DBRS Confirms Fairfax Financial Holdings Limited at BBB and Pfd-3

DBRS Limited (DBRS) has today confirmed the Issuer Rating and Senior Unsecured Debt of Fairfax Financial Holdings Limited (Fairfax or the Company) at BBB. The Preferred Shares are confirmed at Pfd-3. The trends are Stable. The Company’s consolidated underwriting result has been weak in recent years, aggravated by competitive conditions in the commercial lines of the general insurance industry globally and several years of relatively high catastrophic insurance claims, primarily related to the Japan tsunami, Thai floods, New Zealand and Chilean earthquakes and various storm events in North America. Some firming in the market and a recovery in written premiums in 2012 gave rise to a positive underwriting result in the first nine months of 2012. However, DBRS expects that much of this improvement will prove to have been undone by the adverse impact of Hurricane Sandy when Q4 2012 financial results are reported.

Strong investment results, largely reflecting gains on the Company’s large fixed income portfolio and a positive contribution from equity market hedges, offset underwriting weakness yielding a mere 1.6% core return on equity (ROE) in 2011. In the first three quarters of 2012, a weaker investment result reflected negative contribution from equity hedges, fewer gains on bonds (following the sale of government bonds during 2011 and 2012) and lower investment income, as proceeds on the earlier sale of government bonds were reinvested in lower yielding short-term instruments and common equities. The weaker investment result offset the stronger underwriting result to return a marginal ROE of 1.5% for the first three quarters of 2012.

The Company’s recent weak underwriting results are symptomatic of the industry generally and therefore not a particular concern to DBRS, except as it impacts our broader rating for the global property and casualty industry. With good underwriting discipline and proper diversification, Fairfax and its subsidiaries should be able to perform in line with the industry, even as it copes with traditional industry cyclicality and increased catastrophic activity.
Some of the weak underwriting result stems from the Company’s decision not to write unprofitable business in the soft market while also not undermining the business franchise by cutting overhead spending. Correspondingly, expense ratios have become inflated in the current soft markets. Excess industry capital continues to create soft markets for commercial rates, given the weak economic environment in many of the Company’s markets. Neither the U.S. insurance nor Canadian insurance operations have been profitable from an underwriting perspective since 2007. While the Company has demonstrated discipline in not writing unprofitable business at low rates, prior to the impact of acquisitions, net premiums written in the first nine months of 2012 increased 6.5% over the same period in 2011 as the Company targeted specific profitable market niches to address deficient underwriting profitability, including specialty lines and workers compensation. Longer-term catastrophic risk is generally mitigated through immediately responsive pricing, suggesting that such risks are not expected to be a long-term source of earnings vulnerability. The Company has established an oversight role with respect to insurance operations that should allow it to exploit revenue and expense synergies across the Company’s various insurance subsidiaries, thereby reinforcing underwriting profitability as a strategic priority.

The strong buildup of capital as a result of the Company’s continued strong investment earnings and active use of financial leverage has given Fairfax the financial resources to make acquisitions that add to its global insurance platform and diversification. Expansion in the faster-growing markets of Asia, Latin America and Eastern Europe, which currently have low insurance penetration, adds to the Company’s organic growth potential in what is otherwise a mature industry in North America and Western Europe. Growth is also expected to be achieved through the leveraging of the Company’s strong capital position as the insurance market firms up. With just 83 cents of premium written (NWP) for each dollar of capital on a consolidated basis in 2012, the Company has capacity for organic growth before it comes close to the 1.6 to 1.8 NWP/capital ratios achieved in earlier hard markets.

The strategy of Fairfax has historically been to achieve growth by acquisition and to invest acquired premiums to outperform the market benchmarks for equities and fixed income. The Company’s unique long-term value approach to investing has well served this end over time. The investment strategy is geared to maximizing the Company’s book value, thereby protecting its capital. While this investment style gives rise to what might be perceived as aggressive market calls, Fairfax actively manages its equity portfolios with hedges to limit short-term market losses and to realize value over the long term. By actively protecting its capital, the Company expects to be better positioned to increase its written premiums and investable float when the prospect of stronger underwriting results improves.

The Company is continuing to grow through strategic acquisitions that have been largely funded through increasing financial leverage. Consolidated debt plus preferred shares as a percentage of capitalization has increased from just over 25% in 2009 to over 36% at September 30, 2012, which is above the current DBRS guidance for a BBB-rated credit. Financial leverage is increasingly taking the form of more tax-efficient preferred share capital and borrowings at the holding company rather than at the operating subsidiary level. With reduced earnings, the corresponding fixed-charge coverage ratios in the past two years have averaged less than 1.5 times, which is below the threshold for an investment-grade company, recognizing that underwriting results have been at a cyclical low point and aggravated by unusual catastrophic claims. The recent addition of $250 million in debt, which will increase the financial leverage ratio in the short term, is mitigated by the fact that the proceeds will be used to retire maturing debt before the end of 2013.

Much of the residual concern that DBRS has for the Company’s increased financial leverage and coverage ratios is mitigated by the close to $1 billion in liquid assets at the holding company level as of September 30, 2012, and a strong component of “permanent” preferred share capital. 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. The strong liquidity at the holding company helps ensure that the fixed charges can comfortably be paid over time, even though the coverage ratios may tend to suffer through the cycle.

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

Despite the Company’s growing sophistication with respect to enterprise risk management, central oversight of underwriting and operating results and traditional investment outperformance, the competitive and cyclical nature of the underlying insurance business, including the increasing risk of catastrophic claims and the unpredictability of investment returns, limits the upside potential for Fairfax’s ratings, especially as financial leverage increases.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodologies are Rating Canadian Property and Casualty Insurance Companies (March 2011), DBRS Criteria: Preferred Share and Hybrid Criteria for Corporate Issuers (November 2012) and Rating Holding Companies and Their Subsidiaries (September 2012), which can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.