Fairfax 2020

[petec]

There wasn’t a gain on APR so that’s not it and I don’t think the transaction will contribute earnings, high quality or low.

 

I suspect what they’re referring to is gains on the exercise of SSW warrants.

 

 

That could very well be the case.  They would definitely have a gain from exercising the SSW warrants, but it doesn't much change the economic reality (outside of FFH having to add some cash to the existing investment).

 

Keg/Recipe wasn't the correct transaction for me to reference.  In 2018 the "accounting" transactions were Grivalia being consolidated, and Thomas Cook/Quess triggering a bunch of paper gains.  In 2019, it was Quess triggering a bunch of paper losses and Eurolife/Grivalia triggering a bunch of paper gains. 

 

For the past few years, most of us have cooked up an adjusted BV to get an idea of the significance of some of the excess in value over book.  But, really it might be time to create an adjusted net income to strip out the impact of some of the one-time transactions to better portray ongoing economic performance.

 

 

SJ

 

Ah I see what you’re getting at.

 

Personally I care more about BV than earnings so I’m happy with the disclosure they’ve often provided on what BV would be if they marked to market.

 

 

Agreed that the BV metric is the more important metric for valuing the insurance end of the operations, and it's been important to cook up an adjusted-BV estimate for the past few years to better reflect reality.  But, it's also important to try to measure operational performance against any number of metrics, including EPS, ROE, CR and investment return.  That's where some of these non-cash items muddy the water.  This year, the dollars are small, with Eurobank/Grivalia being $6 or $7 per share...but the Thomas Cook/Quess number from 2018 was absolutely enormous, and the Grivalia consolidation number from 2018 was a smaller number added to it.  A large head-line EPS number is nice to see and it definitely feels good, but...

 

SJ

 

I’m not against the idea. Although it does make me smile - the BAM thread is full of suggestions that “management metrics” like that is a red flag for fraud. Sometimes feels like management can’t win ;)

 

Also - I initially read your comment about low quality earnings as a criticism of FFH management for massaging the numbers. But on reflection maybe you’re just saying that accounting treatment doesn’t always reflect reality. Is that right?

[StubbleJumper]

While we’re at it I don’t recall Grivalia/Eurobank generating a paper gain either, and it’s clearly been value-enhancing because it was effectively a capital raise for the bank.

 

"Net gains on long equity exposures of $1,631.1 million in 2019 was primarily comprised of unrealized appreciation of preferred shares of Go Digit Infoworks ($350.9 million), the sale of the company's remaining interest in ICICI Lombard ($240.0 million), a non-cash gain on the merger of Grivalia Properties into Eurobank ($171.3 million) and significant unrealized appreciation of common stocks."

 

Sorry - I doing a very poor job of expressing myself (possibly because I’m also trying to feed a 3 month old!).

 

What I meant to say was:

1) I couldn’t remember whether they booked a gain on the Eurobank/Grivalia deal, but

2) if they did I’m pretty sure it did reflect economic reality in the sense that it moved book value closer to the mark-to-market book value. Until the deal Grivalia was consolidated so the rise in the share price since acquisition wasn’t reflected in FFH BV.

 

I may be remembering wrong - don’t have my notes to hand.

 

 

Agreed that the only way to move the BV measurement closer to economic reality is to book the gain -- that's a fact of accounting.  But, when you see an EPS number with that kind of gain baked in, it's essential to not view that number as a sustainable measure of annual economic performance.  FFH's PE is now <7, but does that metric mean anything at all?  Has it meant anything at all for the past two years when the paper gains have been so important?

 

It's also an interesting thing for FFH's target of growing BV by 15%.  A "successful" year would be more or less like 2019 when BV grew by 14.8%.  But, really, you'd probably want to strip out those one-time paper gains to get a better sense of how successful 2019 truly was (unless we believe that paper gains of that magnitude are sustainable and repeatable).

 

I don't want to make it seem like FFH has done something wrong here.  I'm just suggesting that people should take that headline EPS number with a grain of salt.  And, I wonder how the market will end up viewing it.

