Despite the prevalence of powerful and destructive natural forces, the cost of reinsurance cover for the associated exposures in the Mexican market is primarily governed by the flow of capital into and out of the industry. Jorge Liñero explains.

When the Spanish arrived in 1519, Mexico City was ideally situated for its population of around 250,000 inhabitants. Over 300 km from the sea to the west and 200 km to the east, the city stood on an island close to the shore of a great lake at the centre of a wide valley surrounded by magnificent mountains - including two large volcanoes, their peaks perpetually covered in snow. Over the past five centuries the city has grown continuously at the expense of the lake that used to surround it. Gradually drained and filled over the centuries, the lake has all but disappeared under a layer of concrete.

Today Mexico City is one of the largest cities on earth. With over 25 million inhabitants, it accounts for around a quarter of Mexico's total population and a large proportion of the country's GDP. But its historic location on an ancient lake bed leaves this vast concentration of people and property severely exposed to the threat of earthquake damage. A large proportion of the modern city stands on sediments of sand and clay. This soft soil modifies the period of vibration and dangerously amplifies the shock waves set up by seismic activity. In practice, this means that the earth in Mexico City will move far more than in other places equidistant from an earthquake's epicentre.

Most large earthquakes in Mexico occur along the Pacific coast, created by the interaction of the Cocos and North American tectonic plates. The zone of interaction where the Cocos plate slides underneath the North American plate generates large earthquakes as energy is accumulated and then released in periodic seismic episodes.

Due to the marked periodicity of these “typical” earthquakes, statisticians modelling seismic activity have favoured a renewal stochastic process with a risk function that increases over time - rather than a Poisson process. The subduction zone to the south of Mexico generated 25 earthquakes of a magnitude greater than 7.5 on the Richter scale during the twentieth century. Eight of these measured above 8 on the Richter scale (see table above).

The earthquake of 19 September 1985 showed most clearly and tragicallythe effect of subsoil conditions in Mexico City. Measuring 8.1 on the Richter scale, it originated on the Pacific coast near the border between Michoacan and Guerrero, around 400 kilometres from the capital.

In Mexico City ground movement was amplified by up to 20 times due to the lack of subsoil rigidity. Many buildings with a resonance period of around two seconds - typically those ranging from around 6 to 12 storeys high - started to move in harmony with the shock waves and collapsed or suffered severe damage due to the huge forces created by this movement.

Unfortunately, it is inevitable that such events will continue to occur in future. A number of research projects detail where and how this is likely to happen. The authors of a 1992 study entitled Probable Damage in Mexico City as the Result of a Large Earthquake off the Coast of Guerrero, Luis Esteva and Mario Ordaz, contend that a powerful earthquake is almost certain to affect Mexico City in the relatively near future. The fault running between Petatlan and Ometepec (near Acapulco) in the state of Guerrero has been associated with a string of earthquakes in the past (1899 M=7.9, 1907 M=7.7, 1908 M=7.6 and 7.0, 1909 M=6.9 and 1911 M=7.6). Since then the region has remained generally quiet. However, sufficient flexible deformation energy has accumulated during these years of relative calm to cause a significant earthquake.

A number of studies exist to show, by various different methods, that, if the rupture length corresponded with the full length of the Guerrero fault, the magnitude of the earthquake would reach around 8.2 on the Richter scale, with a minimum distance of just 280 km from Mexico City. An event of this scale with its epicentre so close to the capital would be likely to cause very severe damage.

Earthquakes aside, Mexico is also significantly exposed to the threat of hurricanes. Both its Atlantic and Pacific coasts lie directly in the path of oncoming storms that hit the country even more frequently than earthquakes. It is estimated that, on average, 3.75 hurricanes affect Mexico's Pacific coast every year and 1.3 the Atlantic coast.

In 1989, the catastrophic affects of Hurricane Gilbert provided yet another stark example of just how exposed Mexico is to natural disasters. Gilbert was one of the strongest hurricanes ever seen in the Atlantic, Caribbean and the Gulf of Mexico. Its central pressure fell as low as 888 mb - the lowest measurement ever recorded for an Atlantic hurricane. Gilbert hit the Yucatan peninsula shortly after this reading was taken, and caused severe damage to hotels, roads and the telecommunications infrastructure in nearby Cancun. Gilbert also displaced over a million square metres of sand, completely altering the face of the resort. After it had passed over Yucatan, the strength of the hurricane diminished from category 5 to category 3. It crossed the Gulf of Mexico, but never re-intensified before making landfall again in northern Mexico. It did, however, cause serious flooding in the Monterrey region.

Despite the prevalence of such powerful and destructive natural forces, the cost of reinsurance cover for the associated exposures in the Mexican market is primarily governed by the flow of capital into and out of the industry. Though “state of the art high tech property-catastrophe loss exposure analysis” (and advanced tools for assessing the anticipated costs of damage and predicting deviation scenarios) are now in widespread use - the laws of supply and demand largely determine catastrophe reinsurance pricing.

Over the past few years catastrophe excess of loss rates in Mexico have decreased from around 6% on line (rate on line being equal to premium divided by capacity purchased) to around 1% on line today (see table above). Quite clearly, this decrease in price does not reflect any corresponding fall in exposure to catastrophes. Nor is this situation particular to Mexico. It can be seen almost anywhere in the world today, as reinsurers must either reduce prices year after year or cancel treaties.

Reinsurers' abilities and aptitudes in confronting this dissociation between pricing and risk varies widely. Some more disciplined companies are able to withdraw from certain markets when they anticipate negative results. Others may have accumulated sufficient reserves to tide them through the “soft market”. However, companies that fail to provide adequately for the exposures they face leave themselves in the hands of fate. As Shaw put it elsewhere: “Nature's way of dealing with unhealthyconditions is unfortunately not one that compels us to conduct a solvent hygiene on a cash basis. She demoralises us with long credits and reckless overdrafts, and then pulls us up cruelly with catastrophicbankruptcies.”

Unless a dramatic change in the reinsurance industry occurs, we are likely to see a major correction in the amount of catastrophe reinsurance capacity available. Not only have premiums decreased to minimal levels, but last year's spate of medium-to-large catastrophes has shown how quickly the industry can incur huge liabilities and berequired to transfer billions of dollars to its clients the ceding companies. The first signs of an upturn in the reinsurance cycle are now appearing in the retrocession catastrophe market, where prices have risen sharply during the last renewal season. For some facultative programmes hit by both single losses and catastrophes, the increases were more dramatic. Operations without an adequate balance may now face a choice between buying retrocession at prices in excess of those warranted by their book of business, or exposing their capital andsurplus to the vagaries of the catastrophe market.

The experience of Latin America and the Caribbean has been particularlybad in recent years as the industry has suffered a number of catastrophes such as flooding related to El Niño, Hurricanes Georges, Mitch, Floyd and Lenny, and flooding in Mexico and in Venezuela. The premiums paid by some regional retrocession programmes have increased in multiples for the second year in a row. In this unstable environment it is not unlikely that a number of players will be forced to quit the reinsurance market altogether. Insurance companies need to select carefully to be sure that their reinsurers will still be around to pay for future losses. At the end of the day capital in the reinsurance industry will either be remunerated or exhausted or leave. Whatever else may change, insurers in Mexico and Latin America will continue to face an ever present exposure to natural events against which they will always need to protect.

Jorge Liñero is chief underwriting officer at AXA Re Latin America.