Q1 2024

[glider3834]

just a thought I had on total return swap (TRS) on 1.964M shares, even though Fairfax has kept TRS on the same quantity of shares as 3 years ago, its now based on 8.6% of FFH shares effectively outstanding up from 7.5% around 3 years ago, due to buybacks reducing share count from 26.04M (1Q21) to 22.83M(1Q24)

 

 

 

 

 

 

 

 

 

 

Edited May 6 by glider3834

[Cigarbutt]

On 5/3/2024 at 9:25 PM, nwoodman said:

Just got done listening to the CC.  Great notes above by all. A couple of things that caught my attention

...

3.  A shame that the last question got cut off on the amount that could be reallocated from bonds to equities in a market sell off. It would be nice to get an idea of the number.  They have been pretty clear that it would be a move from treasuries to corporate debt but any further capacity for equities would have been an interesting insight.

There are many ways to guess and each market transition comes with its own flavor.

Using some kind of float coverage ratio concept, one could come up with a theoretical "number".

Using cash and fixed income float portfolio over insurances float reserves, for example, for BRK, the ratio was 106% at end of 2023 and 112% at end of Q1 2024. During various opportunistic times in the past, this coverage ratio for BRK went slightly below 100%, even close to 90% for relatively short periods. For FFH, this ratio (slightly apples to oranges comparison with the mentioned ratio in this post, slightly overestimating the FFH coverage) was 131% at end of 2021, 127% at end 2022 and 130% at end 2023. In theory, FFH could sell about 25% of its bond portfolio in order to buy any assets (including equities).

-----

Yogi Berra said (apparently) that, in theory, there is no difference between theory and practice but, in practice, there is. Mike Tyson also had a similar theory related to what could be done when punched in the face.

-----

So, in practice, the limiting factors would be coming from regulators and from rating agencies. In a downturn, many present equity and equity-like holdings held by FFH would go down also and regulators would apply a risk-based capital haircut to risky assets (held and to be acquired). For the rating agency, using Fitch as an example who recently released an update, at end of 2023, the risky assets ratio is already at 85%. In a downturn, even absent any "tactical" asset allocation move by FFH, this ratio would tend to go up...towards BBB which makes it uncomfortable to write new insurance business..

Fitch Revises Fairfax's Outlook to Positive; Affirms Ratings (fitchratings.com)

Fitch uses (and publishes) a relevant table:

FFH has been known to be unusually creative during transitions (in the spectrum from survival to capacity to benefit from opportunities) but (opinion) the capacity to move float funds from fixed income to equity would be limited, much much less than 25% of their fixed income portfolio.

[nwoodman]

Thanks @Cigarbutt

 

 

That was very helpful to kickstart my thinking.  Ultimately the management at FFH has their arms fully around this. However it prompted me to give your numbers a revisit  and also do some quick and dirty numbers of my own

 

Key point

Statutory requirements for insurance companies typically include risk-based capital (RBC) ratios, which measure an insurer's capital adequacy relative to its risk profile. In the United States, the National Association of Insurance Commissioners (NAIC) recommends a minimum RBC ratio of 200%. In Canada, the Office of the Superintendent of Financial Institutions (OSFI) requires a minimum Minimum Capital Test (MCT) ratio of 150%.

Assuming Fairfax maintains a conservative RBC ratio well above the minimum requirements (e.g., 300% or higher), the company might have some flexibility to reallocate a portion of its bond portfolio to equities during a market sell-off. However, the exact amount would depend on various factors, such as:

1. The overall capital position and RBC ratios of Fairfax's insurance subsidiaries
2. The liquidity and credit quality of the bond portfolio
3. The expected impact of the reallocation on the company's risk profile and capital adequacy
4. Regulatory restrictions and approval from the relevant insurance regulators

 

Rerunning your numbers - we must be calculating different things

 

Using the ratio of the company's cash and fixed income float portfolio over its insurance float reserves as a proxy for the Minimum Capital Test (MCT) ratio is an interesting approach, but it has some limitations and may not provide a fully accurate representation of the company's capital adequacy.

