Comments and Observations about A/R

[StubbleJumper]

 

 

We kicked the ball around a bit when Q4 numbers were released in mid-February.  It's nice to have gotten the A/R to get a more fulsome picture:

 

1) General comments - Nice to see double-digit increases in Net Written and hopefully the pricing environment drives better CRs, but unfortunately the interest rate environment over the coming months does not look favourable.  This was always the risk of the move to a tight duration that was initiated two years ago -- in a rising rate environment, FFH would have come out ahead, but pandemic-phobia is that slightly unexpected grey swan.  The question is how long these silly low rates will last...a poster last week compared them to crack cocaine and I can't really say that I disagree.

 

 

2) International insurance companies - For the second consecutive year, Prem has dedicated a considerable amount of ink to the international insurance companies (see page 6 of the AR).  For a second consecutive year, that all of that ink seems to be an attempt to put a positive spin on a collection of pretty shitty CRs.  And for the second consecutive year I will observe that those subs should be considerably more profitable.  Seriously, if FFH is going to invest capital in banana republics like Columbia or Chile, or in the potential kleptocracies of Eastern Europe the investments should at least be quite obviously profitable.  Much is made about premium growth, but in most cases the CRs are so high that the value of underwriting growth is dubious.  Interestingly enough, unlike last year, FFH did not provide a break down of the international sub profitability this year so it is no longer possible for us to assess whether the investment returns are an adequate enticement to accept this collection of disappointing CRs.  Should we take Prem at his word that these subs are valuable contributors?

 

 

3) Included in the table of international insurance companies was a bit of disclosure about GroupRe, probabably because it is domiciled in the Carribean (again see pages 6 and 7 of the AR).  GroupRe put up a 96 CR, in large part by re-insuring a portion of the other subsidiaries' books of business.  Prem goes on to note that GroupRe has racked up a CR of 88 over the past 5 years by re-insuring portions of the other subs' underwriting.  That's pretty good, but if reinsuring FFH's book is that lucrative, it does call into question whether FFH isn't ceding too much premium to reinsurers (invert, always invert!).  Would an extra $1B of capital scattered amongst the primary subs result in a similar level of profitability?  Obviously you do need some amount of reinsurance, but maybe the current attachment points don't offer particularly good value?

 

 

4) When does Farmers Edge start to make money for FFH? - It has lost about $1.50/sh for each of the past two years (see page 183).  Did this investment ever fall within Prem's circle of competence? 

 

 

5) The Loss Triangles - it was nice to get updated loss triangles because they are essential to better understand what's going on with UW (see page 79 of the AR).  As I have observed on several occasions over the past year, favourable development has been chronically ridiculous, regularly clocking in at 10% of reserves.  All of that came to a screeching halt in 2019, with only $100m of redundancies on $29B of reserves.  The decline has actually been a bit more gradual than it appears, if you strip out the impact of currency translation and getting slapped in the head once again by APH (it's really a "gift" that keeps on giving...how much of the APH liability is related to the TIG and C&F acquisitions?).  Stripping out those two factors, the change in favourable development isn't so bad.  Once again, this year I would note my disappointment about not getting the loss triangles for each of the major subs....somehow I suspect that C&F's is a bit of a shit-show, but we'll never know.

 

 

6) Capital adequacy / underwriting capacity - Prem trotted out his usual bravado about FFH's financial position being rock solid (see page 20 of the AR), but I'm not sure that I like everything that I see.  The holdco is down to about $1.1B in cash, so it will need a fair infusion of divvies from the subs during 2020.  On page 95 of the AR, the dividend capacity of the major subs is depicted and the lion's share is found in Allied World and ORH.  It is quite likely that the holdco will need to draw at least some divvies from NB, Brit and C&F during 2020.  However, on page 195 of the AR underwriting capacity is described through a table which displays the existing premiums to statutory capital ratios.  C&F, NB and Brit still have room to grow their book, but it would be disappointing if FFH were forced to draw $200m or more of divvies from those subs during 2020.  It has been years since I have fussed about the holdco's liquidity and prepared a cash sources-uses analysis, and I really hope we are not headed back into that world.  There will be cash coming down the pipe shortly from the Riverstone sale, and there will be cash used to buy up some of the minority stakes in 2020, but let's just say that Toronto and Omaha have different preoccupations when it comes to the cash balances.

