Fairfax 2008 Year-end Results (February 19, 2008)

[millsman]

Thanks t-bone for your analysis. You are right. But 104 uw it's too high. We are lucky than competitions are bad assets allocators because we will be dreaming for a hard market. I just dream one day this company will be at 99, with big cat, at the bottom of soft market. I really thinks Hamblin Watsa are wonderful investor, and they need a strong brand to feed them. They don't need to accept bad float with their ability. They are well positionned again, but the portfolio is less concervative, and they not really showing uw control. Imagine uw at 95 plus investment results.

[T-bone1]

Millsman,

 

I think you have to expect combined ratios to occassionally be above 100%. If not, everyone would sell insurance, buy treasuries with the proceeds, and get rich.

 

Last year was a tough year, the market was soft and their were a lot of expensive cat events. But even just combining the last two years gets them under 100% on average. I think this is a great result.

 

Unless a company has invested a ton of time and money into growing a specialty insurance business in some inefficient niche (like MKL), I don't think you can expect the CR to be below 100 every year. It just doesn't make sense, because the market is competitive and efficient.

 

t-bone1

[Mikenhe]

There’s a couple of factors at work here that need to be considered.

First it how long the tail is on this business. If Fairfax have a longer tail on their business then they have access to the premium for investment purpose for a longer period of time. And I can’t think of anyone I’d want investing the premium ahead of those guys.

 

Secondly  - how accurate is the loss reserving and how is it reported? If you reserve on a discounted basis then your ratios look better but you have to “stepladder” those reserves up toward the final payment on the claim. If you reserve undiscounted then your ratio looks worse (especially if you commute like the C&F deal) but you know what your future payouts are now.

 

 

Maybe the cost of doing business the Fairfax way looks worse.. but it’s the bottom line results that really matter and that’s always post investment income. Id’ rather have 100%+ of ratio and a big book of invested funds out there than be able to report 95% and have funds that have returns in the negatives…

 

[Guest ericopoly]

For those mathematically inclined, you might find this interesting:

 

$8,000m of float invested at roughly 10% pre-tax earns $800m

 

Last year the CR was 104.  If that happens again we have to give back roughly $160m

 

That still leaves $640m.

 

Can you smile now?  $640m in pre-tax profit despite the 3rd most expensive hurricane on record?

 

[amecham]

The CR is just a component of the net result... Seems a bit silly to bemoan in my opinion. It's like getting all worked up over the Buffett partnership fees - The end result, NET OF FEES, was spectacular... Similar to FFH's results this year - absolutely spectacular! I could care less what the CR is if the net result is 25% growth in BV.

[SharperDingaan]

 

T-Bone

 

It's worth looking at where FFH might expect to make its money over each of the next 3 years.

 

Assume (1) 2009 earnings come primarily from UW (hardening market, higher div/int etc). If the market continues to fall, investment gains on the remaining hedges will largely be offseting investment losses on the growing equities/bond portfolio (2) Assume 2010 earnings is a 50/50 mix (3) Assume 2011 earnings is again primarily from investment gains. 2 variables; (a) how profitable is the UW, (b) how long to the next round of investment gains.

 

Depending on the weather, UW could be wildly profitable - or a dog. Long term holders see this as an inherent part of the business. But Mr Market is short-term orientated & sees this as terrible. The more so as investment gains may not start showing up again untill 2010. Manic prices.

 

Should you buy?

 

On a different thread we suggested that over a 5 yr horizon the threshold YTM is about 25%.

 

Mr Market was offering US 239.55 today. If 2009 BV growth was only 15% (< 20% expected average), there was no year-end div, & the 1 yr multiple was only 1.05x you'd earn 43% [(282.70x1.15x1.05)/239.55]-1. If you bought you'd make roughly double what you were allready expecting to make, for simply acting.

 

If you're confident the market will not fall further it makes sense.

If you're not so sure, hedge.   

 

 

 

 

[Guest ericopoly]

"They don't need to accept bad float with their ability."

 

You'll note that C&F saw a 20% drop in volume. 

 

They used their capital to take NB private instead of chasing bad business at C&F.

