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Mexico - Life & Non-LifeBEST’S SPECIAL REPORTOur Insight, Your Advantage.

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Performance of Mexico’s Insurance Market in 2016, Following Implementation of Solvency IIIntroductionIn the fi rst quarter of 2016, due to the enforcement of Solvency II and its quantitative requirements, the Mexican insurance sector faced challenges related to Pillar I and the changes resulting from it. The cornerstones of these regulatory changes follow:

1. Valuation principles for assets and liabilities consistent with the generation of an economic balance at market value

2. Procedures for the evaluation of technical reserves using the “best estimate method,” registered by insurers with the local regulator, Comisión Nacional de Seguros y Fianzas (CNSF), which avoids explicit security margins in the valuation of reserves and therefore in premium pricing

3. Calculation of the Solvency Capital Requirement (using the general formula or internal methods) using a 99.5% confi dence interval and a one-year time horizon, to establish a risk-based capital requirement

4. A technical reserve scheme that incorporates changes in investment management and solvency capital through capital resources considered “Eligible Own Funds,” of different levels according to permanency and liquidity

5. A change in life and credit insurance accounting methods, recognizing the term of obligations

This document aims to analyze the effects of these changes on the Mexican insurance market a year after implementation, in terms of its participants, growth, penetration, density, depth, concentration, profi tability, and fi nancial strength.

Number and type of CompaniesAs of December 2016, Mexico’s insurance and pensions sector comprised 99 companies, of which 52 were foreign subsidiaries (53%), and 47 were national companies (47%). Of the 99 companies (Exhibit 1), only eight belonged to fi nancial groups (16%). Compared to 2015, the sector is down by three companies: two national companies’ subsidiaries and one foreign.

Mexican insurance market overview during fi rst year of new regulatory regime

Market Review September 1, 2017

Analytical Contact:Eli Sanchez, Mexico City [email protected]

Contributor:Manuel A. Calderón de las Heras, Mexico City

SR-2017-930

Exhibit 1Institutions in the Insurance Market (2015/2016)(Number of Institutions)

Institution in the Insurance Market 2015 2016Foreign Subsidiaries 53 52

Foreign subsidiaries that do not belong to a financial group 45 44Foreign subsidiaries that do belong to a financial group 8 8

National Institutions 49 47National capital institutions that do not belong to a financial group 41 39National institution that do belong to a financial group 8 8

Total 102 99Source: Comisión Nacional de Seguros y Fianzas

2

Special Report Mexico - Life & Non-Life

The decline in the number of companies in 2016 was due to the voluntary liquidation of Vitamédica and Genworth Daños (both lacking relevant market share), and the merger of Inbursa Seguros de Crédito and Fianzas Guardiana. Furthermore, two companies were sold off in 2015 and subsequently operated under different names in 2016: First American Title Insurance (now Nezter) and Seguros Multiva (now Seguros Ve por Más). Overall, this restructuring is the result of the companies’ specific circumstances and not due to the implementation of Solvency II.

In terms of market share (Exhibit 2), foreign entities accounted for 59% of the market (46% did not belong to a financial group; 13% did), while the remaining 41% was held by national companies (30% did not belong to a financial group; 11% did).

Of the 80% of premiums issued by 17 institutions (17.2% of all institutions), foreign companies hold 37% of the market; foreign subsidiaries belonging to financial groups hold 12%; national companies, 21%; and national companies belonging to a financial group, 10%. This industry structure denotes that major business development is undertaken first by foreign subsidiaries, then by national companies or foreign subsidiaries that belong to a financial group, and last by national companies. Companies with access to resources from other institutions—either financial, operational, technical, or risk management—realize greater business development, while those companies with limited access to additional capital or reinsurance support are less favored in competitive terms.

Sector Size and International Comparisons of Penetration, Density, and DepthPremium volume in Mexico’s insurance industry is MXN 447.6 billion (USD 23.9 billion). Mexico accounts for around 0.5% of global premium volume and is the second largest insurance market in Latin America after Brazil. By segment, life accounts for 43% of premium volume; auto, 21%; P/C (excluding auto), 16%; accidents & health, 16%; and pension funds, 4%.

There were no major changes in premiums written by segment (Exhibit 3) related to the change in the regulatory regime, with the exception of the life segment, which increased due to the new accounting treatment for premium recognition, in conjunction with the term of obligations.

