Unsure Times for Insurer Fairfax Financial

Companies must write down deferred tax assets if it becomes clear that a company can't produce the profits to make use of the assets. And while U.S. operations may have eked out a small operating profit up until the third quarter, it's likely that their performance is still deteriorating badly, given the fact that Fairfax announced a drastic restructuring of TIG in December. As part of the cleanup, it strengthened TIG's reserves by $200 million, suggesting that a third-quarter improvement in TIG's profitability numbers was a mirage. Fairfax has $1 billion of deferred taxes. Write that down by half and book value is cut by 20%.

The liability side of the balance sheet is more complex still. The basic question to be asked here is whether liabilities are somehow understated. In particular, how likely is it that the reinsurance written by Swiss Re is tantamount to a debt financing? It is impossible to tell without extra details from the company. But reinsurance can be structured to behave like debt.

Fairfax took out the Swiss Re reinsurance to cover itself against insufficient loss reserves at the distressed U.S. insurers that it bought at what looked like bargain-basement prices. It is known that Fairfax bought $1 billion of cover from Swiss Re, and has paid back a certain amount in premium. But beyond that it's close to impossible to gauge the true nature of the contract.

However, even if the Swiss Re policy is not debt, investors need to be aware that the cost of it is borne by the parent, not the insurance subs, which would appear to give an artificial boost to margins at the subs. Of course, the sniping on the Swiss Re deal may turn out to be groundless, but investors still need to focus hard on Fairfax's habit of using its own offshore entities to reinsure its onshore business.