DBRS Confirms Fairfax Financial Holdings Limited and Affiliates at BBB, Positive Trend, after Announced Purchase of Allied World Assurance

DBRS Limited (DBRS) has today confirmed Fairfax Financial Holdings Limited’s (Fairfax or the Company) Issuer Rating at BBB, its Senior Unsecured Debt rating at BBB and its Preferred Shares rating at Pfd-3. In addition, DBRS has confirmed the Issuer Rating and the Financial Strength Ratings (FSR) of Fairfax’s Canadian operating subsidiaries at A (low). All trends remain Positive. This rating action follows Fairfax’s announcement that it has agreed to purchase Allied World Assurance Company Holdings, AG (AWAC) in a friendly merger for combined cash and stock considerations of $4.9 billion, a premium of 18% per share. The transaction is expected to close in H1 2017, subject to Fairfax and Allied shareholder approvals as well as regulatory approvals. The transaction is also subject to a 30-business day period to allow other potential bidders to make a tender offer for AWAC. Once complete, a shareholder vote will be held.

The rating action reflects DBRS’s view that the purchase is consistent with Fairfax’s strategy to extend its franchise globally through opportunistic acquisitions of companies with strong underwriting disciplines. The Company engages in property and casualty insurance, reinsurance and investment management. AWAC is a large global insurer focusing on commercial and specialty risks with net written premiums of $2.3 billion for the last 12 months (LTM) ended Q3 2016. The acquisition will present an opportunity for Fairfax to increase gross premiums by a significant 32%. The combination is also expected to benefit the Company by expanding its franchise, broadening the risk markets in which it operates and providing greater diversification in dividend flows to the holding company, coupled with a modest increase in its earnings ability. Fairfax’s risk profile should also experience modest diversification benefits while AWAC’s management has demonstrated a good track record of writing profitable business (five-year average combined ratio of 91.4%). This acquisition will position the combined entity to be the 14th-largest commercial writer in the United States in terms of direct written premium. Currently, Fairfax is the 25th-largest commercial writer while AWAC is the 40th largest.

The Positive trend, originally assigned in December 2015 and maintained, considers the Company’s improving fundamentals, including its expanding global operations and strengthening franchise as well as its ability to adapt to the current challenging operating environment.

The purchase’s cooperative nature is an important advantage from DBRS’s perspective as the strong support of AWAC’s management is likely to ease any transitional challenges and ensure the retention of management. AWAC is expected to retain its management and operate on a decentralized basis. Fairfax places a high reliance on local management to manage its businesses prudently, but manages the investment portfolios of its subsidiaries centrally. The Company will assume AWAC’s investment portfolio under Hamblin Watsa Investment Counsel while also providing corporate risk oversight. This decentralized structure has allowed Fairfax to grow by acquisition globally and to take advantage of profitable niches held by existing businesses that are run by good management teams with a track record of writing profitable businesses.

Fairfax has successfully completed over nine acquisitions since January 2015, but most have been modest in size with the exception of Brit PLC. This current transaction will be the largest transaction in the Company’s acquisition history, if successfully completed. Fairfax has the processes in place to integrate the necessary corporate reporting and risk management functions, but DBRS is also mindful that the size of this deal may potentially present some resource challenges for Fairfax at the holding company level. There is also a potential risk that AWAC may be acquired by another firm during the 30-business day bidding period. AWAC’s organization has demonstrated excellent performance by both profitably underwriting business and returning capital to shareholders. The retention of key management individuals is essential to realize transaction benefits and continued positive results. Fairfax has developed a reputation for successfully accomplishing collaborative acquisitions; this track record forms one of DBRS’s considerations for confirming the rating.

DBRS considers the financing risk of the transaction to be low. Fairfax has announced its intention to finance the acquisition through both cash ($0.9 billion) and stock ($4.0 billion) consideration. This financing mix will reduce the Company’s financial leverage to 30.1% on a pro forma consolidated basis, down from 32.7% at Q3 2016. DBRS considers this decreased leverage to be a positive attribute in funding this acquisition. The capitalization of Fairfax will also improve modestly with the issuance of new common equity, although balance-sheet goodwill is expected to increase by $1.7 billion, becoming 31.3% of equity on a pro forma basis, up from 28.5% at Q3 2016.

RATING DRIVERS
Further positive ratings pressure could emerge if the Company (1) demonstrates continued progress in strengthening its franchise, particularly through its acquisitions, including this announced acquisition agreement; (2) reduces its leverage and improves its fixed-charge coverage ratios; (3) improves income stability; (4) and demonstrates significantly increased market shares on a prudent basis. Negative ratings pressure could arise from materially reduced liquidity levels, inadequate monitoring and oversight of assumed risks as well as sustained deterioration in underwriting results.

Notes:
All figures are in U.S. 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 Global Methodology for Rating Life and P&C Insurance Companies and Insurance Organizations (December 2015), DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (December 2016), DBRS Criteria: Rating Corporate Holding Companies and Their Subsidiaries (December 2016) and DBRS Criteria: Guarantees and Other Forms of Support (February 2016), which can be found on our website under Methodologies.

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

Lead Analyst: Stewart McIlwraith
Rating Committee Chair: Roger Lister

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.