Exhibit 2Market Share by Origin of Insurers' Capital (2016)

Source: Comisión Nacional de Seguros y Fianzas

30%

11%46%

13%

59%

National Capital

National Capital part of a FinancialGroup

Foreign Subsidiary

Foreign Subsidiary part of a FinancialGroup

3


Potential GrowthThe industry’s potential growth can be estimated by the Insurance Protection Gap (IPG)1 in Mexico, which represents the difference between the acquired insurance coverage in one country against that which would be economically efficient; this gap is quantified by comparing the insurance penetration indicator in Mexico with that of developed economies.2 The gap is a differential derived from the amount that would be covered by GDP if Mexico had the same penetration rate as developed economies, in comparison to the amount currently covered by its actual insurance penetration. The underlying idea is that, owing to their macroeconomic characteristics, income distribution, and the capacity of their insurance industries to provide more coverage for more diverse risks, more developed countries serve as a benchmark for developing economies.

For this exercise, A.M. Best used the penetration ratio for developed economies of 8.2% for 2015 and of 8.4% for 2016, to quantify the amount of premiums needed each year to reach the same penetration ratio in Mexico, which results in a required increase of MXN 1,169 billion (USD 67,821 million) for 2015 and MXN 1,296 billion (USD 62,862 million) for 2016, expressed as the number of times the actual premium volume would need to increase to close the gap for each year. For 2015, it would have had to increase 2.69 times and for 2016, 2.58 times (Exhibit 4), indicating progress in the evolution of the insurance market in 2016 that goes hand in hand with the income elasticity of the Mexican economy, standing at 3, which allowed the penetration ratio in Mexico to improve to 2.34% in 2016 from 2.21% in 2015.

A.M. Best expects that the gap (expressed as a multiple of the current annual premium) will continue to narrow favorably, as experience under the new regulatory scheme develops, given that it allows for reserves to be valued based on the best estimate of liabilities and for more efficient use of capital, achieving a higher offer capacity by institutions, either through larger operations or through innovation in new segments or distribution channels.

1 For more information on the Insurance Protection Gap, please refer to Fundación MAPFRE report, “The Latin Insurance Market in 2015.”2 Developed economies as defined by the Swiss Re Institute in its publication Sigma No 3/2017.

Exhibit 3Direct Written Premium by Segment (2016/2015)(MXN millions)

Source: Comisión Nacional de Seguros y Fianzas

187,839, 43%

91,117, 21%

72,647, 16%

69,623, 16%

19,286, 4%

December 2016

Life Auto P/C Without Auto A/H Pension Funds

162,199, 42%

75,665, 19%

73,223, 19%

59,395, 15%

19,719, 5%

December 2015

4


The Depth indicator, on the other hand, measures the ratio of life premiums written to total premiums written. When compared with the penetration ratio (Exhibit 5), the fundamental role of achieving larger insurance coverage and the ability to reach the individual segment are notable —in Mexico, the penetration ratio in 2016 was 2.34% and the depth ratio, 43%. Both indicators are below those of developed countries with a high Human Development Index (HDI),3 a classification that takes Mexico into account, and even lower than those of countries with a medium HDI. In those countries with a high HDI, total penetration4 is more than double that in Mexico. Nevertheless, the participation of life insurance relative to the total business portfolio has evolved favorably over the last ten years, reflecting a more mature market. One can conclude that, even if the Mexican insurance market has reached an adequate level of maturity, it still has a significant potential for growth.

The insurance market’s penetration and depth correlate significantly with income distribution, as measured by the Gini5 Index (Exhibit 6), denoting that penetration ratios are higher in countries with less income disparity and lower in countries with high income disparity. Some countries —like South Africa —are characterized by high income disparity and superior penetration compared to developed countries, due to innovation in distribution channels; life insurance programs that feature savings components; initiatives to reach higher penetration levels; and the distribution of micro insurance to lower-income segments of the population. A.M. Best believes that if the Mexican market, in conjunction with economic growth and improvements in income distribution, is able to better exploit consumption structures as distribution channels—through retail stores, banks, or telecommunication services for the macro and micro insurance segment—the sector’s penetration ratio could expand.

3 The Human Development Index (HDI) is calculated by the United Nations and captures the expectancy of life at birth, years of education, and national income per capita.4 The Depth ratio and the Penetration ratio by HDI were calculated by weighting the countries that belong to each category by their relative participation in the total premiums of the group.5 A value of zero in the Gini Index indicates equitable income distribution among all inhabitants; a value of one indicates the opposite.

