Author Topic: Comments and Observations about A/R  (Read 5500 times)

StubbleJumper

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Comments and Observations about A/R
« on: March 07, 2020, 02:09:03 PM »


We kicked the ball around a bit when Q4 numbers were released in mid-February.  It's nice to have gotten the A/R to get a more fulsome picture:

1) General comments - Nice to see double-digit increases in Net Written and hopefully the pricing environment drives better CRs, but unfortunately the interest rate environment over the coming months does not look favourable.  This was always the risk of the move to a tight duration that was initiated two years ago -- in a rising rate environment, FFH would have come out ahead, but pandemic-phobia is that slightly unexpected grey swan.  The question is how long these silly low rates will last...a poster last week compared them to crack cocaine and I can't really say that I disagree.


2) International insurance companies - For the second consecutive year, Prem has dedicated a considerable amount of ink to the international insurance companies (see page 6 of the AR).  For a second consecutive year, that all of that ink seems to be an attempt to put a positive spin on a collection of pretty shitty CRs.  And for the second consecutive year I will observe that those subs should be considerably more profitable.  Seriously, if FFH is going to invest capital in banana republics like Columbia or Chile, or in the potential kleptocracies of Eastern Europe the investments should at least be quite obviously profitable.  Much is made about premium growth, but in most cases the CRs are so high that the value of underwriting growth is dubious.  Interestingly enough, unlike last year, FFH did not provide a break down of the international sub profitability this year so it is no longer possible for us to assess whether the investment returns are an adequate enticement to accept this collection of disappointing CRs.  Should we take Prem at his word that these subs are valuable contributors?


3) Included in the table of international insurance companies was a bit of disclosure about GroupRe, probabably because it is domiciled in the Carribean (again see pages 6 and 7 of the AR).  GroupRe put up a 96 CR, in large part by re-insuring a portion of the other subsidiaries' books of business.  Prem goes on to note that GroupRe has racked up a CR of 88 over the past 5 years by re-insuring portions of the other subs' underwriting.  That's pretty good, but if reinsuring FFH's book is that lucrative, it does call into question whether FFH isn't ceding too much premium to reinsurers (invert, always invert!).  Would an extra $1B of capital scattered amongst the primary subs result in a similar level of profitability?  Obviously you do need some amount of reinsurance, but maybe the current attachment points don't offer particularly good value?


4) When does Farmers Edge start to make money for FFH? - It has lost about $1.50/sh for each of the past two years (see page 183).  Did this investment ever fall within Prem's circle of competence? 


5) The Loss Triangles - it was nice to get updated loss triangles because they are essential to better understand what's going on with UW (see page 79 of the AR).  As I have observed on several occasions over the past year, favourable development has been chronically ridiculous, regularly clocking in at 10% of reserves.  All of that came to a screeching halt in 2019, with only $100m of redundancies on $29B of reserves.  The decline has actually been a bit more gradual than it appears, if you strip out the impact of currency translation and getting slapped in the head once again by APH (it's really a "gift" that keeps on giving...how much of the APH liability is related to the TIG and C&F acquisitions?).  Stripping out those two factors, the change in favourable development isn't so bad.  Once again, this year I would note my disappointment about not getting the loss triangles for each of the major subs....somehow I suspect that C&F's is a bit of a shit-show, but we'll never know.


6) Capital adequacy / underwriting capacity - Prem trotted out his usual bravado about FFH's financial position being rock solid (see page 20 of the AR), but I'm not sure that I like everything that I see.  The holdco is down to about $1.1B in cash, so it will need a fair infusion of divvies from the subs during 2020.  On page 95 of the AR, the dividend capacity of the major subs is depicted and the lion's share is found in Allied World and ORH.  It is quite likely that the holdco will need to draw at least some divvies from NB, Brit and C&F during 2020.  However, on page 195 of the AR underwriting capacity is described through a table which displays the existing premiums to statutory capital ratios.  C&F, NB and Brit still have room to grow their book, but it would be disappointing if FFH were forced to draw $200m or more of divvies from those subs during 2020.  It has been years since I have fussed about the holdco's liquidity and prepared a cash sources-uses analysis, and I really hope we are not headed back into that world.  There will be cash coming down the pipe shortly from the Riverstone sale, and there will be cash used to buy up some of the minority stakes in 2020, but let's just say that Toronto and Omaha have different preoccupations when it comes to the cash balances.


7) Drawing on the revolver - continuing from the previous observations on capital adequacy, I found it interesting that FFH drew $300m on its revolver in Q1 (see page 88 of the AR).  I expressed a bit of bemusement when FFH renegotiated a $2B revolver 2 years ago when the holdco was swimming in cash, but observed that the best time to obtain revolving credit is probably a time that you don't really need it.  But, why did they draw the $300m and is it the plan to continue to draw on that revolver rather than to dividend money up to the holdco? 