 

 

[oec2000]

I would ask the question to those who are not interested in FFH at current prices (or roughly at book value):

 

You should not automatically draw the conclusion that anyone who raises questions about FFH does not like the stock and is critical of mgmt. I like the company and management, bought the stock yesterday and today, but also hope to see underwriting results approach mgmt's 100% target. I don't see anything inconsistent with this.

 

Consider the alternative question: If we think that mgmt can achieve a 10% return on float, and assuming that the average duration of the float is 2 years (meaning that a 103% CR equates to a 1.5% p.a. cost of float), should we, as shareholders, prefer to see FFH underwrite more aggressively (say, to 105% or even 110% CR target) so that they can have more float on which to make more money?

 

To me, it boils down to the margin of safety that we require and I feel that 100% CR gives more margin. The second point is that normalised CR affects the market perception of the "riskiness" of earnings and hence the valuation multiple it accords to the stock. (In other words, higher CRs may result in higher earnings but a lower share price.

 

There is no question that Prem and his team have done an excellent job overall. But, does this mean that shareholders cannot question why they are unable to meet their own CR target? Someone else on this board made the valid point that FFH did not back out the FX effect on CR when the USD was weakening.

 

I can't speak for everyone else but my goal in raising questions about uw is not to criticise mgmt but to try and better understand the business. The level of CR that is achievable and realistic is material to how I evaluate my potential returns from FFH.

 

Id’ rather have 100%+ of ratio and a big book of invested funds out there than be able to report 95% and have funds that have returns in the negatives…

 

Fair enough but is it wrong for me to want to have 100% CR COMBINED with good investment returns. The point is that mgmt gives the impression that this is possible - why would you, as a shareholder, not want it?

 

[Guest ericopoly]

Someone else on this board made the valid point that FFH did not back out the FX effect on CR when the USD was weakening.

 

The problem I have with a lot of the crticisms is that... it is just plain wrong!

 

The hell they didn't point out the currency impacts on combined ratio in prior years!

 

Let's look at 2007:

 

 

http://www.fairfax.ca/Assets/Downloads/2007Q4.pdf

 

"Included in 2007 underwriting results was the benefit of 6.9 combined ratio points ($70.3)

arising from favourable development of prior years’ claims, including 4.0 combined ratio points of benefit attributable to foreign

currency movements (the impact of appreciation of the Canadian dollar relative to the U.S. dollar on U.S. dollar-denominated claims

liabilities of Commonwealth and Markel)."

 

 

[Guest ericopoly]

I think the main problem is not reading their reports.  You are just looking at the CR and figuring it speaks for itself.

 

You bitch them out when they explain that the combined ratio is artificially inflated due to strengthening USD, but you don't bitch them out when they explain the CR is misleadingly low from weakening USD.

 

In both cases, they are merely giving you all the information that you need.

 

You call them excuses in 2008.  In 2007, you did not call them excuses.

[watsa_is_a_randian_hero]

Ericopoly-  I commented the following on the CR & currency-

"Yeah, when the CAD went beyond parity with the USD we never heard of any huge gain on the CR.  Whats up with that?"

-I meant by this not that there was no disclosure, it just seems the magnitude of the gain was different.

[FlyingArrow]

Someone else on this board made the valid point that FFH did not back out the FX effect on CR when the USD was weakening.

 

The problem I have with a lot of the crticisms is that... it is just plain wrong!

 

The hell they didn't point out the currency impacts on combined ratio in prior years!

 

Let's look at 2007:

 

 

http://www.fairfax.ca/Assets/Downloads/2007Q4.pdf

 

"Included in 2007 underwriting results was the benefit of 6.9 combined ratio points ($70.3)

arising from favourable development of prior years’ claims, including 4.0 combined ratio points of benefit attributable to foreign

currency movements (the impact of appreciation of the Canadian dollar relative to the U.S. dollar on U.S. dollar-denominated claims

liabilities of Commonwealth and Markel)."

 

 

 

Eric,

 

My comment was this:I'm still trying to wrap my head around this. We've seen the US/CAD dollar swing wildly over the past year and I don't ever recall seeing any discussion of combined ratio points swing associated with currency movements (either way) in previous quarterly or annual reports. I hope they make a point of discussing this on the call tomorrow.

 

The issue was adequately addressed on the conference call and I was more than satisfied. I also figured that it must then have been in previous reports and I just couldn't recall it. Thanks for digging into this and pointing out for all what is in fact reality. I haven't had the time and I'm quite pleased that the swing the other way was just as big.

