# Market sell off equity reallocation

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Posted (edited)

@Cigarbutt, thanks again.  This is a quick follow up in relation to a question that was posed in the Q1 24 Conference call regarding the potential to rotate into equities from the fixed income portfolio during a market sell off.

Running the numbers again based on Fairfax’s definition of float as provided in the annual, agree with you ratio of around 1.3 as follows:

Step 1: Calculate the approximate insurance float

Insurance contract liabilities (Note 8): \$45,918.1 million
Insurance contract payables: \$1,065.0 million
Reinsurance contract assets held (Note 9): \$10,808.6 million
Insurance contract receivables: \$811.0 million

Float = Insurance contract liabilities + Insurance contract payables - Reinsurance contract assets held - Insurance contract receivables
= \$45,918.1 + \$1,065.0 - \$10,808.6 - \$811.0
= \$35,363.5 million

Step 2: Calculate the total cash and fixed income portfolio

Holding company cash and investments:
Holding company cash and investments (including assets pledged for derivative obligations): \$2,496.4 million

Portfolio investments:
Subsidiary cash and short term investments: \$7,801.6 million
Bonds: \$36,131.2 million
Subtotal: \$43,932.8 million

Assets pledged for derivative obligations:
Bonds: \$115.5 million

Total cash and fixed income portfolio = Holding company cash and investments + Portfolio cash and fixed income investments + Assets pledged for derivative obligations (Bonds)
= \$2,496.4 + \$43,932.8 + \$115.5
= \$46,544.7 million

Step 3: Calculate the ratio of cash and fixed income portfolio over insurance float

Ratio = Total cash and fixed income portfolio / Insurance float
= \$46,544.7 / \$35,363.5
= 1.32

Based on the information provided in Fairfax's Q1 2024 interim consolidated financial statements, the company's cash and fixed income portfolio is approximately 1.32 times its insurance float. However, as mentioned earlier, the float calculation is subject to adjustments for discounting, risk adjustment, and life insurance operations, which are not provided in the interim financial statements. As a result, the actual ratio may differ from this approximation.

At least I agree with your starting number of 1.3, thanks

MCT Approach with lots of assumptions (I think this might be flawed too)

Ran the numbers in Chat GPT and end up with \$3.6 bn realllcation based on MCT.  The asset weightings and hence MCT ratios were completely different to Claude.  So unfortunately it is numberwang.  Not to mention we have two approaches MCT and RBC.

FWIW based on RBC it looks like this and solving for an RBC ratio of 300% (320% currently) gives you the following table:

Conservative RBC Ratio Standards:

- Very Strong: 400% and above. This level is often seen as very conservative, providing a substantial cushion against potential losses.

- Strong: 300% to 399%. This is still considered a robust conservative level, offering good financial stability and less risk of breaching lower thresholds under normal market conditions.

The National Association of Insurance Commissioners (NAIC) in the U.S., which introduced the RBC system, sets various action levels based on the RBC ratio. Here’s a general overview of these levels:

1. Company Action Level: When the RBC ratio falls to 200% of the required minimum, the company must submit a comprehensive financial plan outlining how it will improve its capital situation.

2. Regulatory Action Level: If the ratio falls to 150% of the required minimum, state regulators may intervene more directly, possibly requiring changes in operations or financial restructuring.

3. Authorized Control Level: At 100% of the required minimum, regulators may assume control of the insurer to protect policyholders and creditors.

4. Mandatory Control Level: If the RBC ratio falls below 70% of the required minimum, regulators are typically mandated to take over the insurer

The Risk-Based Capital (RBC) and Minimum Capital Test (MCT) are both regulatory standards used to ensure that insurance companies maintain adequate capital to support their risks, but they differ in their scope, methodology, and geographical usage. Here’s a detailed comparison:

Geographical Usage
- RBC: Primarily used in the United States, established by the National Association of Insurance Commissioners (NAIC).

