Just a simple question:
1) When determining the statutory surplus, is it almost equivalent to Common shareholder's equity + preferred shares + minority interest?
2) Just a simple observation:
Referring to their annual report's total return on investment portfolio footnote, it appears that they under-perform their 7% investment return hurdle rate 39% of the time over the past 33 years.
If that is true, that means under-performing 5 years in a row, would put it at less than a 1% probability.
For 1), statutory surplus is determined by state regulators who typically use a risk-based capital framework (similar to banks) to reduce the value of certain elements (and increase the margin of safety for the policyholder) of the balance sheet, as reported. The discounts vary and depend on the perceived level of risk. FWIW, I've been looking at a few insurers who carry a heavy load of BBB rated corporate bonds (not the case for FFH). An interesting feature is that, in the event of a recession, on top of the decrease in market value for the bonds, surplus capital gets a double whammy because the discount factor is higher for downgraded securities.
For 2), your statistical appreciation of forward returns is interesting and is in line with the idea of reversion to the mean, which has been a significant long-term feature at Fairfax (investment strategy, seven lean years analogy etc) but I wonder if such an approach is satisfactory on a forward basis as the investing environment has changed and the Fairfax investment recipe has been changing (some aspects dramatically so) so the future may not be correlated to the past. I think I read you're an MD and the following statistical "joke" came to mind when reading your post. There's this surgeon who comes to the patient waiting to be rolled in and explains that the death risk with the procedure is 1 in 2 but that the patient should not worry because the previous patient did not make it.
Thanks For the detailed response.
You are absolutely right if the underlying people, processes, and investing environmental context change then the underlying distribution will change and the mean reversion effect may not happen.
I love the joke, as most physicians have no or little statistical training/understanding despite three decades of evidence based medicine.
I guess the meta question is “has hamblin watsa adapted to the environment and learned from its mistakes. Is their devil’S advocacy before investment commitment as a effective as they think it is?” That the distribution of investment outcomes is something other than 60-40 for 7%? With so many interacting variables involving a biological system, I guess this question may be impossible to estimate with any precision. We know their value principles but how about their learning and leadership principles. Certainly it appears there are a number of individuals that no longer think they have the adaptability moving forward to make decent investment returns.
But everything has its price in the market and there is an argument that the past is a sunk cost and all that matters is future behaviour.
Ps
You might enjoy this randomized control trial from the British journal of medicine
https://www.bmj.com/content/363/bmj.k5094