Exhibit 4Insurance Protection Gap (2015/2016)(Shown as a Multiple of the Indicated Year Premium)

Sources: Swiss Re Institute, Sigma No 3/2017; World Insurance in 2016: The China Growth Engine Steams Ahead, July 2017; Fundación MAPFRE, El mercado asegurador latinoamericano en 2015, Noviembre 2016; and A.M. Best Research

0.0x

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

7.0xTh

aila

nd

Mal

aysi

a

Chi

na

Braz

il

Leba

non

Col

ombi

a

Pana

ma

Uru

guay

Mex

ico

Cos

ta R

ica

Bulg

aria

Serb

ia

Iran

Jord

an

Peru

Ecua

dor

Turk

ey

Ukr

aine

Dom

inic

an R

epub

lic

2015 2016

5


Exhibit 6Gini Coefficient, Penetration and Insurance Density (2016)

Note: Gini coefficient for the 2010-2015 period.Note: The bubble indicates Insurance Density in USD.Sources: Swiss Re Institute, Sigma No 3/2017; World Insurance in 2016: The China Growth Engine Steams Ahead, July 2017; Fundación MAPFRE, El mercado asegurador latinoamericano en 2015, Noviembre 2016; United Nations Development Programme, Human Development Report 2016: Human Development for Everyone, 2016; and A.M. Best Research

Germany

Switzerland

Japan

United Kingdom

France

Canada Australia

India

Italy

Spain

USA

RussiaUruguay

ChinaArgentina

Peru Ecuador

Mexico

HDI Low

Chile

Brazil

Colombia

HDI Medium

South Africa

HDI High

HDI Very High

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6 0.65

Pene

tration (201

6)

Gini (2010‐2015)

Exhibit 5Depth, Penetration, and Gross Domestic Product (2016)

Note: Penetration, Depth, and Gini for the HDI categories were calculated by A.M. Best.Note: The bubble indicates Gross Domestic Product in USD billions.Sources: Swiss Re Institute, Sigma No 3/2017; World Insurance in 2016: The China Growth Engine Steams Ahead, July 2017; Fundación MAPFRE, El mercado asegurador latinoamericano en 2015, Noviembre 2016; and A.M. Best Research

RussiaEcuador

Argentina

HDI Low

Colombia

Uruguay

USA

Canada

Germany

Mexico

Spain

Peru

Brazil

HDI Very High

China

Switzerland

HDI High

Chile

AustraliaFrance

United Kingdom

Italia

HDI Medium

Japan

India

South Africa

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

10% 20% 30% 40% 50% 60% 70% 80% 90%

Pene

trat

ion

Depth

6


Insurance density, measured as premium per capita, which in Mexico reached USD 189.4 as of 2016, also correlates positively with income distribution, representing a challenge for countries with large populations and income disparity, and limiting their capacity to reach the majority of the population. However, it also creates opportunities for micro insurance, macro products, and distribution channels, as used in developed countries.

Real Growth AnalysisThe insurance industry, including pensions but without taking into account the 24-month accrual on the PEMEX policy, had a real growth rate of 9.2% as of year-end 2016—10% if the 24-month accrual on the PEMEX policy is taken into account. Both of these growth rates incorporate the effect of the accounting change in recognizing the term of obligations in life and credit insurance, for which premiums are annualized. Without this effect and without the accrual of the PEMEX policy, the industry grew 6.6%, and accounting for both, 6.1%, representing growth of more than 2.8 times that in Mexico’s economy, which maintained income elasticity of 3 on average during the last few years.

Direct Premium Adjusted Real Growth by SegmentReal growth in the insurance segment, excluding pensions, accounting for the 24 month accrual of the PEMEX policy, and discounting for the annualized premium, was 6.7% (Exhibit 7). Auto and accidents & health had a higher growth rate. Including pensions, the sector grew 6.1%. The growth of the sector excluding the PEMEX accrued policy and including the annualization effect is shown in Exhibit 8. Sixty-six percent of the sector is composed of personal insurance, taking into account the annualization effect, and 34% of non-personal insurance. In real terms, the share of personal insurance grew by 11.8% in 2016, while the share of non-personal insurance shrank by 6.8% (Exhibit 9).

Exhibit 7Adjusted Growth Rate by Segment (2016/2015)(MXN millions)

Life Auto P/C Without auto Accidents and Health Total

2016 173,692 91,117 75,958 69,727 410,494

2015 162,199 75,665 74,879 59,395 372,138

% Nominal 7.1% 20.4% 1.4% 17.4% 10.3%

% Real 3.6% 16.5% -1.9% 13.6% 6.7%

Note: Excludes pension funds, includes the 24-monthly accrual of the PEMEX policy, and discounts the annualization effect of life policies.