 

 

SJ

[StubbleJumper]

There wasn’t a gain on APR so that’s not it and I don’t think the transaction will contribute earnings, high quality or low.

 

I suspect what they’re referring to is gains on the exercise of SSW warrants.

 

 

That could very well be the case.  They would definitely have a gain from exercising the SSW warrants, but it doesn't much change the economic reality (outside of FFH having to add some cash to the existing investment).

 

Keg/Recipe wasn't the correct transaction for me to reference.  In 2018 the "accounting" transactions were Grivalia being consolidated, and Thomas Cook/Quess triggering a bunch of paper gains.  In 2019, it was Quess triggering a bunch of paper losses and Eurolife/Grivalia triggering a bunch of paper gains. 

 

For the past few years, most of us have cooked up an adjusted BV to get an idea of the significance of some of the excess in value over book.  But, really it might be time to create an adjusted net income to strip out the impact of some of the one-time transactions to better portray ongoing economic performance.

 

 

SJ

 

Ah I see what you’re getting at.

 

Personally I care more about BV than earnings so I’m happy with the disclosure they’ve often provided on what BV would be if they marked to market.

 

 

Agreed that the BV metric is the more important metric for valuing the insurance end of the operations, and it's been important to cook up an adjusted-BV estimate for the past few years to better reflect reality.  But, it's also important to try to measure operational performance against any number of metrics, including EPS, ROE, CR and investment return.  That's where some of these non-cash items muddy the water.  This year, the dollars are small, with Eurobank/Grivalia being $6 or $7 per share...but the Thomas Cook/Quess number from 2018 was absolutely enormous, and the Grivalia consolidation number from 2018 was a smaller number added to it.  A large head-line EPS number is nice to see and it definitely feels good, but...

 

SJ

 

I’m not against the idea. Although it does make me smile - the BAM thread is full of suggestions that “management metrics” like that is a red flag for fraud. Sometimes feels like management can’t win ;)

 

Also - I initially read your comment about low quality earnings as a criticism of FFH management for massaging the numbers. But on reflection maybe you’re just saying that accounting treatment doesn’t always reflect reality. Is that right?

 

 

No, it's not at all about massaging the numbers in this case.  If you are worried about numbers being massaged you should be looking for a cookie jar.  If a cookie jar exists, you should focus of the reserves because if something is hidden that's where it will be.  Despite the supervision provided by the various regulators, we should always squint a little bit when we look at reserve levels, reserve releases, reserve bolstering, U/W profit and CRs.  The truth about those numbers can only really be verified over a period of 5 or more years....  IMO, a little suspicion, a dose of skepticism and a great deal of scrutiny are appropriate.

 

 

SJ

[petec]

Cool - we are on the same page.

[Xerxes]

Just started reading the transcript. “Realised gains in Seaspan and Brookfield” - sounds like they’ve sold some SSW and owner BAM? Unless there’s been a transcription error...

 

Petec,

i heard Brookfield as well when i was listening to the conference call.

search the release and there was nothing there.

 

putting my conspiracy theorist hat on:

i believe Prem might have blurted that out, because he was thinking about it, and he was thinking about it because something is in the works with Brookfield that is not public yet.

 

i figured that the Airport unknown buyer in India might have been a BAM related/affiliated entity. Makes sense given all the talks that Bruce has been doing about India's opportunity today given the current financial crisis. But then again he was not talking about the Airport he was talking about Seaspan when he mentioned Brookfield. 

[petec]

Just started reading the transcript. “Realised gains in Seaspan and Brookfield” - sounds like they’ve sold some SSW and owner BAM? Unless there’s been a transcription error...

 

Petec,

i heard Brookfield as well when i was listening to the conference call.

search the release and there was nothing there.

 

putting my conspiracy theorist hat on:

i believe Prem might have blurted that out, because he was thinking about it, and he was thinking about it because something is in the works with Brookfield that is not public yet.

 

i figured that the Airport unknown buyer in India might have been a BAM related/affiliated entity. Makes sense given all the talks that Bruce has been doing about India's opportunity today given the current financial crisis. But then again he was not talking about the Airport he was talking about Seaspan when he mentioned Brookfield.

