Fairfax Financial Holdings Limited

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Fairfax Financial Holdings Limited

95 Wellington Street West
Suite 800
Toronto, Ontario M5J 2N7
Canada
Telephone: (416) 367-4941
Fax: (416) 367-4946
Web site: http://www.fairfax.ca

Public Company
Incorporated: 1985
Employees: 9,764
Total Assets: $22.3 billion (2002)
Stock Exchanges: Toronto New York
Ticker Symbol: FFH
NAIC: 524126 Direct Property and Casualty Insurance Carriers

Toronto-based Fairfax Financial Holdings Limited, a dealer in insurance and reinsurance services, has gained notoriety through its acquisition strategy and success in bringing financial gains to shareholders by means of its investments. Fairfax is led by CEO Prem Watsa. The company reported net income of $264 million in 2002, on revenues of just over $5 billion.

Acquiring Mind: 1985–95

Canada’s Fairfax Financial Holdings Limited is synonymous with V. Prem Watsa. Born in India, Watsa eventually trained to be a chemical engineer. He changed his path in 1972, however, moving to London, Ontario, where his brother resided. After earning a business degree from the University of Western Ontario, Watsa worked for Confederation Life Insurance Co. in Toronto. He quickly moved from his position as an analyst to one of portfolio manager.

With ten years of experience under his belt, Watsa signed on with a start-up asset management firm. When the endeavor failed, he contacted his former boss at Confederation. The pair established Hamblin Watsa Investment Counsel in 1984. Soon after, Watsa raised the $9 million that Markel Insurance, a trucking insurance underwriter, needed to stay afloat. Markel’s holding company would later be renamed Fairfax.

When the company began trading on the market in 1985, shares went for C$3.25. Revenues for the year were C$17 million. By 1992, Fairfax subsidiaries operated in the areas of property and casualty insurance, investment management, insurance claims management, and life insurance, pulling in revenues of C$286.8 million. From 1985 to 1992 shareholder equity had grown from C$10.4 million to C$143.8 million. Return on equity exceeded 20 percent in all but one year during the period.

In November 1993, Duff & Phelps Credit Rating Co. lauded the market positioning, financial status, and management team of Fairfax property and casualty subsidiaries. But the rating agency voiced concerns as well, included among them, the issue of financial leverage. Fairfax depended on borrowed funds to grow. Its planned purchase of Houston-based specialty insurer Ranger Insurance Company, for example, would be financed by a stock offering and issuance of notes.

Buying good companies down on their luck also factored into the Fairfax acquisition strategy. A company in its fold since 1990, Vancouver-based Commonwealth Insurance Company had a strong core business but had been held back by a struggling parent company.

By 1995, a decade into operation, Fairfax consisted of six insurance companies, an investment management firm, a claims adjusting company, and a Bermuda-based reinsurer. In addition, the holding company put forth solid numbers. Profit for the year was C$87.5 million, up from C$38.1 million in 1994. Stock price closed in on C$80—a respectable showing to be sure, but it paled in comparison to what happened next.

Flying High: 1996–98

Fairfax stock began a dizzying climb when Watsa purchased Skandia America Reinsurance Corp., a major U.S. property-casualty reinsurer, in early 1996. During the years 1992 and 1993, both Skandia America and its parent Skandia Ins. Co. Ltd. were hit with significant losses. Hurricane Andrew pummeled the American operation, while the Sweden-based parent company grappled with a downturn in Scandinavian real estate and corresponding investment losses. In response, Skandia America was downsized: the property business was phased out. Premium volume fell by more than half. Meanwhile, casualty insurance prices were driven down by stiff competition.

Under Fairfax, Skandia would reenter the property business and continue to operate independently, in accordance with Fairfax’s decentralized operating system. Eric Simpson, vice-president in A.M. Best’s property/casualty division, told National Underwriter in March 1996, “Generally, and almost without exception, Fairfax has taken solid properties and turned up the performance several notches.”

