Your 2008/2009 Experience

[giofranchi]

Eric,

That is a strange way to look at it... Usually, the more businesses you have, the more diversified you are... Of course, all of them can go wrong together... But most of the times, when one thing doesn't work, the other helps to mitigate the negative outcome... And that's precisely what's happening this year... Losses from investments are somewhat mitigated by an underwriting profit.

Of course, everythig CAN go against you... That's why you want to rely on people you have great faith in and respect for, who know how to build both a portfolio of investments and a portfolio of insurance contracts together.

Let me ask you a question: would you ever bet against the couple Mr. Buffett + Mr. Jain?

Why would you then bet against the couple Mr. Watsa + Mr. Barnard?

 

Gio

[ERICOPOLY]

Eric,

That is a strange way to look at it... Usually, the more businesses you have, the more diversified you are... Of course, all of them can go wrong together... But most of the times, when one thing doesn't work, the other helps to mitigate the negative outcome... And that's precisely what's happening this year... Losses from investments are somewhat mitigated by an underwriting profit.

 

What happened to preferring lumpy returns? 

 

Of course, insurance returns will generally be SMOOTHER due to the income from (a forced allocation into) bonds and (potential) underwriting profit.

 

They say they are all about lumpy results though, and total returns over long periods -- so they're not in it for smoothness.  That's not the attraction.

 

Of course, everythig CAN go against you...

 

That's why you want to rely on people you have great faith in and respect for, who know how to build both a portfolio of investments and a portfolio of insurance contracts together.

Let me ask you a question: would you ever bet against the couple Mr. Buffett + Mr. Ajin?

Why would you then bet against the couple Mr. Watsa + Mr. Barnard?

 

Gio

 

 

So I ask why they are in insurance, and in return you ask if I would bet against them?

 

I don't see the connection. 

 

Would you bet against HWIC running an equities-only fund without insurance?  There, does that question mean anything?

[giofranchi]

What I mean is they are in insurance for the same reason the couple Mr. Buffett + Mr. Jain is in insurance.

 

Anyway, I think they can have a portfolio of investments in equities worth as much as their equity, cannot they?

Therefore, provided they know what they are doing writing insurance contracts, and don't accept undue risks, it is clear that it is better to also have float rather than not to have it. Isn't it?

 

Gio

[ERICOPOLY]

Anyway, I think they can have a portfolio of investments in equities worth as much as their equity, cannot they?

 

Without it impacting their ratings?  Nope, I don't.

 

They dropped their hedges when the market was at S&P 800.  Let's say they are 100% (of shareholder equity) invested at that point in equities.

 

Then let's say the market drops to S&P 400.

 

So they're now taking a 50% haircut on their equity.

 

Is that okay with their regulator?

[giofranchi]

So, which percentage of equity could they invest in stocks?

 

And what about wholly owned businesses?

 

Gio

[ERICOPOLY]

So, which percentage of equity could they invest in stocks?

 

And what about wholly owned businesses?

 

Gio

 

That depends on how much their float leverages their equity.  You have a certain amount of equity that services the float (not sure "services" is the right term), and beyond that the equity would be free to use for anything you wish.

 

I don't know what the amount is.  I've asked the board before and nobody knew.

 

Common sense tells me there is a limit to how much an insurance regular can tolerate.

[giofranchi]

Of course, if we don't know the exact percentage, it is not possible to make a comparison with an equity fund.

Yet, look at BRK's balance sheet: FFH might come to resemble something like that in the future. An equity fund simply cannot.

I see much more room for growth in FFH than in any fund.

 

Gio

[wisdom]

I would agree with Gio -

 

BRK has shown the way and FFH is smart enough to copy and learn from the best. All they have to do is emulate BRK at different stages and it is very likely that they end up like BRK.

 

That is where they are headed.

[ERICOPOLY]

Of course, if we don't know the exact percentage, it is not possible to make a comparison with an equity fund.

 

Gio

 

So if they were running an all-equities fund, it's reasonable to conclude that they would have only invested 50% into equities in March 2009? 

 

I think that ludicrous, personally.  That's just an opinion and everyone has one.

 

[Uccmal]

I would agree with Gio -

 

BRK has shown the way and FFH is smart enough to copy and learn from the best. All they have to do is emulate BRK at different stages and it is very likely that they end up like BRK.

 

That is where they are headed.

 

Except they are not as good as Buffett and Ajit Jain.  The equivalent time frame would be around 1993.  Buffett owned the best underwriters by then.  They had a stable of wholly owneds that were pouring out massive amounts of cash, a huge investment in Coke.  BRK was getting annual returns closer to 30%.  FFh is targeting 15% and barely reaching it over the last 15 years.

 

Unless FFh buys some wholly owneds that really put fuel on the fire they are doomed to mediocre results going forward.

