Prem Watsa Says on Call that Fairfax’s Equites are 100% Hedged

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Prem Watsa’s Fairfax Financial recently reported third quarter earnings. Prem Watsa does not speak much, but he spoke on the conference call at great lengths. Additionally, Watsa answered several questions from analysts on the call. The conference call is an interesting read on the insurance company and Watsa’s current investments and views. We have obtained a copy of the call, and have detailed the parts where Prem Watsa is on the call.

Prem Watsa – Fairfax Financial Holdings Limited (PINK:FRFHF) (TSE:FFH) – Chairman and CEO, Good morning, ladies and gentlemen. Welcome to Fairfax’s third-quarter conference call. I would like to give you some of the highlights, and then pass it on to Dave Bonham, our CFO, for additional financial details.

In the third quarter of 2012, book value per share was up slightly 1.7% from year-end, adjusted for the $10.00 per share common dividends paid out in the first quarter of this year. We have continued improved underwriting results on increased premiums as we produced a small investment loss, due to unrealized investment losses, related to our defensive hedging strategy. We finished the quarter with cash and marketable securities at the holding company of $967 million.

The consolidated combined ratio for Fairfax Financial Holdings Limited (PINK:FRFHF) (TSE:FFH) in the third quarter and the year-to-date was 95.4% and 97.1%, respectively. Reserve redundancies were $38 million, or 2.4 percentage points on the combined ratio in the quarter. We continue to reserve conservatively.

As I have said in recent calls, we continue to grow our premiums. The large catastrophe losses in 2011, very low interest rate, and the reduced reserve redundancies means that there is no bridge as high for the industry. Combined ratios have to drop well below 100% for the industry to make a single-digit return on equities received low interest rates.

In the third quarter, net premiums written by our insurance and reinsurance operations increased by 5.6% to $1.51 billion, from $1.43 billion in 2011. At the subsidiary levels net premiums in the third quarter of 2012 were as follows — for Zenith, up 27.3%; Crum & Forster, up 19.7%; Odyssey Re Holdings Corp, up 6.1%;  Fairfax Financial Holdings Limited (PINK:FRFHF) (TSE:FFH) Asia, up 8.2%; and Northbridge in Canadian dollars down 5.5%, after eliminating the nonrenewable of Northbridge’s US property line, which was transferred to OdysseyRe. Net investment losses of $23.6 million in the third quarter of 2012 consisted of the following. Please note the table on page 2 of our press release.

In the third quarter, the net realized gains and on bonds and equities of $340 million, as you can see from the table, was upset by net unrealized losses of $364 million, primarily from our equity hedges. In the nine months, net realized gains from equities and bonds in the main of approximately $730 million were offset by net unrealized losses of $723 million, primarily from our equity hedges and CPI-linked derivatives, and other losses.

We continue to be approximately 100% hedged in relation to our equity and equity-related securities, which includes convertible bonds and convertible preferred stock. We have said for some time that we are concerned about the economies of North America and Western Europe, accentuated by the breaking of the real estate bubble in China in late 2011. And we continue to believe that we are not adequately paid to take risks with bonds and stock markets at current levels.

As of September 30, 2012, we have almost $8.1 billion in cash and short-term investments, about 33% of the investment portfolio, to take advantage of opportunities that may come our way. In the short term, our investment income will be reduced. On October 12, 2012, the Company completed the purchase of the runoff business of Brit Group, with a cash payment by the Company’s runoff operations of $332 million at a discount to book value, Brit Insurance at an investment portfolio of approximately $1.4 billion.

On October 1, 2012, the Company announced they had (technical difficulty) Cunningham Lindsey for about $260 million and we expect it to close in the fourth quarter. In the fourth quarter we also completed a debt offering of CAD200 million and announced a note repayment of $200 million for [Chipec].

During the quarter, the Company completed the purchase of Thomas Cook India for about $173 million. We are very positive about the long-term prospects of this company in India. The class-action litigation against Fairfax was dismissed with prejudice, which means that no further possibility of appeal. Fairfax did not make any payments in connection with this dismissal.

The New Jersey litigation against hedge funds and other defendants was dismissed without prejudice on legal grounds. We believe the decision was incorrect and we plan to appeal. Now I would like to turn it over to Dave, so he can give you some information on the underlying financials. Dave?

Tom MacKinnon – BMO Capital Markets – Analyst

Good morning. What we are seeing here, we are certainly seeing underwriting results improve, both for you guys and for the industry. But your, to some extent, your investment portfolio was conservative and a cautious stance doesn’t really allow you to participate fully in any kind of earnings run-up associated with what could be potentially firming markets. I’m wondering what you — what’s your message to investors,  relative to this? Is this just to continue to be patient? And what would it take to change your mind vis-a-vis the equity hedges and the significant cash position?