With Skandia aboard, Fairfax’s assets reached C$3.2 billion, a doubling effect. Stock price went along for the ride, reaching the C$100 level when the deal was announced. The climb continued despite the concerns of bond rating agencies. The Skandia purchase, worth approximately $230 million, was to be financed by issues of debt and stock.

Fairfax stock passed the C$200 mark in September, when the purchase of Compagnie Transcontinentale de Reassurance (CTR) from its Paris-based parent was announced. Watsa planned to finance the CTR deal with a private placement, setting the per-share price above the going rate. The C$260 offering price nudged Fairfax stock even higher.

Analysts, while surprised by the acceleration of the stock price, remained cautious, pointing to the cyclical nature of the industry, the uncertainties related to the new businesses, and the debt accumulated to bring them aboard. “And while Watsa has an excellent management team, Fairfax is mainly Watsa,” observed the Financial Post in September 1996. What would happen to Fairfax without Watsa

Fairfax added yet another reinsurance concern in 1997 and broadened its global reach. Business had been slipping for Sphere Drake Holdings Ltd. (Bermuda). Under Fairfax the company hoped for a more solid footing financially. In turn, Fairfax gained underwriting outlets in London and Bermuda.

Through its Odyssey Re Group, formed from Skandia and Transcontinentale, Fairfax already had reinsurance offices in the major markets of New York, Paris, and Singapore. The addition of Sphere Drake placed Odyssey Re among the world’s 20 largest reinsurers, according to Business Insurance.

Watsa’s penchant for insurance companies, his aversion to stock splits, and the company’s elevated stock price begged comparisons with Warren Buffett and Berkshire Hathaway. “Like Buffett, Watsa understands how a smart investor can exploit the float. Fairfax, accordingly, owns ten property and casualty insurers, whose huge reserves he uses to play the stock and bond markets,” wrote Bruce Upbin for Forbes.

But there were significant differences between the two, as Upbin pointed out. “Buffett increases his book value by buying solid companies and letting them grow. Watsa does it by issuing new shares. In the last two years he has increased the number of common shares outstanding by 25%.” Watsa held 15 percent of stock, valued at C$648 million.

Moreover, Fairfax had been posting underwriting losses on its insurance policies while Berkshire took in more in premiums than it paid out in claims and costs. Fairfax’s underwriting problems were not over, however. Skandia and Sphere Drake, for example, came with significant asbestos and environmental claim exposure.

Fairfax picked up another company in March 1998, Crum & Forster Holdings Inc., an entity Xerox Corporation had been trying to sell for a number of years. Crum & Forster (C&F) served mid-sized companies in the U.S. commercial market and, like the others new to the Fairfax fold, came with its own set of problems.

Despite hot spots smoldering in some of its subsidiaries, Fairfax stock continued to hold the distinction of being the most expensive stock on the Toronto Exchange. It did experience volatility, ranging from C$265 in January to nearly C$500 per share in March 1998. The peak period coincided with the announcement of the C&F deal. Fairfax rounded out the year by purchasing New York-based TIG Holdings, which served specialty commercial markets. The company had been spiraling down for a number of years and had just posted a large quarterly loss.

“Clearly Fairfax is a deep-value investor looking for turnaround candidates,” insurance analyst Weston Hicks told National Underwriter. TIG, like other struggling companies Watsa had acquired, came at a discount price, but Fairfax got more than it bargained for this time.

The Unforeseen: 1999–2003

Fairfax moved to restructure its London reinsurance business in May 1999. Business written by Sphere Drake prior to its integration with Fairfax hurt the Odyssey Re subsidiary of which it was now a part. According to a May 1999 Business Insurance article, the reinsurer contended that it had been used as “a dumping ground for underpriced coverages.” In addition to shutting down some of its London business, Fairfax purchased $1 billion in stop-loss reinsurance coverage to mitigate the flow of any more red ink. Fairfax also had a runoff operation to handle matters related to discontinued lines of business.