Purpose and Scope
- RBC: Designed to establish minimum required capital for insurance companies to support their overall business operations while covering various risks, such as underwriting, credit, market, and operational risks. RBC aims to provide a buffer against insolvency by requiring higher capital for higher risks.
- MCT: Similar to RBC, MCT measures the sufficiency of an insurance company's capital, focusing on its ability to withstand financial instability or claims. It also looks at various risks but is tailored to the specific regulatory environment in Canada.

Methodology
- RBC: Uses a formula-based approach where different risk elements (C1 through C4) are quantified:
- C1 (Asset Risk): Reflects the risk of default and changes in market values of assets.
- C2 (Insurance Risk): Covers risks associated with underwriting liabilities and pricing.
- C3 (Interest Rate and Market Risk): Addresses the potential for asset and liability mismatches due to changes in market conditions.
- C4 (Business and Operational Risk): Concerns with business operations and management risks.

- MCT: Also formula-based, MCT quantifies assets, liabilities, and off-balance-sheet exposures, assigning them into various categories with corresponding risk factors. The calculation considers:
- Assets Quality: Different assets are assigned risk weights based on their likelihood of loss or impairment.
- Liabilities: Liabilities are evaluated for their potential impact on capital, including insurance liabilities and operational liabilities.

Calculation Outputs
- RBC: Produces a capital ratio that insurers must meet or exceed, which is set by regulatory authorities. Insurers are required to take corrective action if their RBC falls below the mandatory threshold.
- MCT: Produces a similar ratio, the MCT ratio, which indicates the capital adequacy relative to the risks the insurer holds. A threshold is set, and if an insurer’s MCT ratio falls below this, they must increase their capital or reduce their risk.

Regulatory Actions
- RBC: If an insurer’s RBC ratio falls below regulatory thresholds, a range of actions can be triggered, from requiring a comprehensive business plan to direct regulatory intervention.
- MCT: Similarly, falling below the MCT ratio can lead to enhanced regulatory supervision and may require the insurer to submit plans on how they will improve their capital position.

- RBC: Highly sensitive to changes in asset values and risk profiles, requiring frequent updates and recalculations.
- MCT: Also requires updates based on changes in the company's financial condition and market dynamics, but may differ in how sensitivities are treated under Canadian regulations.

Both systems aim to protect policyholders and ensure market stability by preventing insurance company failures, but they do so through region-specific frameworks that reflect local market conditions, regulatory environments, and insurance practices.

Edited by nwoodman
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4 hours ago, nwoodman said:

...This is a quick follow up in relation to a question that was posed in the Q1 24 Conference call regarding the potential to rotate into equities from the fixed income portfolio during a market sell off.

Unusually busy day for me today so i didn't spend the time your post deserved but i'm wondering if there is a problem with the effect of funds reallocation on regulatory capital.

Since you refer to GPT, here's a screenshot from Perplexity with info to ponder on, us (still) humans:

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Posted (edited)

laws of diminishing returns but I took one last look at this from an RBC perspective.  I split bonds into first mortgages and treasuries based on the CC.

The RBC weightings are important and I simply don’t have a way of checking them.  Assuming the following I get a very healthy RBC ratio of 627% currently and if I run that down to a still conservative 400% then I get an answer of \$7.4bn that could go from treasuries to equities. I think the answer lies somewhere in that range \$2bn-\$7bn.  So perhaps the analyst is roughly right at \$4bn.  The reason I am also interested is Fairfax’s capacity to fund some or all of IDBI if that comes to pass.

Edited by nwoodman
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1 hour ago, nwoodman said:

laws of diminishing returns but I took one last look at this from an RBC perspective.  I split bonds into first mortgages and treasuries based on the CC.

The RBC weightings are important and I simply don’t have a way of checking them.  Assuming the following I get a very healthy RBC ratio of 627% currently and if I run that down to a still conservative 400% then I get an answer of \$7.4bn that could go from treasuries to equities. I think the answer lies somewhere in that range \$2bn-\$7bn.  So perhaps the analyst is roughly right at \$4bn.  The reason I am also interested is Fairfax’s capacity to fund some or all of IDBI if that comes to pass.