 

 

7) Drawing on the revolver - continuing from the previous observations on capital adequacy, I found it interesting that FFH drew $300m on its revolver in Q1 (see page 88 of the AR).  I expressed a bit of bemusement when FFH renegotiated a $2B revolver 2 years ago when the holdco was swimming in cash, but observed that the best time to obtain revolving credit is probably a time that you don't really need it.  But, why did they draw the $300m and is it the plan to continue to draw on that revolver rather than to dividend money up to the holdco? 

 

 

8) Euro denominated debt - It's neither here nor there, but I found it a bit strange that Prem dedicated some ink to the fact that FFH issued Euro denominated debt (see page 20 of the AR).  It makes perfect sense to issue some Euro notes as a hedge if you expect to have Euro denominated income.  But it seems a bit strange that notes for 750m Euros would merit mention, particularly when FFH had French Franc denominated notes decades ago.

 

 

9) Legacy debt interest rates - it's nothing new, but while reading the financials I always look at the note about historical debt issuance (page 86 of the AR).  Zenith still has debentures on their books that mature in 2028 at a 8.55% interest rate and the holdco has notes outstanding at 8.40% interest.  It's amazing how much the operating environment has changed!  If you floated debt at 5% today, we would say that you had gotten scalped!

 

 

10) What caused pension assets flop in 2019? - On page 97 of the AR the financial situation of the pension plan is depicted.  The fair value of pension plan assets declined from $727m to $606m during 2019.  That's only $4 or $5 per share, but what the hell is going here?  How did FFH manage to register a decline in the value of pension assets during 2019?  Were there *any* asset classes that declined in 2019?  Seriously, Prem's dog could have chosen a portfolio of stocks and bonds by shitting on the investment pages of the newspaper and those securities would likely have registered a gain in 2019.

 

 

11) Is FFH reaching for yield? - On page 109 of the AR, fixed income ratings are depicted.  In 2019, 66% of fixed income was rated A level or higher, while in 2018 74% of fixed income was A or higher.  Some of this was due to moving from fixed income to cash, but there does seem to be a bit of a move down the credit quality scale.  IMO, this is not the time to reach for yield because you really don't get paid to take on the credit risk.

 

 

12) What the hell is going on with duration? - On page 114 of the AR, the interest rate sensitivity chart is about our only insight on the duration of the fixed income portfolio.  What is going on here?  There is an asymmetric impact of interest rate changes.  A 200bp increase wacks the FI portfolio by $463m, but a 200bp decrease is a $696m gain. 

 

 

13) More adverse development from Allied (see page 174 of the AR): Are there still more skeletons in the closet, or what is going on here?

 

 

Anyway, that's my stream of consciousness.

 

 

SJ

 

[petec]

And a very useful stream of consciousness it is, too.

 

I can’t read the AR properly until next week so I can’t comment on much, but I would politely suggest that you educate yourself a bit before referring to Chile and Colombia as banana republics. I spend a lot of time in both countries and am currently in Chile. They have their faults but neither is a banana republic. Both grow consistently, have fiscal deficit rules unseen in the developed world, have reasonably low levels of debt, are functioning democracies with strengthening institutions, and have independent central banks that don’t resort to panic rate cuts every time the stock market falls 5% or the president sends a tweet.

 

Sorry for the rant ;)

[StubbleJumper]

I would politely suggest that you educate yourself a bit before referring to Chile and Colombia as banana republics. I spend a lot of time in both countries and am currently in Chile. They have their faults but neither is a banana republic. Both grow consistently, have fiscal deficit rules unseen in the developed world, have reasonably low levels of debt, are functioning democracies with strengthening institutions, and have independent central banks that don’t report to panic rate cuts every time the stock market falls 5% or the president sends a tweet.

 

Sorry for the rant ;)

 

 

I referred to them as "shit-holes" last year, so I didn't want to be repetitive.  :D

[maxthetrade]

If I only could get a dollar for each exclamation mark in the letter this would be a fantastic investment ;)

[petec]

I would politely suggest that you educate yourself a bit before referring to Chile and Colombia as banana republics. I spend a lot of time in both countries and am currently in Chile. They have their faults but neither is a banana republic. Both grow consistently, have fiscal deficit rules unseen in the developed world, have reasonably low levels of debt, are functioning democracies with strengthening institutions, and have independent central banks that don’t report to panic rate cuts every time the stock market falls 5% or the president sends a tweet.

