DBRS Confirms Fairfax Financial Ratings at BBB and Pfd-3

DBRS has today confirmed the Senior Unsecured Debt rating of Fairfax Financial Holdings Limited (Fairfax or the Company) at BBB and its Preferred Shares rating at Pfd-3. The trends are Stable. The confirmation reflects the fact that the Company has continued to enjoy strong earnings despite negative underwriting results stemming from ongoing competitive market conditions in commercial insurance markets and adverse catastrophic claims from the tsunami in Japan, earthquakes and storm activity. Strong investment results, including both interest and dividends and gains on investments, continue to distinguish Fairfax’s unique in-house investment management operation, funded through premiums taken in by its insurance operating subsidiaries, although maintaining underwriting profitability is a strategic priority. With an investment bias, Fairfax is able to avoid the worst of the cyclicality inherent in the property and casualty (P&C) insurance industry by choosing not to write policies where inadequate pricing would only give rise to additional underwriting losses.

Over time, Fairfax has proven its ability to outperform substantially most of the equity and fixed-income indices through its long-term value approach to investing. The investment strategy is geared to maximizing the Company’s book value, thereby protecting its capital. While this investment style gives rise to what might be perceived as aggressive market calls, Fairfax actively manages its equity portfolios with hedges to limit short-term market losses and to realize value over the long term. By preserving capital, the Company expects to be better positioned to increase its written premiums when the prospect of stronger underwriting results improves.

Reported underwriting losses in 2011 and 2010 reflect the Company’s exposure to catastrophic claims through its reinsurance operations, especially as a result of the Japan tsunami and the Chilean earthquake. As a larger percentage of the planet becomes developed and weather patterns become more extreme, insured risks similarly increase. However, longer-term catastrophic risk is generally mitigated through immediately responsive pricing, suggesting that it is not expected to be a long-term source of earnings vulnerability. Beyond catastrophic risks, however, the Company’s underwriting profitability continues to be exposed to the cyclicality and risks of the commercial insurance business. Excess industry capital continues to create a soft market for commercial rates, especially given the weak economic environment in the United States, which accounts for close to 50% of the Company’s premiums. Neither the U.S. nor Canadian insurance operations have been profitable from an underwriting perspective since 2007. While the Company has demonstrated discipline in not writing unprofitable business at low rates, prior to the impact of acquisitions, gross and net premiums written in the first nine months of 2011 increased 9.4% and 11.2%, respectively, over the same period in 2010 as the Company targeted specific profitable market niches to address deficient underwriting profitability. Net premiums earned were up 6.3% on the same basis.

The strong buildup of capital as a result of the Company’s continued strong investment earnings and active use of financial leverage has given Fairfax the financial resources to make acquisitions that add to its global insurance platform and diversification. Expansion in the faster-growing markets of Asia, Latin America and eastern Europe, which currently have low insurance penetration, adds to the Company’s organic growth potential in what is otherwise a mature industry in North America and western Europe.

Fairfax continues to hold a large pool of liquid assets at the holding company level, with more than $1.2 billion as of September 30, 2011. The Company remains committed to keeping at least $1 billion in cash and liquid securities at the holding company in addition to the excess capital embedded in its operating subsidiaries. While the holding company cash position effectively reduces the Company’s net debt position substantially, it is regarded primarily as a pool of capital and liquidity that can be used to fund unexpected underwriting losses should the capital markets become inaccessible. The Company’s financial flexibility has also been enhanced by the continued reduction of operating losses in its large runoff business, which was a source of financial stress for the Company prior to 2007. While underwriting results in the runoff segment are expected to continue to be negative given the absence of any earned premiums, reduced expenses and strong investment earnings are expected to support runoff operating results going forward.

Financial leverage is increasingly taking the form of more tax-efficient preferred share capital and borrowings at the holding company rather than at the operating subsidiaries. With 100% control of its major operating subsidiaries, the holding company’s cash position is more secure since the upstream dividend flow from its operating subsidiaries has become more predictable, albeit subject to regulatory approvals, especially given excess regulatory capital at all its major operating subsidiaries. Financial leverage, given the Company’s cash position, excellent liquidity and underlying strong regulatory capital ratios, is well within the limits of the assigned rating category.

The closely held nature of the Company gives rise to a very long-term perspective on the insurance business and investment returns on the part of both long-tenured managers and shareholders. In this context, senior managers are all shareholders of the Company and subscribe to a risk management and governance structure that echoes the long-term perspective of the chairman and major shareholder, Prem Watsa. With this long-term perspective, Fairfax is not likely to sacrifice its current financial strength in the interest of either organic growth or growth by acquisition, but rather it will continue to leverage its financial strength in order to benefit from growth opportunities as they emerge.

Nevertheless, despite the strong investment management track record of the Company, accompanied by growing sophistication around enterprise risk management, the underlying competitive and volatile nature of the underlying insurance business, including the increasing risk of catastrophic claims, suggests that the upside potential for Fairfax’s ratings remains limited.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Canadian Property and Casualty Companies, which can be found on our website under Methodologies.