Maverick47

I’m not a US investment tax expert by any means, but I believe that in community property states, of which California is one, that if a married couple’s assets in a taxable brokerage account are considered community property before the death of one of the spouses, then the surviving spouse receives a step up in cost basis to the market value at the date of death on 100% of the account. (In non-community property US states, I believe the surviving spouse would get a step up only on the half of the account deemed to have belonged to the spouse who died.) In both cases though, this would be a nuance that might provide an additional incentive to let unrealized capital gains accumulate in a taxable community property investment account, since it would be a potential benefit for the surviving spouse, and not just something that would benefit eventual heirs. Has anyone on this COBF board had any experience with either of these US tax scenarios?

The second less-common source of corporate funding that Buffett referred to in the 2018AR is also a source that Fairfax enjoys, though to a much smaller extent than Berkshire: deferred income tax liabilities. While float generated along with underwriting profits is a huge benefit to both, equivalent to being paid to borrow money from others, deferred tax liabilities are also more valuable than raising funding from equity or debt, since is essentially an interest free loan from the government. @Viking often calls Fairfax’s management best in class. The fact that Fairfax manages to qualify for an interest free loan from the government via deferred tax liabilities, just as Berkshire does, is another credit to their understanding of how to optimize corporate funding costs, and helps place them in that best in class management group in my opinion. Just for fun, you might look at the balance sheets of other insurance companies to which the market assigns rich valuations, whether Chubb, Travelers, Allstate, Intact Financial, Progressive, Hartford, WRB, etc. I think you’ll find that in many of the balance sheets of those well regarded companies, there will be a deferred tax asset, not a deferred tax liability…meaning that they are providing an interest free loan TO the government instead of receiving an interest free loan FROM the government.

@SafetyinNumbers, Are you thinking about the chance that FFH might use their stock more frequently than cash as currency for acquisitions when and if it starts selling in the market for a higher multiple to book than it does now? That would be consistent with the Henry Singleton/Teledyne example. It’s a nuance that I have to confess I hadn’t been thinking of…I’d mostly been focused on the opportunity for FFH to reduce share count and hadn’t been thinking that when presented with the right set of circumstances by Mr. Market, a rational capital allocator would serve the owners well by being willing to increase share count from time to time….

@Viking I always appreciate the opportunity to revisit the Fairfax investment thesis in your book of posts! Doing so last night revived my excitement for the future prospects of the company…and this morning as I was tweaking my retirement portfolios (selling some of it to generate cash for the coming year’s income requirements) I also took the opportunity to sell some of the names I’m less confident of, and redeployed some of the additional funds into Fairfax.