 

 

Cheers,

 

[Guest ericopoly]

I'm just in a lousy mood because I have a cold.

 

Ericopoly-  I commented the following on the CR & currency-

"Yeah, when the CAD went beyond parity with the USD we never heard of any huge gain on the CR.  Whats up with that?"

-I meant by this not that there was no disclosure, it just seems the magnitude of the gain was different.

 

The magnitude is different because the exchange rate swing was probably the most sudden and violent in decades.

 

I bought more calls today, I cannot believe that I can still buy at 6x operating earnings.  P/E including normalized capital gains is probably more like 4x or 3x.

 

 

[watsa_is_a_randian_hero]

I bought a call spread yesterday.  Bought the Jan 11 $300's, sold the $350's.  Total cost of $14.70 for a payoff of $50 if the stock is over $350 two years from now.

[FlyingArrow]

 

I bought more calls today, I cannot believe that I can still buy at 6x operating earnings.  P/E including normalized capital gains is probably more like 4x or 3x.

 

 

I'm with you. I loaded up on more today. I actually sold some common so I could get more options. I bought across the range. I think I'm an FFH leverage junky.  :-[

 

With the volatility over the last few years I've been able to consistently do this to increase my holdings and average down. At first I always feel like my wealth has evaporated when we get these dips. Then I realize it for what it is. An opportunity to get a larger interest in something I know very well and feel very good about over the next five years. It's not the same opportunity we had a couple of years ago with the leaps but an opportunity none the less.

[value-is-what-you-get]

I bought a call spread yesterday.  Bought the Jan 11 $300's, sold the $350's.  Total cost of $14.70 for a payoff of $50 if the stock is over $350 two years from now.

 

Does the Call Spread pay off if the stock price goes over 350 at any time between now and expiry or only if it is above 350 on or after a certain date?

[watsa_is_a_randian_hero]

No - the call spread only pays off at expiration.  I paid $14.70 for the spread between $300 and $350.  I am entitled in Jan 2011 to the profits on FFH between $300 and $350.  My breakeven is if the stock is $314.70. 

 

The IRR on the trade, if FFH is over $350 and I get the $50, would be 90%.  To get the same IRR on FFH common shares over the same period, the stock would need to be $855 in 2011.

 

If the stock only goes to $320, I'll get $20, and have an IRR of 17%.  Buying the common at $250 and holding for $320 over the same period is still a lower IRR, only 13.8%. 

 

The risk is we have something worse than Katrina or 911 and BV is only $250 or something in 2011.

[Crip1]

"I think the main problem is not reading their reports.  You are just looking at the CR and figuring it speaks for itself.

 

You bitch them out when they explain that the combined ratio is artificially inflated due to strengthening USD, but you don't bitch them out when they explain the CR is misleadingly low from weakening USD.

 

In both cases, they are merely giving you all the information that you need.

 

You call them excuses in 2008.  In 2007, you did not call them excuses."

 

Eric, you are right, I did miss that, my apologies for doing so.

 

However, that means that FFH underwrote in 2007 at an adjusted CR of 98. Chubb had an 82 and I want to say that Markel was at 89 or thereabouts. I still stand by my assertion that as an owner of this company, I would like to see management consistently hit the target of an underwriting profit, and the more the better. FFH out-invests their competition by a significant margin, but the best in the industry out-underwrite FFH. It is encouraging to see two strait prior year redundencies factored in, especially considering it was not that long ago when it seemed an annual December event was to receive an announcement of reserve additions. Things are better. There are those who took umbridge when concerns over underwriting were pointed out. I recognize the performance of the company overall has been stellar, but simply piont out that this is an area where improvement would be most welcome. I'll bet that Prem and co feel similiarly.

 

This is key going into 2009. FFH has some tailwinds in the form of a hardening market, ratings upgrades (which would presumably enable them to bid on business on which, up to now, they were unable to participate), and increased statutory capital, which is most certainly the exception in the industry. If they can execute, the combination of underwriting earnings, investment earnings and P/BV multiple expansion from the collective awakening of the investing public will provide some very handsome returns.

 

-Crip

[Guest ericopoly]

I don't mind pointing out that we would make more profit if CR were a lot lower.

