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Fairfax and inflation


petec
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I've had a deflationary bias for years, but it is clear that the policy response to deflation is pretty inflationary and inflation is a risk that can't be dismissed lightly.

 

Fairfax is well-prepped for deflation: the swaps, the bonds, and also the likelihood of good combined ratios as costs of claims decline in a deflationary environment.

 

In fact, one could argue that deflation isn't much of a risk to insurance companies anyway given their bond portfolios and the likely impact on the combined ratio.

 

Inflation, on the other hand, could be an absolute killer.  This is my one criticism of Prem over the last few years: he's described a lot of what he has done not as outright bets but as protecting the company against a worst-case economic outcome.  But I don't think deflation is the worst case economic outcome for insurance companies.  I think inflation is. 

 

We have plenty of good inflation vs. deflation coverage on other threads, so let's not repeat that here.  But what are your thoughts about how Fairfax (and other insurers) would perform in an inflationary environment?  Have I missed something?

 

Pete

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I think simple answer is that FFH will perform better than other insurance companies since they hold some percentage of stocks instead of bonds and presumably stocks work better than bonds in inflation / rising rates.

 

But that's just simple thought. There might be other more complicated answers. 

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Historically stocks have been a poor hedge for inflation.

 

And to answer the Pete's original question: yes, you missed what the impact of inflation will be on the rate of return that insurance companies will be able to earn on their float. In the current low rate environment that is almost zero, but when rates go up they gain earning power.

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I don't think that you have any reason to worry about inflation right now.

 

That being said, insurance companies do poorly in times of inflation because they generally hold long dated bonds which take a beating.

 

 

And to answer the Pete's original question: yes, you missed what the impact of inflation will be on the rate of return that insurance companies will be able to earn on their float. In the current low rate environment that is almost zero, but when rates go up they gain earning power.

 

In regards to how profitability is impacted on earnings on float, this depends on the duration of float and competitive factors. If interest rates rise and float is short lived then a higher % of the float is invested at the higher interest rates. But keep in mind that insurance is a commodity business so if they can earn more on float they'll compete more on price and that reduces underwriting profits.

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Historically stocks have been a poor hedge for inflation.

 

They clearly perform better than cash and any non-trivial-longevity bonds.

Anyway, read what Buffett said and all that. :)

 

And I agree with rb. Just a note that Fairfax's competitive advantage against other insurance companies is their stocks and captive business portfolio. The same as BRK - though BRK has possibly better quality inflation resistant businesses and stock holdings.

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It may be worth looking at insurance companies in Japan over the last 25 years. They haven't done well during deflation that lasts that long.

 

Right. That's one of the reasons most insurance companies still trade at book or below book even after the tremendous bull market we've had last couple years.

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Re stocks, the right stocks (with pricing power and low capital intensity) are good inflation hedges but they will still trade down from current levels going into an inflation because the discount rate rises.  Look at the '70's.

 

Re bonds, yes they will be able to reinvest short term bonds at higher rates but the long term ones will take a big capital impairment.

 

Re whether higher investment returns leads to lower underwriting prices: that will ultimately depend on whether management teams aim for a real rate of return on equity or a nominal one.  In a 15% inflation environment (for example) a 10% RoE is basically lossmaking, and I'd hope managements would aim for 25% (for example).  Interesting.

 

Re Japan, what has hurt those insurecos?  Not that this thread is about deflation, but I'm interested.  I'm aware that the lifecos have gotten hurt by deflation because it's impossible to earn a return on long dated assets, but what of other insurance?

 

Feels to me like this is the key risk for FFH holders.  Not in the sense that it is likely any time soon, but in the sense that it is the black swan that could hurt the most.

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  • 4 weeks later...

Anyone know what the general composition of the Fairfax bond portfolio is to have any idea of the duration risk we're facing?

I'm in the camp of lower rates for longer, but I certainly want to have a better idea of how it will affect Fairfax if I'm wrong than I currently do.

 

Thanks,

 

They give this out in the AR, page 99. Change in earnings at 1% and 2% change in rates is about -$700 million and -$1.3 billion. This assumes a parallel rise in rates.

 

Vinod

 

 

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