Sources: Comisión Nacional de Seguros y Fianzas Asociación Mexicana de Instituciones de Seguros and A.M. Best Research

Exhibit 8Growth Rate by Segment (2016/2015)(MXN millions)

Life Auto P/C Without Auto Accidents and Health Total2016 187,839 91,117 72,647 69,623 421,2262015 162,199 75,665 73,223 59,395 370,482% Nominal 15.8% 20.4% -0.8% 17.2% 13.7%% Real 12.0% 16.5% -4.0% 13.4% 10.0%Note: Excludes pension funds, the 24-monthly accrual of the PEMEX policy, and accounts for annualization effect of life policies.Sources: Comisión Nacional de Seguros y Fianzas; Asociación Mexicana de Instituciones de Seguros and A.M. Best Research

7


Market Concentration AnalysisThe Mexican insurance market, excluding pension funds, specialized health companies, financial guarantees, and mortgage insurance, reported MXN 420 million in direct premium; is composed of 74 companies, with the five largest companies accounting for a 48% market share; and has a Herfindahl-Hirschmann Index (HHI)6 of 7%, indicating that market concentration is low (Exhibit 10).

The life segment is the largest, with direct premium of MXN 190 billion (USD 10.1 billion), accounting for 45% of the total market, with its five largest participants holding 45% of the segment, and has an HHI of 12%.

The auto segment reported direct premium of MXN 91 billion (USD 4.9 billion), accounting for 22% of the total market, with its five largest participants holding 67% of the segment, and has an HHI of 15%.

The property and casualty segment, excluding auto, reported direct premium of MXN 73 billion (USD 3.9 billion), accounting for 17% of the total market, with its five largest participants holding 37% of the segment, and has an HHI of 5%.

6 The Herfindahl-Hirschman Index ranges from zero to 100%, with zero indicating the lowest concentration in the market and 100% indicating a monopoly.

Exhibit 9Growth Rate by Operation (2016/2015)(MXN millions)

Personal Insurance

Non-personal Insurance

DEC 16 RR7 275,230 139,563DEC 15 SIIF 238,078 144,949% Nominal 15.6% -3.7%% Real 11.8% -6.8%Note: RR7 stands for Regulatory Report 7; SIIF stands for Integral System of Financial InformacionSources: Asociación Mexicana de Instituciones de Seguros and A.M. Best Research

Exhibit 10Concentration by Segment in Mexico (2016)

Note: The bubble indicates premiums written in MXN billions.Sources: Comisión Nacional de Seguros y Fianzas and A.M. Best Research

6691

73

190

420

0%

5%

10%

15%

20%

30 40 50 60 70 80

HH

I

Number of Institutions

Accident & Health Auto P/C (Without Auto) Life Total

8


The accident & health segment reported direct premium of MXN 67 billion (USD 3.6 billion), accounting for 16% of the total market, with its five largest participants holding 71% of the segment, and has an HHI of 13%.

Market concentration is not low for segments with higher premium retention and a higher claims incidence, such as auto, accident & health, and life. The bulk of the premiums is in these segments, in which a few participants have greater influence over the market.

According to Mexico’s Federal Commission for Economic Competence (Comisión Federal de Competencia Económica, or COFESE), an HHI lower than 20% has a low probability of negatively affecting economic competence. None of the segments discussed in this report has an HHI lower than 20%, indicating a healthy competitive environment for the industry.

Results AnalysisThe insurance market in Mexico, including pension funds, reported MXN 447.6 billion (USD 23.9 billion) in gross premiums written, for a 6.4% real growth rate as of year-end 2016. Excluding pension funds, discounting the effect of the annualization of life premiums, and accounting for the 24-month accrual of the PEMEX policy issued in 2015, the sector had a 6.7% real growth rate, driven mainly by the auto and accident & health segments.

The life segment’s direct premiums grew 12% in real terms, taking into account the annualization of premiums; without this effect, the growth rate was 3.6%, below the 7.9% growth in 2015. The P/C segment, excluding auto and accounting for the 24-month accrual of the PEMEX policy, grew 1.9% in real terms.

Premium retention increased to 84.7% from 83% in 2015; net premium earned stood at MXN 305.1 billion (USD 16.3 billion), rising 16% versus 11% the previous year, reflecting the following effects: reserves released owing to the regulatory change in the reserve calculation; an increase in reserves due to the recognition of larger obligations; and the annualization of premiums. All of these factors are due to the one-off changes—not to structural dynamics. The overall increase in reserves was MXN 74.1 billion (USD 4 billion).

Claims costs increased 14% versus 10% in 2015, resulting in an improved loss ratio of 73.4% (versus 74.3% in 2015), heavily influenced by the larger growth in earned premium in 2016 relative to the growth of net claims. The life and auto segments saw the largest increases in claims costs, but owing to the growth in premiums in both segments, loss ratios improved marginally.

Acquisition costs improved marginally to 17.5%, also due to the effect of larger retained premium volume in the life, auto, and accident & health segments. These segments were all able to improve their acquisition ratios.

