Maverick47

I don’t have an estimate of how much could be deployed from fixed income to equities, but I think it’s not uncommon for insurance company managements to choose to hold their insurance loss, and expense reserves (and unearned premium reserves) in the form of relatively secure fixed income instruments. The amount of float held by Fairfax might be a reasonable approximation for such a lower bound on fixed income — roughly $35 billion? I’d be surprised if they chose to hold fixed income investments in an aggregate amount less than that. I think they currently hold over $40 billion in bonds? in addition, there may well be some regulatory or rating agency constraints on investments in equities. There’s often an implicit trade off between underwriting and investment risk for a company. When a company expands its premiums written such that they become sizeable relative to supporting surplus or equity, then they generally have less of an ability to accept risk on the investment side of the house by moving into equities. A company such as Progressive, with premiums to surplus/equity ratios in the high 2+ area (sometimes close to 3.0) takes much of its risk on the underwriting side, so not surprisingly will not hold a sizable investment in equities. Fairfax has written premiums of about $29 billion, and equity including both preferred and common of about $24 billion. So they can be heavier into equities than a company like Progressive, and they are…with about $15 billion invested in equity-like instruments, associates, etc. If they anticipated opportunities to grow premiums dramatically, then they’d probably hold off on a further move from fixed to equities. But if they anticipated a soft market in which they even saw premiums shrinking, they might well choose to offset a reduction in insurance related risk with an increase in investment risk via a shift from bonds to equities.

From an economic standpoint, as long as Fairfax continues to prefer to hold equity investments for the long term and allow the gains to compound on the balance sheet unrealized, there should be no dramatic reduction in reported after tax income. But if as you’ve noted, the deferred tax liability would increase by $18 per share, the book value ought to drop by an equal amount. However, in my opinion, that is a somewhat misleading effect. A deferred tax liability is an interest free loan from the government which has to be paid back only when gains are realized. And a deferred tax asset is an interest free loan to the government that only is paid back to the company as future income is generated and able to be shielded from taxes because of the prepaid tax asset. Neither of these are present valued on the balance sheet. An asset that earns no interest is not worth as much in my opinion as a similar amount invested in 5% government bonds. Similarly, a no interest loan that might not have to be paid off until years in the future is not as large a liability as a similar amount borrowed by means of a 6% interest 10 year bond issue. Fairfax has about a $1 billion net deferred tax liability (interest free loan from the taxing authority) on the balance sheet at year end 2023. That is a sign of a savvy insurance company in my opinion, and if the liability grows to $1.4 billion after a tax change, it just makes the comparison with peer insurance companies that often record net deferred tax assets on their balance sheets that much more favorable.

I got a look at a prior report of Brett’s and noticed that he projects Earnings per diluted share…so presumably he converts actual book value per share at year end 2023 to a book value per diluted share instead. I think diluted shares are about 8% higher than actual shares. That may well explain the disconnect between his report and the reality that I care about personally.

Agreed! Thanks to @John Hjorth for reaching out to Andy!

I’m not an expert on surety bonds, but it can help to understand that these are probably quite different from a typical insurance risk transaction. I believe the provider of the appeal bond has to guarantee payment of the cash amount of the bond plus any accrued interest in the event that the appeal is lost. Generally speaking, the insurer wants a source of liquid collateral from the client at least equal to the amount they might have to pay. They basically just provide guaranteed liquidity to a client. It is the appellant who is supposed to pay the amount of any financial judgement, and an insurance company isn’t interested in providing coverage for the full amount of the award in exchange for a premium smaller than that. This is different from catastrophe reinsurance where the insurer accepts a relatively small premium compared to the total payout required against the risk of a catastrophe and so has to have an opinion on the probability of the event. As Greenberg’s letter noted, the surety bond provider does not actually assess the likelihood of the success of the appeal. Unfortunately, commercial real estate, which may or may not be unencumbered, is not viewed by surety providers as a desirable source of collateral. If an appeal fails, and the insurer has to pay the face value and accrued interest on the bond immediately, then they are stuck with having to collect on the collateral. Foreclosure on real estate is not high on the list of things that insurance companies want to deal with. The Chubb bond by contrast was secured with readily liquidated brokerage investments.

@Thrifty3000 : I’m not aware of how Fairfax’s share-based plans work. Is this something you can educate me on? Are they based on options grants or are shares given directly? Many companies do purchase sufficient shares to offset dilution resulting from share-based compensation, but Fairfax has been reducing share counts outstanding, and given the highlighting of Henry Singleton’s example of reducing Teledyne’s share count outstanding by something like 90% over his tenure, I think we can safely assume that the only way share counts might increase would be if additional shares were issued to help pay for an acquisition like Allied World in the future. Absent that possibility, I’m not personally worried about diluted per share earnings.

