DBRS Upgrades Fairfax Financial to BBB, Pfd-3, Stable Trend

DBRS has today upgraded the ratings on the Senior Unsecured Debt and Preferred Share obligations of Fairfax Financial Holdings Limited (Fairfax or the Company) to BBB and Pfd-3, respectively. The Positive trend, which has been in place for the past year, has been replaced with a Stable trend. The rating upgrade reflects the fact that the Company has maintained a more conservative financial profile in the wake of its strong earnings performance in 2008 and 2007, largely related to strong investment returns. The Company’s improved financial strength has allowed it to access the capital markets on numerous occasions in the past year, including three issues of preferred shares totaling close to $700 million, an issue of senior debt at the holding company level and a common share issue, the proceeds of which were used to partially fund the $1.3 billion cash acquisition of Zenith National Insurance Company (Zenith) in May 2010. Following the 2009 purchase of the minority interests in Northbridge and Odyssey, the Company now benefits from access to free cash flow of all of its major operating subsidiaries. The Company’s financial flexibility has also been enhanced by the continued reduction of operating losses in its large run-off business, which had been a source of financial stress for the Company for many of the past ten years.

Fairfax continues to hold a large pool of liquid assets at the holding company level. DBRS estimates that Fairfax will hold approximately $1.3 billion as of September 30, 2010. The Company remains committed to keeping at least $1 billion in cash and liquid securities at the holding company in addition to the excess capital embedded in its operating subsidiaries. While the holding company cash position effectively reduces the Company’s net debt position substantially, it is regarded primarily as a pool of capital and liquidity with which to fund unexpected underwriting losses and acquisition opportunities should the capital markets become inaccessible. This commitment to maintaining financial flexibility also supports the rating upgrade.

Having peaked at over 45% in 2005, the Company’s consolidated debt plus preferred ratio was reduced to 25.3% as of year-end 2009, largely reflecting a $2.8 billion increase in retained earnings in the wake of strong investment results starting in 2007, $1.2 billion of new common equity issues and recognition of unrealized gains in the Company’s available-for-sale investment portfolio. Over the same period, the Company’s holding company cash position increased by close to $700 million. More recent acquisition activity has prompted the Company to increase its issuance of preferred shares, which has increased the estimated total debt plus preferred ratio to an estimated 32% as of the end of Q3 2010. Double leverage, which had been as high as 150% in 2005, has been reduced to just over 110%. Current levels of financial leverage, given the Company’s cash position, its excellent liquidity and underlying strong regulatory capital ratios are well within the limits for the assigned rating category.

Despite improved earnings in line with the Company’s strong investment performance, the Company’s underlying underwriting profitability continues to expose the fundamental cyclicality and risks of the commercial insurance business. In absence of major catastrophe losses in 2009, excess industry capital continues to create a soft market for commercial rates, especially given the weak economic environment in the United States which accounts for over 50% of the Company’s premium. The Company has nevertheless demonstrated discipline in not writing unprofitable business at these low rates. Net written premium in 2009 was almost 9% below the level of 2005. This reduction in volume has put some upward pressure on the Company’s expense ratios. The Company also remains exposed to catastrophic losses such as the Chilean earthquake and the Deepwater Horizon oil spill in the Gulf of Mexico, which adversely impacted the Company’s reported underwriting profitability in the first half of 2010. The risk fundamentals of the insurance industry limit the potential upside for the Company’s ratings.

The large investment gains realized over the past 2.5 years were the result of a unique set of factors and portfolio responses but which are nevertheless consistent with the Company’s long-term investment horizon and deep-value strategy. The decision to reinvest Treasuries into tax-free local government bonds is paying off in higher reported interest income, which should offset some of the volatility associated with the equity portion of the portfolio which will always be actively managed in line with the Company’s deep value strategy and philosophy.

The Company’s runoff book, which had been an earlier source of concern to DBRS as net adverse reserve development continued to be experienced in prior years, continues to shrink in line with expectations. While underwriting results in the runoff segment are expected to continue to be negative given the absence of earned premiums, reduced expenses and strong investment earnings are expected to support runoff results going forward.

The closely-held nature of the Company gives rise to a very long-term perspective on the insurance business and investment returns both on the part of long-tenured managers and shareholders. In this context, senior managers are all shareholders of the Company and subscribe to a risk management and governance structure which echoes the long-term perspective of the chairman and major shareholder, Prem Watsa. With this long-term perspective, the Company is not likely to sacrifice its current financial strength in the interest of either organic growth or growth by acquisition, but rather continue to leverage its financial strength in order to benefit from growth opportunities as they emerge.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Canadian Property and Casualty Insurance Companies, which can be found on our website under Methodologies.