Operating costs have been constant, at 7.6%. On the whole, claims, acquisition, and operating costs contributed to the improvement in the industry’s combined ratio of 98.5%, versus 99.8% the previous year, achieving greater premium sufficiency and amounting to MXN 14.6 billion (USD 779.6 million), a 59% increase over MXN 9.1 billion (USD 485.9 million) in 2015.

9


The sector’s performance benefited from a smaller increase in other technical reserves, as well as stable income from other operations, although one of the main reasons for the positive performance was the rise in financial income (Exhibit 11), which amounted to MXN 63.7 billion (USD 3.4 billion) versus MXN 47.6 billion (USD 2.5 billion) in 2015, up 34% due to the increases in both investment valuations at market rates and foreign exchange results owing to the appreciation of the USD, on which the sector has a long position.

The industry’s net income was MXN 38.7 billion (USD 2.1 billion), up 82.5% in nominal terms and 76.5% in real terms, explained mainly by the lower reserve development as a consequence of using the new best estimate method, a beneficial investment valuation at market rates under the “financing the operation” accounting criteria, and the favorable long position in USD, which appreciated relative to the MXN; all of these changes are considered one-off in nature.

Financial income plays a pivotal role in industry results (Exhibit 12), mainly on the increase in income from investment valuations and foreign exchange, which combined accounted for 5.3 percentage points of the total return of financial products over earned premiums (Exhibit 13)—20.9% in 2016 versus 18.1% the previous year.

In terms of profitability, the one-time effect of the changes in accounting is evident in the higher return on earned premiums, 17.4% versus 11.7% in 2015, and in the higher return on adjusted equity (including catastrophic reserves), 18% versus 10% the previous year, despite a 24% increase in capital during the year. This was driven mainly by the effect of the valuation surplus resulting from the new regulatory scheme, which represents 32% of the reported capital growth. The return on assets was 3.1%, compared to 1.8% in 2015.

Exhibit 11Mexican Insurance System Revenue (2016)(MXN millions)

Sources: Comisión Nacional de Seguros y Fianzas and A.M. Best Research

447,

638

38,1

01

9,13

3

6,98

8

6,40

7

3,09

0

2,11

4

1,49

1

395,

083

33,9

95

1,53

0

4,19

5

4,90

7

3,02

0

1,16

9

1,19

3

Gross WrittenPremiums

Investments InvestmentValuations

ForeignExchange

Other FinancialReturns

Sale ofInvestments

Share ofPermanentInvestments

OtherOperations

2016 2015

10


Exhibit 13


Relative Share of Components of Financial Income in Financial Income Return on Earned Premiums (2016/2015)

12.5% 12.9%

1.0% 1.1%

3.0%0.6%

2.3%

1.6%

2.1%

1.9%

21%

18%

2016 2015

Other

Foreign Exchange

Investment Valuations

Sale of Investments

Investments

Investment Income/Earned Premiums

Exhibit 12Return on Earned Premiums (2016/2015)

Source: Comisión Nacional de Seguros y Fianzas A.M. Best Research

20.9

%

17.4

%

12.7

%

5.2%

4.8%

-4.2

%

18.1

%

11.7

%

8.0%

2.7% 3.

5%

-6.8

%

Financial Income Earnings BeforeTaxes

Net Income Gross Results Technical Results Operating Results

2016 2015

11


Balance Sheet AnalysisAssetsTotal industry assets came to MXN 1,333 billion (USD 71 billion), up 14% from 2015, due mainly to increases in volume and in the valuation of investments resulting from the accounting changes implemented in 2016. Insurance industry assets accounted for 6.8% of Mexico’s GDP.

The industry’s investment portfolio is healthy and conservative, consisting mainly of fixed-income government instruments. The investment portfolio yield was 6.7%, a 0.79 percentage point premium over the risk-free rate of Mexico’s 91-day Treasury certificates (CETES), due to investment valuations and foreign exchange results that were up 66.6% in comparison to the previous year.

Accounts receivable, mainly premiums not yet collected, came to 8.9% of total assets without counting reinsurers’ technical reserves, which constituted 8.3% of total assets. Asset quality is adequate, as the reinsurance policies of the segment’s major institutions require a secure grade rating, and many subsidiaries have reinsurance programs with parent companies with a 95% cession rate.

The industry’s return on average assets was 3.1%, up from previous year’s 1.8% due to the larger impact on net income of financial products, because of the growth in the investment portfolio in sector assets resulting from the new valuation method.

LiabilitiesThe industry’s liabilities came to MXN 1,147 billion (USD 61 billion), up 13% from the previous year, driven mainly by an increase in life reserves resulting from the recognition of the term of life insurance obligations, which mitigated the decrease that would have occurred in mathematical reserves owing to the use of the best estimate method on the obligations.

