Description

Odyssey Re (ORH) is a leading underwriter of reinsurance, providing a full range of property and casualty products on a worldwide basis and offering both treaty and facultative reinsurance to other property and casualty insurers and re-insurers. ORH also writes primary insurance focused on liability lines in the United States and London. Net written premiums were over $2 billion in 2008, and shareholder equity was approximately $2.8 billion as of June 30, 2009. ORH went public in June of 2001, prior to which the company was wholly-owned by Fairfax Financial Holdings (FFH). As of June 30, 2009, FFH owned about 72% of ORH. Given that Fairfax has control of the business, one obviously needs to believe that FFH CEO Prem Watsa is a good steward of shareholder capital, which we certainly do.

The company's operations are managed through four divisions: Americas, EuroAsia, London Market and U.S. Insurance. The Americas division is comprised of the reinsurance operations in the United States, Canada and Latin America. The Americas division primarily writes treaty property, general casualty, specialty casualty, surety, and facultative casualty reinsurance business through professional reinsurance brokers. The EuroAsia division, headquartered in Paris, writes mostly treaty and facultative property reinsurance. The London Market division operates through Newline Syndicate (1218) at Lloyd's and Newline Insurance Company Limited, where the business focus is casualty insurance, and the London branch, which focuses on worldwide property and casualty reinsurance. The U.S. Insurance division writes specialty insurance in the United States, including medical malpractice, professional liability and non-standard personal auto. ORH also owns about 24% of Fairfax Asia and about 6.2% of ICICI Lombard, one of the largest private insurance companies in India. 

Like Fairfax, the company's stated objective is to build shareholder value by achieving an average annual growth in book value per common share of 15% over the long-term by focusing on underwriting profitability and generating superior investment returns using a total-return, value-investing style. It has actually achieved about 21% in compounded annual growth in book value per share from its IPO in 2001 through June 30, 2009. In this time period ORH has grown year-end book value per share from $15.80 as of year-end 2001 to $51.90 as of June 30, 2009.  

Odyssey Re turned in an outstanding 2008 performance, one that was virtually unique in the insurance industry (with the exception of its parent, FFH). ORH grew book value per share by 23.4% in 2008 (24.1% if we include dividends paid to ORH shareholders for 2008), despite turning in an underwriting loss on the year due to Hurricanes Gustav and Ike and snowstorms in China. Here are some highlights: 

• Despite having net written premiums decline for the fourth consecutive year, ORH turned in a profit of $543.1 million, or $8.50 per share. ORH has now produced net profits in the $500 million range or better three straight years ($499.7 million in 2006, $587.2 million in 2007, and $543.1 million in 2008).
• ORH spent a whopping $351 million in share repurchases in 2008, at an average cost of $37.06, and every share was bought at a price below book value. The total reduction of over 9 million shares caused the year-end weighted average share count to decline by 13.3% from December 31, 2007 to December 31, 2008.  
• The combined ratio in 2008 of 101.2% was the first year since 2005 (which featured hurricanes Katrina, Rita, and Wilma) that ORH posted an underwriting loss. Hurricane Ike was the third most costly weather event in the history of the insurance industry, causing massive damage to oil platforms in the Gulf of Mexico and causing damage inland from Texas to Ohio. The snowstorm in China in February was also one of the worst on record in that part of the world. Overall, ORH suffered heavy losses in the U.S. reinsurance business, but the other three insurance units all turned in underwriting profits in 2008, making the full year consolidated combined ratio of 101.2% very acceptable and favorable relative to peers in the industry.

Of course, in 2008 the story in the insurance industry wasn't the natural catastrophes, but the man-made ones, namely the massive destruction on the asset side of the books suffered by most insurance participants. Of course, ORH spent the vast majority of 2008 fully hedged against a decline in equity value, holding excess cash, and sitting on a decent sized credit default swap portfolio.  During the fourth quarter, ORH covered its remaining equity hedges, sold most of its U.S. treasury bonds to purchase higher yielding municipal tax-advantaged bonds (most insured by Berkshire Hathaway), and added selectively to its equity portfolio. This led to a slight decline in book value from Q4'08 to Q1 '09, but also allowed ORH to enjoy a very strong gain in book value per share during Q2 '09.

On July 30, 2009, ORH reported a very strong Q2 featuring net income of $121.8 million, or $2.03 per share, and an 18.5% increase in book value (to $51.90 per share) due to a modest underwriting profit and the significant improvement in the company's equity and debt investment portfolio during the quarter. The company's total invested assets at June 30^th were $8.1 billion, or about $138 per ORH share. The company also took advantage of the stock weakness during the second quarter, buying back another 1.2 million shares for $47.5 million, averaging under $40 per share.  After the quarter, the company repurchased another 532,000 shares through July 29th at a cost of $21.6 million, or about $40.60 per share. These purchases reduced the shares outstanding by 2% during the quarter and by 2.9% through the end of July.

