Fairfax logic

[Guest Dazel]

 

I would be more concerned with what you are saying Cardboard if they did not have the bond team that they have. If you look at Capital gains in aggregate over their lifetime you have to realize that a large portion of the gains have come from bonds and other investments...You have to include the cds gains as the bond team because that is where they came from...This board and others have been calling the bond gains one time events since I have been talking about them in 2003...Guess what?

 

Take a look at what the corporate and munipal bonds are looking like. To me gains are gains and the percentage equity scenario does fit when you look at Fairfax. The math lies in the hands of your biggest asset allocation. At Fairfax it is bonds...and I would bet anyone around they cannot find a better bond investing record on the planet over the last 20 years.

 

We were able to buy Fairfax in 2003 because they had a billion dollar unrealized gain in bonds...It has been quite profitable ever since!

 

Dazel.

[Tommm50]

Regarding the insurance cycle I agree with Cardboard, anticipation of a hard market as an investing strategy in insurance companys is buitling your portfolie on quicksand.

 

To understand the insurance cycle (lunatic as it is) it's helpful to put it in historical context. Back in the 60's and 70's (and decades before) the insurance cycle was regular as the seasons, three years hard, three years soft. Beginning in the 70's that began to change. The mid 70's brought the medical malpractice insurance crisis. Insurance companies stopped writing it altogether. It forced doctor groups and hospital groups to form their own insurance companies or alternate funding mechanisms. The next real hard market in the mid 80's did the same for U.S. Excess Casualty business. The Fortune 1000 were unable to purchase adequate Product Liability, Auto Liability, Workers Compensation, or General Liability coverage. They were forced to create their own insurance companies (that's how ACE and XL came to be) or find alternative funding mechanisms (a lot of legislation was passed to allow Purchasing Groups, Risk Retention Groups, Captives, Self Insurance Retentionss, etc.).

 

The end result was that by the end of the 80's half the U.S. Casualty Insurance business was removed from the "standard" insurance company market, never to return. The myopic strategies of the insurance companies forced their customers to, in effect, write their own insurance. This means that the insurance premium pie is half what is was (at least for Casualty). The supply and demand cycle of the old markets is forever changed to have relatively less demand vs the same supply.

 

The other big influence on the insurance cycle is the evolution of tremendous flows of capital the financial markets now provide. A graphic demonstration was 9/11. Almost overnight $12 billion or so in capital arose in Bermuda to take advantage of the "opportunity" provided by the hard market. This had the effect of dramatically shortening a real hard market because you can only get better prices and terms if there is no other alternative. If you have extensive inflows of new capital that hard market is extinguished rapidly.

 

That's a long winded way of saying the old fashioned "hard market" environment is history.

 

I don't agree with Cardboard about Fairfax's UW results. The huge reserve hole TIG and C&F created is now behind us but has left it's mark on Fairfax management. I think Fairfax will keep their U.S. uw combined ratio around 100 going forward (letting their top line decline in the U.S.) allowing the investment returns and growing foreign insurance operations to generate the "lumpy" 20% average annual growth Prem espoused.

 

My two cents anyway

[oec2000]

If you think this is crazy, then I encourage you to do the math. Check the ratio of equities in their portfolio vs book value over time. Then check the cost (underwriting losses) over time and add to it the interest cost on the debt that they took to maintain this level of underwriting. You should come to the conclusion that whatever they earn on what is not equities in their portfolio is used up to pay for insurance and debt costs.

 

Cardboard

 

Cardboard,

 

No time to look at detailed numbers but here's a quick and rough response.

 

Over time FFH's cost of float has been about 3%, their bond returns about 10%, and equity returns at least 15% (I think it is 20% but as I'm not 100% sure, I'll just go with 15%; and it is not clear how much the recent CDS gains will add to this).

 

These numbers show that the insurance businesses add value. The preferreds and bonds issued during "the lean years" were more expensive and may have added less value but they are being/will be replaced with cheaper issues.

 

As for the ratio of equities to book value, this is a function of the degree of leverage they have and as this leverage drops, they will be able to raise the ratio of equities to book, as we have indeed seen recently.

 

So, while what you point out may be true of the 7 lean years, the prospects looking forward are quite different because of their now more fortress-like balance sheet. The perverse thing about the insurance business is that the weaker your balance sheet, the more difficult it is to maintain underwriting discipline (because you need to sustain the cash flow) when the right thing to do is actually the opposite. I believe that FFH's underwriting performance will improve because of their increased financial strength.

[SharperDingaan]

 

The reality is that by itself, the move will not do much for immediate valuation ... but going forward an upward bias is probably realistic. How much? is anyone's guess.

 

We know that FFH is not run with a short-term bias. So why the insistance on seeing the benefits from the voluntary delisting in strictly 'now' terms? It's highly likely that we don't have all the facts.

 

SD

 

 

 

[Uccmal]

Cardboard, Not to be facetious.  If it is such as bad business then why are some of the very best investors using float - Buffett, Markel come to mind?

 

Each time Buffett takes over an insurance company it goes in the dumper for years until He and Mr. Jain clean up its underwriting practice.  But he persists in buying up float.  With FFH, I contend that the amount of business being written when the 25% of the time hits will more than make up for the down time since 2003. 

[Guest Dazel]

"Over time FFH's cost of float has been about 3%, their bond returns about 10%, and equity returns at least 15% (I think it is 20% but as I'm not 100% sure, I'll just go with 15%; and it is not clear how much the recent CDS gains will add to this)."

 

It is important that you use weight when you are looking at these over time as I mentioned with reference to Cardboard's post. He is very correct that Fairfax is limited by the 25% equity weight. However, if you look at the 75% of the float at a 10% return... it is massive and we feel it is completely ignored at Fairfax. If you include the cds gains in bonds which is where they should be since it was Brian Bradstreet who bought them... the bond side has outperformed the equity side in percentage return. On a weighted basis it is Brian Bradstreet who is the rock star yet no one even knows he exists. We are watching Brian!

 

Sorry a bit off topic but I am truly amazed at how little repect Fairfax gets for its bond investing!

 

Dazel.

[vinod1]

 

If you think this is crazy, then I encourage you to do the math. Check the ratio of equities in their portfolio vs book value over time. Then check the cost (underwriting losses) over time and add to it the interest cost on the debt that they took to maintain this level of underwriting. You should come to the conclusion that whatever they earn on what is not equities in their portfolio is used up to pay for insurance and debt costs.

 

Cardboard

 

If rate of increase of book value is greater than the rate of return on equities, does this not indicate that insurance business providing additional value over just plain investing? Book Value increased roughly about 26% from end of 1986 to end of 2008. Equity performance has been mentioned in various contexts as around 20% (but I did not calculate this number). Based on this I would assume that insurance business adds value compared to just plain investing by HW.

 

Vinod

[FlyingArrow]

 

If rate of increase of book value is greater than the rate of return on equities, does this not indicate that insurance business providing additional value over just plain investing? Book Value increased roughly about 26% from end of 1986 to end of 2008. Equity performance has been mentioned in various contexts as around 20% (but I did not calculate this number). Based on this I would assume that insurance business adds value compared to just plain investing by HW.

 

Vinod

 

You're missing the impact of leverage Vinod. If the float is $20B and we average 10% on that (mix of equity and bond returns) that's $2B. If insurance is break even and assume equity was $6B you would have a 33% increase in book from a 10% overall return on the portfolio - all of it from investing operations, none from insurance. Except of course that it was the insurance operations that gave you the float to invest... ;)