The insurance float represents the funds generated by insurance operations that an insurer can invest until claims are paid out. Fairfax's float primarily consists of the following components:

1. Insurance contract liabilities: $45,918.1 million as of March 31, 2024
2. Insurance contract payables: $1,065.0 million as of March 31, 2024

The cash and fixed income float portfolio includes:

1. Holding company cash and investments: $2,496.4 million as of March 31, 2024
2. Subsidiary cash and short-term investments: $7,801.6 million as of March 31, 2024
3. Bonds: $36,131.2 million as of March 31, 2024

 

Calculating the ratio:

(Cash and Fixed Income Float Portfolio) / (Insurance Float Reserves) = ($2,496.4 million + $7,801.6 million + $36,131.2 million) / ($45,918.1 million + $1,065.0 million) = $46,429.2 million / $46,983.1 million = 0.99

This ratio of 0.99 suggests that Fairfax's cash and fixed income float portfolio is nearly sufficient to cover its insurance float reserves. However, it's important to note that this ratio does not fully capture the company's capital adequacy for several reasons:

1. It does not consider other types of investments, such as preferred stocks, common stocks, and investments in associates, which may also be used to support insurance liabilities.
2. It does not account for the risk characteristics of the assets and liabilities, which are a key component of the MCT ratio calculation.
3. It does not include other components of the MCT ratio, such as available capital, surplus allowance, and eligible deposits.
4. It does not reflect the specific regulatory requirements and risk factors used in the MCT ratio calculation.

 

While this ratio provides a simplified view of Fairfax's ability to cover its insurance float reserves with liquid assets, it should not be considered a substitute for the more comprehensive MCT ratio. The MCT ratio is a risk-based capital adequacy measure that considers a wider range of factors and is specifically designed for property and casualty insurance companies in Canada.

 

In summary, while the ratio of cash and fixed income float portfolio over insurance float reserves can provide some insight into Fairfax's liquidity and ability to cover its insurance liabilities, it is not a perfect proxy for the MCT ratio, which is a more comprehensive and risk-based measure of capital adequacy.

 

Taking a stab at MCT

 

I take it MCT and RBC are actually confidential.  Makes sense you don’t want to be giving your opposition a leg up in terms of capacity to write.  

 

However upper level (and treat the numbers with contempt)

 

To calculate Fairfax's Minimum Capital Test (MCT) ratio based on the asset classes detailed in the Q1 2024 report, we will make assumptions about the risk factors associated with each asset class. Please note that these assumptions are for illustrative purposes only and may not reflect the actual risk factors used by Fairfax or its regulators.

 

Assumptions:

1. Available Capital: We will assume that Fairfax's available capital is approximately 70% of its total equity.
2. Minimum Capital Required (Risk Factors): a. Cash and cash equivalents: 0% risk factor b. Short-term investments: 1% risk factor c. Bonds: 3% risk factor (assuming a mix of high-quality government and corporate bonds) d. Preferred stocks: 15% risk factor e. Common stocks: 20% risk factor f. Investments in associates: 30% risk factor (assuming illiquid investments) g. Derivatives and other invested assets: 10% risk factor h. Insurance risk: 20% of net premiums written

 

Calculation:

Step 1: Estimate Available Capital Total Equity as of March 31, 2024: $27,643.5 million Assumed Available Capital = 70% × $27,643.5 million = $19,350.5 million

 

Step 2: Estimate Minimum Capital Required

 

a. Cash and cash equivalents: $7,023.2 million × 0% = $0 million

b. Short-term investments: $2,266.0 million × 1% = $22.7 million

c. Bonds: $36,722.3 million × 3% = $1,101.7 million

d. Preferred stocks: $2,447.8 million × 15% = $367.2 million

e. Common stocks: $7,172.5 million × 20% = $1,434.5 million

f. Investments in associates: $6,833.6 million × 30% = $2,050.1 million

g. Derivatives and other invested assets: $1,574.2 million × 10% = $157.4 million

 

Total Minimum Capital Required for Assets = $0 + $22.7 + $1,101.7 + $367.2 + $1,434.5 + $2,050.1 + $157.4

Total Minimum Capital Required for Assets = $5,133.6 million

 

h. Insurance risk:

Net premiums written (Q1 2024): $6,249.3 million

Annualized net premiums written = $6,249.3 million × 4 = $24,997.2 million

Risk factor for insurance risk: 20%

Minimum Capital Required for Insurance Risk = 20% × $24,997.2 million = $4,999.4 million

Total Minimum Capital Required = $5,133.6 million + $4,999.4 million = $10,133.0 million

 

Step 3: Calculate the MCT Ratio

MCT Ratio = (Available Capital) / (Minimum Capital Required)

MCT Ratio = $19,350.5 million / $10,133.0 million MCT Ratio = 1.91 or 191%

 

Based on the asset classes detailed in the Q1 2024 report and the assumed risk factors, Fairfax's estimated MCT ratio would be approximately 191%. This suggests that the company would have sufficient available capital to cover the assumed risk exposures associated with its investments and insurance operations.

