For many financial institutions being whacked by the asset-backed commercial paper crisis, the ABCP episode has been a nightmare. For Fairfax Financial Holdings Ltd., it has been anything but. The Toronto-based property and casualty insurer has used the crisis as an opportunity to make money.

Earlier this year, Fairfax increased its investment in credit-default swaps. These are contracts under which two parties agree to isolate and separately trade the credit risk of a third party or parties. In this case, Fairfax was betting on deterioration in the credit market, which, indeed, did happen.

Fairfax has already made $41 million by selling some of these swaps, and there may be much bigger gains to come. The unrealized gain on these swaps was $546.8 million as of Sept. 30. (All figures are U.S. dollars unless otherwise noted.) However, there is no guarantee that this amount — or, indeed, any gain — will be realized, as Fairfax president and CEO Prem Watsa pointed out during the company’s Nov. 2 third-quarter conference call with analysts.

Credit markets are very volatile, and Fairfax’s unrealized gains on these swaps likewise have been jumping around. The gains have been as high as $1 billion in both August and early November, but dropped to around $440 million in early October. Before Fairfax has a chance to sell all its swaps, the potential gains could drop lower and even disappear entirely. Nevertheless, there is no indication that the ABCP crisis has abated, so Fairfax may well make substantial gains.

The swaps do carry a $344-million cost, which the gains have to cover before Fairfax actually makes money on the investments.

It’s also important to note that Fairfax has $5.2 billion in receivables from reinsurers on its balance sheet. And if some of those companies are badly hurt by the credit crisis, they may take a long time to pay Fairfax — or they may not be able to pay at all.

But the market seems to be banking on Fairfax realizing gains on its credit swaps. Fairfax’s shares trade on both the Toronto Stock Exchange and the New York Stock Exchange. As of mid-November, the share price had moved up, presumably reflecting the potential gain on the credit swaps, to C$288 on the TSX and to $290 on the NYSE from the low C$210/$200 range this past summer.

And there may be more upward movement in the near future. Four analysts surveyed by Thomson/First Call Research have declared price targets of $280-$340 a share, with an average target of $300 a share. On Nov. 6, CIBC World Markets Inc.put a “sector perform” rating on the stock.

Fairfax has 1.5 million multiple voting shares with 10 votes each, all owned by Watsa, and 17 million subordinate voting shares, of which Watsa owned 50,620 as of March 7. Watsa’s holdings give him 47.8% of the overall votes. Southeastern Asset Management Inc. owned 22.2% of the subordinate shares as of March 7; Mackenzie Financial Corp., 16.2%.

As witnessed by the recent success Fairfax has seen as a result of its credit swaps, it’s the investment side of the business that usually generates most of its earnings. Indeed, Fairfax is primarily an investment company, with its insurance operations providing the investment capital.

Watsa has a reputation as a very savvy investor, in the vein of Warren Buffett. Watsa is not as forthcoming as Buffett, however. The reclusive Watsa rarely talks to the press and speaks to analysts only during the quarterly conference calls. His theory is that the results should do the talking. He has maintained this position throughout the past seven years, when Fairfax’s results were weak because of problems on the insurance side. Indeed, Watsa has declined to hold the firm’s annual investor conference the past two years.

Although the insurance operations’ main function is to provide investible capital, they have to be run profitably. Otherwise, they take away from investment earnings. For instance, from 2004 through to 2006, losses from discontinued businesses amounted to $1 billion; in 2005, losses due to major hurricanes in the U.S. totalled $716 million.

In addition, if serious problems arise on the insurance side, those operations may require large infusions of capital. This has happened a number of times in the past six years. For example, in 2001, $400 million was needed to shore up the reserves of Morristown, N.J.-based subsidiary Crum & Forster Holdings Corp. (C&F); in 2002, $264 million was required when the decision was made to pull the plug on Dallas-based subsidiary TIG Insurance Co.

@page_break@Currently, Fairfax’s insurance operations are doing well, although premium revenue is down. Its subsidiaries refuse to lower premium rates or underwriting standards, which other insurers are doing in order to increase volumes in this period of above-average profitability for the sector.

Fairfax is, however, streamlining its insurance holdings. It recently announced a deal that reduces its interest in Cunningham Lindsey Group Inc. Its ownership in the Toronto-based claims service provider has dropped to 45% from 86%. This is expected to produce a small gain for Fairfax.

Earlier this year, Fairfax sold its 26% interest in Chicago-based Hub International Ltd. , a network of insurance advisors in the U.S. and Canada, for a pretax gain of $220 million.

In 2006, Fairfax sold its 10% share in Woodlands Hills, Calif.-based Zenith National Insurance Corp. for a gain of $130 million.

These manoeuvres have added to Fairfax’s bottom line. In the nine months ended Sept. 30, its net income was $532.2 million, a significant increase from $68.4 million during the same period in 2006. At that time, the company took a $412.6-million non-cash charge in its written-down or discontinued operations. Revenue for the nine months was $5.1 billion vs $5.2 billion a year prior. Long-term debt as of Sept. 30 was $2 billion, with $914 million of that at the subsidiary level.

There are some downside risks. Fairfax is involved in two lawsuits relating to the trading of its shares, as well as a U.S. Securities Exchange Commission investigation into its products.