 

Not impossible, but intend to avoid conspiracy theories. I doubt Brookfield were the BIAL buyer because they usually buy control and trumpet their deals. I suspect Prem just misspoke. He’s not the clearest of communicators.

[Viking]

Does anyone have thoughts on the RiverStone UK sale? Fairfax mentioned when they announced the sale that there will be a $10 gain in BV. My guess is that is still coming in Q1 when the deal is announced (i.e. it did not hit in Q4 financials). Correct?

 

Prem on the conference call said the benefit of selling 40% and getting OMERS involved is it will provide access to $ to grow the business. It will be interesting to see how fast Riverstone UK grows post acquisition. Sounds like there are lots of opportunities.

 

That deal closes soon (sometime in the next 6 weeks). Fairfax will be able to put the $600 million to work. They will likely use it to buy 10% of Brit and Eurolife minority interests. And grow the business at the insurance subs.

 

Prem mentioned they may IPO Riverstone UK down the road. Perhaps that is the plan for how they will take out their minority partners in Allied. Trade runoff (Riverstone UK) for minority positions in Allied and Brit looks like a good trade to me. Makes Fairfax more of a pure play insurance operation and removes the overhang of having to find a big chunk of cash to buy out minority partners (especially in a hard market when your stock is trading below BV).

 

It really is amazing how much stuff is going on under the hood at this company. My guess is 2020 will see lots more developments just like 2019 :-)

[petec]

Does anyone have thoughts on the RiverStone UK sale?

 

I think they needed capital. If the deal was intended to give RUK capital to grow, it would have been structured as a capital injection rather than a partial sale. Frustrating they can’t be more honest when they describe these things. Plus, they said they’d never sell the insurance subs and now they’ve sold (part of) two in two years.

 

Agree re what’s going on under the bonnet. It’s felt like that for a couple of years.

[Viking]

Does anyone have thoughts on the RiverStone UK sale?

 

I think they needed capital. If the deal was intended to give RUK capital to grow, it would have been structured as a capital injection rather than a partial sale. Frustrating they can’t be more honest when they describe these things. Plus, they said they’d never sell the insurance subs and now they’ve sold (part of) two in two years.

 

Agree re what’s going on under the bonnet. It’s felt like that for a couple of years.

 

I agree, they need capital. But not to put out a fire. Rather, they need capital to take advantage of some once in 10 year opportunities:

1.) aggressively grow business in hard market at some insurance subs

2.) stock price below BV

 

They also need $ to buy out minority partners.

 

Bottom line, their need for cash today is what i would call a good problem.

 

Also, my guess is the market will never value the runoff businesses favourably (in the Fairfax family). In the current environment i am very much in favour of them selling/monetizing undervalued assets (like Riverstone) to fund hard market growth and share buybacks (the hard market in pricing will not last forever and when it ends we can expect Fairfax to get very aggressive on share buybacks).

 

It will be interesting to see what Fairfax plans to do with Seaspan. This has become such a large position. Another first class type of problem to have :-) My guess is nothing happens until after the APR aquisition which is expected to close some time in 1H 2020 if memory serves me correctly. Seaspan reports Feb 19.

[petec]

 

Bottom line, their need for cash today is what i would call a good problem.

 

 

Agreed. I did not mean to suggest they were in trouble. I do, however, find it annoying that they spent years trumpeting the excess capital in the insurance subs and how they could as much as double premiums in a hard market - and now that one is here, we find they can’t, without injecting capital.

[petec]

We now have an idea of what Riverstone UK is worth. Does anyone have a handle on what the rest of Riverstone is worth? I don’t recall seeing disclosure that would allow one to estimate that.

[Viking]

Here is a summary from RBC of what they heard about insurance pricing on Q4 conference calls:

 

“What we heard was really bullish. We heard current rate increases were averaging anywhere from mid-single digits to low double digits depending on business mix. The more specialty, the more large account, the more excess casualty and D&O the more likely the average had two digits. The more workers comp, the more small account, the more standard lines, the more likely the average was around +/-5%. Heading in we expected the latter group would be around 5% and it was. We expected the former group however to be around 8% and we would say based on commentary it was probably a little higher than that.