 

However, it's crucial to reiterate that this calculation is based on illustrative risk factors and limited information from the Q1 2024 report. The actual risk factors used in the MCT calculation would be determined by the regulatory guidelines and the specific characteristics of Fairfax's assets and liabilities. Additionally, the MCT ratio is a comprehensive measure that considers various other risk factors, such as interest rate risk, foreign exchange risk, and operational risk, which are not captured in this simplified calculation.

 

In summary, while this calculation provides a more granular estimate of Fairfax's MCT ratio based on the asset classes reported in the Q1 2024 report, it remains an illustrative example based on assumed risk factors. The actual MCT ratio would need to be determined using the specific regulatory guidelines and a more comprehensive risk assessment of Fairfax's operations.

 

Equity Reweighting

 

To determine how much could be reallocated from bonds to equities while maintaining a conservative approach, we will target an MCT ratio of 200%, which is comfortably above the regulatory minimum of 150%. We will also assume that the risk factors for the other asset classes and insurance risk remain constant.

Given:

• Current MCT ratio: 191%
• Target MCT ratio: 200%
• Current bond allocation: $36,722.3 million
• Risk factor for bonds: 3%
• Risk factor for equities: 20%

Step 1: Determine the excess available capital at the target MCT ratio

Target Minimum Capital Required = (Available Capital) / (Target MCT Ratio)

Target Minimum Capital Required = $19,350.5 million / 2.00 Target Minimum Capital Required = $9,675.3 million

Excess Available Capital = (Current Minimum Capital Required) - (Target Minimum Capital Required) Excess Available Capital = $10,133.0 million - $9,675.3 million Excess Available Capital = $457.7 million

 

Step 2: Calculate the amount that can be reallocated from bonds to equities

Reallocation Amount = (Excess Available Capital) / (Difference in Risk Factors)

Difference in Risk Factors = Equity Risk Factor - Bond Risk Factor

Difference in Risk Factors = 20% - 3% = 17%

Reallocation Amount = $457.7 million / 0.17 Reallocation Amount = $2,692.4 million

 

Therefore, based on the assumptions and the target MCT ratio of 200%, Fairfax could reallocate approximately $2,692.4 million from bonds to equities while maintaining a conservative capital position.

 

After reallocation:

• Bond allocation: $36,722.3 million - $2,692.4 million = $34,029.9 million
• Equity allocation: $7,172.5 million + $2,692.4 million = $9,864.9 million

 

It's essential to note that this calculation assumes that the reallocation would not impact the other risk factors or the available capital. In practice, any significant changes to the investment portfolio would need to be carefully analyzed to assess their impact on the company's overall risk profile and capital adequacy.

 

Furthermore, it's crucial to consider that this reallocation is based on a static view of the MCT ratio and does not account for potential changes in market conditions, asset valuations, or insurance risks over time. Any reallocation decisions would need to be made in the context of Fairfax's long-term investment strategy, risk appetite, and regulatory requirements.

In summary, based on the conservative target MCT ratio of 200% and the assumed risk factors, Fairfax could potentially reallocate approximately $2,692.4 million from bonds to equities. However, this calculation is for illustrative purposes only and does not consider the dynamic nature of capital adequacy or the specific factors that may influence Fairfax's investment decisions.

 

Final Take

 

So after all that and probably too many assumptions, and no doubt some AI hallucinations,  the answer is 2.7 bn.  i.e not much and below the $4bn the questioner suggested.  

Edited May 7 by nwoodman

[Haryana]

12 hours ago, Cigarbutt said:

For the rating agency, using Fitch as an example who recently released an update, at end of 2023, the risky assets ratio is already at 85%. In a downturn, even absent any "tactical" asset allocation move by FFH, this ratio would tend to go up...towards BBB which makes it uncomfortable to write new insurance business..

