Maverick47

Thanks Viking -- I continue to think that the disparity in how Fairfax has navigated the latest interest rate increase effect on their book value and future interest income relative to other large insurance companies is something that they will be able to take advantage of over at least the next few years. A number of large competitors have had their credit ratings put on watch for potential downgrades, both because of underwriting losses and investment results. I'm pretty sure that GAAP results in changes in market value of securities being recorded as part of comprehensive income for US based insurers. And the investments on their balance sheet should be recorded at market value as well. I suppose that headline earnings reports focusing on operating or underwiring earnings would exclude changes in market value of bond portfolios, but GAAP balance sheet comparisons can still show the impact on book value. As investors, it's important to remember that future ROE reports will be based on both the size of the return and the size of the underlying equity. Competitors that have destroyed their equity denominators, may have an advantage in the future by reporting "better" or "improving" ROEs, but I much prefer a company such as Fairfax which has a reasonable shot at reporting favorable ROEs based on improvements in BOTH the numerator and the denominator.

This strikes me as a very insightful comment. Much of the insurance industry is capital constrained given the unrealized losses on bond portfolios, poor underwriting results, and recent inflationary environment driving significant rate increases to keep up with inflated insured values, loss trends, etc. Fairfax’s competitors are likely to be wounded for longer than prior patterns of underwriting cycles might lead us to expect.

Thanks @Viking! I’ve learned a lot from your posts, and am grateful that you’ve consolidated so many of them in a single document. With your generous sharing, I feel as if I have gained a comprehensive understanding of the company that makes up a large portion of my retirement account. Much appreciated!

Charlie Munger made a similar observation applicable to compounding investments inside taxable accounts. Something like the difference between making investments that would return 15% annually (but selling at the end of each year, thus paying capital gains tax each year) and letting a 15% return investment ride untouched for thirty years and only paying the long term capital gains tax at the end, with the after tax result being truly eye-popping. He talks about the after tax benefit you get from merely “sitting on your ass” while staying invested in great companies. This “turnover issue” isn’t a concern for investments made in tax sheltered or deferred accounts, but it can be something to keep in mind for taxable brokerage accounts. And it helps to have folks who are managing investments on our behalf at the corporate level who understand this as well.

In California I think it’s fair to say that neither the state government itself nor the taxpayers are currently on the hook for insurance losses, nor are they providing any capital to support the writing of risks in the property insurance marketplace. There are some CA state run/organized providers of basic property insurance (the FAIR plan for example was set up to provide basic property insurance to customers who can’t find coverage in the voluntary market). But all property insurers in the state are required to belong to and support the program. If there are any losses not covered by the FAIR plans surplus, then, just as with mandatory Guaranty Fund membership, the member companies who are not bankrupt themselves are levied assessments to pay for any shortfall in claims paying ability for FAIR plan customers’ losses…and they can then pass on those assessments to their own customers (I may have the details of this wrong — it’s possible that they may just be ordered to add an assessment to their own customers and forward the collected funds to the FAIR plan without having to first pay an assessment up front). As long as there are private insurers to levy assessments against who can in turn charge their own customers in the future to repay those assessments, then it is private insurance customers who in essence are paying the “tax” to provide a backstop for coverage provided to customers who live in risky areas and can only find insurance coverage in the FAIR plan. The California Earthquake Authority is a somewhat different animal. It was funded with surplus contributions from member companies who were allowed thereby to offer earthquake coverage to their own home insurance customers from the Earthquake Authority and not expose their own company’s surplus to a large quake. The Authority does not pay income tax on any underwriting profits, so its surplus can grow much as an individual’s 401k retirement account. The major flaw is that its investment strategy is pretty much forced to only invest in government bonds and so cannot grow anywhere near as rapidly as would be the case if it were allowed a wider range of investments. Nevertheless it does have many billions of dollars of retained earnings/surplus and also purchases cat reinsurance (Berkshire provided one of its initial multi year cat reinsurance covers when it started in 1996). However,if there ever is an EQ shake event or perhaps several in close succession to each other that might exhaust the claims paying ability, beyond a modest assessment against member companies, it’s technically possible that claimants would not be made whole….and would have to receive prorata settlements of their claims. The CEA is not a member of the Guaranty Fund, so if it becomes insolvent, there is no Guaranty Fund backstop for individual claims, so in this case, neither the state’s taxpayers nor private insurer customers provide a backstop. When the private property insurance market shows strains, the effect is most likely to drive a reduction in the rate of economic growth in the state. Real estate transactions become more difficult if buyers are not able to find affordable policies (which is a requirement for any mortgage provider). Homeowners may find it more difficult to sell when they want to move, and to the extent that insurance becomes more difficult to obtain and the price increases, I would presume that it would impact home prices. In the long run, if the private marketplace doesn’t improve, then it could very well be the case that the state ends up becoming a provider of last resort. In my opinion that would likely be a mistake for California as I don’t have great confidence in the ability of a single state to manage insurance risks…nor does it make sense to end up with the only providers being the state itself or companies that only write property in that state. Florida is a poster child in this regard. Citizens Insurance, the state run insurer of last resort is often the largest provider of property insurance in the state. Very few national companies have a material market share in the state, so the ability to spread risks nationally across many risk geographies is lost. Insurance is a form of lubrication to keep the gears of an economy moving after catastrophes. When the insurance system in a given state loses the ability to spread risk broadly, the probability increases that a large, somewhat uninsured catastrophe in a state would effectively throw sand into the gears of the economy and cause it to slow down if not stop temporarily. That is one way in which a state itself (or rather its economy) would be paying after the fact for a regulatory failure to support the private insurance marketplace.

