Property and casualty insurer Fairfax Financial Holdings Ltd.’s goal is to generate an average annual return on equity of 15%. But the Toronto-based insurer has hit some roadblocks, the least of which are hurricane losses and the U.S. Securities and Exchange Commission’s subpoenas for information. It has more enduring problems — losses from discontinued business, interest on high levels of debt and relatively weak investment returns. Yet the company is confident that, in the longer term, it will hit its target.

Fairfax has a large amount of investible assets for a property and casualty insurer. Although most P&C companies’ investible assets are about 1.5 times annual net premiums earned, investments are twice that much at Fairfax, at three times annual net premiums earned.

This makes investment returns more important to Fairfax than underwriting profits.
With $5 billion in net earned premiums (all figures are in U.S. dollars unless otherwise indicated), its target of a 5% underwriting profit would generate $250 million. A 5% return on its $15 billion in investments, on the other hand, would produce $750 million; the 9.5% return the company believes it can achieve in favourable markets would generate $1.4 billion.

Fairfax has always focused on investments and looks to its insurance business to build investible assets. Chairman, CEO and controlling shareholder Prem Watsa is an investment expert who manages the firm’s portfolio through subsidiary Hamblin Watsa Investment Counsel. However, he has no direct insurance experience.

This may be why Fairfax has made some poor acquisitions. Although it has experienced relative success in the Canadian insurance market — cushioned by a superb investment performance, the company delivered 20%-plus ROEs in all but three years from 1986-98 — it has not fared well with its U.S. purchases. It acquired Crum &
Forster Holdings Inc. for $565 million in 1998 and TIG Holdings Inc. for $847 million in 1999. Unfortunately, both turned out to be lemons. The insurer had to pour C$600 million-C$700 million into each company to shore up their reserves and still had to discontinue one of TIG’s major operations.

Fairfax is still feeling the pain, with the discontinued business — or “runoff,” as it’s known in the insurance business — posting a pre-tax loss of $176 million in the six months ended June 30. In addition, the company paid $98 million in interest expenses, with its long-term debt reaching $2.5 billion as of June 30, up from $736 million before the acquisitions.

The bond rating agencies have shown their disapproval. Toronto-based Dominion Bond Rating Service Ltd. has cut Fairfax’s rating from BBB (high) in 2000 to BBB (low) in 2001, then to BB (high) — below investment-grade — in 2002. Standard & Poor’s Corp. rated Fairfax at BB+ in 2001 and dropped it to BB in 2003. The rating agencies still dislike Fairfax’s high debt/equity ratio of 80%, significantly higher than its 1997 level of 53%, and are concerned about its runoff liabilities and the ability of its insurance operations to be profitable in soft markets.

Concerns are well founded. Fairfax posted a net loss of $17.8 million in 2004, on revenue of $5.8 billion, due to losses in the U.S. resulting from four hurricanes. It’s estimating a loss from hurricanes Katrina and Rita of $465 million — or $275 million after tax. That will be partially offset by a pre-tax $131-million gain from the sale of part of its holdings in Zenith National Insurance Corp. In the fist six months, the company had net income of just $40.2 million, vs $84.5 million during the same period in 2004, the result of a $103.1-million charge for the removal of $300 million of adverse development insurance for TIG’s runoff operations. Despite the initial negative impact on earnings, this is positive in that it reflects progress made in the runoff.

All of this has had a devastating effect on Fairfax’s share price. It was trading at C$605 a share in 1999, but plunged when troubles in its U.S. insurance subsidiaries surfaced.
More bad news — in the shape of hurricane Katrina and the SEC subpoenas for information on Fairfax’s use of loss-mitigation insurance products, which can be used to smooth out earnings — knocked down the share price to C$165 on Oct. 18, a 24% drop from its yearly high of C$218.50 in early August.

@page_break@There are two classes of shares outstanding — 15.3 million subordinate voting shares with one vote apiece, of which Watsa owns 2%, and 1.5 million multiple-voting shares with 10 votes apiece, all of which Watsa owns or controls. Watsa therefore controls 51.2% of the votes attached to shares.

