Tough TimesFairfax, recently listed on the New York Stock Exchange, has been hit by credit downgrades and deep reserve deficiencies in its U.S. insurance companies, including TIG Insurance, which is highly exposed to the disastrous workers compensation product. True, Watsa, in Fairfax's faux-frank Berkshire-style annual reports, has readily confessed that times are tough and that big acquisitions have failed to hit targets. But investors want more than selective repentance. Indeed, to understand the true health of Fairfax, details are needed on a number of key, but complex, areas. First, there are reinsurance deals. Reinsurance at its simplest -- and rarely is it simple -- is the insurance that insurance companies themselves purchase to adjust their exposure, free up capital and manage earnings. Reinsurance can take many forms, however, and some deals can be structured so that the reinsurer is, for all intents and purposes, lending money to the company ceding the risk. With Fairfax, some investors wonder whether a large and critical reinsurance deal struck with Swiss Re is really a form of debt, which, if treated as such, would increase the company's leverage. In addition, the Swiss Re premiums are being paid by the Fairfax holding company, not the insurance subs, where cost trends are closely watched.
Hanging in the BalanceThe value investor's book value approach fails to hold up if Fairfax's assets are lower than the balance sheet indicates and liabilities are in fact higher. On the asset side, one item looks particularly doubtful: a deferred tax asset, which represents tax deductions Fairfax might be able to take on future profits. Notably, to utilize these deductions, Fairfax subs will actually have to show strong profits, which they didn't in the first nine months of 2002. For example, Fairfax's third-quarter numbers show the U.S. subs making an operating profit of just $5 million.
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 CircleAll 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|