[giofranchi]

Except they are not as good as Buffett and Ajit Jain.  The equivalent time frame would be around 1993.  Buffett owned the best underwriters by then.  They had a stable of wholly owneds that were pouring out massive amounts of cash, a huge investment in Coke.  BRK was getting annual returns closer to 30%.  FFh is targeting 15% and barely reaching it over the last 15 years.

 

Unless FFh buys some wholly owneds that really put fuel on the fire they are doomed to mediocre results going forward.

 

Al,

of course I already knew what your answer would be. And you might be right. But please consider:

 

1) You don’t want to compare returns in the midst of a spectacular secular bull, with returns in the midst of a secular bear.

 

2) Sincerely, I think OdysseyRe is among the best underwriters today.

 

3) Mr. Watsa + Mr. Barnard don’t have really to be as good as Mr. Buffett + Mr. Jain, otherwise we would be expecting 20%-25% returns, instead of 15%.

 

4) With all due respect for BRK and all Mr. Buffett has accomplished, in 1993 they certainly weren’t what they are today: net operating earnings were $477.7 million, of which $321.3 were Net Investment Income and $20.1 million came from underwriting. Operating businesses earned: Dexter $28.8 million, Commercial & Consumer Finance $14.1 million, Fechheimer $6.9 million, Kirby $25 million, Nebraska Forniture Mart $10.4 million, Scott Fetzer $23.8 million, See’s $24.4 million, World Book $13.5 million. BVPS increased 14.3% and BRK’s net worth increased by $1.5 billion, which means that stock investments (increase in value + sales) contributed more or less $1 billion… It is clear to me that in 1993 BRK still counted on insurance and investing for most of its increase in net worth.

 

5) Please, also note that as good as those other operating businesses truly were, they almost count for nothing in today’s BRK.

 

Listen, what I see in FFH is at least two bright and trustworthy people at the helm of a vehicle that could eventually follow in the footsteps of BRK. They have the brains and they have the right mean to achieve such a goal… This being said, I am certainly not saying they will succeed! Nobody of course can be sure about it.

 

Gio

 

[giofranchi]

So if they were running an all-equities fund, it's reasonable to conclude that they would have only invested 50% into equities in March 2009? 

 

I think that ludicrous, personally.  That's just an opinion and everyone has one.

 

At 2009 year end FFH had an equity worth $7,619 million, with common stocks, investments in equity, and preferred stocks worth $5,621.3 million, or 73.8% of equity.

Did they stretch their investment into equities to the upper limit? I cannot say…

 

Gio

 

[alertmeipp]

so how would you value Fairfax if Prem is not there tmw?

how much lower?

[ERICOPOLY]

So if they were running an all-equities fund, it's reasonable to conclude that they would have only invested 50% into equities in March 2009? 

 

I think that ludicrous, personally.  That's just an opinion and everyone has one.

 

At 2009 year end FFH had an equity worth $7,619 million, with common stocks, investments in equity, and preferred stocks worth $5,621.3 million, or 73.8% of equity.

Did they stretch their investment into equities to the upper limit? I cannot say…

 

Gio

 

73.8% after they appreciated off the March bottom.

[jay21]

Eric, I don't get what point you are making.  Maybe it would be in their self interest to do an equity fund as opposed to an insurance co.  The same thing was probably true for Buffett.  Is there something else you are trying to get at?

 

That shouldn't affect the merits of BRK or FFH as an investment, imo. 

[ERICOPOLY]

Eric, I don't get what point you are making.  Maybe it would be in their self interest to do an equity fund as opposed to an insurance co.  The same thing was probably true for Buffett.  Is there something else you are trying to get at?

 

That shouldn't affect the merits of BRK or FFH as an investment, imo.

 

It's a long running thought to determine how much reward they get from all the risk and effort of having an insurance company.

 

You know, like if you can compound equities at 15% anyhow, without using leverage, then what do you gain by running an insurance company (leverage) for 15% aspirational result?  It's an open question.  I have seen historical evidence that suggests they can make 15% returns from equities.  So why all the extra insurance stuff?

 

Gio says that Mr. Brindle can make returns like that from insurance alone.  But obviously FFH can't.  HWIC can make 15% from equities alone, and perhaps Mr. Brindle can't.  Gio says that we should just let these guys do what they are good at, but then he takes issue when I suggest that would be HWIC without insurance.  Or are they better when insurance is added to the fold?  By how much?

[ERICOPOLY]

I can't believe you guys never ask how much is gained by the more complicated structure.  Are you just toying with me or are you really not curious?

[ERICOPOLY]

See, I am naturally lazy.  I prefer to take on non-recourse leverage (at a high "combined ratio") when selective opportunities arise.  I can put all of that into equities.  The prospective gains at such times far exceed the high leverage cost.  And it's non-recourse.  It costs more, but it's all in equities at times when they are heavily discounted (you get to choose when you have the leverage, and when you don't).

