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Prem Watsa: Very Concerned About US, Europe, China

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Prem Watsa’s Fairfax Financial Holdings Ltd (TSE:FFH) reported results yesterday. We noted that “The Warren Buffett Of Canada” has been bearish for a while and that was affirmed once again through the firm’s quarterly filing. Below are the remarks from Watsa on the conference call this morning as well as those from the Q&A section.

Good morning, ladies and gentlemen.

Welcome to Fairfax Financial Holdings Ltd (TSE:FFH)’s third quarter conference call.

Our insurance companies are doing very well with a combined ratio.

In the first nine months of 2013. And we continue to be soundly financed with quarter end cash and marketable securities at the holding Company of $1.1 billion.

However, we were affected in the quarter with mark-to-market losses on bonds because of rising interest rates in the quarter and a mismatch in our equity portfolios between our common stocks and our hedges.

The Russell 2000 index used for much of our hedging was up about 10%, while the S&P 500 index was up about 5%. Our common stock portfolios were up in the 6% range, not dissimilar to the S&P 500, but significantly less than the Russell 2000. Our long-term performance as you know has been in excess of most indices.

As you know, on a quarterly basis we get fluctuations in our hedging but over time it has been very effective and we expect the mark-to-market losses in this quarter to reverse over time.

In the meantime, we continue to be protected from a significant decrease in the equity markets.
Our insurance and reinsurance businesses continue to expand profitably.

Net premiums written by the Company’s insurance and reinsurance operations in the third quarter of 2013 increased by 3.9%.

As I said, the combined ratio for our insurance and reinsurance operations in 2013 was 93.4% for the third quarter and 93.9% for the first nine

At the subsidiary level, the percentage increase in net premiums written in the third quarter compared to the third quarter 2012 and the combined ratios were as follows.

OdysseyRe, a 7% increase in net premium with a combined ratio of 87.6%, Crum & Forster, 1.8% increase in net premiums, 99.3% combined ratio,

Northbridge, 1% increase in the net premium, 101.5% combined ratio, Zenith, 12.4% increase in premium with a combined ratio of 96.8, and Fairfax Asia, 1.3% increase in net premiums and a combined ratio of 80.9%.

During 2013 many underwriting initiatives have been implemented but I wanted to highlight the progress of a couple of companies.

Zenith, which has demonstrated many times over the years its ability to manage the underwriting cycle has done it again.

Cut premiums during the soft market years, 2008-2010, combined ratios for them because of the lesser premium has increased, driven by higher expense ratios, other participants, competitors have entered the market to grow their business significantly, as the industry’s underwriting loss
increases, prices begin to increase.

Reserves develop and peer companies exit the industry which is what is happening today.

Rates continue to increase and Zenith continues to grow its exposure base.

Zenith cut its premium base from $1.1 billion to about $450 million, when we bought it in 2010. It now writes approximately $700 million, and it’s rising.

Over time, I have no question it will write more than $1.1 billion.

Although Crum & Forster’s gross premiums written remain flat for the first nine months of the year, its more profitable specialty business was up 11%, while its standard lines business was down 33%.

This has led to a 2.5% improvement in that combined ratio year-over-year.

Fairfax Brazil, a start-up in 2010 with zero premium has built a first class operation over the last three years with approximately 60 people.

For the nine months of this year, the Company has written $115 million gross, $48 million net at a combined ratio approaching 100%.

We expect Brazil to be a contributor to our overall under writing profitability well into the future under leadership.

Odyssey and Fairfax Asia

Odyssey and Fairfax Financial Holdings Ltd (TSE:FFH) Asia of course continue to hit the ball out of the park with excellent combined ratios.

So we continue to grow, depending on the Company.

As we have said before, very low interest rates and the reduced reserve redundancies mean there’s no flies hide for the industry.

Well below 100% for the industry to make a single digit return on equity with these low interest rates.
While the short-term is always tough to predict, fundamentals we think will eventually play out.

Now, in terms of the investment area net investment losses of $828.6 million in the third quarter of 2013 consisted of the following.

Please note table on page two of our press release.

Net losses on equity and equity related investments of $478 million was after an $816 million net loss on our equity hedge.

Because of the mismatch between the Russell index and our portfolios, we expect trends to reverse over time.

This happened before in the fourth quarter of 2011. The realized loss of $577 million on our equity hedges was due to the sale of common stocks and consequently a permanent reduction in our hedges and also the reduction of our hedge ratio to our target 100%.

On a year-to-date basis, our net equity losses after our equity hedge was approximately $300 million.

As we have mentioned in our annual meetings, annual reports and quarterly calls, with IFRS accounting where stocks and bonds are at market and subject to mark-to-market gains or losses, quarterly and annual income will fluctuate significantly and will only make sense over the long term.

Because of rising interest rates in the quarter, we had $215 million in unrealized mark-to-market bond losses, a majority of which are in munis insured by Berkshire Hathaway.

