15 November 2017 Alternative Risk Transfer

Earthquakes may sour appetite of ILS investors

The series of earthquakes that took place in Mexico in September and their impact on the Fonden catastrophe (cat) bond may sour the appetite of insurance-linked securities (ILS) investors going forward.

The Fonden cat bond is supported by the World Bank.

“In addition, an increase in interest rates could retrieve some of the excess capital that previously sought returns in ILS and similar risk transfer vehicles,” said Alfonso Novelo, senior director of analytics at AM Best.

Novelo added that the “nature of the securities will become better understood in the region, as principal is at risk”.

Eli Sanchez, senior financial analyst at AM Best, noted that there would be an increased awareness on the structuring of these instruments, as “magnitude alone does not express the potential damage that a seismic event can cause”.

This is exemplified when comparing the 8.2 magnitude earthquake on September 7 with the 7.1 magnitude earthquake in Mexico City on September 19, which had a major intensity and resulted in larger losses.

“When compared with other earthquake-prone countries in the region, Mexico’s penetration rate for earthquake insurance is low, representing just 0.03 percent of the country’s gross domestic product and 1.62 percent of the insurance industry’s gross written premiums,” explained Novelo, adding that the rates trail behind those in Colombia, Chile and Peru.

Although these policies tend to be purchased by middle and high income households and business owners in Mexico, AM Best is “cognisant of a poor risk culture among the population, which translates in a low level of earthquake or hurricane coverage for the average household”, added Sanchez.

It’s not all doom and gloom: based on AM Best’s discussions with Mexico’s earthquake insurers, the earthquake claims will be manageable, according to Sanchez.

This is because of “the local regulator’s willingness to allow the use of the EQ Catastrophic reserve, the low retention level in earthquake coverage among primary insurers and their highly rated reinsurance partners”.

Novelo concluded: “While AM Best expects loss ratios to increase, this impact will be mitigated by the aforementioned reasons.”

As a result of the earthquakes, AM Best predicts “some modest price hardening for loss-affected areas as well as additional review of loss corridors and harder cash calls, along with more stringent terms and conditions”.

The rating agency also expects reinsurance renewals to be orderly, despite reinsurers having to face pressure not only from the events in Mexico, but also from the catastrophes in the Caribbean and the Asia-Pacific region.

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