 

Sorry for the rant ;)

 

 

I referred to them as "shit-holes" last year, so I didn't want to be repetitive.  :D

 

Ha ha ok you win ;)

 

Btw my view on the international subs is that they’re options. If one turns into anything like another First Capital or ICICI Lombard we’re doing ok. If I had to bet I’d say it will be Brazil - the operation seems to be on track and it’s in a top ten world economy on the verge of liftoff. Eurolife is valuable but I don’t know how much it can grow. And Digit is shaping up to be a home run although since they don’t consolidate it I assume it’s not one of the companies you’re talking about. (Even if it isn’t, it’s important because many of the lessons learned via Digit may be applicable elsewhere.)

 

It’s also worth remembering that insurance is hugely underpenetrated in many of these countries and multiples of book in the private markets are high.

 

[petec]

SJ why do you think the holdco needs dividends from the less well-capitalised subs )Crum, Brit etc.)?

[StubbleJumper]

SJ why do you think the holdco needs dividends from the less well-capitalised subs )Crum, Brit etc.)?

 

Frankly, I don't know how the holdco will finance its activities in 2020.  Working from memory, it's been a decade or so since FFH published an unconsolidated holdco income statement, so we don't have much visibility on what they are doing.  But, short of going back to the old sources-uses analysis, this is what I think we know:

 

Sources:

-the revolver and whatever new debt FFH might float ~$2B

-Riverstone proceeds ~$600m

-subsidiary dividends (see page 95 of the AR for capacity)

-management fees (Fairfax India, Africa, and whatever Hamblin Watsa gets for managing the subs' portfolios)

-interest and divvies on the holdco's $1.1B balance (less than $50m?)

-divvies (if any) from non insurance companies (zero?)

-tax loss carry-forwards (zero?)

 

 

Uses:

-Common and pref divvies ~ $300m

-Holdco interest payments = $4.1B debt x weighted interest rate = ~$250m

-Operating expenses

-purchase of minority stakes (Brit ~$100m, Allied in next 3 or 4 years ~$1.5B)

-stock buybacks (zero?)

 

 

 

So, how does it shake out?  My take is that the holdco needs at least $700m in 2020.  They've taken $300 from the revolver and are getting $600 for Riverstone.  Is that how the year shakes out?  If they want to pay back the revolver then they likely need some divvies from the subs.  ORH has some cash, Allied has some cash....but if you need $500m from the subs, you'd need to draw from the less capitalized subs (in actual fact, they took a divvy from C&F in 2019, but then they injected an offsetting capital investment...not sure I understand that).

 

This was all much clearer when they published a hold co income statement.  But, then again, those were the bad old days.

 

 

SJ

[petec]

If they want to pay back the revolver in 2020 then I agree. But why would they? They’ve always talked about cash at the holdco in absolute terms, not net terms. My guess is they set up the big revolver for exactly this eventuality and they’re happy levering the holdco at the start of a hard market. Absent the Allied minority buy-in, which doesn’t have to happen soon, one could argue they’re really quite liquid.

[StubbleJumper]

If they want to pay back the revolver in 2020 then I agree. But why would they? They’ve always talked about cash at the holdco in absolute terms, not net terms. My guess is they set up the big revolver for exactly this eventuality and they’re happy levering the holdco at the start of a hard market. Absent the Allied minority buy-in, which doesn’t have to happen soon, one could argue they’re really quite liquid.

 

 

Oh, there are lots of options available.  That;s not really the issue.

 

The increase in the debt load over the past couple of years, the sale of part of Riverstone and drawing on the revolver are all things that make me raise my eyebrows.  I have commented previously on the quality of earnings in 2018 and 2019 which reflect that value has been created over the past 5 or 6 years, but has not really generated distributable cash.  What happened to the song and dance from a couple of years ago that the insurance side of the business was adequately built, the acquisitions were done, and reducing the share count was the way forward?  Fast forward a couple of years, and now FFH is reliant on operating credit in the form of a revolver, they are selling the crown jewels (okay, mild exaggeration!), and they seem to be challenged to fully exploit a hardening market.  It will all probably work out just fine, but there's a bit of a history here.

 

 

SJ

 

 

SJ

[petec]

I broadly agree. The share buyback doesn’t make me scratch my head because I always read that as a long term thing. Riverstone UK does a little - not sure why it’s better placed to grow with OMERS as a partner, which is what Prem says - but that negative is offset by my surprise at how much it’s worth and we have to consider the possibility that the motivation for the deal may simply have been to surface value and get the BV mark.