Insurance reserves have been stable, consisting of unearned premium reserves (80%), loss reserves (15%), and catastrophic reserves (5%). In 2016, reserve coverage—the ratio of net reserves to net premiums, indicating the capacity to hedge risks relative to reserves—decreased to 2.57 times, from 2.67 times in 2015, due to the 16% growth in net premium in comparison to the 12% growth in net reserves, which was anticipated owing to the excess reserves that resulted from the new valuation and the resulting decline in needed reserves.

With the changes in the reserve estimate applicable in 2016, the difference between the percentage change in retained premiums and the percentage change in technical reserves (Exhibit 14), increased significantly over the previous year, reaching 1.4. This showed a higher trend in premium growth compared to initial reserve development, as was expected after implementing the new best estimate method for company obligations—from 2006 to 2015, the indicator average was 0.8.

The coverage of net premium reserves (Exhibit 15) has also narrowed in those segments that are the most sensitive to the valuation of obligations such as life insurance on its own and life insurance with accidents & health; the multiline insurers have also seen this coverage diminish.

Regulatory reserve coverage was 1.09 times, versus 1.10 last year, calculated by individually weighting each company’s reserve coverage by its premium volume relative to the industry total.

In conclusion, the new Solvency II method of calculating reserves had a relevant effect on the adequacy of reserves, resulting in an increase in net premium growth that was not matched by reserve growth, which resulted in a decrease in the ratio of net reserves to net premiums,

12


especially for the sectors that are the most sensitive to the valuation of reserves, such as the life segment. In contrast, the regulatory coverage of the investment base needed to cover reserve requirements did not change significantly because of the new regulatory scheme

Exhibit 15Net Reserves to Net Premiums

Note: To calculate the ratio of net reserves to net premiums, companies were separated according to segments that are authorized to issue, i.e., those that issue exclusively in one segment are shown separately from those that issue in multiple segments, to achieve partial segregation of balance sheet data and these indicatorsSources: Comisión Nacional de Seguros y Fianzas and A.M. Best Research

0.62

x

0.76

x

2.40

x

1.21

x

1.64

x 2.33

x 2.94

x

5.90

x

2.67

x

0.69

x

0.74

x

0.75

x

1.07

x

1.35

x

1.52

x

2.93

x

6.17

x

2.58

x

0.0x

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

7.0x

Health Auto Multiline P/C withAuto

Life Life andA/H

A/H P/CWithout

Auto

Total

2015 2016

Exhibit 14Relation of Change in Retained Premiums to Change in Technical Reserves


1.8

0.7

0.3

0.9

0.50.7

1.2

0.8

0.50.6

1.4

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

0%

5%

10%

15%

20%

25%

30%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

% C

hange in Retained P

remium

s/%

Change in Technical R

eserves%

Cha

nge

in R

etai

ned

Pre

miu

ms

and

Res

erve

s

Change in Retained Premium/Change in Technical Reserves

Change in Retained Premium

Change in Technical Reserves

13


Capital and Risk Adjusted CapitalizationTo evaluate the sector’s risk-adjusted capitalization, A.M. Best uses the Best Capital Adequacy Ratio (BCAR), which measures Adjusted Policyholder Surplus versus the Net Capital Requirements for risks. To obtain the Adjusted Policyholder Surplus, capital is adjusted to contribute or discount the different factors that may affect insurers’ equity. The risks contemplated in the Net Capital Requirements are divided into three: asset risk (fixed-income securities, equity securities, interest rates, and credit); underwriting risk (from net reserves and net premiums); and business risk, giving us the Gross Capital Requirement, which when adjusted by covariance gives us the Net Capital Requirement. Dividing the Adjusted Capital by the Net Capital Requirement gives us the BCAR Coefficient, which is matched with the guidelines for each level of the coefficient, resulting in a score for Implicit Balance Sheet Strength.

The industry’s risk-adjusted capitalization strengthened by a 3.2-fold increase in surplus in 2016 from 2015 due to the Solvency II regime, whereby reserves are estimated using the best estimate method on the obligations reported by each institution, resulting in a reserve surplus. Because of the valuation with the curves of risk-free rates, this surplus can be recognized in the surplus account as capital, so long as the obligations remain outstanding; at termination they can be recognized on the income statement. The industry’s capital amounted to MXN 186 billion (USD 10 billion) in 2016, up by MXN 36 billion, or 24% (Exhibit 16) from MXN 150 billion (USD 8 billion) in 2015.