 

Now, if I instead switched to insurance float (as if I could just hit a switch), I would be taking on liabilities hanging over my head for years.  And this float would be low cost (maybe), but I could only invest it in low-yielding bonds (they pay how much right now?).

 

I can't get 3x leverage (as with float), but I don't need 3x leverage.  I can put a higher percentage (all of it) into very high "Beta" stocks, so even if I don't use leverage I still might cream the results of an insurance company.  And then during a crash I can sprinkle a few calls in there for leverage (my high-cost float).  The float costs more, but equities when heavily depressed offer a lot of return in reward.

 

So I sit around thinking of this stuff a lot.  I'm pretty sure they held Kraft and Johnson and Johnson not because it was the best value out there at the time, but rather because they probably have to manage the investment mix to some degree keeping in mind that they have all this insurance liability.

 

So...  these are things that spin in my head.  Apparently just me?

[racemize]

See, I am naturally lazy.  I prefer to take on non-recourse leverage (at a high "combined ratio") when selective opportunities arise.  I can put all of that into equities.  The prospective gains at such times far exceed the high leverage cost.  And it's non-recourse.  It costs more, but it's all in equities at times when they are heavily discounted (you get to choose when you have the leverage, and when you don't).

 

Now, if I instead switched to insurance float (as if I could just hit a switch), I would be taking on liabilities hanging over my head for years.  And this float would be low cost (maybe), but I could only invest it in low-yielding bonds (they pay how much right now?).

 

I can't get 3x leverage (as with float), but I don't need 3x leverage.  I can put a higher percentage (all of it) into very high "Beta" stocks, so even if I don't use leverage I still might cream the results of an insurance company.  And then during a crash I can sprinkle a few calls in there for leverage (my high-cost float).  The float costs more, but equities when heavily depressed offer a lot of return in reward.

 

So I sit around thinking of this stuff a lot.  I'm pretty sure they held Kraft and Johnson and Johnson not because it was the best value out there at the time, but rather because they probably have to manage the investment mix to some degree keeping in mind that they have all this insurance liability.

 

So...  these are things that spin in my head.  Apparently just me?

 

I used to think the float let them invest in more equities, but I've had a huge turn-about on that view in the past year.  Maybe levered bonds is generally attractive, except in the current environment?  Certainly FFH's path has been much more rocky than BRK or MKL.

 

Perhaps we can ask the levered bond question at one of the various annual meetings this year.

[wachtwoord]

See, I am naturally lazy.  I prefer to take on non-recourse leverage (at a high "combined ratio") when selective opportunities arise.  I can put all of that into equities.  The prospective gains at such times far exceed the high leverage cost.  And it's non-recourse.  It costs more, but it's all in equities at times when they are heavily discounted (you get to choose when you have the leverage, and when you don't).

 

Now, if I instead switched to insurance float (as if I could just hit a switch), I would be taking on liabilities hanging over my head for years.  And this float would be low cost (maybe), but I could only invest it in low-yielding bonds (they pay how much right now?).

 

I can't get 3x leverage (as with float), but I don't need 3x leverage.  I can put a higher percentage (all of it) into very high "Beta" stocks, so even if I don't use leverage I still might cream the results of an insurance company.  And then during a crash I can sprinkle a few calls in there for leverage (my high-cost float).  The float costs more, but equities when heavily depressed offer a lot of return in reward.

 

So I sit around thinking of this stuff a lot.  I'm pretty sure they held Kraft and Johnson and Johnson not because it was the best value out there at the time, but rather because they probably have to manage the investment mix to some degree keeping in mind that they have all this insurance liability.

 

So...  these are things that spin in my head.  Apparently just me?

 

It's definitely not just you. I just don't know the answer. Your line of thought does sound plausible and I never thought of it this way. I thought they would be allowed to invest however they choose and their sheer size would allow them to take the hits (and if you don't think it can, don't buy insurance from them).

 

Having read your recourse it does sound very plausible. But if you're right then the guys at FFH are being suboptimal (not impossible of course, people do make mistakes) or we're missing something.

[tombgrt]

See, I am naturally lazy.  I prefer to take on non-recourse leverage (at a high "combined ratio") when selective opportunities arise.  I can put all of that into equities.  The prospective gains at such times far exceed the high leverage cost.  And it's non-recourse.  It costs more, but it's all in equities at times when they are heavily discounted (you get to choose when you have the leverage, and when you don't).

 

Now, if I instead switched to insurance float (as if I could just hit a switch), I would be taking on liabilities hanging over my head for years.  And this float would be low cost (maybe), but I could only invest it in low-yielding bonds (they pay how much right now?).