 

But what does really piss me off is that Prem keeps banging on about how well capitalized the subs are while not mentioning that they had to squirt equity into some of them during the year. Just feels like a lie.

[StubbleJumper]

I broadly agree. The share buyback doesn’t make me scratch my head because I always read that as a long term thing. Riverstone UK does a little - not sure why it’s better placed to grow with OMERS as a partner, which is what Prem says - but that negative is offset by my surprise at how much it’s worth and we have to consider the possibility that the motivation for the deal may simply have been to surface value and get the BV mark.

 

But what does really piss me off is that Prem keeps banging on about how well capitalized the subs are while not mentioning that they had to squirt equity into some of them during the year. Just feels like a lie.

 

 

 

My take is that they sold Riverstone because they needed the cash, and even when added to the divvies from the subs, the $560m that they are getting probably won't be enough to fund the holdco's activities for 2020.  So, until they float a debt offering, they seem to be reliant on that revolver -- IMO, it is not a great idea to have your operations reliant on operating credit because usually it is accompanied by 25 pages of covenants which means that your operating credit can get pulled if something weird happens (ie, debt:equity soars due to stock market crash or asset write-downs, EBITDA drys up for some reason, etc).  A large revolver is a nice tool to keep around for emergencies or to opportunistically exploit opportunities (ie, suddenly buy a $1B sub or buy $1B of convertible notes on short notice).  But, once you draw on it, the preferred approach would be to replace it by floating a bond issue to obtain long term funds for which the indentures are less restrictive than the 25 pages of revolver covenants.

 

My point about the buybacks was about both tone and strategic direction.  Pull up the annual letter from March 2018 and read it again.  There's the usual rah-rah, we're awesome, and more than a few humble-brags.  But the message was that the masterpiece was pretty much painted, the acquisitions were about done and buybacks would be the way forward -- heavens, Prem even had the temerity to trot out Henry Singleton's name, as if to suggest that FFH would initiate a long-term process to buy back ~90% of its shares!  In that letter, he shared the usual "Financial Position" Table, but for the first time that I can recall he gave us the song and dance about dividing the insurance companies from the non-insurance companies and differentiating the debt by claiming that the non-insurance debt is non-recourse, so somehow that made it okay (more on that later).  But, take a look at that same table from Friday night.  Using Prem's mental accounts approach, compare the Net debt/Equity Ratio from two years ago to that from Friday.  That ratio has risen from 16% to 25.5%.  Seriously, pull up the those two letters and read them in succession and tell me that you are not left scratching your head. 

 

So the announced strategy in 2018 was to temper growth through external acquisitions, solidify the balance sheet, and return capital to shareholders through buybacks, but what we instead saw was injections of capital into Toys R Us, Carillon, AGT, Stelco, Fairfax Africa, Seaspan, etc, in addition to the expected investment in Brit (at least the Brit injection was consistent with the announced direction).  From the outside it is difficult to assess where they sourced the cash for those moves -- it could have been subsidiary cash or it could have been holdco cash, but it doesn't really matter.  The fact of the matter is that Prem's behaviour as a serial acquirer does not seem to have changed one whit, and FFH has continued on a debt-financed growth spree for the past two years.

 

This is, unfortunately, a little reminiscent of the past.  Debt-financed growth is great when it works and disastrous when it doesn't.  Prem's protestations about non-insurance debt being non-recourse are not re-assuring.  At least in '03 or '04 he postured-up and publicly declared that ORH debt was FFH debt and it would be managed and treated as such, irrespective of whether ORH and the other FFH subs were cross-collateralized.  Now we have this strange weasle-ish notion that FFH would walk away from a troubled non-insurance sub, so we don't need to bother counting that debt.  But, on that, I call bullshit.  If FFH ever walks away from any debt, insurance or non-insurance, who the hell would ever trust them to honour an insurance policy?  It's *all* FFH debt, irrespective of whether it is cross-collateralized, full-stop.

 

So, yes, I am just a little bit uncomfortable that quality of earnings has been dubious for the past two or three years, debt has grown, some of the subs seem to be capital constrained, a portion of Riverstone is being sold despite Prem's assertion from two years ago and this year that it is an excellent vehicle for organic growth, and FFH seems to be using operating credit at the holdco.  Does this seem like well planned implementation of strategy to you?  It strikes me as a bit of a chaotic and ad hoc approach to managing a $70B enterprise.  We've been here before.

