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FFH relative valuation to MKL


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I am trying to tease out why exactly MKL is priced at roughly 1.34x reported book and FFH is priced at roughly 1x reported book.

 

Assuming they both have roughly the same allocation to equities (they do after accounting for FFH's hedge).  

Assuming the same investment results (let's ignore for a minute that HWIC has handily beaten Gaynor's record)

Assuming they both have tremendous capacity to grow in a hard market

 

About the only thing I can see that differentiates the two of them is the past superior underwriting profit at MKL.

 

So, one might come to conclude that the relative premium paid for MKL is effectively the capitalized value of that underwriting profit.

 

I know that over the long term profits are profits, but... were the profits at FFH to be just a little bit higher and to come in the form of underwriting gains, it would translate to a current stock price of $500.

 

I think at 1.34x people are effectively paying about 10x earnings for MKL's underwriting profit.

 

A conclusion one might make:

It might be tempting for some to want to go with MKL based on the theory that the underwriting profit will drive book value gains at a higher pace (assuming identical investment gains), but I don't believe it will translate into higher investor returns when you are diluting those returns by investing 0.34x at 10% returns (unless 10% turns out to be the highest component of the return).  

 

And there are better business trading at or below 10x earnings than MKL's underwriting.  Take WFC for example -- that should presently be trading at no higher than 10x earnings... and one could argue that it's business is much more enduring and scalable than MKL's insurance underwriting profits.

 

So if one assumes that FFH and MKL earn identical returns in their business before including the underwriting profits, then at these prices I would have to conclude that for a $13,400 investment it would be better to go with $10,000 in FFH and $3,400 in WFC rather than going with $13,400 in MKL.

 

Have I vastly miscalculated what people are paying for MKL's underwriting profits?  I get about 10x.

 

 

 

 

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Did you ever asked yourself why Berkley, Markel, Chubb, Berkshire Hathaway and some others who publicly state that they are disciplined underwriters all show combined ratios below 100% and Fairfax who states the same thing rarely ever does?

 

Cardboard

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Did you ever asked yourself why Berkley, Markel, Chubb, Berkshire Hathaway and some others who publicly state that they are disciplined underwriters all show combined ratios below 100% and Fairfax who states the same thing rarely ever does?

 

Cardboard

 

Their volumes are dropping hard though.  It's true that they are walking away from business, yet they're just not getting meaningfully below 100%.

 

Could it be that they are weighted towards lines of business that are easier to enter and so capital flows in freely (aka:  fiercely competitive).  I don't know... you have to wonder that this might be the case.  Otherwise, why do they keep giving up business and tend to write aggregate CRs much higher than WR Berkeley and Markel?  It has to be that however they're set up, they're fishing in the wrong pond.

 

Some ponds have trout and some have carp.

 

Better theory?

 

 

 

 

 

 

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Did you ever asked yourself why Berkley, Markel, Chubb, Berkshire Hathaway and some others who publicly state that they are disciplined underwriters all show combined ratios below 100% and Fairfax who states the same thing rarely ever does?

 

Cardboard

 

Their volumes are dropping hard though.  It's true that they are walking away from business, yet they're just not getting meaningfully below 100%.

 

Could it be that they are weighted towards lines of business that are easier to enter and so capital flows in freely (aka:  fiercely competitive).  I don't know... you have to wonder that this might be the case.  Otherwise, why do they keep giving up business and tend to write aggregate CRs much higher than WR Berkeley and Markel?  It has to be that however they're set up, they're fishing in the wrong pond.

 

Some ponds have trout and some have carp.

 

Better theory?

 

Here are my thoughts, I can't speak for the other companies, but I wonder if they follow the same policy as Fairfax.

 

1. Fairfax buys reinsurance to cap losses on most of their contracts.

From the Annual:

"The company follows the policy of underwriting and reinsuring contracts of insurance and reinsurance which,

depending on the type of contract, generally limits the liability of the individual insurance and reinsurance

subsidiaries to a maximum amount on any one loss of $15.0 for OdysseyRe and Advent, $5.1 (excluding workers’

compensation) for Crum & Forster and $3.3 for Northbridge. Reinsurance decisions are made by the subsidiaries to

reduce and spread the risk of loss on insurance and reinsurance written, to limit multiple claims arising from a single

occurrence and to protect capital resources. The amount of reinsurance purchased can vary among subsidiaries

depending on the lines of business written, their respective capital resources and prevailing or expected market

conditions. Reinsurance is generally placed on an excess of loss basis and written in several layers, the purpose of

which is to limit the amount of one risk to a maximum amount acceptable to the company and protect from losses on

multiple risks arising from a single occurrence. This type of reinsurance includes what is generally referred to as

catastrophe reinsurance. The company’s reinsurance does not, however, relieve the company of its primary obligation

to the policy holder."