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO

That’s a very good question. It is a key question. The underwriting operations for our Company, all our Companies, is improving as you pointed out, improving quite significantly. But the investment side, we are very conservative. We have got 33%, $8 billion in cash. Common stock positions are fully hedged. We have very little corporate borrowings. Muni bonds are predominantly guaranteed by Berkshire Hathaway. So it is a very conservative portfolio and the reason for our conservative portfolio is very simply that we — it seems to us there is a disconnect between the fundamentals in terms of companies and economies and markets so the stock price — stock and bond markets are high. The fundamentals, we think, are quite different, meaning on the low side.

And so, you’ll either have the fundamentals go up over time to catch up with stock prices, catch up with very low spreads, or you’ll have the markets come down. And we have said for some time, this time period we think of it as a one in 30- , one in 100-year event. It is not a normal time period. So we just think you have to be very, very careful.

The fact that we have got cash in our portfolio is making no money today. It’s a big advantage as and when opportunities come, because of course, the only people who can take advantage of it, is the people who have cash.

In 2008, Tom, 2008, 2009 you had a very significant — two things happened, right. You had the stock market drop almost 30% and the spreads widened significantly. And in that time period, we had 75% of our portfolios in cash and government bonds. So we could take advantage of the opportunity that presented themselves to us, and 2010, 2011 we have started hedging, and in 2011 we’ve hedged significant parts of our portfolio. But on the other hand we [haven’t] realized very significant gains. So, in the first nine months I think we realized $730 million, but it is masked in a way by the unrealized losses on the hedges. And we expect that to reduce over time, and perhaps even become profits as it has in 2008, 2009.

So to summarize, Tom, we just — we have always been long term. Our long-term results are excellent. In any single year, in any single quarter, we can’t tell you what we will make. Investment results have been lumpy. They are not smooth. We are not looking at providing 5, 10, 15% growth every quarter. We don’t know how to do it. We would love to do it if we could, but we have focused our Company, from inception 27 years ago, is on the long term. And that continues to be the case.

Mark Dwelle – RBC Capital Markets – Analyst
Good morning. Couple of questions that kind of relate to the acquisitions recently and divestitures. Let me start with the Cunningham Lindsey sales. If I am following the one chart correctly, a $260 million proceed, that should put results in plus or minus around $150 million of realized gain in the fourth quarter?

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
Yes, I think that is right. That’s exactly right.

Mark Dwelle – RBC Capital Markets – Analyst
I guess following on with that, $35 million that you will reinvest related to that, that will just, I guess, remain as an investment and affiliate. I would deal it in with the new, but it is the same thing.

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
It is a small investment. Dave, would you put it and affiliates, or where would you characterize that?

Dave Bonham – Fairfax Financial Holdings – CFO and EVP

It will just go into our common stock portfolio and it would be carried on a fair value basis.

Mark Dwelle – RBC Capital Markets – Analyst

Very good. The second question I had if you just — the acquisitions, the Brit acquisition, I guess that’s closed now, if I am mapping that out right, about 75% of book value is — was the purchase price.

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
No. It was more like, I think we had said in the past press release we said it was closer to 95% of book value and we had two things that are — we had — it was a discount to book value, closer to 95%. We had the ability to, when we did our due diligence, any liabilities we didn’t like were able to put it in a reinsurance transaction back to the Company. Back to Brit. And so and over 18 months, two years we are going to review those liabilities and if we feel comparable, we will commute that reinsurance transaction.

So from our standpoint, it was we — the advantage of a runoff. We have got a separate runoff company. They review every single claim. Claim by claim by claim, and so we feel very comfortable with what we have taken on. And approximately a little of this comes to book value. But what you have here is $1.4 billion in investment portfolios. That will pay off over time, and we can invest it and make a return.

The Chipec transaction that we did about a year, year and a half ago has been a very positive one for us. In our Annual Report we will give you more of the details. But it is working out very well. And this one we think will work out. This is perhaps the biggest one we’ve done. And we expect it to work out very well also.

Mark Dwelle – RBC Capital Markets – Analyst

And what is the nature of the underlying liabilities? Is it auto or commercial liabilities?

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO

It is from around the UK. It has got a varied liability, book of liabilities. Dave, anything you would add to that?

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO

The duration will be like in five years, say, half the liabilities will be paid. And the remaining will be mostly paid by, say, 10 years. That is the sort of runoff that we get involved in. But the advantage is, we have got a separate marker. I’m sorry, the advantage we’ve got is a separate runoff group that handles these liabilities. And maybe there’s two or three of these groups in North America that can do it.