 

 

SJ

[ValueMaven]

Trading at x0.78 of BV?  What am I missing? 

 

 

[Cigarbutt]

...

5) The Loss Triangles - it was nice to get updated loss triangles because they are essential to better understand what's going on with UW (see page 79 of the AR).  As I have observed on several occasions over the past year, favourable development has been chronically ridiculous, regularly clocking in at 10% of reserves.  All of that came to a screeching halt in 2019, with only $100m of redundancies on $29B of reserves.  The decline has actually been a bit more gradual than it appears, if you strip out the impact of currency translation and getting slapped in the head once again by APH (it's really a "gift" that keeps on giving...how much of the APH liability is related to the TIG and C&F acquisitions?).  Stripping out those two factors, the change in favourable development isn't so bad.  Once again, this year I would note my disappointment about not getting the loss triangles for each of the major subs....somehow I suspect that C&F's is a bit of a shit-show, but we'll never know.

...

SJ

Thank you for the salient points. Below are some thoughts on reserves.

Reviewing the annual report is a reminder of how FFH has built amazing zones of strength while keeping areas of vulnerability. I guess that's why the stock is hard to handicap, especially at this juncture.

Insurance and reinsurance remains the backbone of the business.

 

Favourable loss reserve development (2010-2018, without the currency effect)

336.9  432.1  1,136.9  1,383.7  1,429.0  1,549.3  907.0  608.2  166.0

FFH does not disclose that but it’s possible to reconstruct year by year development for each calendar year business. A potential problem is the embedded currency effect which was quite positive in the 2018 annual report (2017 reserves column listed below).

The following is unaudited:

Reserve development (numbers in (    ) are unfavorable, as reported end of year+1)

                2016    2017    2018

2013        74.3      45.0      3.5

2014        175.9    91.4    25.9

2015        40.5    296.0  144.1

2016      (69.8 )    67.2    18.6

2017                    483.2  (37.3)

2018                                84.7

 

-The trend is variable but down.

-The 2017 reversal is significant.

It’s conceivable that FFH reports net negative adverse development as early as next year..

 

@ValueMaven

With marked-to-market rules and perhaps a transitional new normal for volatility, book value may be a moving target.

[StubbleJumper]

...

5) The Loss Triangles - it was nice to get updated loss triangles because they are essential to better understand what's going on with UW (see page 79 of the AR).  As I have observed on several occasions over the past year, favourable development has been chronically ridiculous, regularly clocking in at 10% of reserves.  All of that came to a screeching halt in 2019, with only $100m of redundancies on $29B of reserves.  The decline has actually been a bit more gradual than it appears, if you strip out the impact of currency translation and getting slapped in the head once again by APH (it's really a "gift" that keeps on giving...how much of the APH liability is related to the TIG and C&F acquisitions?).  Stripping out those two factors, the change in favourable development isn't so bad.  Once again, this year I would note my disappointment about not getting the loss triangles for each of the major subs....somehow I suspect that C&F's is a bit of a shit-show, but we'll never know.

...

SJ

Thank you for the salient points. Below are some thoughts on reserves.

Reviewing the annual report is a reminder of how FFH has built amazing zones of strength while keeping areas of vulnerability. I guess that's why the stock is hard to handicap, especially at this juncture.

Insurance and reinsurance remains the backbone of the business.

 

Favourable loss reserve development (2010-2018, without the currency effect)

336.9  432.1  1,136.9  1,383.7  1,429.0  1,549.3  907.0  608.2  166.0

FFH does not disclose that but it’s possible to reconstruct year by year development for each calendar year business. A potential problem is the embedded currency effect which was quite positive in the 2018 annual report (2017 reserves column listed below).

The following is unaudited:

Reserve development (numbers in (    ) are unfavorable, as reported end of year+1)

                2016    2017    2018

2013        74.3      45.0      3.5

2014        175.9    91.4    25.9

2015        40.5    296.0  144.1

2016      (69.8 )    67.2    18.6

2017                    483.2  (37.3)

2018                                84.7

 

-The trend is variable but down.

-The 2017 reversal is significant.

It’s conceivable that FFH reports net negative adverse development as early as next year..

