Unsure Times for Insurer Fairfax Financial

Reassuring Reinsurance?

The suspicion here is that offshore reinsurers are being used to get liquidity out of regulated entities and transfer it to the parent. A Dublin-based entity called ORC Re, which had only seven employees at the end of 2001, appears to play a large role. For example, TIG's 2001 statutory accounts show ORC Re agreeing to indemnify TIG for up to $340 million of losses -- at a cost of $115 million. When a company reinsures, it is able to free up capital and boost the capital and surplus measures that regulators keep a close eye on.

But why didn't TIG carry out that reinsurance with a non-Fairfax entity? Without disclosure from ORC Re, investors have been left to make guesses.

One viewpoint is that Fairfax, perhaps due to regulatory pressure, doesn't get to extract dividends from a stressed entity like TIG. So, instead, TIG pays out reinsurance premium to ORC Re, which then pays dividends to the Fairfax parent. Indeed, Fairfax's insurance subs are paying a lot less to the parent, forking out only $36 million to the parent in 2001, compared with $210 million in 2000. What's more, the subs' maximum dividend capacity shrunk in 2002 to $150 million from $223 million in 2001, due to poor operating results. It is believed that the Fairfax parent gets around 75% of its dividends from offshore subs, not U.S. and Canadian entities.

The seemingly central role of ORC Re, and perhaps others, seems questionable enough, but there is another twist: The Fairfax parent also uses its bank lines to place letters of credit at its regulated and offshore subs to shore up their capital. Letters of credit are commitments from a bank to pay out a certain amount of money, and are often used to boost capital at insurance companies. Indeed, Fairfax clearly states in its 2001 annual report that its letters of credit had been "pledged as security for subsidiaries' reinsurance balances, principally relating to intercompany reinsurance between subsidiaries."

Squared Circle

All this has led some investors to surmise that liquidity is simply swirling in a circle.

Dry Wells? Dividends paid to Fairfax holding company by subsidiares (U.S. dollars)

Sources: Fairfax, Detox

The theory goes: Dividends mainly from the offshore subs are being paid to keep enough liquidity at the parent to reassure the banks so that Fairfax will have letters of credit to place with the subs so they can pay dividends to the parent. If this is so, and the basic business continues to deteriorate, the banks and the insurance regulators are likely to call a stop to it soon. Indeed, the banks don't seem to be renewing the credit lines on which the letters of credit are issued. In February 2002, Fairfax had $595 million of unsecured committed bank lines, compared with $821 million in 2001.

So, what might be Watsa's next move? There is still $365 million of cash at the holding company and some unrealized gains on some spectacularly clever derivative bets on the S&P 500 and U.S. Treasuries. And, of course, some bank lines are still available. This is not much of a margin of safety. Just next month, a $140 million issue of debtlike securities comes due. No surprise that Fairfax is trying to extend it.

Watsa may try and buy more reinsurance coverage for TIG so that regulators agree to allow the entity to sell assets, such as Odyssey Re (ORH Quote). But such a deal could be punitively expensive. As part of the December TIG restructuring, Fairfax had to put $800 million of TIG assets in a trust "principally pending TIG's satisfaction of certain financial tests at the end of 2003." Watsa could forego an early reinsurance deal and wait till then, but presumably it's not certain TIG will be able to pass those tests.