 

2. Fairfax doesn't discount their liabilities.

From the annual:

"Under Canadian accepted actuarial practice, the valuation of policy liabilities reflects the time value of money.

Management has chosen not to reflect the time value of money in its valuation of the policy liabilities."

 

If the other companies don't follow this specific policy, it will affect the CR's given similar reserving and make it an unequal comparison.

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If the other companies don't follow this specific policy, it will affect the CR's given similar reserving and make it an unequal comparison.

 

Assume that over the past 4 years the market has been getting soft...

 

Let's say that you write $100m of business 4 years ago and only write $50m of business today.  And let's say you reserve too high all along, such that 5% of your business written in any given year will come back out as a reserve release 4 years later.

 

This means that today you are excessively reserving only $2.5 million for the business you wrote this year, but you are getting a favorable reserve release of $5m from the business you wrote 4 years ago.

 

So doesn't this tend to INFLATE your current combined ratio by the net $2.5m reserve benefit?  And in 4 more years if you are still writing the same volume of business, that $2.5m benefit will vanish.

 

So Fairfax might actually be seeing a tailwind from their reserving practices as they shrink their business -- but if their business stops shrinking the tailwind drops off.

 

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If the other companies don't follow this specific policy, it will affect the CR's given similar reserving and make it an unequal comparison.

 

Assume that over the past 4 years the market has been getting soft...

 

Let's say that you write $100m of business 4 years ago and only write $50m of business today.  And let's say you reserve too high all along, such that 5% of your business written in any given year will come back out as a reserve release 4 years later.

 

This means that today you are excessively reserving only $2.5 million for the business you wrote this year, but you are getting a favorable reserve release of $5m from the business you wrote 4 years ago.

 

So doesn't this tend to INFLATE your current combined ratio by the net $2.5m reserve benefit?  And in 4 more years if you are still writing the same volume of business, that $2.5m benefit will vanish.

 

So Fairfax might actually be seeing a tailwind from their reserving practices as they shrink their business -- but if their business stops shrinking the tailwind drops off.

 

 

I agree with the over reserving showing up later as reserve releases. The question is when those reserves are released and how much they have affected the CRs. I haven't tracked where they have been for the last couple of years.

 

My only other concern would be with the use of reinsurance versus competitors.

 

That's all I can think of for now.

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Their volumes are dropping hard though.  It's true that they are walking away from business, yet they're just not getting meaningfully below 100%.

 

Could it be that they are weighted towards lines of business that are easier to enter and so capital flows in freely (aka:  fiercely competitive).  I don't know... you have to wonder that this might be the case.  Otherwise, why do they keep giving up business and tend to write aggregate CRs much higher than WR Berkeley and Markel?  It has to be that however they're set up, they're fishing in the wrong pond.

 

Some ponds have trout and some have carp.

.

.

I believe it is called disipline.  Let the others write the unprofitable business.

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My own valuation of MKL says that price to earnings is a little bit lower than 10X normalized earnings.

 

But I guess that the premium accorded to Markel is relative to the conservativeness of reserves (wich has a very high impact on stated book) Again, I'm just guessing here, but people might fear less the "oopps" risk of Markel reserves than FFH. Remember too well the lean years that are still not too far away in time.

 

 

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I believe it is called disipline.  Let the others write the unprofitable business.

 

We're in agreement that they are disciplined... look at their dropping volumes.  Absent discipline, they wouldn't be walking away from business.

 

The topic is what Cardboard asked... why is their level of discipline not winning the CRs of others who make the same claim of discipline (he mentioned by name Berkshire and Markel and Chubb)?

 

So I reasoned that they are simply fishing in different ponds (different lines of business) -- you can be an extremely good fisherman but only catch carp if you are fishing in a pond that only holds carp.

 

If that isn't right, then what is?  The fact is that they are disciplined (backing away from unprofitable business) yet their CRs are still far higher than respectable underwriters like Markel,Berkshire,Chubb... or is it that Fairfax is disciplined but these other three companies are not?  I can't buy that given their long track records.

 

 

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Keep in mind that not discounting the reserve, & reinsuring, are additional costs & revenue haircuts that MKL doesn't bear. The result is a lower CR for MKL offset by greater cat risk (which Mr Market attaches no 'value' to) & MKL effectively having a higher operating leverage than FFH.