 

@ValueMaven

With marked-to-market rules and perhaps a transitional new normal for volatility, book value may be a moving target.

 

Thanks for the accident year transposition.  I hope your concern about 2017 and onward is wrong.  FFH has gone from providing copious detail about reserve development to providing very little.  I guess that's one of the challenges of reporting on such a large enterprise.  If you don't want a 1,000 page AR, you need to chop some material.

 

 

SJ

[petec]

Trading at x0.78 of BV?  What am I missing?

 

The fact that BV has dropped a lot - check out the Eurobank and Atlas Holdings share prices.

 

Now, those stocks are cheap so plenty of value has opened up. But it’s arguably in the holdings, not Fairfax.

[TwoCitiesCapital]

Trading at x0.78 of BV?  What am I missing?

 

The fact that BV has dropped a lot - check out the Eurobank and Atlas Holdings share prices.

 

Now, those stocks are cheap so plenty of value has opened up. But it’s arguably in the holdings, not Fairfax.

 

And that interest rates are below 1% all the way down the curve meaning getting a 10-15% ROE is a pipe-dream unless if the insurance markets just go gangbusters.

[petec]

Trading at x0.78 of BV?  What am I missing?

 

The fact that BV has dropped a lot - check out the Eurobank and Atlas Holdings share prices.

 

Now, those stocks are cheap so plenty of value has opened up. But it’s arguably in the holdings, not Fairfax.

 

And that interest rates are below 1% all the way down the curve meaning getting a 10-15% ROE is a pipe-dream unless if the insurance markets just go gangbusters.

 

Agreed. Although *arguably* one ought to be looking at the ROE/risk free rate spread when valuing a stock.

[jfan]

Just a simple question:

 

1) When determining the statutory surplus, is it almost equivalent to Common shareholder's equity + preferred shares + minority interest?

 

Just a simple observation:

 

Referring to their annual report's total return on investment portfolio footnote, it appears that they under-perform their 7% investment return hurdle rate 39% of the time over the past 33 years.

 

If that is true, that means under-performing 5 years in a row, would put it at less than a 1% probability.

[TwoCitiesCapital]

Trading at x0.78 of BV?  What am I missing?

 

The fact that BV has dropped a lot - check out the Eurobank and Atlas Holdings share prices.

 

Now, those stocks are cheap so plenty of value has opened up. But it’s arguably in the holdings, not Fairfax.

 

And that interest rates are below 1% all the way down the curve meaning getting a 10-15% ROE is a pipe-dream unless if the insurance markets just go gangbusters.

 

Agreed. Although *arguably* one ought to be looking at the ROE/risk free rate spread when valuing a stock.

 

I think that makes sense in theory, but in practice the swings in the "risk free rate" are far too volatile to be basing my values off of.

 

I don't think the actual values of companies have swing as dramatically upward as the 10-year going from 3.25% down to 0.3% might imply. Nor do I think those same companies lose dramatic value if it goes back to 3.25% in the next 18-24 months. Even using Fed funds rate instead, pretty dramatic swings.

 

So either an absolute rate of return or some longer-term moving average need to be used as your risk free rate.

 

Also, I'd say the swings with Fairfax should be more muted relative to the risk free rate as well given its future earnings are somewhat counter-cyclical (i.e. interest earnings dramatically increase as your discount rate is rising offsetting some of the impact. Vice versa as rates are falling).

[Cigarbutt]

Just a simple question:

 

1) When determining the statutory surplus, is it almost equivalent to Common shareholder's equity + preferred shares + minority interest?

 

2) Just a simple observation:

 

Referring to their annual report's total return on investment portfolio footnote, it appears that they under-perform their 7% investment return hurdle rate 39% of the time over the past 33 years.

 

If that is true, that means under-performing 5 years in a row, would put it at less than a 1% probability.

For 1), statutory surplus is determined by state regulators who typically use a risk-based capital framework (similar to banks) to reduce the value of certain elements (and increase the margin of safety for the policyholder) of the balance sheet, as reported. The discounts vary and depend on the perceived level of risk. FWIW, I've been looking at a few insurers who carry a heavy load of BBB rated corporate bonds (not the case for FFH). An interesting feature is that, in the event of a recession, on top of the decrease in market value for the bonds, surplus capital gets a double whammy because the discount factor is higher for downgraded securities.