 

I know nothing about this but looking at it logically, why would this ratio go up in a downturn. When those risky assets are either in a down marked or forcibly marked down, their dollar amount will go down and, therefore, their proportion compared to the rest of the assets will go down and thus risky assets ratio going down may improve rating. 

[Cigarbutt]

2 hours ago, nwoodman said:

Thanks @Cigarbutt

 

 

That was very helpful to kickstart my thinking.  Ultimately the management at FFH has their arms fully around this. However it prompted me to give your numbers a revisit  and also do some quick and dirty numbers of my own

 

Key point

Statutory requirements for insurance companies typically include risk-based capital (RBC) ratios, which measure an insurer's capital adequacy relative to its risk profile. In the United States, the National Association of Insurance Commissioners (NAIC) recommends a minimum RBC ratio of 200%. In Canada, the Office of the Superintendent of Financial Institutions (OSFI) requires a minimum Minimum Capital Test (MCT) ratio of 150%.

Assuming Fairfax maintains a conservative RBC ratio well above the minimum requirements (e.g., 300% or higher), the company might have some flexibility to reallocate a portion of its bond portfolio to equities during a market sell-off. However, the exact amount would depend on various factors, such as:

1. The overall capital position and RBC ratios of Fairfax's insurance subsidiaries
2. The liquidity and credit quality of the bond portfolio
3. The expected impact of the reallocation on the company's risk profile and capital adequacy
4. Regulatory restrictions and approval from the relevant insurance regulators

 

Rerunning your numbers - we must be calculating different things

 

Using the ratio of the company's cash and fixed income float portfolio over its insurance float reserves as a proxy for the Minimum Capital Test (MCT) ratio is an interesting approach, but it has some limitations and may not provide a fully accurate representation of the company's capital adequacy.

The insurance float represents the funds generated by insurance operations that an insurer can invest until claims are paid out. Fairfax's float primarily consists of the following components:

1. Insurance contract liabilities: $45,918.1 million as of March 31, 2024
2. Insurance contract payables: $1,065.0 million as of March 31, 2024

The cash and fixed income float portfolio includes:

1. Holding company cash and investments: $2,496.4 million as of March 31, 2024
2. Subsidiary cash and short-term investments: $7,801.6 million as of March 31, 2024
3. Bonds: $36,131.2 million as of March 31, 2024

 

Calculating the ratio:

(Cash and Fixed Income Float Portfolio) / (Insurance Float Reserves) = ($2,496.4 million + $7,801.6 million + $36,131.2 million) / ($45,918.1 million + $1,065.0 million) = $46,429.2 million / $46,983.1 million = 0.99

This ratio of 0.99 suggests that Fairfax's cash and fixed income float portfolio is nearly sufficient to cover its insurance float reserves. However, it's important to note that this ratio does not fully capture the company's capital adequacy for several reasons:

1. It does not consider other types of investments, such as preferred stocks, common stocks, and investments in associates, which may also be used to support insurance liabilities.
2. It does not account for the risk characteristics of the assets and liabilities, which are a key component of the MCT ratio calculation.
3. It does not include other components of the MCT ratio, such as available capital, surplus allowance, and eligible deposits.
4. It does not reflect the specific regulatory requirements and risk factors used in the MCT ratio calculation.

 

While this ratio provides a simplified view of Fairfax's ability to cover its insurance float reserves with liquid assets, it should not be considered a substitute for the more comprehensive MCT ratio. The MCT ratio is a risk-based capital adequacy measure that considers a wider range of factors and is specifically designed for property and casualty insurance companies in Canada.

 

In summary, while the ratio of cash and fixed income float portfolio over insurance float reserves can provide some insight into Fairfax's liquidity and ability to cover its insurance liabilities, it is not a perfect proxy for the MCT ratio, which is a more comprehensive and risk-based measure of capital adequacy.

 

Taking a stab at MCT

 

I take it MCT and RBC are actually confidential.  Makes sense you don’t want to be giving your opposition a leg up in terms of capacity to write.  

