Central America offers reinsurers the chance to grow and diversify their portfolios across international markets. However over the last decade, insurer retentions have risen and property rates in the region have continued to fall. Is this sustainable? We take a look at the various drivers behind the trends, consider some of the potential sticking points and highlight the value of reinsurance.

Regionalization and catastrophe losses

One of the main drivers of property rate reduction and increased retentions has been the move over recent years to create a single market. This has enabled primary insurers to write business in different Central American countries - the result being a market with fewer but more regionalized insurance players with larger and better diversified portfolios.

For catastrophe risks in particular, this regional diversification can enable an insurer to reduce the amount of economic capital it needs to hold against its premium base. It also impacts the cost of reinsurance: a regionalized catastrophe program for example can be cheaper than a set of stand-alone country programs because the total limit is likely to be less than the sum of the individual programs. In addition, a lower capital loading will be applied to the treaty compared to the sum of individual capital loadings, especially for non peak regions.

Other benefits of being a regional insurance player include having a higher capital base, and a higher premium base relative to costs.

The other principal factor to consider is losses. Despite a number of catastrophe events, insured losses for the region over the last decade have been relatively moderate. When we consider this fact combined with the above-mentioned regionalization benefits, it is not surprising that the Central American insurance market is in such a financially strong position, that property rates have significantly fallen and that the trend is to increase retentions and to cede less premium to reinsurers.

Reinsurance capacity in good supply

Central American regional catastrophe programs are potentially very interesting to global reinsurers for reasons of growth, because they are not highly correlated with other peak zones, and because they do not represent a large enough peak exposure to be a capital driver in their own right. This means that the global reinsurance market can offer catastrophe risk transfer at very low capital cost, and depending on a given reinsurer's view of the pure risk cost, at potentially very competitive absolute prices.

Sticking points

Risk correlation, solvency regulations and worsening catastrophe losses all pose a potential threat to the status quo in Central America.

As regards correlation, while earthquake risk does not correlate significantly across Central American countries, hurricane risk can do so. Hurricane Mitch in 1998 for example brought heavy rains to Honduras, Guatemala and Nicaragua. For international reinsurers, it is also not universally the case that Central American hurricane does not correlate with other peak catastrophe zones (e.g. the Peak Atlantic Hurricane Zone). Again, hurricane Mitch in 1998 crossed Florida as a strong tropical storm after leaving Central America. It is easily conceivable that it could have strengthened again as hurricane Wilma did in 2005 (producing over $ 10 billion of losses in Florida after having caused over $ 1 billion of losses in Mexico).

For sustainability, these correlations must be fully assessed and incorporated into robust risk accumulation control and capital allocation processes. This requires modeling know-how that includes the ability to incorporate non- or poorly-modeled perils as well as peril zone dependencies. See section 'Related PartnerRe Content' for further information on this topic.

In addition, solvency laws do not always allow companies to fully benefit from diversification. Specific regulations and future changes in regulation will affect diversification credit and pricing.

Finally, an extreme catastrophe event or a sequence of less severe catastrophe events, especially if several Central American counties are impacted, could swing the market as high retentions and insufficient capital could in such circumstances spell disaster for insurers. The recent major earthquake in Chile has refocused attention on the significant loss potential from this peril and may prove to be the event that brings about this change.

In all, Central America is a market that has real potential to attract global reinsurers, the interest and potential is certainly there. Reinsurance can offer the market considerable know-how and security to ensure a successful, stable future, founded in particular on a shared understanding by all parties of the risks and their complex correlations.