For 2), your statistical appreciation of forward returns is interesting and is in line with the idea of reversion to the mean, which has been a significant long-term feature at Fairfax (investment strategy, seven lean years analogy etc) but I wonder if such an approach is satisfactory on a forward basis as the investing environment has changed and the Fairfax investment recipe has been changing (some aspects dramatically so) so the future may not be correlated to the past. I think I read you're an MD and the following statistical "joke" came to mind when reading your post. There's this surgeon who comes to the patient waiting to be rolled in and explains that the death risk with the procedure is 1 in 2 but that the patient should not worry because the previous patient did not make it.

 

[petec]

Now we have this strange weasle-ish notion that FFH would walk away from a troubled non-insurance sub, so we don't need to bother counting that debt.  But, on that, I call bullshit.  If FFH ever walks away from any debt, insurance or non-insurance, who the hell would ever trust them to honour an insurance policy?  It's *all* FFH debt, irrespective of whether it is cross-collateralized, full-stop.

 

I keep meaning to come back to this thread and read/reply properly, but life and markets are getting in the way. But I have been thinking about this part and would make two observations:

 

1) The trust of insurance customers in FFH has survived far worse than having an AGT, or a Mosaic, or any of the myriad other organisations that end up consolidated on FFH's BS, default on its debt due to a localised issue. It is entirely reasonable to talk about non-recourse debt.

 

2) Whether it is important for investors or clients may not be the point. It's likely to be important for ratings agencies.

 

 

[StubbleJumper]

Now we have this strange weasle-ish notion that FFH would walk away from a troubled non-insurance sub, so we don't need to bother counting that debt.  But, on that, I call bullshit.  If FFH ever walks away from any debt, insurance or non-insurance, who the hell would ever trust them to honour an insurance policy?  It's *all* FFH debt, irrespective of whether it is cross-collateralized, full-stop.

 

I keep meaning to come back to this thread and read/reply properly, but life and markets are getting in the way. But I have been thinking about this part and would make two observations:

 

1) The trust of insurance customers in FFH has survived far worse than having an AGT, or a Mosaic, or any of the myriad other organisations that end up consolidated on FFH's BS, default on its debt due to a localised issue. It is entirely reasonable to talk about non-recourse debt.

 

2) Whether it is important for investors or clients may not be the point. It's likely to be important for ratings agencies.

 

 

We will have to agree to disagree.

 

 

SJ

[petec]

Now we have this strange weasle-ish notion that FFH would walk away from a troubled non-insurance sub, so we don't need to bother counting that debt.  But, on that, I call bullshit.  If FFH ever walks away from any debt, insurance or non-insurance, who the hell would ever trust them to honour an insurance policy?  It's *all* FFH debt, irrespective of whether it is cross-collateralized, full-stop.

 

I keep meaning to come back to this thread and read/reply properly, but life and markets are getting in the way. But I have been thinking about this part and would make two observations:

 

1) The trust of insurance customers in FFH has survived far worse than having an AGT, or a Mosaic, or any of the myriad other organisations that end up consolidated on FFH's BS, default on its debt due to a localised issue. It is entirely reasonable to talk about non-recourse debt.

 

2) Whether it is important for investors or clients may not be the point. It's likely to be important for ratings agencies.

 

 

We will have to agree to disagree.

 

 

SJ

 

What, twice in a day? ;)

[jfan]

Just a simple question:

 

1) When determining the statutory surplus, is it almost equivalent to Common shareholder's equity + preferred shares + minority interest?

 

2) Just a simple observation:

 

Referring to their annual report's total return on investment portfolio footnote, it appears that they under-perform their 7% investment return hurdle rate 39% of the time over the past 33 years.

 

If that is true, that means under-performing 5 years in a row, would put it at less than a 1% probability.

For 1), statutory surplus is determined by state regulators who typically use a risk-based capital framework (similar to banks) to reduce the value of certain elements (and increase the margin of safety for the policyholder) of the balance sheet, as reported. The discounts vary and depend on the perceived level of risk. FWIW, I've been looking at a few insurers who carry a heavy load of BBB rated corporate bonds (not the case for FFH). An interesting feature is that, in the event of a recession, on top of the decrease in market value for the bonds, surplus capital gets a double whammy because the discount factor is higher for downgraded securities.