 

However upper level (and treat the numbers with contempt)

 

To calculate Fairfax's Minimum Capital Test (MCT) ratio based on the asset classes detailed in the Q1 2024 report, we will make assumptions about the risk factors associated with each asset class. Please note that these assumptions are for illustrative purposes only and may not reflect the actual risk factors used by Fairfax or its regulators.

 

Assumptions:

1. Available Capital: We will assume that Fairfax's available capital is approximately 70% of its total equity.
2. Minimum Capital Required (Risk Factors): a. Cash and cash equivalents: 0% risk factor b. Short-term investments: 1% risk factor c. Bonds: 3% risk factor (assuming a mix of high-quality government and corporate bonds) d. Preferred stocks: 15% risk factor e. Common stocks: 20% risk factor f. Investments in associates: 30% risk factor (assuming illiquid investments) g. Derivatives and other invested assets: 10% risk factor h. Insurance risk: 20% of net premiums written

 

Calculation:

Step 1: Estimate Available Capital Total Equity as of March 31, 2024: $27,643.5 million Assumed Available Capital = 70% × $27,643.5 million = $19,350.5 million

 

Step 2: Estimate Minimum Capital Required

 

a. Cash and cash equivalents: $7,023.2 million × 0% = $0 million

b. Short-term investments: $2,266.0 million × 1% = $22.7 million

c. Bonds: $36,722.3 million × 3% = $1,101.7 million

d. Preferred stocks: $2,447.8 million × 15% = $367.2 million

e. Common stocks: $7,172.5 million × 20% = $1,434.5 million

f. Investments in associates: $6,833.6 million × 30% = $2,050.1 million

g. Derivatives and other invested assets: $1,574.2 million × 10% = $157.4 million

 

Total Minimum Capital Required for Assets = $0 + $22.7 + $1,101.7 + $367.2 + $1,434.5 + $2,050.1 + $157.4

Total Minimum Capital Required for Assets = $5,133.6 million

 

h. Insurance risk:

Net premiums written (Q1 2024): $6,249.3 million

Annualized net premiums written = $6,249.3 million × 4 = $24,997.2 million

Risk factor for insurance risk: 20%

Minimum Capital Required for Insurance Risk = 20% × $24,997.2 million = $4,999.4 million

Total Minimum Capital Required = $5,133.6 million + $4,999.4 million = $10,133.0 million

 

Step 3: Calculate the MCT Ratio

MCT Ratio = (Available Capital) / (Minimum Capital Required)

MCT Ratio = $19,350.5 million / $10,133.0 million MCT Ratio = 1.91 or 191%

 

Based on the asset classes detailed in the Q1 2024 report and the assumed risk factors, Fairfax's estimated MCT ratio would be approximately 191%. This suggests that the company would have sufficient available capital to cover the assumed risk exposures associated with its investments and insurance operations.

 

However, it's crucial to reiterate that this calculation is based on illustrative risk factors and limited information from the Q1 2024 report. The actual risk factors used in the MCT calculation would be determined by the regulatory guidelines and the specific characteristics of Fairfax's assets and liabilities. Additionally, the MCT ratio is a comprehensive measure that considers various other risk factors, such as interest rate risk, foreign exchange risk, and operational risk, which are not captured in this simplified calculation.

 

In summary, while this calculation provides a more granular estimate of Fairfax's MCT ratio based on the asset classes reported in the Q1 2024 report, it remains an illustrative example based on assumed risk factors. The actual MCT ratio would need to be determined using the specific regulatory guidelines and a more comprehensive risk assessment of Fairfax's operations.

 

Equity Reweighting

 

To determine how much could be reallocated from bonds to equities while maintaining a conservative approach, we will target an MCT ratio of 200%, which is comfortably above the regulatory minimum of 150%. We will also assume that the risk factors for the other asset classes and insurance risk remain constant.