Risk-adjusted capitalization also benefited from a 82.5% increase in net income linked to the strong results from investment products, owing to the reclassification of investments from “held to maturity” to “to finance operations,” as well as foreign exchange earnings and improved

BCAR = (Adjusted Policyholder Surplus)(Net Required Capital)

Exhibit 16Relative Contribution of Components of Equity to Equity Changes (2012-2016)


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

-10,000

0

10,000

20,000

30,000

40,000

2016 2015 2014 2013 2012

Profit R

etention of Previous

Year's N

et Income (%

)

Cha

nge

in E

quity

(MXN

milli

ons)

Other Capital Components

Previous Year's Net Income

Valuation Surplus

Paid Capital

Current Net Income

Profit Retention of Previous Year'sNet Income

14


financial returns. Profit retention from previous years was good, reaching 78% in 2016, compared to an average of 68% during 2012 to 2015, and demonstrating the strengthening of the capital base due to operating performance and the effect of regulatory changes.

In terms of risks, the gross capital requirements of the BCAR model are 33.5% for investments other than fixed income; 23.2% for reserve risk; 16.9% for premium risk; 13.4% for fixed-income investments; 9.5% for credit risk (mainly for reinsurance); and 3.4% for interest rate risk. The composition of net capital requirements was broadly similar in 2015.

Based on the BCAR coefficient, the assessment of the industry’s Implicit Balance Sheet Strength is “Superior.” To arrive at a credit rating, the analysis would still need to incorporate operating performance, business profile, and enterprise risk management, in addition to country risk. The Superior category is defined as the superior ability of an institution to meet its current insurance obligations compared to other institutions.

Opportunities in the Mexican market and the availability of capital that can be used to take advantage of those opportunities can be assessed by analyzing the solvency margin of the institutions as published by the CNSF and premium leverage, measured as gross premium divided by capital (Exhibit 17). For this exercise, leverage was calculated by segment, taking into account those companies registered exclusively in the indicated segments and grouping those that issue policies in several segments as multiline.

Analysis of these two indicators makes it possible to assess, through premium leverage, how much capital is available to cover the risk that premium has been insufficient and that capital must be used to pay the obligations. In addition, the minimum solvency capital coverage tells us how much capital is available to cover potential risks in the company’s operations. Thus, when the regulatory indicator approaches one—that is, the capital surplus decreases as the risk increases—a company’s ability to take on more risk is limited, which inhibits business growth.

Exhibit 17Leverage by Segment (2016)

Note: To calculate the regulatory solvency requirement, companies were separated by the segments that are authorized to issue, i.e., those that issue exclusively in one segment are shown separately from those that issue in multiple segments, to achieve partial segregation of these indicators.Sources: Comisión Nacional de Seguros y Fianzas and A.M. Best Research

2.77x3.44x 3.62x 3.75x

4.15x

5.02x 5.29x

6.35x

2.36x2.28x

1.95x

1.13x

3.67x

1.70x2.15x 2.38x

1.36x2.04x

Life andA/H

Multiline Auto Health P/CWithout

Auto

A/H P/C withAuto

Life Total

Gross Premium Leverage Weighted Regulatory Solvency Requirement

15


For the life and auto segments, the opportunities to grow capital (relative to the minimum solvency capital coverage published by the CNSF and weighted by gross premiums) are more limited, because the indicators for these two sectors are closer to one, in contrast to the health and life segment, for which the regulatory indicator is farther from one, which means these two sectors have more capital available to assume more risk.

The industry’s gross premium leverage measured as a ratio of direct premium to capital is 2.36 times, compared to 1.91 times for adjusted capital,7 while net leverage, measured as the ratio of net premium to capital, is 2.03 times, compared to 1.62 times for adjusted capital.

Financial leverage, measured as the ratio of liabilities to liabilities plus capital, declined to 86% from 87.1% reported in 2015, due to the decline in needed reserves and the increase in capital related mainly to the effects of the new accounting standards. The industry’s return on average capital in 2016 was 18% (Exhibit 18), versus 10.8% in 2015, compared to the 6.20% return from the Index of the Mexican Stock Exchange, and the 5.62%8 yield on 10-year Mexican government bonds.

ConclusionThe effects of Solvency II in Mexico can be measured, as an approximation of A.M. Best’s rating process, through Balance Sheet Strength, Operating Performance, and the Business Profile. Mexico’s insurance sector remains stable. The number of companies changed, but this was not related to the new regulatory framework; neither sector dynamics nor insurance segments changed significantly—except for the life sector, owing to the annualization of life premiums.