I was the “analyst” and was just throwing a number out there with hopes they would correct me with the right number! I appreciate though that’s probably not a number they want us to know as it could lead to a lot of second guessing if they aren’t as aggressive as they could be if an opportunity does present itself. I do think it’s important for investors to think about as it’s more right tail optionality that markets are ignoring and is another reason for multiple expansion.

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Posted (edited)
2 hours ago, SafetyinNumbers said:

I was the “analyst” and was just throwing a number out there with hopes they would correct me with the right number! I appreciate though that’s probably not a number they want us to know as it could lead to a lot of second guessing if they aren’t as aggressive as they could be if an opportunity does present itself. I do think it’s important for investors to think about as it’s more right tail optionality that markets are ignoring and is another reason for multiple expansion.

All good, it was definitely worth a try.  After thinking about it today I am not sure why it is such a secret.  It strikes me anyone in the business probably has access to the weightings so could run the numbers on each other.  There obviously comes a time though where you need to do a little convincing of the regulators about the “true” risk weightings and perhaps that is where things get a little more complicated and hence privacy is key..

The exercise at least gave me some insight into the process and a range of capacity.  My conclusion, and I think we all knew it anyway, is that IDBI at \$7-8bn is a stretch even for Fairfax (let alone FIH) and they will need to pull in some partners. Even if it turns out to be ~60% its is still a lot (30% government 30% Life Insurance Corporation)

Can they grow into it in 2-3 years, at a 60% stake of \$4-5bn, I think very easily.  Is it the wrong time/price to do it?  Not sure, but a lot easier to digest now than 2 years ago.  If they can get a deferred or staggered settlement (free option) then it looks even better.

All speculation of course, but as usual they appear to have been skating towards the puck in terms of their balance sheet.  If not IDBI, then the number you intuitively threw out there for equities in general, iwas decent guesstimate based on  my fumblings

Edited by nwoodman
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13 hours ago, nwoodman said:

@Cigarbutt The RBC weightings are... important and I simply don’t have a way of checking them.  Assuming the following I get a very healthy RBC ratio of 627% currently and if I run that down to a still conservative 400% then I get an answer of \$7.4bn that could go from treasuries to equities. I think the answer lies somewhere in that range \$2bn-\$7bn.  So perhaps the analyst is roughly right at \$4bn.  The reason I am also interested is Fairfax’s capacity to fund some or all of IDBI if that comes to pass...

Interesting.

FFH, when compared to peers, for float investments, is more of a return (risk) seeker. Rating agencies would probably be more flexible these days because of more recent positive and consistent underwriting performance but i wonder if the high level of financial flexibility that you suggest is there (assuming FFH would want now to switch funds from bonds to a compelling equity or equity-like opportunity). i remember the days when Northbridge and OdysseyRe were minority privatized in order to get some flexibility and can't help notice that several subs are still characterized by non-controlling interest sold to "financing" partners. Why would this be the case now if there was such excess capital available?

In the 2023 AR, they mention that Northbridge has an MCT of 255% and most other subs (apart from TIG and run-off) have a 320% RBC. These numbers don't include the dividends sent to parent in Q1 2024.

Anyways, if interested, there's this note from CIBC which contains some relevant material for this discussion, including a case study describing the cost to MCT when switching funds from low return (low risk) securities to higher (expected) return (higher risk) securities:

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@Cigarbutt thanks for the heads up.   On a sub level the RBC ratio is a lot lower than what I was calculating for the whole shooting match.  It might be possible to calibrate using Note 19: Statutory Requirement, that Jen referred to as dividend capacity and assume that is based off an RBC ratio of 300%. Or perhaps it is as simple as seeing the total in Note 19 as the starting point in terms of the capital that could be reallocated as it is truly surplus if it can be dividended and the max is then some conservative multiple.