 

To compare fairly you really need to leverage the FFH holding to make the (FL+OL) of each company comparable, then look at successive (yearly share price change x #of shares)/starting equity. They're probably about the same, but with FFH having more volatilty.

 

SD

 

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My own valuation of MKL says that price to earnings is a little bit lower than 10X normalized earnings.

 

Just to clarify, I was ignoring all other qualitative factors and sources of earnings.  MKL and FFH I like to compare to one another because if you had the same investment team managing both companies then perhaps the only significant qualitative difference would be the underwriting profits.

 

So I took the gap in their respective underwriting profits and put a P/E of 10 on it.  I found that it generally explains rather nicely the entire relative premium to book value enjoyed by MKL vs FFH.

 

 

The reason why I brought this thread up is that I was once an MKL shareholder (back when I joined this board) but I sold it at a very high multiple to book.  Now I am a Fairfax shareholder and don't own any MKL.  I like the investment team better at FFH but from time to time I wonder if I would do better at MKL due to the relatively better underwriting profit -- this of course makes me ask whether it is worth making a switch given the much higher P/B that I have to pay in order to get that relatively better underwriting profit advantage.  That's what drove me to ask how much I am paying for the underwriting profit at MKL... and when I discovered that it's about 10x earnings, then I thought well there's really no reason for me to switch because I could put that extra bit of money (the relative difference in book value multiples) in a better business like WFC for what I think would be better results.

 

I think over time Fairfax's underwriting profit will get better because their worst businesses seem to be shrinking and their best one (Fairfax Asia) is growing.  Plus they just bought Zenith and in a hard market they could always favor growth there over their other less profitable lines.

 

Partly I'm writing out my thoughts here hoping somebody will correct me if the logic is horribly wrong.

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Keep in mind that not discounting the reserve, & reinsuring, are additional costs & revenue haircuts that MKL doesn't bear. The result is a lower CR for MKL offset by greater cat risk (which Mr Market attaches no 'value' to) & MKL effectively having a higher operating leverage than FFH.

 

MKL does purchase reinsurance.  The 2009 annual report claims that MKL has $952m reinsurance recoverables.  That's 1/3 of their shareholders' equity. 

 

I'm not sure how much reinsurance coverage they purchase in total, but their recoverable balance must be some indication.

 

By comparison, Fairfax has recoverables of $3,809m (about 1/2 of shareholders' equity).  However, in Fairfax's case a good deal of that is held in the runoff units.

 

Where did you hear that the operating companies of FFH have more reinsurance protection vs the operating companies of MKL?

 

I also looked at the total leverage of the two firms.  They both operate at 3.7x leverage.  (total assets / total equity)  However in Fairfax's case I think that's overstated because they seem to keep a much greater sum of money at the holding company just waiting for it to rain.

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Have you guys considered the possibility that FFH just sets aside 10-15 combined ratio points each year, in order to make the reserves more and more conservatively stated?

 

That would help explain that net provision for claims have increased from $7,822 in 2004 to $11,438 in 2009 while both annual actual payments on claims and net premiums earned have been relatively unchanged (slight drop actually).

 

From the face of it, it might be that the reason for 100 CR is not bad underwriting, but simply that FFH sets aside more provision for claims each year than what other insurers might have chosen to set aside. This would seem to agree with statements made by the company.

 

Aside from lowering the annual tax bill - and possibly ease attracting customers - this would also seem to reduce the risk from the insurance business. 

In no way however, could this be considered bad underwriting. And the effect of getting investment results of a larger float with less tax and less risk would trickle into shareholders equity in the form of superior results over the long haul.

 

Maybe the market is just pricing the two issues (FFH and MKL) wrongly?

 

Cheers

 

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Have you guys considered the possibility that FFH just sets aside 10-15 combined ratio points each year, in order to make the reserves more and more conservatively stated?

 

The first thing that comes to mind is that... is it illegal to deliberately inflate reserves for the purpose of reducing taxes?  I can understand that being a little bit conservative is perfectly okay, but there must be a threshold where this gets abusive in the eyes of the law.

 

Second thing that comes to mind is that... now that volumes are dropping this should be showing up as a tailwind to their CR, not a headwind.  See my example above about the company that, over a span of 4 years soft market, winds up writing $50m business instead of their past $100m.  If they were overreserving by 5% in every year, then they would be getting a tailwind of $5m worth of reserve releases to offset $2.5m of reserve additions.  The net result is an improvement to the CR.  Now, with Fairfax we know that they are writing less business -- so the reserve releases from past conservatism ought to be more than offsetting the present year loss reserving... or at least we should be getting to the point where they nearly cancel one another out.  My point is that you can't just keep hiding your taxable income in a reserve -- at some point it comes out and gets taxed.  So if they have been so conservative for so many years, why aren't they showing up today to offset this headwind of conservative reserving?

