DBRS Comments on Fairfax Acquisition of Zenith

DBRS has reviewed the recently announced acquisition by Fairfax Financial Holdings Limited (Fairfax) of the outstanding shares of Zenith National Insurance Corp. (Zenith) which it currently does not own. The acquisition of the 92% interest will cost Fairfax just over $1.3 billion to be funded through a release of excess capital at Fairfax subsidiaries, a $200 million common share issue planned for Fairfax and available cash on hand. The current DBRS ratings for the senior debt and preferred share obligations of Fairfax remain at BBB (low) and Pfd-3 (low) with Positive trends, respectively.

Zenith, through its subsidiaries, provides workers’ compensation insurance in California (58% of gross written premiums) and Florida. The company provides insurance coverage for the statutorily prescribed benefits that employers are required to provide to their employees, who may be injured in the course of employment. Zenith’s chosen market is small- to medium-sized employee groups with dentist offices accounting for the largest proportion of policies outstanding and agricultural operations accounting for the largest proportion of policy premiums. Zenith was founded in 1971 and is based in Woodland Hills, California.

For the year 2009, Zenith would have accounted for approximately 10% of Fairfax’s net written premium on a pro forma basis. As part of the acquisition, the existing management team, including the long-time CEO Stanley Zax, will remain in place. Fairfax will roll Zenith’s investment management operations into its own, which should be the limit of integration risks. There should also be some opportunities for additional revenue and expense synergies as the best practices of Zenith are extended into the specialized market niches of Crum & Forster, which also writes workers’ compensation insurance products in the U.S. market. Crum & Forster products can also be sold through Zenith’s distribution system.

In the past, Fairfax purposefully sought out turnaround acquisitions with the intention of improving underwriting results while adding incremental value through its own investment prowess. In as much as it employed debt to acquire operations where reserves developed adversely following the acquisition, the financial flexibility of Fairfax was impaired while it was forced to raise capital and liquidity. In the case of the Zenith acquisition, there will be no incremental financial leverage as Fairfax buys a company which it knows well, having once owned almost 40% as recently as 2006. In addition, Zenith is in a strong capital position (Zenith is currently only writing premiums at 0.4 times policyholder surplus) and moreover has a strong track record of consistent underwriting profitability which exceeds that of the industry. In addition to being selective as to the quantity and quality of business which it is prepared to underwrite, Zenith also has in place an effective claims management department which minimizes the time off work for its clients’ employees. Results in 2009 have continued a decline which started in 2007 in line with the reduction in premium related to the severe economic contraction in California and Florida. Year-over-year policy counts are off 14% and gross premiums have dropped 23%. Despite a 13% reduction in head count in 2009, a relatively fixed expense base spread over declining premiums caused the full year expense ratio to increase. Loss ratios have also increased as the company has exhausted most of the favourable reserve development that it enjoyed on account of earlier accident years in the wake of 2003 workers’ compensation reform in Florida and California. Nevertheless, Zenith’s long-run loss ratio at approximately 50% is stronger than that of the industry, positioning it to enjoy sustained underwriting profitability. The acquisition of Zenith is strategically well-aligned with the Fairfax focus on the importance of underwriting profitability at the expense of top line growth conducted through relatively decentralized operating subsidiaries.

Since Fairfax is funding this acquisition largely through internal sources, its capitalization will be mostly unchanged, with reported total debt ratios remaining well below the levels of several years ago. In deploying some of its excess capital in Zenith, there is a marginal reduction in financial flexibility which is more than made up through Fairfax’s demonstrated access to the equity market at close to book value. Moreover, following the expected Q2 closing of this transaction, Fairfax will continue to have close to $1 billion in cash on hand at the holding company to fund any contingent obligations and opportunities.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Canadian Property and Casualty Insurance Companies.

This is a Corporate (Financial Institutions) rating.