Will have a read and a think.  The relevant section of Note 22: Financial Risk Management, you were referring to is reproduced from the AR below:

In the United States, the National Association of Insurance Commissioners ("NAIC") applies a model law and risk-based capital ("RBC") formula designed to help regulators identify property and casualty insurers that may be inadequately capitalized. Under the NAIC's requirements, an insurer must maintain total capital and surplus above a calculated threshold or face varying levels of regulatory action. The threshold is based on a formula that attempts to quantify the risk of a company's insurance and reinsurance, investment and other business activities. At December 31, 2023 Odyssey Group, Crum & Forster, Zenith National, Allied World and U.S. Run-off subsidiaries had capital and surplus that met or exceeded the regulatory minimum requirement of two times the authorized control level; each subsidiary had capital and surplus of at least 3.2 times (December 31, 2022 - 3.0 times) the authorized control level, except for TIG Insurance which had at least 2.0 times (December 31, 2022 - 2.0 times).

In Bermuda, insurance and reinsurance companies are regulated by the Bermuda Monetary Authority and are subject to the statutory requirements of the Bermuda Insurance Act 1978. There is a requirement to hold available statutory economic capital and surplus equal to or in excess of an enhanced capital and target capital level as determined under the Bermuda Solvency Capital Requirement model. The target capital level is measured as 120% of the enhanced capital requirements. At December 31, 2023 and 2022 Allied World's subsidiary was in compliance with Bermuda's regulatory requirements.

In Canada, property and casualty companies are regulated by the Office of the Superintendent of Financial Institutions on the basis of a minimum supervisory target of 150% of a minimum capital test ("MCT") formula. At December 31, 2023 Northbridge's subsidiaries had a weighted average MCT ratio of 255% (December 31, 2022 - 241% of the minimum supervisory target.

Brit is subject to the solvency and regulatory capital requirements of the Prudential Regulatory Authority in the

U.K. for its Lloyd's business and the Bermuda Monetary Authority for its Bermudan business. The management capital requirements for Brit are set using an internal model based on the prevailing regulatory framework in these jurisdictions. At December 31, 2023 Brit's total capital consisted of net tangible assets (total assets less any intangible assets and all liabilities), subordinated debt and contingent funding from its revolving credit facility and amounted to \$2,545.7 (December 31, 2022 - \$2,052.7). This represented a surplus of \$1,050.4 (December 31, 2022 - \$709.5) over Brit's management capital requirements.

Gulf Insurance is governed by the local capital adequacy regulations issued by the Insurance Regulatory Unit

("IRU") in the State of Kuwait. At December 31, 2023 Gulf Insurance had Regulatory Solvency Capital of 998% of the minimum capital required.

In countries other than the U.S., Bermuda, Canada, the U.K. and Kuwait where the company operates, the company met or exceeded the applicable regulatory capital requirements at December 31, 2023 and 2022.

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^Yes the dividend capacity is a good starting point and it looks like FFH has already started to use this capacity in Q1 to buy back FFH shares.

Opinion: it's a good starting point but, under present conditions, the capacity to switch the asset allocation (bonds to equities) may be less than 3.0B because the Northbridge capacity is contingent upon regulatory approval and dividend capacity as reported above includes the 'dividends' (fixed by contract, at 9-10% of funding) to Allied, Brit and Odyssey minority 'co-investors' (carrying value at around 2,5B).

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12 minutes ago, Cigarbutt said:

^Yes the dividend capacity is a good starting point and it looks like FFH has already started to use this capacity in Q1 to buy back FFH shares.

Opinion: it's a good starting point but, under present conditions, the capacity to switch the asset allocation (bonds to equities) may be less than 3.0B because the Northbridge capacity is contingent upon regulatory approval and dividend capacity as reported above includes the 'dividends' (fixed by contract, at 9-10% of funding) to Allied, Brit and Odyssey minority 'co-investors' (carrying value at around 2,5B).

Cheers,  there is also a similar positive feedback loop that facilitates share buybacks via the TRS.  It’s a fascinating set up.My view is that IV is signalled when they close out the TRS and apologies for stating the obvious.

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