We considered these unrealized bond losses as fluctuations and expect them to reverse over time.

Our muni bond portfolio as you know was mainly acquired in the last quarter of 2008 after an aftertax yield of 5.7% — 79%.

The core inflation continues to be at or below 1% in the United States and Europe.

Levels not seen since the 1950s.

This is in spite of QE1, QE2 and QE3. Our CPI linked derivatives, however, are down 76% from our cost.

And are carried on our balance sheet at $130.5 million.

Even though they have almost eight years to run.

Our CDS experience comes to mind.

When you review our statements, please remember that we own more than 20% — when we own more than 20% of a Company, we equity account and above 50% we consolidate so that mark-to-market gains in these companies are not reflected in our results.

Let me mention some of these gains.

As you can see on page 13 of our quarterly report, that’s page 13 of our quarterly report, the fair values of our investment in associates is $1.752 billion.

Versus a carrying value of $1.409 billion.

And unrealized gain of $343 million not on our balance sheet.

Also, we own 75% of Thomas Cook, 74% of ridly, which are consolidated in our statements, unrealized gains on market values a as of October 29, 2013 on both these positions is approximately $146 million.

That’s total unrealized gains, not reflected on our balance sheet is $490 million.

Finally Europe properties and investment.

With outstanding management where we have increased our investment through their rights issue has another unrealized depreciation of $141 million as of October 29th, 2013. And that also is not included in our balance sheet.

So when you add all of that, we have a total of $631 million of unrealized gains that are not on our balance sheet.

Of course, all of this works out in the long term, so take these mark-to-market fluctuations as just that, fluctuation that’s will have no impact in the long term.

The worst mark-to-market loss we’ve had was in the fourth quarter of 2011 of $915 million.

Again, when the Russell 2000 significantly outperformed the S&P 500 (INDEXSP:.INX). As I’ve said before, the Company held in excess of $1.1 billion of cash, short-term investments and marketable securities at the holding Company level at September 30, 2013. We continue to be approximately 100% hedged in relationship to our equity and equity related securities, which include convertible bonds and convertible preferred stock.

We continue to be very concerned about the prospects for the financial markets and the economies of North America and Western Europe, accentuated as we have said before by potential weakness in China.

As we have said now for some time, we believe there continues to be a big disconnect between the financial markets and the underlying economic fundamentals.

As of September 30th, 2013, we have over 30% or $7.2 billion in cash and short-term investments in our portfolio to take advantage of opportunities that come our way.

As a result, in the short term our investment income will be reduced.

Unknown Speaker

Just wanted to find out in regards to the BlackBerry Ltd (NASDAQ:BBRY) (TSE:BB) offer, wanted to see if there was any update, I believe the deadline’s coming up on Monday, so just wanted to see where things stood, if there was a chance for a possible extension or just wanted to get a little of understanding on that situation.

Thank you.

Prem Watsa

thank you for your question.

As you know, we cannot make any comments on BlackBerry Ltd (NASDAQ:BBRY) (TSE:BB) as we have a bid for the Company.

So we really can’t make any more comments on it until, as you say, November the fourth.

So thank you for your question.

Next question, please.


Thank you.

(Operator Instructions).

There’s a question from Paul Holden with CIBC.

Your line is open.

Unknown Speaker*

Thank you.

Good morning.

Unknown Speaker*

Wanted to ask you about Northbridge.

So if you look at the accident year combined ratio for Northbridge, I mean, 2013 has been another tough year, granted some of that has been related to cats, but I think even if you factor that in it’s still not a great year relative to your other underwriting businesses.

You mentioned that competitive conditions remain challenging so that’s probably fair. So sort of a three-part question for you on Northbridge.

A, do you see any early signs that competitive conditions in Canadian P&C are easing, i.e.
are rates starting to firm following 2013 cat events?

B, are there Company-specific actions that you’re taking that could lead to an improved accidents year combined ratio in 2014?

And C, would you ever consider trading this asset for a higher margin business in a different market?

Prem Watsa

Thank you, Paul.

First of all, yeah, the accident year combined ratios are high, I think ran at 115%, but you’ll notice there was — we have very significant reserve redundancies.

So our reserve accident year combined ratios are high but on the other side, our redundancies are also high and so we’re very careful in our reserving and over time that accident year combined ratio will reflect the underlying conditions.

But we’re very, very careful in terms of reserving.

We want to be sure that the reserves are appropriate.

In terms of your first question, in terms of the industry changing, Canada’s always lagged the United States.

The US first moves up and then Canada follows.

We have had the catastrophes, Calgary floods, the Toronto storms. Rates are not going down.

They’re going up some.

And we think it will improve over time.

And this applies to the United States too.