@Thrifty3000 Back of the envelope math is helpful to aggregate the numbers to a state level as you’ve done. I would just extend the scenario to take into account expenses of the insurance companies, customer acquisition and retention costs, claims adjustment costs, and even the cost to purchase reinsurance from companies like Odyssey of Fairfax and National Indemnity of Berkshire so that the primary companies can stay in business after one or more hurricanes in a given year. First, it would not be unexpected for companies to only be able to pay out 50% of the premiums they collect in a state like Florida. Their expenses for claims and company management are likely to be near 20% of premiums, and they probably have to pay commission of 10% or more to the agents. They would probably require a profit load of 10 to 20% to compensate for the risk that they might have to pay many times the premiums they collect in a given year in a bad hurricane year. They might also have to pay 10 to 20% of premiums to purchase property reinsurance. In a best case view, they might only have 40 to 50% of premiums available to pay all homeowners losses. Some of the expected losses such as fires, theft and plumbing related water damage will happen every year with or without hurricanes. And in a total loss of a home, the $400,000 home would need to be rebuilt, but the policy would also pay to replace personal property (contents), damage to outbuildings, fences, sheds, etc, and also pay for loss of use until the home was rebuilt. In a large catastrophe, rebuilding costs can inflate, making a $400,000 home cost perhaps $100,000 more to replace. So let’s use close to million for the total loss to a home insured for $400,000, with $300,000 of personal property, $40,000 of outbuildings, $100,000 for loss of use and another $100,000 for increased building costs also needing to be paid. The balance to add up to $1 million may be covered by debris removal costs that are also covered, as well as increased costs to rebuild a home to current building codes, since many customers purchase coverage to pay for increased costs associated with these. Maybe half of the state’s loss budget is available for annual hurricanes, with the other half paying for all of the other causes of loss (fires, theft, water damage, etc). So a company can afford to pay annually perhaps 20 to 25% of premiums for hurricane losses. With 9 million $400,000 homes paying $11,000 annual premiums, let’s round the collected state premiums to $10 billion and the industry has a chance to achieve target profitability with annual hurricane losses of 20 to 25% of that, say $2.5 billion in hurricane losses allowable for target profitability to be achieved. Most homes damaged by hurricanes completely are likely to be more expensive homes with ocean views and proximity, so I think it’s fair to say they would cost on average well over $1 million for a total loss, but let’s stick with $1 million. How many homes can $2.5 billion replace in Florida if each home costs the industry $1 million? Now that we account for coverages beyond the home itself, and subtract annual expenses other than loss dollars alone, as well as losses that happen unrelated to hurricanes, it seems as if the adjusted back of the envelope math says that the industry can afford to replace only 2500 homes per year in Florida as a result of total hurricane losses and still make enough profit to choose to remain in business for the future. If they go 10 years without hurricanes, total hurricane related profit would be $2.5 billion for year or $25 billion in aggregate. But if in year 11, one or more hurricanes were to destroy only one half of 1 percent of all homes in the state (1 out of 200) that would be 45,000 homes costing $45 billion to replace, wiping out total profit from almost 20 years of no hurricanes. Now consider that a direct category 5 hurricane hit on Miami could cost the industry $160 billion or more and that single event could wipe out 64 hurricane free years of profits and you might begin to gain an appreciation why most national and multi state insurance companies are reluctant to write much business in the state, and why the state run carrier of last resort (Citizens Insurance) has the largest market share in the state with more than 1 million of the total 9 million homes in the state insured.

Personally I’m not too worried about corporate tax rate changes over the long term. Insurance companies will set rates targeting their desired after tax returns on allocated capital. So if tax rates on US based income increase, and if target after tax returns are unchanged, insurers’ pricing formulas will simply adjust to charge their customers rates that will be sufficient to generate those after tax returns. You are correct to be concerned about what would happen in the short term. Since rates are set in advance, to the extent that premiums in force are set based on lower tax rates, they will generate lower than desired profits between the time when tax rates are changed and when the rates can be adjusted upwards. This should affect all insurance companies in the taxing jurisdiction relatively equally as a one time upward or downward impact on after tax earnings, depending on whether corporate tax rates are increased or decreased.

@Viking I think you actually understand the forest of the P/C business as well as, if not better than, most folks who worked in a particular area of the business (such as myself) and who thus perhaps know more than you do only about a particular grove of trees in that forest! That said, humility is one of the better characteristics of true value investors, so far be it from me to ever ask you not to employ it…. As you alluded to, some of those groves are longer or shorter tailed, or are primary rather than reinsurance, or commercial vs personal, to say nothing of the various geographies and regulatory regimes. I do know enough about the surviving competitors in the business to feel optimistic about a soft cycle not necessarily hitting all lines at the same time, and that we’ve seen enough discipline from many participants in the business to not expect that this would necessarily mean a reversion to a 100 CR for Fairfax. If you search Buffett’s letters from first decade or so after he bought all of Geico, he would often bemoan the lack of underwriting discipline of GEICO’s competitor, State Farm, which as a mutual insurance company, had accumulated a massive amount of surplus and was apparently more than willing to expend that surplus in support of CR’s well above 100 to maintain their industry leading market share. This has changed over time, and as an example, State Farm is no longer willing to write business at a loss even in very large states such as Florida and California simply to maintain market share. I’ve seen similar examples of numerous US competitors also “getting religion” about the need to achieve CRs below 100. That is exactly the right question to focus on. They have exhibited this discipline in the recent past and Prem certainly highlights the CRs by subsidiary in his letters, which shows to us shareholders (and the leaders of the insurance subs) that he cares about this a great deal. I suppose the only thing that I might like to know in addition is whether the incentive compensation plans for employees value this as well. I do like it when everyone’s interests are aligned….