 

As far as how long pricing conditions would last, again we were positively surprised. Our going in expectation was that companies would be cagey about addressing this topic and would give luke warm responses like ‘several more quarters’ or something like that. To our surprise there was pretty good unanimity that pricing power would persist throughout 2020. To our further surprise there were plenty suggesting the good times could roll well into 2021. While the latter corresponds with our own bullish viewpoint, we did not really expect to hear it said aloud. It was. Which gives us quite a bit of confidence in our conviction that we are only in the first or maybe second innings of a very favorable P&C market.”

[Cigarbutt]

Viking, it looks like you made some money on this short ride. Based on a three to five year outlook, I didn't feel comfortable with the short term nature of the trade but well done for you.

 

FFH announced (on the call, not in the news release) that a 216M charge was recorded in the run-off section for asbestos and environmental reserve strengthening in 2019. This comes after an asbestos-related charge of 143.6M in 2018 and 182.5M in 2017 (ultimately and mostly due to 'legacy' units from C+F, Clearwater etc). Concerning the asbestos reserves, it's interesting to note that net reserves are still at the same level as 20 years ago. Since then, a lot of cash has been paid out, reserves have been raised along the way and there have been a few acquisitions with embedded asbestos reserves. I come to the conclusion that FFH's progress has been largely in line with the industry in that regard (FFH has a leading global market share in asbestos reserves; for example BRK has only 1.7x FFH exposure in that area despite being much larger overall as an insurer). Recently, the social inflation has played a role (even more than the usual trend and JNJ's talc issue may help to inflate the issue) but I think that the asbestos question is now under control and will likely show a material run-off (reserves heading towards zero) within the next 5 to 7 years. At large, it seems that the industry is reserved at 90% of the ultimate amount and if FFH continues to stick to the average evolution, it is reasonable to expect 350 to 400M further reserve strengthening during that period.

 

The potential relevant aspect here is the fact that the setup of the run-off sub came with many advantages (efficient way to run-off inside claims, potential profit center with acquisitions and especially the ability to separate poor results from 'continuing' operations). FFH has recently shown better than average underwriting results from continuing operations but it is helpful to remember that they were effectively able to segregate (channel is too strong a word) poor results into the run-off segments. Only for the asbestos charges, in the last 3 years, including these in the 'continuing' operations would have meant a combined ratio higher by about 2% each year. This is just to say that adjustments have to be made to the reported record.

 

Speaking of adjustments, here's an update on reserve releases (unaudited) as a % of CR improvement ('continuing' operations).

2016:  7.8%

2017:  8.5%

2018:  6.8%

2019:  3.8%

Overall, it seems that FFH has been able to develop a slightly better underwriting culture than the relevant part of the insurance industry (which is an amazing improvement compared to a certain period many years ago) but I would say that they are not much better than average and the true nature of reserves of recent acquisitions (Brit, Allied) is still, and will be, discovery in the making. Why this may be relevant, given a 5 year outlook?. IMO, the industry is shaping up for an unusual degree of hardening that could surprise to the upside if the capital "suppressants" that have been described eventually revert to the mean or more. I think the best way to make money here will be to invest in new capital ventures that will form opportunistically (ventures that will not have 'legacy' issues and that can set up a robust operating platform). But this comes down to timing the market versus time in the market and an alternative is to invest in companies that will be able to meaningfully grow (absolute and relative market share when the time comes). I happen to think that a lot of policies that have been written in the last few years and that have been associated with reserve releases will ultimately show a reversal of the trend with reserve deficiencies, to an extent that is not appreciated now.

 

The following is potentially interesting (especially figure 17, which can even be more instructive if put in a longer historical perspective). JLT Re has cried wolf for a while underlining that timing may make you look stupid but looking stupid does not necessarily mean that all your arguments are.

https://www.jltre.com/our-insights/publications/viewpoint-reinsurance-cycle/the-economic-cycle

We are truly living through unusual times and I'm glad to be alive.