8) Euro denominated debt - It's neither here nor there, but I found it a bit strange that Prem dedicated some ink to the fact that FFH issued Euro denominated debt (see page 20 of the AR).  It makes perfect sense to issue some Euro notes as a hedge if you expect to have Euro denominated income.  But it seems a bit strange that notes for 750m Euros would merit mention, particularly when FFH had French Franc denominated notes decades ago.


9) Legacy debt interest rates - it's nothing new, but while reading the financials I always look at the note about historical debt issuance (page 86 of the AR).  Zenith still has debentures on their books that mature in 2028 at a 8.55% interest rate and the holdco has notes outstanding at 8.40% interest.  It's amazing how much the operating environment has changed!  If you floated debt at 5% today, we would say that you had gotten scalped!


10) What caused pension assets flop in 2019? - On page 97 of the AR the financial situation of the pension plan is depicted.  The fair value of pension plan assets declined from $727m to $606m during 2019.  That's only $4 or $5 per share, but what the hell is going here?  How did FFH manage to register a decline in the value of pension assets during 2019?  Were there *any* asset classes that declined in 2019?  Seriously, Prem's dog could have chosen a portfolio of stocks and bonds by shitting on the investment pages of the newspaper and those securities would likely have registered a gain in 2019.


11) Is FFH reaching for yield? - On page 109 of the AR, fixed income ratings are depicted.  In 2019, 66% of fixed income was rated A level or higher, while in 2018 74% of fixed income was A or higher.  Some of this was due to moving from fixed income to cash, but there does seem to be a bit of a move down the credit quality scale.  IMO, this is not the time to reach for yield because you really don't get paid to take on the credit risk.


12) What the hell is going on with duration? - On page 114 of the AR, the interest rate sensitivity chart is about our only insight on the duration of the fixed income portfolio.  What is going on here?  There is an asymmetric impact of interest rate changes.  A 200bp increase wacks the FI portfolio by $463m, but a 200bp decrease is a $696m gain. 


13) More adverse development from Allied (see page 174 of the AR): Are there still more skeletons in the closet, or what is going on here?


Anyway, that's my stream of consciousness.


SJ


petec

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Re: Comments and Observations about A/R
« Reply #1 on: March 07, 2020, 02:41:10 PM »
And a very useful stream of consciousness it is, too.

I canít read the AR properly until next week so I canít comment on much, but I would politely suggest that you educate yourself a bit before referring to Chile and Colombia as banana republics. I spend a lot of time in both countries and am currently in Chile. They have their faults but neither is a banana republic. Both grow consistently, have fiscal deficit rules unseen in the developed world, have reasonably low levels of debt, are functioning democracies with strengthening institutions, and have independent central banks that donít resort to panic rate cuts every time the stock market falls 5% or the president sends a tweet.

Sorry for the rant ;)
« Last Edit: March 07, 2020, 05:28:40 PM by petec »
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StubbleJumper

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Re: Comments and Observations about A/R
« Reply #2 on: March 07, 2020, 02:48:34 PM »
I would politely suggest that you educate yourself a bit before referring to Chile and Colombia as banana republics. I spend a lot of time in both countries and am currently in Chile. They have their faults but neither is a banana republic. Both grow consistently, have fiscal deficit rules unseen in the developed world, have reasonably low levels of debt, are functioning democracies with strengthening institutions, and have independent central banks that donít report to panic rate cuts every time the stock market falls 5% or the president sends a tweet.

Sorry for the rant ;)


I referred to them as "shit-holes" last year, so I didn't want to be repetitive.   :D

maxthetrade

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Re: Comments and Observations about A/R
« Reply #3 on: March 07, 2020, 02:51:13 PM »
If I only could get a dollar for each exclamation mark in the letter this would be a fantastic investment ;)

petec

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Re: Comments and Observations about A/R
« Reply #4 on: March 07, 2020, 03:08:23 PM »
I would politely suggest that you educate yourself a bit before referring to Chile and Colombia as banana republics. I spend a lot of time in both countries and am currently in Chile. They have their faults but neither is a banana republic. Both grow consistently, have fiscal deficit rules unseen in the developed world, have reasonably low levels of debt, are functioning democracies with strengthening institutions, and have independent central banks that donít report to panic rate cuts every time the stock market falls 5% or the president sends a tweet.

Sorry for the rant ;)


I referred to them as "shit-holes" last year, so I didn't want to be repetitive.   :D

Ha ha ok you win ;)

Btw my view on the international subs is that theyíre options. If one turns into anything like another First Capital or ICICI Lombard weíre doing ok. If I had to bet Iíd say it will be Brazil - the operation seems to be on track and itís in a top ten world economy on the verge of liftoff. Eurolife is valuable but I donít know how much it can grow. And Digit is shaping up to be a home run although since they donít consolidate it I assume itís not one of the companies youíre talking about. (Even if it isnít, itís important because many of the lessons learned via Digit may be applicable elsewhere.)

