Mexico City's Fragile Foundation: Is Your Portfolio At Risk?

Includes: BRK.A, BRK.B, C, GS, PEP, RE, WRB
by: Gary Hirst


Recent earthquakes in and around Mexico City highlight a unique challenge to risk-averse investors.

The city's perilous history, location, and foundation have set the stage for a catastrophic insurance disaster should another major earthquake occur.

Reinsurance companies face the biggest exposure, including RE, WRB, and BRK.A.

Other companies with much to lose in Mexico include C and PEP.

Knowledgeable investors seek to protect their portfolios from all manner of man-made fiscal, political, and cultural risks. However, a recent rash of sizable earthquakes around Mexico City provides a clear reminder that some portfolio risks caused by natural events are more difficult to manage. While singular events such as major earthquakes are unpredictable at best, investors should at least understand and quantify the potential impact of such a natural disaster on their portfolio.

In this vein, Mexico City provides a unique challenge to the risk averse investor and therefore a glimpse into how perilous our world can be. Those seeking to protect their portfolio against an earthquake in this major metropolis must understand how destructive past earthquakes have been, where the city is located both geographically and seismically, the characteristics of its water-logged soil foundation, and finally, which international corporations have major exposure to the area. Using history as a guide, let us first examine how destructive the last great quake was to the region.

The Last Big Earthquake of 1985

On Sept. 19, 1985, Mexico City was struck by one of the costliest earthquakes of the modern era. The powerful magnitude-8.1 earthquake, with an epicenter 250 miles from what was then the largest city in the world, officially claimed the lives of over 10,000 people. Many experts believe that this official figure is grossly understated and that the actual death toll was closer to 45,000.

On top of the horrific human toll, Mexico City's infrastructure and economy was crippled as a third of the city was reduced to rubble. Nearly 3,000 buildings were damaged and over 720,000 tons of debris had to be removed within the first six weeks of the catastrophe. Electricity and phone lines were severed across the city and access to potable water was reduced from 6 million to 90,000 citizens. Experts estimated the total cost of the earthquake and its aftershocks at over $5 billion, equivalent to 2% of Mexico's GDP at the time.

Insurance losses were also astronomical. Even though earthquake insurance coverage was low relative to other at-risk regions, international reinsurance companies suffered nearly $1 billion in insured losses after adjusting for inflation. Munich Re still lists the earthquake as the largest claims burden since the company was founded in 1880. So why does this city fare so poorly when there is substantial seismic activity?

Ancient City Built Atop Ring of Fire

Any earthquake near Mexico City has the potential to be immensely costly. Its precarious position is both a product of its ancient history and geographic location.

Originally settled by the Aztecs as the wondrous city of Tenochtitlan in 1325, Mexico City began its existence on a small, protected island in the middle of Lake Texcoco. Mexico's modern flag even takes its crest from the Aztec myth of Tenochtitlan's founding. As the story goes, their principal god Huitzilopochtli indicated where they should build the capital of their empire with a divine marker in the form of an eagle, with a snake in its mouth, perched on top of a nopal cactus.

Over the years, Lake Texcoco was drained to make way for urban expansion and Mexico City was built atop the muddy sediment underneath the lake. As the city grew, newer development proceeded directly on top of older foundations, qualifying Mexico City as a modern metropolis on top of an ancient foundation.

Not surprisingly, the city is immensely vulnerable to quakes. The silt and volcanic clay sediments of the lakebed amplify seismic shaking and the high water content of the soil can cause the soil to completely lose its consistency and stiffness through a process called soil liquefaction. Once the soil loses its rigidity, the structural integrity of all buildings in the area is compromised.

Further adding to Mexico City's precarious seismic position is its location relative to the notorious Ring of Fire, where approximately 90% of the world's earthquakes occur. The Ring of Fire runs along Mexico's Pacific Coast, where the Cocos tectonic plate slips underneath the North American plate. Volatile plate movement has resulted in a major seismic event every 30 to 70 years in this region. Considering the last big quake happened just shy of 29 years ago, it can be argued that the region is due for another major event. Despite this, many of its citizens have actually scaled back their insurance coverage over the last few decades. In 2013, earthquake insurance contracts were down 9.4% from the previous year alone. Many people in the region decline earthquake coverage not only due to the great cost, but also because of the assumption that "the big one" occurred only 30 years ago and therefore it should be many years before another big event occurs. According to Lucia Bevere, Senior Catastrophe Data Analyst at Swiss Re Economic Research & Consulting:

The low frequency of earthquake events, compared to other natural catastrophes, tends to shape the perception that earthquake risk is much lower than it actually is, even in places where there have been very deadly and damaging occurrences...

Contrary to what earthquake insurance premiums suggest, another major earthquake is quite probable in Mexico City. The economic fallout from this catastrophe would impact many industries and would likely be more costly than the last big one in 1985.

Companies With the Most at Stake

While local Mexican and international earthquake insurers will suffer large losses, it is the large, publicly traded reinsurers that will suffer the most economically from a major earthquake in Mexico City. This is because insurers manage their exposure to catastrophe risk through the use of excess loss reinsurance contracts with conservative priority and capacity levels.

As of early 2014, there were 223 foreign reinsurance companies authorized by the Mexican National Insurance and Bonding Commission to provide reinsurance services within Mexico. The largest U.S.-based, publicly traded reinsurers with exposure to Mexico include: Everest Re Group (NYSE:RE), W. R. Berkley (NYSE:WRB), and Berkshire Hathaway (NYSE:BRK.A) through its subsidiaries National Indemnity Co. and Gen Re. While German-based Munich Re has scaled back its exposure to Mexico after suffering immense losses in 1985, the other companies continue to have much to lose in Mexico.

While reinsurers are posed to lose the most should another major earthquake hit, other publicly traded conglomerates have invested heavily in Mexico and could see their profits take a major hit should disaster strike. In a unique twist, large international corporations tend to operate in Mexico through domestic intermediaries rather than through their own brand. Therefore, it can be hard to uncover who is really at risk. For instance, Citigroup (NYSE:C) owns Mexico's largest local financial institution (Banamex) as well as its largest airline (AeroMéxico). PepsiCo (NYSE:PEP) announced earlier this year that it plans to invest over $5 billion in Mexico; this is in addition to the $3 billion it has invested in the country since 2009. Together, with its wholly owned subsidiary Frito-Lay, it owns both the largest snack (Sabritas) and cookie (Gamesa) manufacturers in Mexico. Revenues from both companies would be greatly impacted from a major earthquake in Mexico.

Purchasers of catastrophe bonds also have significant risk should Mexico be hit with another major earthquake. Originally created in the 1990s during the aftermath of the Northridge earthquake, this form of risk-linked security helps insurance companies relieve some of the costs associated with a major catastrophe. In good times, issuers such as Goldman Sachs (NYSE:GS) pay a coupon on the bonds and return their principal at maturity. If, however, a major natural disaster occurs, then the principal of the bonds is forgiven and the insurance companies instead use this money to pay the claims, essentially transferring the risk of a catastrophe from the issuers to the bond holders.

Currently, Mexico is the only sovereign nation to issue catastrophe bonds. However, this is a shrewd move considering how underinsured its populace is. If a major earthquake were to occur in Mexico City, as can be expected in the not too distant future, its citizens would be hit the hardest. Without ample earthquake insurance coverage, the state would have to step in and provide immense amounts of aid. Let us all hope it never comes to this, but as an investor, you have to understand the risks and be prepared for the worst.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.