Description

Fairfax Financial Holdings (FFH-tsx) is a Toronto-based insurance holding company with an exceptional record of growth through astute acquisitions of troubled insurance companies at depressed prices. From 1985 to 2000, book value has grown at 37% compounded, and ROE has averaged just under 20%. At the current price of C$183, the shares are down 70% from their peak of C$610 reached in 1999, and trade at 75% of book value, which is C$242.75 per share. In 1999, Fairfax earned C$32.63 per share, so the shares trade at 5.5x peak earnings. Fairfax has 13.1m shares outstanding.

The shares are down due to problems with two large U.S. acquisitions completed in 1998 and 1999 - Crum & Forster (C&F) and TIG. These companies have produced large underwriting losses and required reserve strengthening for previous accident years, causing Fairfax to report combined ratios of 114.6% and 116.3% in 1999 and 2000. In 2000, Fairfax’s Canadian insurers wrote at 102% and Odyssey Re (A U.S. reinsurance subsidiary – see “catalyst” below) wrote at 108%, while C&F and TIG wrote at 124.3% and 123.1%, respectively.

The questions to ask are:

1) Are reserves sufficient/realistic or will it be necessary to strengthen reserves again (and again, and again, and again…)?

2) Will Fairfax be able to underwrite with an acceptable combined ratio going forward?

3) If so, does Fairfax have the potential to earn a sufficient amount to make the current share price attractive?

Analysis:

1) Fairfax has a good degree of leverage, with C$3.2b of equity versus C$31.8b of total assets. In view of the leverage, the following points should be considered: Fairfax purchased a US$1bn reinsurance cover from Swiss Re in April of 1999 to guard against any surprises from the TIG acquisition. The cover is good for any Fairfax subsidiary. At the end of 2000, C$715m of the cover remained. Also, Fairfax received vendor indemnifications for pre-acquisition reserve development and unrecoverable reinsurance, of which C$463m remained at the end of 2000. In addition, Fairfax has negative goodwill of C$129.8m. The total of these is C$1,308m, which is 4.1% of total assets or 6.5% of reserves.

2) Fairfax is broadly diversified across commercial lines and reinsurance, and sells through traditional broker channels. They are not in niche lines like Markel, nor do they have an edge in distribution, like GEICO. Accordingly, I do not expect Fairfax to be able to write below a 100% combined ratio in what is essentially a commodity business. Given more reasonable performance at TIG and C&F, it should be possible to write at 105% or 107% going forward. It does appear that rates are turning in commercial lines. I am not an insurance broker, but Markel’s annual report arrived the other day and confirmed what the people at Fairfax are saying re rate increases. AIG’s earnings announcement last week also confirms this. Finally, the quarterly trend of C&F’s combined ratio was favorable last year: Q1=133.3%, Q2=123.9%, Q3=119.9%, Q4=111.5%. At the annual meeting, Fairfax’s CEO (Prem Watsa) stated that renewal rate increases continued in Q1 2001.


3) Earnings going forward: The following table was presented at Fairfax’s annual meeting. Assumptions were 1) Net premiums written = C$4.6 bn. 2) bond portfolio has current yield of just over 5%, 3) between 1985 and 2000 realized gains equaled an average of 4% of total investment portfolio. 3) Book value = C$3.2bn. 4) investment portfolio of C$15.3b. (Some of the figures below were evidently presented conservatively).

Combined ratio 100% 105% 110%
Underwriting loss 0 -230 -460
Int+div income 725 725 725
Gross 725 495 265
Overhead & Interest cost -285 -285 -285
Cap gains 400 400 400
Pretax 840 610 380
Tax -210 -150 -95
Net 630 460 285
Per Share 47 34 21
ROE 20% 14% 9%


Investments:

On the asset side of the balance sheet, Watsa is a risk taker with a value-oriented approach. Fairfax has equity investments of C$880m, most of which are in value stocks outside the U.S. (Watsa believes the U.S. market is overvalued). Fairfax also has S&P 500 Index put options with a notional value of US$800m at an average strike price of 1277, and put options on a basket of Tech stocks, some of which were realized last year. The S&P put options were written down to C$48m from their cost of C$163m. Of course, the put options are now in the money (for how long?) and some gains should be realized this year. C$5bn of Fairfax’s bond portfolio consists of putable bonds, which trade like 3 yr. bonds if rates rise and 30 yr. bonds if rates fall. The put options cost yield but provide protection in a rising rate environment and outsized returns in a declining rate environment – again, Watsa is bearish on the U.S. economy and markets.

In sum, Fairfax is a well-run insurance company with a degree of leverage that provides significant upside if the current turn in insurance pricing holds. At the same time, on account of the protections highlighted above, Fairfax appears to have a sufficiently strong financial position to weather possible future negative reserve development to the tune of 5%-6% of total reserves if necessary, without eating away at equity. The catalyst in this situation (See below) is important in the short term, but Fairfax appears to be in a position to do stage a strong recovery in the long term even without the Odyssey Re IPO. On possible future earnings of C$35 per share, a share price of C$400 would not be unrealistic, providing a return of 122% from today’s price.

Catalyst

Catalyst: Fairfax’s reinsurance subsidiary, Odyssey Re, recently filed to offer a minority stake to the public. Odyssey Re has a GAAP book value of US$1bn, and competitor Transatlantic trades at approximately 2x book. A rating of 1.5x book would imply a market cap of US$1.5b for Odyssey Re, which is equal to Fairfax’s entire capitalization as of now (13.1m shares x C$180 = C$2.36b, * 0.65 (f/x rate) = US$1.53bn). Catalyst #2, improving rates, improving underwriting results at TIG and C&F, rebounding EPS.