Company Perspectives

Fairfax Financial Holdings Limited is a financial services holding company whose corporate objective is to achieve a high rate of return on invested capital and build long-term shareholder value.

Despite problems brewing in the subsidiaries, the holding company had continued to rack up return on equity in excess of 20 percent. How did Watsa do it “When Watsa spots a cheap insurer, he moves in and buys it. Each purchase adds to Fairfax’s massive $18 billion in investment assets. Watsa then uses that money to do what he does best: play the market. Fairfax’s success depends on its ability to manage that huge float. Last year, the company reaped $441 million from its conservative portfolio of stocks and bonds,” Jonathan Harris explained for Canadian Business in July 1999.

But Watsa’s game plan faltered. In 1999, storms in Europe produced high catastrophic losses and the bottom dropped out of investment gains. C&F and TIG dragged the company down in 2000. Return on equity fell below the 20 percent mark for an unprecedented second year running.

Watsa’s hopeful words in his letters to shareholders did not pan out. In 2001, the company lost money for the first time. The destruction of New York’s World Trade Center and continuing reserve deficiencies at C&F and TIG were the culprits. Watsa also pointed to a generally troubled insurance market.

From year-end 2000 to year-end 2001, stock price fell from C$228.50 to C$164 per share. On the plus side, Fairfax took Odyssey Re public in 2001, trading on the New York Stock Exchange. The initial public offering brought in $434 million in cash and notes for Fairfax. In addition, plans were in the works to take C&F public. Watsa also set aside the Fairfax tradition of growth through acquisition. Internal growth would be the new mantra. New insurance and reinsurance business and an elevated level of retentions would have to keep the ball rolling.

Increased sales activities paid off in 2002. The Markel insurance subsidiary—Watsa’s first acquisition—showed significant gains in net premiums. But the C&F public offering was scrapped. For the first time, Watsa sold Fairfax shares at a level below book value, raising suspicions, according to Forbes, that the company was having cash flow problems.

In December 2002, Watsa said he planned to pull the plug on the troubled TIG operation. “After setting aside sufficient cash to pay future claims on old policies, Watsa will have the right to extract from TIG its $793 million stock portfolio and deliver that to the parent in Toronto a year from now,” explained Bernard Condon for Forbes.

Investors were not impressed and Fairfax stock slipped further. In addition, other questions lingered in the air over the solidity of some of its assets, the repeated additions to reserves, and the movement of capital through offshore subsidiaries. Debt ratings were downgraded. Analysts and regulators were on alert. Adding to the pressure, Fairfax had begun trading on the New York Stock Exchange in mid-December.

Fairfax returned to profitability in 2002, earning its highest profit in history at C$415.7 million. Watsa attributed the turnaround to improvement in underwriting and a strong investment performance. Skeptics remained unconvinced. Fairfax’s stock price continued to be depressed into early 2003, and was generally trading below $90 per share on the Toronto Stock Exchange.

In April 2003, Fairfax announced the formation of Northbridge Financial Corp., a vehicle to spin off four Canadian operating companies: Lombard, Commonwealth, Markel, and Federated. News in May included improved first quarter profit figures and improved liquidity. Watsa, long criticized for his elusiveness with not only the press but with stockholders, had opened up. Investors responded positively, driving up stock, but critics maintained a wait-and-see attitude about Fairfax’s future.

Principal Subsidiaries

Crum & Forster Holdings Corporation.

Principal Competitors

American International Group, Inc.; Aviva pic; Hartford Insurance Group; State Farm Insurance Companies.

Key Dates

1984:: Hamblin Watsa Investment Counsel is founded.
1985:: Now named Fairfax Financial Holdings Limited, the company begins trading on the Toronto exchange.
1996:: Fairfax buys a major U.S. property-casualty reinsurer, Skandia America Reinsurance Corp.
1997:: Fairfax is among the world’s 20 largest reinsurers.
2001:: The company loses money for the first time.
2003:: Fairfax spins off its Canadian business units.