William Kontes – Boenning & Scattergood Inc. – Analyst
Good morning. My question regards the OdysseyRe political donation. And I was wondering if you could just help us understand a little bit more about why that was done, and how you see it as being important to the success of the firm? Thank you.

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
Thank you for that question. Yes, the contribution was made by OdysseyRe and the decision to make the contribution was made entirely by OdysseyRe. Fairfax did not participate in the contribution or the decision to make the contribution. OdysseyRe chose to make that contribution because it is one of the only remaining reinsurers in the United States, and it is paying US taxes.

The fact that competitors have moved offshore and pay lower taxes is a competitive disadvantage to OdysseyRe, and OdysseyRe believes Governor Romney is the best choice to rectify this inequality. So that is why they made the donation. But thank you for asking that question. Next, Audra.

Chris Lafayette – – Analyst
Thank you for taking my question. I was wondering if you guys could talk a little bit about how you manage risk to any single catastrophic event?

And then, given various operating structures and reinsurance agreements, how much of your book value would be at risk to any single event?

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
Yes. That is a very good question. It’s one that we, in the property casualty business, catastrophe risk is the biggest risk that you trade. And we’ve, 27 years, we’ve focused on it single-mindedly. Each of our companies look at it at their level and it comes right up to Fairfax, comes right through our [cheap red carpet], comes to our officers, and I am involved in it myself because this is the type of thing that can impact our Company.

And what we do broadly speaking, is OdysseyRe is our main source of exposures. And they have said that they would expose their common equity, OdysseyRe’s common equity, to about 15% of shareholders equity. And we link that 15% to the rate of return we expect to make over time. So if you think of 15% return that we make and 15% exposure, it is sort of a one-year payback. So that we will expose our Company, not to capital, but to one year’s worth of income. And last year is a good test because we had almost $1 billion of catastrophe losses and we still made $40 million or $50 million after-tax.

But that is what we — and we look at it very carefully. We look at it at different scenarios, $100 billion events. Events that have not taken place. You have got to look at events that have not taken place. So you have got to look at the possibility. We have never had a $100 billion event or a $200 billion event. But we simulate that in our companies. And but our exposure is mainly from OdysseyRe, and to a large extent, Odyssey has limits so that we know what the exposures can be. But that is a good question. It is one we are focused on all the time.

Chris Lafayette – – Analyst
Illustrate helpful. Thank you. And then just one more if I could. You recently renewed the buyback authorization. I was just wondering how you think about that with the stock trading around book value. The Company has done more aggressive historically. What do you look for as far as (multiple speakers).

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
We are always looking at the alternative of buying back our stock. But we won’t do it at the expense of our holding company cash and marketable securities that we’d like to keep — $1 billion. And in this uncertain environment, we are just very, very careful. But rest assured in any deal that we make that we are always comparing it in by our stock and retiring it. You pointed out in the past we thought maybe, and this goes back a little time, but we might have bought 18%, 20% of our Company back at one point in time. And over time we expect to retire our shares. But in these times we will be careful doing it.

And it will never be done at the expense of our holding company cash and marketable securities of $1 billion. We will always keep that $1 billion there for the unexpected developments.

Paul Holden – CIBC World Markets – Analyst
Good morning. Two questions. First relates to improvements in underwriting margins. So one of the ways I look at the combined ratio is on an accident year basis less cat losses. Year to date I come up with a number of 96.1% and that is versus 96.3% last year. So really not much of an improvement year over year. But I would’ve thought we would’ve seen a bigger improvement, given some of the forces you highlighted in terms of lower investment yields and that’s necessitating higher pricing.

So maybe you can talk about why we haven’t seen a bigger improvement and what might change over the next 12 months to lower that — the combined ratio — on that basis?

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
So, Paul, whenever you are — our premiums are up, I think, for the first nine months approximately 11%. So whenever you — and you look at each of the companies and you look at the (technical difficulty) come through it, but whenever you have premiums going up, your expense ratios come down. And so our expense ratios in the past have gone up because we’ve had soft markets and we reduced our premium. Now expense ratios are coming down because of the fact that premiums are going up.

So if you look at Zenith, for example, Zenith was up 47% in terms of its premium and so the expense ratios came down significantly. The loss ratios we maintained, Zenith has been historically maintaining a very — 60%, 65% areas. But the expense ratios have come down. And so the markets have bottomed out. The rates are going up. But it is not like the hard markets of 2002, 2003, 2004. But the pricing has improved and improved pretty well across the board.