Fairfax insists it has put some of its problems behind it. Excluding catastrophic events, all of its insurance subsidiaries are producing underwriting profits. The company’s runoff subsidiary is slowly working down its discontinued businesses’ outstanding liabilities. Two recent $300-million equity issues and an extension of its debt maturity schedule to after 2011 has improved its financial position. It also has $500 million in cash for emergencies.

However, Fairfax’s outlook for the financial markets is gloomy. The company believes the risk of a downturn is increasing and it’s concerned about the possibility of a significant fall in real estate prices (which would push default rates to very high levels), a derivative mishap or a run on money markets — any of which could lead to the failure of major financial institutions.

Watsa and his team also think equities are very overpriced, with price/earning ratios at levels seen only three to five times in the past 100 years. In fact, the equity portion of the firm’s portfolio is just 13%, vs 28% in cash, 56% in bonds (mainly government), 1% in preferred shares and real estate and 3% in a “strategic investments.”

A long-term value investor, Fairfax isn’t finding many opportunities these days. It has decreased its holdings in U.S. and European stocks but has maintained its Canadian holdings and increased its Asian investments, particularly in India, where Fairfax sells insurance through a 26% joint venture with ICICI Bank.

Fairfax’s investment team also thinks interest rates could decline further and favours long bonds, with an average term to maturity of 7.2 years. The managers have taken out a hedge to protect the company’s capital in the event of a stock market decline.
Should the market “ramp up sharply” instead, Watsa says, Fairfax would lose $200 million.

This strategy is not going to produce the targeted 9.5% return, but it will protect capital.
Yet challenges remain. Good results at Fairfax’s insurance subsidiaries have been achieved in “hard” markets in which rates are increasing or holding firm. The subsidiaries need to prove they can maintain these results in soft markets when fierce competition pushes down prices and/or relaxes underwriting standards. There have been signs of softening, particularly in the U.S., but that softening may not materialize because of losses from this year’s hurricanes.

Fairfax has three main operations: Canadian, U.S. (both mainly commercial P&C) and global reinsurance. Its Canadian operations are run by its star holding, 59%-owned Northbridge Financial Corp. With almost $1 billion in annual net premiums written, Northbridge’s four subsidiaries have an average combined ratio of about 90%, which should ensure that it remains profitable in soft markets. It did have some exposure to the hurricanes through Commonwealth Insurance Co., which insures oil rigs in the Gulf of Mexico, but its estimated net costs of $15 million are small relative to total hurricane-related losses.

The U.S. operations consist of Crum & Forster — which has $457 million in net premiums for the six months and a combined ratio of 95.8% — as well as niche insurer Fairmont Insurance, which has $75 million in net premiums in the same period and a combined ratio of 97.6%. Both are trying to lower their combined ratios to a targeted 95% and could have problems in soft markets. Crum & Forster’s hurricane losses are estimated at $60 million, for a net loss of $39 million.

Fairfax Asia, operating in India, Hong Kong and Singapore, is still very small, with net written premiums of $24 million. But there’s big growth potential there. Its combined ratio is a very satisfactory 90%.

Odessey Re, Fairfax’s 81%-owned global reinsurer, had net written premiums of $1.2 billion in the six months. It is also trying to lower its 97.7% combined ratio to the 95% target. It has 15 branches globally and a growing proportion of its business, 44%, comes from outside the U.S. It was very hard hit by the hurricanes this year, for a $143 million in estimated after-tax losses.

Riverstone Group runs the runoff operations for Europe and the U.S. It winds up operations of discontinued businesses, pays off claims and recovers monies owing from reinsurers. Its team is highly regarded, and Fairfax has encouraged it to provide its services to others. Fairfax has also encouraged Riverstone to buy other runoff operations if the price is right, which it did last December when it acquired Compagnie de Reassurance d’ille de France.

Riverstone still has much to do with TIG’s runoff. TIG has finally stopped writing premiums and has reduced outstanding receivables on this business to $4 billion, which is still a significant figure, from $5.4 billion as of Dec. 31, 2003. Fairfax has another $3.3 billion in outstanding receivables from reinsurers, for a total of $7.3 billion. IE