A lawsuit was launched in 2006 against Fairfax, some of its officers and directors, Stamford Conn.-based reinsurer Odyssey Re Holdings Corp. (60% owned by Fairfax) and Fairfax’s auditor. The allegations include “material misstatements or failing to disclose certain material information regarding, among other things, Fairfax’s and Odyssey Re’s assets, earnings, losses, financial condition and internal financial controls.”

Fairfax’s third-quarter report says this “could result in the award of significant damages and could divert management’s attention away from the company’s business.”

Fairfax also has launched a lawsuit of its own in 2006 against a number of investment firms and analysts, charging stock manipulation, seeking $6 billion in damages.

The SEC’s investigation into non-traditional insurance or reinsurance products, launched in 2005, continues with Fairfax’s full co-operation. In 2006, the company’s review of the material requested by the SEC led to restatements of earnings from 2001 through to 2005 at both Odyssey Re and Fairfax.

Here’s a closer look at Fairfax’s operations:

> Canadian Insurance. Toronto-based Northbridge Financial Corp. , which is publicly traded and 60% owned by Fairfax, handles Fairfax’s Canadian insurance business as well as providing oil and gas, petrochemicals and marine insurance to U.S. and international customers.

Excluding Fairfax’s small Asian operations, Northbridge had the best combined ratio (losses and operating expenses as a percentage of net earned premiums) among Fairfax’s subsidiaries in the nine-month period, at 89.6%. As a result, Northbridge accounted for $77.5 million, or 39%, of Fairfax’s $198.7 million in underwriting profit, even though its net earned premiums of $742.8 million was only 21.4% of Fairfax’s $3.5 billion in net earned premiums.

Northbridge’s contribution to Fairfax’s $1.1 billion in pretax income was only $247.8 million, or 22%. It doesn’t have the assets and, thus, the investment income of Odyssey Re. Northbridge’s contribution has been enhanced by the rise of the Canadian dollar, which increases the value of Northbridge’s profits in US$.

Three of Northbridge’s subsidiaries operate solely in Canada: Federated Insurance Co. of Canada provides commercial P&C products; Lombard Canada Ltd. offers commercial and personal P&C products; and Markel Insurance Co. of Canada specializes in truck insurance.

Commonwealth Insurance Co. is the Northbridge subsidiary offering oil and gas, petrochemicals, marine and commercial property insurance for U.S. and international clients, as well as Canadian firms. Commonwealth used to insure oil rigs in the Gulf of Mexico and was hit hard by the hurricanes in the U.S. in 2004 and 2005. As a result, it has exited that business.

> U.S. Insurance. Fairfax went into the U.S. market in a major way in the late 1990s and was immediately hit with major problems at both C&F and TIG. C&F was eventually turned around, but it took five years. TIG’s operations were written down at the end of 2002.

There was an upside to Fairfax’s southward expansion, however. As part of the reorganization that followed, TIG’s reinsurance business was merged with Odyssey Re, the principle reason Fairfax bought the former company.

C&F offers commercial P&C insurance throughout the U.S. through five subsidiaries. It has another subsidiary that provides P&C insurance for small businesses as well as offering specialty coverages and a division that sells specialty niche P&C and accident and health insurance.

After Fairfax turned C&F around, it ran into unanticipated problems as result of the devastation caused by the massive hurricanes that hit the U.S. in 2004 and in 2005. By contrast, there were no significant catastrophic losses at C&F either this year or last year. C&F’s combined ratio was 95.3%, generating $41.7 million or 21% of Fairfax’s underwriting profit on $893.9 million in net earned premiums in the nine months. It contributed $187 million, or 16.6%, to Fairfax’s pretax profits during the period.

> Asian Insurance. Launched in 1998, this is a small business by Fairfax’s standards, although Fairfax Asia is a major P&C insurer in Hong Kong. Fairfax started doing business in Singapore in 2004. Net earned premiums were $48.5 million in the nine months ended Sept. 30. With a combined ratio of 82.6%, underwriting profit was $8.4 million.

> Reinsurance. Odyssey Re is the big player in this space, but Fairfax also owns three other smaller reinsurers that service its subsidiaries and the written-down business. Referred to as Group Re, the three companies had net earned premiums of $186.8 million in the nine months vs $1.6 billion for Fairfax’s share of Odyssey Re.

Combined ratios were around 96% at Odyssey Re and Group Re. Odyssey Re accounted for $535.3 million, or 47.6%, of Fairfax’s pretax income; Group Re generated only $25.5 million, or 2.3%.

Like many other insurers, Odyssey Re was badly hit by the hurricanes in the U.S. In 2005, Fairfax’s share of Odyssey Re’s underwriting loss was $397.8 million.

> Writedowns. In the insurance industry, discontinued business takes a long time to wind down because previous years’ claims take time to be resolved.

Fairfax took an interest in Britain-based RiverStone Group Inc. , an insurance writedown specialist focused on Europe, in 1999 and has subsequently acquired 100% of that company. RiverStone took on U.S. business when Fairfax decided to discontinue TIG in 2002. After years of losses, these operations are expected to break even on an operating basis this year.

> Investments. There is a separate subsidiary, Toronto-based Hamblin Watsa Investment Counsel Ltd. , that manages Fairfax’s investments. Watsa characterizes the portfolio as “conservative”; it has $3.7 billion in cash and short-term investments and $10 billion in bonds.

There were $2.5 billion in common shares, but Fairfax has hedged 80% of this to limit potential losses from a market downturn. IE