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Have you guys considered the possibility that FFH just sets aside 10-15 combined ratio points each year, in order to make the reserves more and more conservatively stated?

 

The first thing that comes to mind is that... is it illegal to deliberately inflate reserves for the purpose of reducing taxes?  I can understand that being a little bit conservative is perfectly okay, but there must be a threshold where this gets abusive in the eyes of the law.

 

Second thing that comes to mind is that... now that volumes are dropping this should be showing up as a tailwind to their CR, not a headwind.  See my example above about the company that, over a span of 4 years soft market, winds up writing $50m business instead of their past $100m.  If they were overreserving by 5% in every year, then they would be getting a tailwind of $5m worth of reserve releases to offset $2.5m of reserve additions.  The net result is an improvement to the CR.  Now, with Fairfax we know that they are writing less business -- so the reserve releases from past conservatism ought to be more than offsetting the present year loss reserving... or at least we should be getting to the point where they nearly cancel one another out.  My point is that you can't just keep hiding your taxable income in a reserve -- at some point it comes out and gets taxed.  So if they have been so conservative for so many years, why aren't they showing up today to offset this headwind of conservative reserving?

 

First, I don't think they deliberately inflate reserves to reduce taxes; this is merely a side-effect of conservative reserving.

 

Second, the net premiums earned have been of the same order of magnitude for some years now - they haven't really fallen. Also, due to the long tail nature of the business, it will take more than 4 years with this conservative reserving policy in force before we reach break even. If true, we still have a head wind and the tail wind is in the future, but not priced into the issue.

 

Cheers

 

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In comparing FFH to WRB  and MKL,  WRB  does discount their reserves and by a little over 10% over the past yrs.  If this discount is  added back to the LAE , their combined ratio would be 104, 103, 98, 98, 99 over last 5 yrs.  (If the discount is not added back at 100% could someone explain what the ratio is?)

If this is the case their UW  is ok , but not great.  So why the premium in P/BV?

 

MKL states that they do not discount their reserves

 

 

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Have you guys considered the possibility that FFH just sets aside 10-15 combined ratio points each year, in order to make the reserves more and more conservatively stated?

 

So if they have been so conservative for so many years, why aren't they showing up today to offset this headwind of conservative reserving?

 

Doesn't the conservative reserving show up in the provision for claims? For 2009, the provision is approx. $3.6B higher than in 2004, although the actual claim payments and the level of new business is approx. the same. I know this is very simplified and relies on a lot of assumptions, but would nevertheless seem to explain the different numbers and statements by the company?

I get a FFH CR of approx 87 if the reserves should have been on the same level as in 2004 (like premiums and actual payments on claims).

 

Cheers!

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Have you guys considered the possibility that FFH just sets aside 10-15 combined ratio points each year, in order to make the reserves more and more conservatively stated?

 

So if they have been so conservative for so many years, why aren't they showing up today to offset this headwind of conservative reserving?

 

Doesn't the conservative reserving show up in the provision for claims? For 2009, the provision is approx. $3.6B higher than in 2004, although the actual claim payments and the level of new business is approx. the same. I know this is very simplified and relies on a lot of assumptions, but would nevertheless seem to explain the different numbers and statements by the company?

I get a FFH CR of approx 87 if the reserves should have been on the same level as in 2004 (like premiums and actual payments on claims).

 

Cheers!

 

Thank you for giving me something useful to think about.  This will keep me busy for a while.

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I like the topic... I just wish we were able to get a more definitive answer (perhaps it is in the comments... I just do not have a good enough understanding to put it together)!

 

One red flag for me has been the underwriting challenges at NB the past few years. Back when I started following FFH, within FFH the underwriting track record of NB was held up as the model that the other subs aspired to. I get a quarter or two of challenges... I don't get a couple of years of challenges (unless competitors with massive capacity were so uterly reckless that they dropped pricing through the floor). 

 

When I look at C&F I wonder if their business model is as profitable as BRK, MKL or WRB.

I also wonder how FFH lower ratings impacted the business they were able to access.

I like the Zenith purchase because it brings in a skill set FFH can use.