Sandy was a hurricane in 2012, but when it hit the Northeast it had weakened to Tropical Storm strength. A number of the northeastern states had coastal home insurance customers with hurricane deductibles of 1 to 5% of the replacement value of their homes. Insurance commissioners determined that the wind speed at landfall was less than hurricane strength, so did not allow the higher hurricane deductibles to apply. That probably helped contributed to the losses of about $93 billion. Since hurricane deductibles were not triggered, the industry tends to refer to the event as Superstorm Sandy. A category 3 or greater hurricane hitting the right portion of the Northeastern US could cause insured losses many times that of Sandy.

This is pretty typical of the cat risks faced by all reinsurers. The US tends to have the largest concentration of insured property exposures, and all the primary carriers exposed to that are interested in purchasing property cat reinsurance. While the frequency and severity of potential hurricanes hitting concentrated areas of Florida like Miami are of concern, the larger cat risk for the US tends to be Northeastern hurricane. These exposures are modeled, so that the impact of sample hurricanes hitting the current insured properties are estimated. One historical hurricane in 1938 hit Long Island and continued to cause significant damage inland. However, the density of insured dwellings in the area it hit was nowhere near as much as it is today. So a repeat of that exact hurricane would cost quite a bit more than a category 5 hurricane hitting Miami. Odyssey and Allied World and other of Fairfax’s reinsurers are careful to manage the property cat risk they write in aggregate.

You’re right. But perhaps we can learn something about how to prepare ourselves (and our investments) to respond to the sorts of dangers that we are bound to face sooner or later, both those that are unlikely to occur and those we simply cannot anticipate in terms of the timing and the magnitude when they do occur. That’s one of the reasons I was willing to hold on to my Fairfax shares after 2009. Even though I didn’t personally think global deflation was likely, I also didn’t mind paying(in the form of poor returns on the shares) for the insurance policy that investment provided me, in the event that I may have been wrong about the future.

Thank you for clearly adding this observation! I know little about corporate taxation. I had noticed the significant impact on Berkshire’s deferred tax liability driven by BHE and BNSF, but did not realize what exactly was driving this….. I don’t think that Fairfax’s own non insurance operating subsidiaries yet have the same sort of requirements or opportunities for capital investment and accelerated depreciation as Berkshire, but it might be worth looking out for this in the future. Right now though, Fairfax has plenty of opportunities to direct any operating earnings towards stock buybacks, purchasing minority interests, etc, so really have no need to invest in subsidiaries that would also require substantial capital investments.

@Munger_Disciple I like your idea of calling this our personal “float”! It does make sense to take this into account in taxable accounts. Speaking of which, Fairfax and Berkshire both have this additional type of float on their own balance sheets as deferred income tax liabilities. Since the cost of this float is always zero (an interest free loan from the government), it is basically just as valuable to shareholders as insurance float liabilities when combined ratios are at a 100 level. When combined ratios are less than 100, then insurance float is essentially like a loan with a negative interest rate, and thus is more valuable than a deferred tax liability “loan” of the same amount, while combined ratios above 100 imply a positive interest rate on the insurance liabilities, and then they would be less valuable than the interest free loan from the government. But as you note, we (and companies in similar deferred tax situations) can decide “if and when to incur it”). This optionality has some indeterminable but non-zero value which makes it somewhat more valuable than insurance liability float which itself depends upon the vicissitudes of weather and claims behavior as far as identifying when the insurance float “loan” (or a portion thereof) has to be repaid.

Thanks for the recommendation, @Saluki! I’m enjoying this greatly. One can easily draw lessons for investing from some of the stories. For example, the unanticipated results of roping climbers together could be compared with the dangers of tying your investments together, either by concentrating in a single industry, or, worse, by concentrating in the industry that your own employment is dependent upon. Instead of thinking about what could go right with an investment, I expect I’ll want to spend more time thinking of what could go wrong, so, as Charlie Munger notes, “I’ll never go there.” I appreciated his comments recommending writers on wildfire and airline disasters, and picked up some additional books to read on those particular topics…. I’d much rather learn these sorts of lessons vicariously than from personal experience…

Chap 4 of “The First 25 Years of Fairfax” talks about Prem’s controlling Fairfax and Markel owning 20% when Prem wanted to buy Commonwealth Insurance Company of Vancouver, BC. Steve Markel had little interest in expanding in Canada. ”There were only two options: either we put Markel Corporation and Fairfax together or we split them apart. We decided to disentangle them completely so that each of us would have greater freedom to pursue our growth.”