Given:

• Current MCT ratio: 191%
• Target MCT ratio: 200%
• Current bond allocation: $36,722.3 million
• Risk factor for bonds: 3%
• Risk factor for equities: 20%

Step 1: Determine the excess available capital at the target MCT ratio

Target Minimum Capital Required = (Available Capital) / (Target MCT Ratio)

Target Minimum Capital Required = $19,350.5 million / 2.00 Target Minimum Capital Required = $9,675.3 million

Excess Available Capital = (Current Minimum Capital Required) - (Target Minimum Capital Required) Excess Available Capital = $10,133.0 million - $9,675.3 million Excess Available Capital = $457.7 million

 

Step 2: Calculate the amount that can be reallocated from bonds to equities

Reallocation Amount = (Excess Available Capital) / (Difference in Risk Factors)

Difference in Risk Factors = Equity Risk Factor - Bond Risk Factor

Difference in Risk Factors = 20% - 3% = 17%

Reallocation Amount = $457.7 million / 0.17 Reallocation Amount = $2,692.4 million

 

Therefore, based on the assumptions and the target MCT ratio of 200%, Fairfax could reallocate approximately $2,692.4 million from bonds to equities while maintaining a conservative capital position.

 

After reallocation:

• Bond allocation: $36,722.3 million - $2,692.4 million = $34,029.9 million
• Equity allocation: $7,172.5 million + $2,692.4 million = $9,864.9 million

 

It's essential to note that this calculation assumes that the reallocation would not impact the other risk factors or the available capital. In practice, any significant changes to the investment portfolio would need to be carefully analyzed to assess their impact on the company's overall risk profile and capital adequacy.

 

Furthermore, it's crucial to consider that this reallocation is based on a static view of the MCT ratio and does not account for potential changes in market conditions, asset valuations, or insurance risks over time. Any reallocation decisions would need to be made in the context of Fairfax's long-term investment strategy, risk appetite, and regulatory requirements.

In summary, based on the conservative target MCT ratio of 200% and the assumed risk factors, Fairfax could potentially reallocate approximately $2,692.4 million from bonds to equities. However, this calculation is for illustrative purposes only and does not consider the dynamic nature of capital adequacy or the specific factors that may influence Fairfax's investment decisions.

 

Final Take

 

So after all that and probably too many assumptions, and no doubt some AI hallucinations,  the answer is 2.7 bn.  i.e not much and below the $4bn the questioner suggested.  

-The 2.7B may be the right number and looking at this from several perspectives does help.

-If interested look at FFH's 1990, 1991 and 1992 (much smaller insurance operation then) and see their equity exposure relative to capital...

-The reference to BRK and the "ratio" is because it's a simple measure and easy to compute. At BRK, there is probably an embedded margin of safety which may be an adequate reference given FFH's past history during some transitions (many episodes requiring selling stock below intrinsic value, reaching for a line of credit etc).

-The numbers about float need to take into account the definition of float as mentioned in FFH's annual reports: "Float is essentially the sum of insurance contract liabilities and insurance contract payables, less reinsurance contract assets held and insurance contract receivables, on an undiscounted basis excluding risk adjustment." So you need to subtract reinsurance contract assets (among other less important adjustments) to calculate float.

-Questions and comments

     -i guess the idea is to (sell high and buy low) switch funds when equities become available at lower prices. If this idea applies, then the value of those regulatory measures become relevant ie they require a margin of safety. But then, you need a dynamic picture as bonds assets (including mortgage loans) can get downgraded or even default and other equity instruments (including the very significant total return swap on its own stock) can lose value. These changes impact regulatory capital to a very significant degree.

     -As a concept, moving funds from bonds (lower risk-weight) to equities (higher risk-weight) should impact negatively the MCT ratio. Why not in your example?

1 hour ago, Haryana said:

I know nothing about this but looking at it logically, why would this ratio go up in a downturn. When those risky assets are either in a down marked or forcibly marked down, their dollar amount will go down and, therefore, their proportion compared to the rest of the assets will go down and thus risky assets ratio going down may improve rating. 

You are right, this was not well phrased. The risky assets ratio is an indicator of potential future capital impairment. In a downturn, the risky asset ratio may go up if for example many bonds held get downgraded (have a higher risk weighting) or if unimpaired equities become impaired but the ratio may go down as a result of what you describe or if the company sells risk assets and fly to safety. However, when starting with a high risky assets ratio, the risk of capital impairment (including regulatory capital impairment) is higher, which is why FFH is close to the BBB category, a riskier posture for an insurer.

[nwoodman]

@Cigarbutt thanks for the handholding appreciate it.  I will post a reply to a separate thread in order not to clutter up this thread further

 

 

https://thecobf.com/forum/topic/20743-market-sell-off-equity-reallocation/

 

 

 

 

Edited May 7 by nwoodman