The industry’s penetration continues to deepen, as shown by the evolution of the Insurance Protection Gap, which (expressed as a multiple of annual premiums) decreased from the previous year. This was due to changes in Mexico’s economy, but it also reflects the potential growth for the sector, which will strengthen if it can transfer reserve requirements under the best estimate method and use capital more efficaciously, which could give rise to more product offerings in new segments or more efficient distribution channels, thereby expanding the population’s access to insurance.

Operating performance has benefited from the new regulation in two ways: The first is the annualization of life premiums and the declining need for favorable reserve development, which results in better financial ratios (such as the combined ratio). The second is the benefit to financial products of higher interest rates and the new accounting criteria used to value investments. The increase in revenues was initially dampened due to the gradual recognition (to 24 months) for the release of reserves, the effect of which will end at the end of 2017.

7 Adjusted capital takes into account provisional reserves, catastrophic reserves, and contingency reserves.8 ISIN: US91086QAU22, United Mexican States (UMS) 5.625% Global Notes due 2017.

Exhibit 18Main Financial Indicators

2016 2015ROA 3.1% 1.8%ROE* 18.0% 10.8%Net Income/Earned Premium 17.4% 11.7%Gross Written Premium/Capital 1.91 2.02Regulatory Solvency Margin 2.04 1.6Regulatory Reserve Coverage 1.09 1.1* Includes provisional reservesSources: Comisión Nacional de Seguros y Fianzas and A.M. Best Research


Published by A.M. Best

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A.M. Best Rating Services, Inc.Oldwick, NJ

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Best’s Financial Strength Rating (FSR): an independent opinion of an insurer’s financial strength and ability to meet its ongoing insurance policy and contract obligations. An FSR is not assigned to specific insurance policies or contracts.

Best’s Issuer Credit Rating (ICR): an independent opinion of an entity’s ability to meet its ongoing financial obligations and can be issued on either a long- or short-term basis.

Best’s Issue Credit Rating (IR): an independent opinion of credit quality assigned to issues that gauges the ability to meet the terms of the obligation and can be issued on a long- or short-term basis (obligations with original maturities generally less than one year).

Rating Disclosure: Use and LimitationsA Best’s Credit Rating (BCR) is a forward-looking independent and objective opinion regarding an insurer’s, issuer’s or financial obligation’s relative creditworthiness. The opinion represents a comprehensive analysis consisting of a quantitative and qualitative evaluation of balance sheet strength, operating performance and business profile or, where appropriate, the specific nature and details of a security. Because a BCR is a forward-looking opinion as of the date it is released, it cannot be considered as a fact or guarantee of future credit quality and therefore cannot be described as accurate or inaccurate. A BCR is a relative measure of risk that implies credit quality and is assigned using a scale with a defined population of categories and notches. Entities or obligations assigned the same BCR symbol developed using the same scale, should not be viewed as completely identical in terms of credit quality. Alternatively, they are alike in category (or notches within a category), but given there is a prescribed progression of categories (and notches) used in assigning the ratings of a much larger population of entities or obligations, the categories (notches) cannot mirror the precise subtleties of risk that are inherent within similarly rated entities or obligations. While a BCR reflects the opinion of A.M. Best Rating Services, Inc. (AMBRS) of relative creditworthiness, it is not an indicator or predictor of defined impairment or default probability with respect to any specific insurer, issuer or financial obligation. A BCR is not investment advice, nor should it be construed as a consulting or advisory service, as such; it is not intended to be utilized as a recommendation to purchase, hold or terminate any insurance policy, contract, security or any other financial obligation, nor does it address the suitability of any particular policy or contract for a specific purpose or purchaser. Users of a BCR should not rely on it in making any investment decision; however, if used, the BCR must be considered as only one factor. Users must make their own evaluation of each investment decision. A BCR opinion is provided on an “as is” basis without any expressed or implied warranty. In addition, a BCR may be changed, suspended or withdrawn at any time for any reason at the sole discretion of AMBRS. Version 012616

Balance sheet strength improved because of the increase in equity following the creation of the equity account to reflect the investment valuation surplus and in the industry’s profitability, which allowed for the capitalization of earnings from previous periods and resulted in lower rates of premium leverage—which could lead to an increase in the amount of capital available to assume greater risks or encourage the search for new risks, such as cyber risk.

A.M. Best’s view of the implicit balance strength of the Mexican insurance system, without taking into account business profiles, operating performance, enterprise risk management, or country risk, would be “Superior” according to the BCAR, meaning that companies have a superior ability to meet their current insurance obligations. A.M. Best believes that, because of this, along with the improvements in the Solvency Capital regulatory requirement one year after implementation, the industry’s solvency has improved primarily because of one-off changes. However, it is important to note that the capital base resulting from the surplus is vulnerable to changes in interest rates, which could cause some volatility when these obligations are terminated or the investments held available for sale are sold.

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