Both California and Florida are similar in that their primary property rate regulatory regimes are in large part responsible for the insurance availability problems facing their respective insurance markets. Neither state allows the marketplace to work unfettered to set an appropriate price at which a large national insurance carrier would be interested in increasing or even maintaining their exposure in the state. Both states place artificial limits on the profit/risk load that a home insurer may build into their rates. Both states regulators presume to know how much surplus capital an insurer should allocate to support the writing of a home policy in their state, and it is less than an insurer would independently calculate would be necessary to support the writing of a property policy in the state, particularly in the riskiest hurricane or wildfire or Fire following earthquake exposed geographies. Then they attempt to regulate a reasonable allowable return on a surplus/equity amount that is artificially too low. Florida does allow companies to build in the cost of catastrophe reinsurance into their rate levels, but California does not. Florida also encourages thinly capitalized insurers to set up shop in their state to provide home insurance in Florida alone. All insurers are required to belong to the state guaranty fund, so that if any insurer goes bankrupt, their customers claims are paid by he guaranty fund, which is supported by assessments against the remaining solvent insurers. Not surprisingly, large national carriers don’t want to be played as chumps in such a market. Their competition for customers comes from small Florida only home insurance companies that likely will go bankrupt after running into a few back to back years of storms, with the national carriers funding losses for their own Florida customers from national surplus, and left holding the bag for additional assessments from the guaranty fund to pay the claims of their less financially strong competitors. Regulators will retort that guaranty fund assessments may be recouped from customers over time, but that misses the point: those payments come from surviving companies’ surplus equity on which they pay an opportunity cost because it’s no longer available to be invested elsewhere. They are not allowed to earn a return on that capital and they lose the time value of money since they only recover the funds years later. Gresham’s Law states that bad money drives out good. There’s a similar force at work in Florida and California: Bad insurance policies (meaning those provided by financially weak companies) will drive out good policies (those provided by financially strong companies) if they are forced by regulators to be sold at the same price. In California, a prudent home insurer will manage the risk posed by catastrophe exposures such as wildfire or earthquake by purchasing catastrophe insurance from companies such as Odyssey Re or National Indemnity (Fairfax or Berkshire). But they can’t pass this cost on to their customers. Prudent national carriers that can’t afford to expose their owners to the risk of bankruptcy will buy the reinsurance, even though they can’t build the cost into their primary rates. Less responsible carriers will either not buy reinsurance at all, or buy less than they ought to. Either way, Gresham’s Insurance corollary will work its inexorable force on the California market as it has in Florida, and the stronger national carriers will begin to flee the market. California could work to improve their market in three main ways: allow insurers to include the cost of catastrophe insurance in their primary rate making calculations, and allow companies to calculate how much capital they have at risk in supporting their varied exposures, and also let them earn a reasonable return on that risk capital. Currently, California typically assumes that surplus of no more than half the Annual written premium for a policy is at risk. In wildfire exposed areas, that rule of thumb is laughably inadequate. It can easily be the case, even after the purchase of catastrophe reinsurance, that a company will need to hold at least the full amount of an annual policy premium in the form of allocated surplus if not more, instead of merely half. If the state won’t allow you to include the cost of wildfire cat reinsurance in pricing a wildfire exposed home policy, then allows you to earn only an inadequate return on an amount of supporting surplus that is also inadequate for the risk, is it any surprise that rational decision makers decide that they shouldn’t sell policies under such constraints? The good news for Fairfax (and Berkshire) shareholders is that neither company is playing such a game. Both companies sell an absolutely necessary product (cat reinsurance) to companies that absolutely need to buy it (primary property insurance companies).

The balance sheet management for Fairfax has been impressive, compared to almost any other insurer not named Berkshire. With interest rates rising, many other competitors saw the market value of their bond portfolios fall, in many cases reducing their policyholder surplus/shareholder equity year over year for 2022 over 2021, at the exact same time that inflation in loss costs was requiring dramatic rate increases. For competitors that were writing (in 2021) almost as much premium as their surplus could support, 2022 was a rude wake-up call. All else being equal, to keep the same level of claims paying ability/AM Best rating in 2022 that they had in 2021 simply while writing the same customers (no growth in policy count) would require an increase in surplus roughly equivalent to the double digit rate increases many of them filed for in 2022. Since their surplus often dropped year over year at the exact time that they would have desired it to increase, they face some difficult management choices — they can limit their appetite for new business until surplus valuations recover, raise equity or debt, or watch their ratings possibly be put on watch with negative outlooks. Fairfax is in exactly the opposite position (as is Berkshire, and, I believe, Markel). Reminds me of former Citigroup CEO chuck Prince’s famous quote before the 2008 mortgage disaster: “As long as the music plays you have to keep on dancing. We’re still dancing”. With their refusal to reach for yield on their bonds, Fairfax is now reaping the benefits of taking the long term view for the health of their business over the long run. Now Fairfax can dance while most of their competitors have had to take a seat.