ORH posted a strong second quarter in virtually every facet. The combined ratio for Q2 was 96.5%, a slight improvement over last year's second quarter and comprising nearly 100% of the overall underwriting profit at parent company Fairfax. Net investment income increased to $93 million for the quarter, up from $64.7 million in Q2 '08, and even more favorable on a tax-adjusted basis considering the tax-exempt nature of the company's current bond portfolio versus last year. Unrealized gains on the equity and bond portfolio were $346 million for Q2. 

Total net written premiums did decline by 8.7% in Q2 '09, which included slight increases in the Americas and London reinsurance markets and significant declines in the U.S. primary insurance and EuroAsia reinsurance lines. The company turned in profitable underwriting results in every business unit segment except for the 101.1% combined ratio in the Americas. As is the case with Fairfax, however, there is yet still no strong evidence of a significant turn in the insurance and reinsurance markets in general. On the earnings call, CEO Andy Barnard observed that "the hard market that various industry leaders proclaimed last August has not yet arrived. While pricing for hurricane exposed risk is robust, rates in the casualty sector remain under pressure. In response, our global book of business has continued to reflect an expanding share of property risk while casualty risk continues to decline." Barnard noted that he expects full year net written premiums to decline by 10% or so. 

Even after the great Q2 results and the quarter-ending book value of $51.90, ORH remains undervalued at the current $46, or about 88.7% of Q2-ending book value. Even better, we think that ORH will have benefitted from a very strong move in its equity portfolio during July, such that current book value may well be close to $56. Given that we are heading into hurricane season and given the likely volatility of the equity portfolio, I'll not make any assumptions about where year-ending book value will be, but I suspect it will be in the low to mid-$50 range.

ORH clearly does remain heavily leveraged to its investment portfolio, which now stands at the $8.1 billion figure mentioned above - or 260% of shareholder equity. Equities represented about 26% of the portfolio at June 30^th, valued at about $2.1 billion, or about 77% of shareholder equity. The fixed income portfolio is valued at $4.5 billion, or 55% of the portfolio, including $2.5 billion of municipal securities (75% of which are guaranteed by Berkshire Hathaway), $1.1 billion in U.S. and foreign government securities (of which the vast majority is foreign government), with the remainder of the fixed income portfolio invested in corporate bonds. 

Given that FFH spun off ORH in an IPO in late 2001 at well above book value largely to raise cash for the parent, it would be another very smart move for FFH itself to increase its ownership aggressively without reducing its own balance sheet by having ORH do the buying. I would not be surprised to see ORH continue to shrink the float as long as the stock trades at or below book value, to the point where FFH would be comfortably able to re-acquire the business in a year or two. Fairfax has already consolidated one other majority-owned publicly traded insurance subsidiary in January of 2009, and paid 1.3 times book value, so we are inclined to believe that a multiple of 1.2 to 1.3 times book value is a reasonable place to start when talking about a high-quality insurance operation. A 1.2 multiple to book value would put ORH at about $62. Alternatively, assuming that ORH was able to break even from an underwriting perspective and produce 5% after-tax total returns on its investment portfolio (much lower than the company's historical performance), the $138 per share investment portfolio would produce about $405 million, or $6.90 per share in earnings. The implied valuation of this type of earnings power would be less than seven times at the current price. Just as a sanity check, each of the past three years' earnings have been $500 million or thereabouts, and the share count has declined rather significantly since 2006. 

As it relates to FFH, it is my judgment that at the current prices ORH is by far the more attractive of the two securities, for the following reasons: 1) it's more heavily weighted to reinsurance, which is where the market has shown its most promising signs of turning, 2) its combined ratio has been generally better than the other FFH operations, 3) the company is buying its stock back like crazy at prices below book value, and 4) it seems obvious that ultimately FFH is destined to buy out ORH at a nice premium to book value, and 5) ORH trades at a bigger discount to book value than does FFH.   

Of course, we are heading into hurricane season, and ORH has two major risk factors: 1) a terrible storm season that might cost ORH 10% or more of book value in losses, and 2) a nasty stock market correction that hurts the equity portfolio. My guess is that if ORH gets through hurricane season without an extraordinary loss, the stock will go back to a premium to book value (and may get there anyway). Stock market risk can be hedged a number of ways, but also my view is that Prem Watsa himself has been very reliable in taking protective action against excessive stock market exposure in the past. 

Catalyst

• Current soft market for reinsurance and insurance prices becomes firmer; ORH has plenty of capital to write new business.
• Continued strong performance of investment portfolio and growth in book value per share
• Continued share repurchases
• Ultimately, consolidation by parent company Fairfax at a multiple to book value of 1.2 times or higher.