 

 

[petec]

Cigarbutt, would you put Fairfax in the category of companies that can meaningfully grow market share when the time comes?

[Cigarbutt]

^This was touched upon in reply #34.

To expand slightly, the participation will be conditional on (and proportional to):

1-investment performance (absolute and relative)

If the hard market is exacerbated by an impact on the asset side, FFH will not be spared and in fact may be, compared to peers, more significantly compromised (high equity exposure).

2-operating performance

They would require hardening to outpace the typical reversal recognized in prior years' reserves and significant catastrophe losses would impact their regulatory capital to a significant degree given their reinsurance exposure.

 

Reflecting on recent developments, they don't behave as if they have excess capital and we may be only at the beginning so...

In the past, they have issued equity at prices they didn't like in order to 'benefit' from opportunities and that's a possibility that should be considered.

I'm not a shareholder now (and I may be wrong about that) but remembering the last hardening phase, I was a shareholder and increased ownership significantly in the months that followed an end of year share issue in 2001, during a period when the risk-reward looked better (IMHO).

 

https://s1.q4cdn.com/579586326/files/doc_financials/011103ceo.pdf

see p.3, second to last paragraph, shares issued at 200 CDN

https://s1.q4cdn.com/579586326/files/doc_presentations/2013AGMWebsiteCopy_v001_u6w5x6.pdf

2013 slide presentation, see slide 15

 

Take the above with a grain of salt as I sort of prepared for the US 30-yr bond to reach 1.81% (that's where it is now) but I'm still confused about the significance. I'm mentioning that because, recently, FFH shifted attitude on the fixed income side and expected rates to go up significantly so it's not unreasonable to consider the possibility that they're confused too.

[petec]

All very fair. Only thing I’d add is that they do have capacity, it’s just in the wrong place, at Odyssey, which is not seeing the same hardening (yet). That could change the outlook.

 

What gives you the feeling that reserve releases will be reversed, apart from asbestos?

[Cigarbutt]

^Based on the following  assumptions :

 

-The underwriting cycle is typically associated with such a reversal.

-FFH, even if more conservatively reserved than the median insurer, will tend to follow the industry trends of the typical delayed recognition of the trend reversal (business written that was felt to be profitable when, in fact, it was not).

 

So, this educated guess is based on historical assumptions and maybe this time is different (looking to be convinced otherwise for the industry and for FFH specifically). But if history is any guide, the magnitude of the reversal may be correlated to the unusual softness of the previous leg of the cycle.

How this plays out remains to be defined and one may want to play this actively, opportunistically or whatever.

 

[Viking]

Cigar, thanks for taking the time to post. I am not an insurance expert and find your posts to be helpful :-)

 

I am back on the sideline with Fairfax. Their equity portfolio is getting hit pretty hard.

[Cigarbutt]

^just in case you or others are interested, I came across today a recent report by the Argo Group which may be relevant. The idea is not to suggest that FFH is or will be a mirror image but a parallel can be drawn with the realization that previous business written may not be so profitable after all. Even if Argo's evolving situation walks and quacks like a duck (typical reversal of the reserve pattern), it is possible that the issue is isolated and already remediated but I doubt it. When you see a cockroach...and it potentially reflects (as a leading indicator) an industry-wide cyclical pattern.

 

Argo is domiciled in Bermuda and has grown net premiums written at a very high rate during the last few soft years. Here's what happened to reserve development (unaudited):

in combined ratio %    -unfavorable in (  )

2012  2.8%    2013  2.6%    2014  2.8%    2015  2.3%    2016  2.4%    2017  0.5%    2018  1.0%    2019  (8.0%)

details in 2019, per quarter:    Q1  0.6%    Q2  (5.2%)    Q3  (9.3%)    Q4  (17.9%)

 

Argo shows a pattern that moves slowly and then suddenly and rating agencies are getting agitated, which will likely make it hard for the company to grow profitable business to compensate for the reserve issue.

https://www.reinsurancene.ws/argo-reports-operating-loss-unfavourable-reserve-development/

 

To be clear: IMO, FFH is relatively much better positioned but the wave may be coming and some may be more naked than others.

