in Mexico will have an impact on the country’s insurance market. For the time being, the industry is waiting for the results of the hurricane season, which has just begun, and the expectation is that the rates will remain soft for some time yet. “We expect soft conditions to persist through 2008 and 2009,” concludes Powell. “Following Wilma in 2005, rates reduced in 2006 and 2007 with no wind-related losses, other than the Tabasco floods last year which only had a light and temporary impact on automobile rates due to the aggregate effect of the total claim amount, but did not move the market’s overall needle.”

Ana Paula Nacif is a freelance journalist.