For 2), your statistical appreciation of forward returns is interesting and is in line with the idea of reversion to the mean, which has been a significant long-term feature at Fairfax (investment strategy, seven lean years analogy etc) but I wonder if such an approach is satisfactory on a forward basis as the investing environment has changed and the Fairfax investment recipe has been changing (some aspects dramatically so) so the future may not be correlated to the past. I think I read you're an MD and the following statistical "joke" came to mind when reading your post. There's this surgeon who comes to the patient waiting to be rolled in and explains that the death risk with the procedure is 1 in 2 but that the patient should not worry because the previous patient did not make it.

 

Thanks For the detailed response.

 

You are absolutely right if the underlying people, processes,  and investing environmental context change then the underlying distribution will change and the mean reversion effect may not happen.

 

I love the joke, as most physicians have no or little statistical training/understanding despite three decades of evidence based medicine.

 

I guess the meta question is “has hamblin watsa adapted to the environment and learned from its mistakes. Is their devil’S advocacy before investment commitment as a effective as they think it is?” That the distribution of investment outcomes is something other than 60-40 for 7%? With so many interacting variables involving a biological system, I guess this question may be impossible to estimate with any precision. We know their value principles but how about their learning and leadership principles. Certainly it appears there are a number of individuals that no longer think they have the adaptability moving forward to make decent investment returns.

 

But everything has its price in the market and there is an argument that the past is a sunk cost and all that matters is future behaviour.

 

Ps

You might enjoy this randomized control trial from the British journal of medicine

 

https://www.bmj.com/content/363/bmj.k5094

 

 

 

 

 

[TwoCitiesCapital]

Just a simple question:

 

1) When determining the statutory surplus, is it almost equivalent to Common shareholder's equity + preferred shares + minority interest?

 

2) Just a simple observation:

 

Referring to their annual report's total return on investment portfolio footnote, it appears that they under-perform their 7% investment return hurdle rate 39% of the time over the past 33 years.

 

If that is true, that means under-performing 5 years in a row, would put it at less than a 1% probability.

For 1), statutory surplus is determined by state regulators who typically use a risk-based capital framework (similar to banks) to reduce the value of certain elements (and increase the margin of safety for the policyholder) of the balance sheet, as reported. The discounts vary and depend on the perceived level of risk. FWIW, I've been looking at a few insurers who carry a heavy load of BBB rated corporate bonds (not the case for FFH). An interesting feature is that, in the event of a recession, on top of the decrease in market value for the bonds, surplus capital gets a double whammy because the discount factor is higher for downgraded securities.

For 2), your statistical appreciation of forward returns is interesting and is in line with the idea of reversion to the mean, which has been a significant long-term feature at Fairfax (investment strategy, seven lean years analogy etc) but I wonder if such an approach is satisfactory on a forward basis as the investing environment has changed and the Fairfax investment recipe has been changing (some aspects dramatically so) so the future may not be correlated to the past. I think I read you're an MD and the following statistical "joke" came to mind when reading your post. There's this surgeon who comes to the patient waiting to be rolled in and explains that the death risk with the procedure is 1 in 2 but that the patient should not worry because the previous patient did not make it.

 

Thanks For the detailed response.

 

You are absolutely right if the underlying people, processes,  and investing environmental context change then the underlying distribution will change and the mean reversion effect may not happen.

 

I love the joke, as most physicians have no or little statistical training/understanding despite three decades of evidence based medicine.

 

I guess the meta question is “has hamblin watsa adapted to the environment and learned from its mistakes. Is their devil’S advocacy before investment commitment as a effective as they think it is?” That the distribution of investment outcomes is something other than 60-40 for 7%? With so many interacting variables involving a biological system, I guess this question may be impossible to estimate with any precision. We know their value principles but how about their learning and leadership principles. Certainly it appears there are a number of individuals that no longer think they have the adaptability moving forward to make decent investment returns.

 

But everything has its price in the market and there is an argument that the past is a sunk cost and all that matters is future behaviour.

 

Ps

You might enjoy this randomized control trial from the British journal of medicine

 

https://www.bmj.com/content/363/bmj.k5094

 

I don't think they have and whether it's a good thing or a bar thing is up to you to decide. They have decades of making macro calls and decades where it served them well.

 

To expect that they'll stop just because 2011-2016 didn't work out for them seems naive. I also made the point in 2016 that them dumping all duration following Trump's presidency was just another macro call.

 

I believe macro calls will continue to be made in the future and shareholder results dependent largely on the success of those calls.