Itís also worth remembering that insurance is hugely underpenetrated in many of these countries and multiples of book in the private markets are high.
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petec

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Re: Comments and Observations about A/R
« Reply #5 on: March 07, 2020, 03:19:09 PM »
SJ why do you think the holdco needs dividends from the less well-capitalised subs )Crum, Brit etc.)?
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StubbleJumper

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Re: Comments and Observations about A/R
« Reply #6 on: March 07, 2020, 04:18:20 PM »
SJ why do you think the holdco needs dividends from the less well-capitalised subs )Crum, Brit etc.)?

Frankly, I don't know how the holdco will finance its activities in 2020.  Working from memory, it's been a decade or so since FFH published an unconsolidated holdco income statement, so we don't have much visibility on what they are doing.  But, short of going back to the old sources-uses analysis, this is what I think we know:

Sources:
-the revolver and whatever new debt FFH might float ~$2B
-Riverstone proceeds ~$600m
-subsidiary dividends (see page 95 of the AR for capacity)
-management fees (Fairfax India, Africa, and whatever Hamblin Watsa gets for managing the subs' portfolios)
-interest and divvies on the holdco's $1.1B balance (less than $50m?)
-divvies (if any) from non insurance companies (zero?)
-tax loss carry-forwards (zero?)


Uses:
-Common and pref divvies ~ $300m
-Holdco interest payments = $4.1B debt x weighted interest rate = ~$250m
-Operating expenses
-purchase of minority stakes (Brit ~$100m, Allied in next 3 or 4 years ~$1.5B)
-stock buybacks (zero?)



So, how does it shake out?  My take is that the holdco needs at least $700m in 2020.  They've taken $300 from the revolver and are getting $600 for Riverstone.  Is that how the year shakes out?  If they want to pay back the revolver then they likely need some divvies from the subs.  ORH has some cash, Allied has some cash....but if you need $500m from the subs, you'd need to draw from the less capitalized subs (in actual fact, they took a divvy from C&F in 2019, but then they injected an offsetting capital investment...not sure I understand that).

This was all much clearer when they published a hold co income statement.  But, then again, those were the bad old days.


SJ

petec

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Re: Comments and Observations about A/R
« Reply #7 on: March 07, 2020, 05:27:53 PM »
If they want to pay back the revolver in 2020 then I agree. But why would they? Theyíve always talked about cash at the holdco in absolute terms, not net terms. My guess is they set up the big revolver for exactly this eventuality and theyíre happy levering the holdco at the start of a hard market. Absent the Allied minority buy-in, which doesnít have to happen soon, one could argue theyíre really quite liquid.
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StubbleJumper

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Re: Comments and Observations about A/R
« Reply #8 on: March 07, 2020, 06:40:24 PM »
If they want to pay back the revolver in 2020 then I agree. But why would they? Theyíve always talked about cash at the holdco in absolute terms, not net terms. My guess is they set up the big revolver for exactly this eventuality and theyíre happy levering the holdco at the start of a hard market. Absent the Allied minority buy-in, which doesnít have to happen soon, one could argue theyíre really quite liquid.


Oh, there are lots of options available.  That;s not really the issue.

The increase in the debt load over the past couple of years, the sale of part of Riverstone and drawing on the revolver are all things that make me raise my eyebrows.  I have commented previously on the quality of earnings in 2018 and 2019 which reflect that value has been created over the past 5 or 6 years, but has not really generated distributable cash.  What happened to the song and dance from a couple of years ago that the insurance side of the business was adequately built, the acquisitions were done, and reducing the share count was the way forward?  Fast forward a couple of years, and now FFH is reliant on operating credit in the form of a revolver, they are selling the crown jewels (okay, mild exaggeration!), and they seem to be challenged to fully exploit a hardening market.  It will all probably work out just fine, but there's a bit of a history here.


SJ


SJ

petec

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Re: Comments and Observations about A/R
« Reply #9 on: March 08, 2020, 04:23:33 AM »
I broadly agree. The share buyback doesnít make me scratch my head because I always read that as a long term thing. Riverstone UK does a little - not sure why itís better placed to grow with OMERS as a partner, which is what Prem says - but that negative is offset by my surprise at how much itís worth and we have to consider the possibility that the motivation for the deal may simply have been to surface value and get the BV mark.

But what does really piss me off is that Prem keeps banging on about how well capitalized the subs are while not mentioning that they had to squirt equity into some of them during the year. Just feels like a lie.
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