It is very good and anything that is exposed to catastrophe, given the losses of last year, the rates are still full up significantly and are remaining there. But should we see our combined ratios coming down, they — with these low interest rates, you know, even if you have a combined ratio of 95% or less, you are going to have a single-digit return on equity. And so, combined ratios have to come down.

Now what you’re seeing for companies that have not reduced their premium in the last few years, you are seeing reserve development crop up. You are seeing reserves go up and so you are seeing companies being put into runoff, or lose their rating, and that has begun now. And this is usually a sign of change taking place.

We are very careful about our reserving. We like our reserves to be strong. It’s in our 10-year results, reserved redundancies run at 6% to 8% over time. And so we’re very comfortable with where we are right now and we — and the business, it’s improving. But like I said, it’s not a hard market.

We are already approximately net premium — it’s not gross, it’s net. We are already at about $6 billion. And in a really good market — I’ve said that in our annual meeting and I’ve said it elsewhere, that we can double that premium. And we have. We have different units and different management — really good management teams, all focused at the right time, not on our forecast, but actually seeing prices to increase that premium. So we feel very good where we are in terms of our underwriting, and I might say in our investment positions, even though we are not making money for our shareholders. Our Company’s is poised to reap the benefits of being that conservative. So we like where we are.

Paul Holden – CIBC World Markets – Analyst
Okay. And then my second question would be related to the additional investment you made in the CPI derivative this quarter. Maybe just the thought process behind that.

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO
Yes, so, all that is averaging down. We have done that before. And we added about $20 million. And in this case, we have structured it so that we have eight years remaining. It is a 10-year contract when we bought it. There’s eight years remaining. The CPI has gone up a little since that time. So we put $2 million and increased the strike price. So we increased the strike price and we closed it to where the CPI is today. That’s all we did. We just freshened it a little for $20 million, but we will always look at averaging down as we planned a significant unrealized loss by the way. More than two thirds of our investment is now in an unrealized loss position. It’s — I think we have got it at $140 million, something like that. And we’ve never paid more than $400 million to it. But it is all unrealized. It goes to our income statement like it is a loss, but as I said in my prepared comments, it is — we haven’t lost any money. It’s just — it is mark to market and that is what the accounting is these days. So it goes to — it flows to our statement as losses but we haven’t sold anything yet.

Tessad Oki – – Private Investor
I think there is an error there. I am actually not with Fairfax Financial Holdings Limited (PINK:FRFHF) (TSE:FFH). I’m a small investor in Fairfax. And while a small investor, it’s a significant portion of my very modest at work since I have been invested with you since 2010. I think my question is really maybe a follow-on to the gentleman from BMO Capital Markets, where I guess I am looking for some guidance and counsel from you. As it feels like you are going through potentially another seven lean years as you did in the earlier part of 2000s, where at least stock is invested, but book to value hasn’t moved very much, given all of the various forces you talked about at length in various quarterly calls and the annual shareholders meeting.

But if you have increasingly got — as you said, either the markets will come down to the fundamentals or vice versa and it just — I just wonder how you feel about things given every time the market seems to move down towards the fundamentals, the central banks are constantly coming in and priming the pump. And I just wonder if you feel — if you ever feel you are fighting a losing battle against the Fed and the ECB.

Prem Watsa – Fairfax Financial Holdings – Chairman and CEO

Yes, that is a good question. And so the first thing I’d just to say to you is we have always focused on the long term and when we went through our seven lean years so that we were turning around our Company, we were turning around Crum & Forster and the tech reinsurance and all of that, and it took some time to turn it around.

Today, our companies are in excellent position. They are underwriting focus, they are well reserved. They’ve cut back in the soft market and they are well positioned to expand significantly at the right time, and as they are expanding today. You are seeing that in Zenith, you are seeing it in Crum & Forster, you are seeing it in Odyssey and the Canadian markets always lag, have lagged in the past. And you will see it in time in Canada.

So underwriting operations are very well positioned. And our investment philosophy and positions are always long term. So when we have credit to form swaps in the past, it took a few years for it to work out and then, as you know, we made a lot of money. And so right now it is very important not to reach for yield. Because if you do reach for yield or if you put money into the stock market at these prices, you could suffer permanent losses. We will take temporary losses, but we don’t like taking permanent losses.

So I don’t think we will be in a position where our results will be poor for a long period of time. But you are right, for the last year and a half, it hasn’t been good. But our results for year ending 2011 for the five years is among the best in the business. And of course, for the 26 years ending 2011 it is better than anyone else in our industry.

So we are focused on the long term and we continue. We have always been focused on the long term and continue to be focused on doing well for our shareholders.

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