Appreciate the update @Viking, and I like the historical data as well. As I scan the years columns from left to right, I appreciate the growth in interest rate and dividend income relative to underwriting results as well as the share of profits of associates and gains on investments. Rough mental math indicates it would take quite a severe worsening of underwriting results to offset completely the expected normalized income from the other sources given current expectations for them. Something like a Combined Ratio of 115 or so might result in no income (but also no loss) for a future year. Given attention to managing cat exposure, and the fact that a good portion of the premium volume is related to reinsurance, which ought to be able to react somewhat faster to poor underwriting results than a typical primary insurer, as well as the global spread of exposures among a number of independent insurance providers, it’s unlikely in my opinion for that kind of underwriting result to occur, but I do like to get some sense of how bad something might get for the companies I invest in, and a 115 CR is about a 20% worsening from the ideal target of 95. That’s a pretty poor underwriting result, not very likely in my opinion, but a reasonable worst case scenario, and it comes nowhere near to damaging the future viability of the company. I continue to believe we have significant upside for the company, and limited downside

@MMM20 Your point about float appearing on the balance sheet in an overstated manner that an analyst ought to adjust does, I think, also apply to the difference between deferred income tax liabilities and assets. Fairfax has about $1 billion more deferred tax liabilities than assets on their balance sheet. That net liability is akin to an interest free loan from the tax authorities. Not as valuable as float generated at a negative cost with positive underwriting profits, but more favorable than debt or preferred stock issuances.

Thanks for the update @Viking! I feel pretty good about the results relative to expectations. Regarding share count, I’ve got to believe this is a critical denominator for per share estimates. Last time I checked Brett Horn’s Morningstar report, he was projecting roughly 25.5 million shares outstanding for 2023 through 2025. That may be part of the reason he projects earnings per share close to $100 for the next few years. Nice to hear Prem indicate that he’s comfortable with the run rate on interest income for the next four years…

The 18.9 figure does include dividends for all prior periods while 17.8 excludes them. The comparable 37 yr CAGR including dividends is 18.5. Using the same sort of calculations I’m estimating a 34.6% gain in book value in full year 2023, not far off the 33.3 non annualized value through Q3. So maybe an $884 book value per share when we see the full year report Thurs evening?

@Viking Maybe the inclusion of dividends or not? Paragraph 2 of the 2022 letter refers to a 37 year book value including dividends CAGR as being 18.5%. Still a good jump from there to 18.9 by adding one more year, but not as incongruous as moving from 17.8 to 18.9. Likely an early read on how helpful 2023 was….

@Viking Love the football analogy, especially since I missed this game and didn’t know the details of the comeback! To extend the analogy a bit, it strikes me that besides the offensive comeback, part of the reason for the victory might be attributed to the Patriots’ defense that held the Falcons scoreless after they had scored 28 points (could have been Falcons’ offensive ineptitude as well I suppose). Insurance analog? Fairfax defensively protects their balance sheet from massive unrealized losses when they kept their bond durations short in advance of interest rate increases. At worst they were in perhaps an aggregate $1 billion shortfall on the market value of their bonds relative to cost? By contrast, a number of competitors with similar sized bond portfolios but longer durations (Travelers, Chubb, Liberty Mutual, Hartford come to mind) had bond portfolios with market values $5 billion or more below their cost at the same time. So Fairfax’s strong defense in the second half of the latest 4 years of the insurance Super Bowl allows their insurance premium growth and interest rate income offense to shine, while competitors poor balance sheet management takes the wind out of their offensive sails.

We’ll put @dealraker! It reminds me of a comment that I believe Charlie Munger made a few years ago at a Daily Journal meeting… talking about the temperament an investor needs to have in the face of market fluctuations. I think he was talking about his own stake in Berkshire Hathaway, and in his own inimitable phrasing said something like “you have no business investing in individual stocks if you can’t face the possibility of a 50% decline in market value with equanimity”. He then went on to elaborate that two times in his personal ownership of Berkshire Hathaway he had faced that sort of situation….

Thanks @Spekulatius, for the report. I do appreciate the opportunity to see some of the per share projections for 2023 and the two years thereafter. He shows a 2021 EPS of $122, and though the first 9 months of 2023 have come in at $129, his projection for the full year is at $113, with the next two years lower than that. As a likely net acquirer of the stock for the next two years, I would be more than happy if the market valuation takes time to react and respond to what (based on Prem’s expectations and supported by @Viking and the work he has done) are more likely to be EPS results closer to $150 than under $100. As Graham would say, in the short term, the market is a voting machine, in the long run it’s a weighing machine. If the company is able to produce three back to back years with the sort of earnings we think are likely, then we can begin to focus on what the company will do with the $9+ billion of cash added to the corporate coffers in that time frame. If the market provides opportunities for share repurchases, that might be one thing to keep an eye on. There certainly didn’t appear to be any long term expectation in Horn’s model for material investment income reported from the shares of earnings of associates, and he doesn’t seem to have increased the dividend rate to $15 yet. He only projects modest share count reductions. I did just notice that his outstanding share count for 2023 was listed as 25.9 million, whereas I expect we’ll learn next week that the share count is closer to 23.2 million or less. So his EPS modeled estimates are understated by a minimum of 10%. If I’ve gotten this wrong, please correct me. It does seem to be a rather material error in the work when one is advising readers of your analyses what sort of market price per share they should target as a fair valuation… All in all, I’m happy to have his model as a more pessimistic view of the future than I would hold, and if it, along with the Muddy Waters thesis help to keep the overall market valuation from reacting to likely future earnings power while allowing me to add to my position at more favorable prices, then I’m more than willing to be patient.

Thanks @Viking. The only thing I was sorry about was that I didn’t have any dry powder in my personal accounts to do the same. However, I was able to pick up some shares for a family member’s account that I manage.