 

The question I would like answered (was asked earlier) is what does 'conservative reserving' mean at FFH. I know what it means at BRK, MKL & WRB. My HOPE is that over time we will all learn that it means that FFH has been underwriting business with an accident year CR that is closer to the better underwriters in the business. If they are able to demonstrate this then we will see the P/B multiple expand (my guess is this is years away).

 

 

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An interview with William Berkeley that provides color on the risk levels in the policies written by WRB. WRB relies more on policy limits whenever possible instead of buying reinsurance.

 

Beerbaron posted the first part of this video in another thread:

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A very well thought out thread and I learned some things as well.  

 

But... I personally think you are all overanalyzing why FFH is cheaper rather than just accepting that Mr. Market is handing a gift to those who dont own it, or still want to buy more, and of course frustrating those of us who hold it.  It trades at book, will likely show a 20% gain on BV due to investments, dividend, and interest income.  That puts the price next January, before my last options close, at $440, excluding a hard market.  

 

When a hard market does arrive all of these stocks will rise in tandem, and move to book values of greater than 2 which will pitch the extremely thinly traded FFH over $1000 fairly quickly.  The most interesting outcome may be that Berkshire becomes the worlds largest company by market cap.  

 

Incidentally, FFHs companies were designed to write more business and their CEOs have been keeping experienced staff on rather than laying off, in anticipation of the future.  

 

This type of scenario is where diversity in ones portfolio can help out with frustration.  Most everything else I hold has been going up at a rapid clip.  That also indicates what FFHs portfolio has been doing on a look through basis.

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Assume:  Price of $C368, BV of $C370, 15% ROE, rational hedging long-term shareholder, seasonal BV multiple variability of +- 10%, 60% average idea capture, today’s multiple is 1x (368/370), 1 yr holding period, no dividend.

 

The rational shareholder would hedge at 1.1x BV, re-purchase at .9x, & use a stop-loss at 1.1x BV (just in case there’s a surprise). If it were a ‘normal’ year & you hedged today, bought back in 6 months at .90x, & resold in another 6 months - you would make 75 or 20% (75/370) & be in cash over the riskiest part of the insurance year. [[370-(370*(1+(.15/2))*.9)]+[(370*1.15*1.1)- (370*(1+(.15/2)]]*.60

 

To be fair, MKL etc. has to offer you at least a 20% return to be comparable, & they essentially have to do it through better UW. You really need to compare the rational shareholder motivation for the buy & hold of MKL to the buy & hedge of FFH.

 

SD

 

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2. Fairfax doesn't discount their liabilities.

From the annual:

"Under Canadian accepted actuarial practice, the valuation of policy liabilities reflects the time value of money.

Management has chosen not to reflect the time value of money in its valuation of the policy liabilities."

 

If the other companies don't follow this specific policy, it will affect the CR's given similar reserving and make it an unequal comparison.

 

 

Okay, I actually did some research (hurray!)

 

 

First, turn to page 33 of 2009 annual report:

 

The cost of reinsurance purchased by the company (premiums ceded) is included in recoverable from reinsurers and is amortized over the contract period in proportion to the amount of insurance protection provided.

 

Next, turn to page 52 of 2009 annual report:

 

Here on page 52 we find the effects of discounting:

 

insurance and reinsurance liabilities overstated by $539.5m  

ceded reinsurance contracts overstated by $284 million  

 

 

The last thing we need to do is to subtract the overstated reinsurance recoverable assets from the overstated liabilities, and I get $255.5m total overstatement.

 

That's before tax of course.

 

Shareholders' equity is understated by $255.5m (pre-tax) due to their decision to not discount their liabilities and ceded reinsurance contracts.

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1. Fairfax buys reinsurance to cap losses on most of their contracts.

 

The bottom of page 33 (2009 AR) outlines how much this reinsurance program costs them each year.

 

pre-tax net impact of ceded reinsurance transactions

2009:  $337.5m loss

2008:  $144.3m loss

2007:  $388m loss

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1. Fairfax buys reinsurance to cap losses on most of their contracts.

 

The bottom of page 33 (2009 AR) outlines how much this reinsurance program costs them each year.

 

pre-tax net impact of ceded reinsurance transactions

2009:  $337.5m loss

2008:  $144.3m loss

2007:  $388m loss

 

I interpreted this slightly differently. I am not sure if the losses are calculated on a policy year basis. In the table on page 55 (Printed page #53) the losses reported are "Claims incurred ceded to reinsurers", seems to imply it does include IBNR which would be reported in the following years. So the loss of $337.5 reported in 2009 is not the full cost to reinsurer's or to Fairfax if it has not bought reinsurance.

 

Thanks

 

Vinod

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