Of course in some areas like I was talking about Zenith, workers’ compensation, many, many companies in the United States have taken reserve increases, big reserve charges have been pretty well in the course of being put into runoff and so the price increase that Zenith enjoys is in the 15% area.

You have to have not written a lot of business during the soft markets to be able to take advantage, like Zenith is doing today. So we think that will follow in Canada too.

In Canada, we have our Northbridge segmenting the markets and being more focused on certain target markets and so we think over time our combined ratios will be well below 100% under Sylvia Wright’s leadership.

Northbridge, Fairfax, Asia, Odyssey, any of them, Brazil.

Annual report, none of our companies are for sale.

Any of our subsidiaries, insurance subsidiaries are not for sale, going to hold them forever.

Secondly, Fairfax itself is not for sale.

I said it very clearly to companies.

I have in my voting interest, I consider it to be a controlling interest and I said to our shareholders that if someone comes in with a price twice today’s price, I wouldn’t sell.

This is our 28th year.

I’ve said that four or five times over that time period.

Noun None of our companies is for sale.

Because of that, we enjoy a huge amount of loyalty from our people.

I said this also before.

The Presidents of our companies who have run our subsidiaries, we’ve never lost one President, never lost one President who has been successful in our operation.

We’ve had retirement early on in our 28 years.

We’ve had for.

We’ve had people that would leave us but people who have been successful have been with us for a long time.

Andy Bernard the better part of 20 years, Brian Young, the better part of 20 years, on and on and on. Sylvia Wright’s been with us the better part of 20. It’s a competitive advantage we think to have our subsidiaries owned forever, that it will never be sold, so our presidents can look after the operations not having to look back and see if the head office will decide to sell them because of they have a year or two of poor performance.

I want to be very specific.

Thank you forking for asking that question, Paul.

I want to be very specific to all our shareholders.

Next question.


Our next question is from Howard flincher with flincher and Company.

Hello everybody.

A few years ago we pondered what kind of underwriting ratios industry-wide would generate enough returns to attract competition.

The recent week I’ve seen three companies including Chubb with historically respectable underwriting disciplines underwrite in the, say, 85 to 89% rate and their annualized rates of return on moderately leveraged equity are between 8.5 and 11 — 8.5 and 12. So even 85 to 89 doesn’t Jen generate a high enough return to attract a whole lot of competition.

8.5 or 9 or 10 is not really exciting.

So that indicates to me, I’d like you to comment, that indicates to me there’s still plenty of room on the upside in rates.

Is that correct?

Prem Watsa

That’s not a bad comment, Howard.

The only problem is our industry over long periods of time hasn’t made good returns on equity.
I think Chubb or other companies that have been in business for 25 years, if you look at their returns, they’ve been in that 10% area, plus, minus.

And so unlike other industries including the S&P 500, which has had 14 and 15% return on equity, so that’s — but your point’s well-taken.

That’s why with these low interest rates you have to have low combined ratios like combined ratios much below 100%, to even have any chance of making a 10% return.

You say 8.5 to 11, making a 10% return.

So every time a bond, a five-year bond matures and mostly at the investment portfolios of insurance companies are invested, like a five-year bond.

They’re pretty short.

Prem Watsa

Every time it matures, Howard, investment income drops.

Unknown Speaker*

That’s right.

Unknown Speaker*

So this is going to continue.

Unknown Speaker*


Prem Watsa

And the pressure to make a return will be very significant.

To get a really hard market in our experience over the last 30 years is that you need to have an event.

You need to have something that happens either on the liability side, on the insurance side, obviously a big catastrophe or something like that or on the other side, the investment portfolios, like if you have spreads suddenly widening.

Like we have very few corporate bonds today.

One of the reasons is the spreads are very tight and so if spreads widen, people are reaching for yield, not only in the insurance business but all over the United States and Canada and perhaps the world.

As these lower interest rates prevail.

Well, if spreads widen significantly, there will be losses in bond portfolios and so — and I mentioned our CPI deflation swaps.

Inflation is very low today, in spite of QE1, QE2, QE3, lots of fiscal stimulus, inflation is in that 1% area.

The most recent number in Europe was 0.7%, 0.7%.

So if you — it takes some time before deflation sets in.

Unknown Speaker*


Prem Watsa

We continue to, Howard, worry about deflation.

Of course, if that happens we don’t do too badly because of these swaps that we have.

So we protected ourselves for some time from all of these events.

It doesn’t show in our statements.

We’re long-term in building value.

Unknown Speaker*

The record being 110, 115, 100 years, I forget the exact period.

Unknown Speaker*

I think that’s right.

Prem Watsa

That is deflationary in itself.

One other event I was going to add is if 2014, not 1914, 2014 has a severe — has a downward year in the stock market, that could be the event that you’re pondering.

Unknown Speaker*

That would — that’s the sort of environment we’re protecting ourselves against, Howard.

You know, but of course no one knows what will happen in 2000 —

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