 

I just hate the swipes at their making "excuses".  I was looking through the Allstate report, and they too report to shareholders what the CR would have been if not for special events.  It has nothing to do with making excuses, it has to do with giving us some info so we don't scratch our heads wondering how much of an impact Ike had.  People need to be mature and understand this, because next year if we get the same griping I'm going to have to hunt you guys down  :D 

 

 

Here is the wording that Allstate uses to present the "underlying" combined ratio (excluding the big ugly events):

 

PropertyLiability combined ratio excluding the effect of catastrophes and prior year reserve reestimates (“underlying combined ratio”)*

 

http://media.corporate-ir.net/media_files/irol/93/93125/reports2/ALL4Q08ER.pdf

 

 

 

 

[SharperDingaan]

 

We may be a little biased here, but this is an area where the 'business' vs 'investment' view really stands out.

 

FFH's competitive advantage is its ability to consistently invest better than its peers. To do that you need to take on some operational risk, & 'buy' some float. And you have to be willing to pay for it, ie: 2.5%. In Dupont analysis (ROE) terms, they need to weight the business's total degree of leverage more to the operating vs financial end.   

 

This has consequences.

- They don't need to be a top-flight underwriter, but they do need to reliably contain their expenses within the 2.5% net allowance. If they do better great, but only if the operational benefits exceed the operational costs.

- The adverse insurance risk on their UW results increases; so there's more need for exit discipline, & a higher interest/dividend income stream to ensure that their net operating income meets the minimum requirement. A desirable thing , & no different from the standard practice of hedging BS FX risk & not P&L FX risk.

 

We see evidence of exit discipline, & the consequence of increasing the adverse insurance risk to the overall market. If they wrote like Chubb, etc they'd very likely have less float - and might well actually give up more on the investment side than they would save on the UW. Net negative.

 

There is always room for improvement, & operational leverage does change to meet the times.

Perhaps a good time to revisit it ?

 

SD

 

 

[Guest ericopoly]

I know one thing:  the company is a lot less risky when they have incredibly high investment income.  We have the capacity to absorb a KRW year and still wind up with positive operating income!  Incredible.

 

 

 

[Hoodlum]

Looks like Fairfax got into their insured muni bonds just in time.

 

http://www.financial-planning.com/news/buffett-stays-cautious-on-bonds-2661225-1.html

 

Since Warren Buffett's Berkshire Hathaway Assurance Co. entered the bond insurance market, it has limited its production of new business and asked for high premiums.

 

Last year, it wrapped just 22 issues with a par value of $3.3 billion in the primary market, according to Thomson Reuters.

 

In his annual letter to Berkshire Hathaway Co. shareholders released this weekend, Buffett explained why the business has stayed small. He wrote that the company remains "very cautious" about the new public finance business it writes and "regard it as far from a sure thing that this insurance will ultimately be profitable."

 

 

[zarley]

Conference Call transcript from Seeking Alpha:

 

http://seekingalpha.com/article/121766-fairfax-financial-holdings-q4-2008-earnings-call-transcript?source=yahoo&page=1

 

I can understand why people are put-off by all the discussion of why underwriting was bad in 2008.  A CR of 110 is just not very good, and saying that if all this bad stuff we insured against didn't happen and if exchange rates didn't fluctuate, our CR would have been in the mid 90s is a little weak.  Yes, it was an unusual year, but at some point you need to stop talking about all the hows and whys and just continue to work on improving that part of the business.

 

On the bright side, Odyssey's numbers look reasonably good (CR of 103.5 without adjusting for catastrophe losses).

 

zarley

[SFValue]

any general insurance news or specific FFH/ORH that i am missing today; or this is more of the they went all in to equities and their CR sucks repricing by Mr. Market?

 

thanks in advance,

[Viking]

SFValue, your question has been asked on this board once or twice a year for the past 6 or 7 years and I still do not know the answer. Bottom line is FFH is a very volatile stock.

 

When you look at the price of the stock and compare to book value it is trading at an attractive historical valuation. I was asking myself this morning if the stock at current pricing offers a better value than when it traded at $100 two years ago. It may not be as cheap at current levels but offsetting this is the much better financial position the company is in and the fact it also now owns 100% of NB and 70% of ORH. Can FFH go lower? Yup. Past history has taught me that buying at current levels has been a good move.