[Hoodlum]

Cigar, thanks for taking the time to post. I am not an insurance expert and find your posts to be helpful :-)

 

I am back on the sideline with Fairfax. Their equity portfolio is getting hit pretty hard.

 

But shouldn't their bond gains be offsetting this?

[Viking]

I just updated my spreadsheet for tracking Fairfax Equity holdings (attached below). If anyone sees errors in the spreadsheet please let me know :-)

 

From the start of the year (Jan 1) to today (Feb 27) my estimate is their mark to market equity holdings are down $520 million (Eurobank is down $406). I believe they also mark to market the Seaspan warrants; they are down an additional $108 million.

 

The majority of their equity holdings are Associated and Consolidated Equities and I am not sure exactly how all of these are valued on the financial statements at each quarter-end. I like to track what the stock prices are doing to get a handle on how Mr. Market is valuing these holdings over time. These holdings are down $632 million ($740-$108 Seaspan warrants).

 

All three of these items: $520 + $108 + $632 = $1,260. Please note, this is not the hit that Fairfax would take if the quarter ended today; the $632 would not flow through the financials :-)

 

Fairfax is in a very tricky position. They hold a lot of equities in their portfolio. Great with a 'risk-on' trade which is how they have been positioned since Trump was elected. Absolutely brutal position to be in should we get sustained, large stock market sell-off.

 

PS: the portfolio of Fairfax India is actually up nicely since Jan 1 (still even with the global equity sell off). Their holdings are another tab on the spreadsheet. I estimate their mark to market equity holdings are actually up $128 million this year. Pretty interesting :-) 

Fairfax_Equity_Holdings.xlsx

[StubbleJumper]

Cigar, thanks for taking the time to post. I am not an insurance expert and find your posts to be helpful :-)

 

I am back on the sideline with Fairfax. Their equity portfolio is getting hit pretty hard.

 

But shouldn't their bond gains be offsetting this?

 

 

They'll definitely have some bond gains, but they have drastically reduced the duration of the fixed income portfolio over the past couple of years, so gains are muted.  The unfortunate part of the most recent earnings release is that it wasn't accompanied by a full set of financials, but you can at least look to Q3's filings for a bit of inspiration.  At the end of Q3, FFH reported that a 100 bps parallel decline in the yield curve would have resulted in $279m in gains.  Well, bond rates have dropped by more like 40 bps, so the bond gains are probably pretty trivial in the context of the hit to the stock portfolio.

 

 

SJ

[Cigarbutt]

^To add to the pseudo-"hedging" hypothesis mentioned above and to what SJ just described, FFH has substantially changed the duration (since 2016) of their fixed income portfolio with expectations that they would be able to reinvest coupons at higher rates.

 

From their interest rate risk disclosure, with a 100 basis point decrease in interest rates, result in market value of the fixed income portfolio:

2015        928M

2016        125M

2017        161M

2018        290M

Q3 2019  279M

 

Since Jan 1st 2020, the 10-yr Tr. bond has gone down about 65 basis points.

 

Hedging aside, interest rates elevation will require some reversal of fortune and perhaps some Fed cooperation but the Fed, these days, may be more into easing inoculation, not to fight the disease but to numb the pain. (Mr. James Grant compared monetary activism to a virus in 2015; Mr. Grant is sometimes wrong and often early).

[TwoCitiesCapital]

Cigar, thanks for taking the time to post. I am not an insurance expert and find your posts to be helpful :-)

 

I am back on the sideline with Fairfax. Their equity portfolio is getting hit pretty hard.

 

But shouldn't their bond gains be offsetting this?

 

No, because there is very limited duration in their short term portfolio. Short term bonds are up only a few tenths of a percent.

[petec]

I wonder when the share price gets cheap enough to make buybacks a better option than premium growth?

 

Obviously some of the share price fall is to do with falling equity holdings in things like Eurobank and Atlas. But those are big positions FFH can’t realistically add to. If they were comfortable with the value in them 40-50% higher, buybacks are very rational here.

 

My guess is they will stick to premium growth. Also see SJ’s thread for why they may not be able to fund buybacks. Pity.