 

I can't get 3x leverage (as with float), but I don't need 3x leverage.  I can put a higher percentage (all of it) into very high "Beta" stocks, so even if I don't use leverage I still might cream the results of an insurance company.  And then during a crash I can sprinkle a few calls in there for leverage (my high-cost float).  The float costs more, but equities when heavily depressed offer a lot of return in reward.

 

So I sit around thinking of this stuff a lot.  I'm pretty sure they held Kraft and Johnson and Johnson not because it was the best value out there at the time, but rather because they probably have to manage the investment mix to some degree keeping in mind that they have all this insurance liability.

 

So...  these are things that spin in my head.  Apparently just me?

 

Nope, great remarks!

[Liberty]

Very interesting line of inquiry, Eric.

 

I wonder if it depends on how much permanent capital you have access to.

 

ie. When starting out with almost nothing, it was better for Hamblin-Watsa to get into the insurance business and use float as a form of 'permanent' capital (not exactly, but acts like it) to be able to invest without having fickle investors who tend to pull out their capital every time there's a downturn or if an idea takes more than a year to play out. Maybe that worked better with their style of investing than taking money from investors who have a short-term view and are scared of deep value stuff. Maybe dealing with  that would've crimped their returns quite a bit?

 

But now that they have this very valuable business, it's plausible that they might be able to get better returns in the future if they sold the whole thing except the investing group for a few billions  and then used these few billions to run a kind of public hedge fund with their own permanent capital. This way, they wouldn't be forced to invest in things that are sub-optimal just to meet insurance obligations (regulator, claims, etc).

 

Of course, that's only if the insurance operations keep forcing sub-optimal decisions and aren't profitable enough to more than compensate. If they become very profitable, that's another story.

[vinod1]

See, I am naturally lazy.  I prefer to take on non-recourse leverage (at a high "combined ratio") when selective opportunities arise.  I can put all of that into equities.  The prospective gains at such times far exceed the high leverage cost.  And it's non-recourse.  It costs more, but it's all in equities at times when they are heavily discounted (you get to choose when you have the leverage, and when you don't).

 

Now, if I instead switched to insurance float (as if I could just hit a switch), I would be taking on liabilities hanging over my head for years.  And this float would be low cost (maybe), but I could only invest it in low-yielding bonds (they pay how much right now?).

 

I can't get 3x leverage (as with float), but I don't need 3x leverage.  I can put a higher percentage (all of it) into very high "Beta" stocks, so even if I don't use leverage I still might cream the results of an insurance company.  And then during a crash I can sprinkle a few calls in there for leverage (my high-cost float).  The float costs more, but equities when heavily depressed offer a lot of return in reward.

 

So I sit around thinking of this stuff a lot.  I'm pretty sure they held Kraft and Johnson and Johnson not because it was the best value out there at the time, but rather because they probably have to manage the investment mix to some degree keeping in mind that they have all this insurance liability.

 

So...  these are things that spin in my head.  Apparently just me?

 

The way I see it, Fairfax model has been to invest Float in Bonds to fund expected liabilities. It was costing 3% but they had generated close to 10% on these bonds.

 

Equity which is available to fund any unexpected liabilities is being invested anywhere from 45%-80% in stocks and they are able to generate 17% on the invested amount. The 17% return on stocks might be less than what HWIC is able to achieve if they are completely unconstrained in their stock allocation as you mentioned.

 

However, since they are able to generate above 22% returns on total equity a while back, insurance operations providing float have on the whole added to the return since their returns on stock have provided only 17% returns. Would they have been able to add 5% annually if they are completely unconstrained? I am not so sure. JNJ and Kraft might not be the cheapest at that time but in an alternate scenario where we ended up in Great Depression II or something similar, others might not have survived. Given Watsa's bearishness, I suspect even in an unconstrained stock portfolio JNJ & Kraft would have had a place.

 

With bond yields where they are now, I suspect insurance operations are likely going to be a drag going forward and we would likely see the scenario you suggested being played out.

 

Vinod

 

[vinod1]

Looking another way, how much is HWIC really being constrained if

 

1. They are able to invest in CDS

2. They are able to invest in deflation swaps (or whatever they are called)

3. Or in any number of distressed investments they are able to make

 

The primary constraints are really

1. Taking whole companies private and being able to count it towards statutory assets

2. Percentage of the shareholders equity being allocated to stocks. They have reached 80%, so the additional 20% is really the biggest drag that I see.

 

Vinod

[Uccmal]

Except they are not as good as Buffett and Ajit Jain.  The equivalent time frame would be around 1993.  Buffett owned the best underwriters by then.  They had a stable of wholly owneds that were pouring out massive amounts of cash, a huge investment in Coke.  BRK was getting annual returns closer to 30%.  FFh is targeting 15% and barely reaching it over the last 15 years.

 

Unless FFh buys some wholly owneds that really put fuel on the fire they are doomed to mediocre results going forward.

 

Al,

of course I already knew what your answer would be. And you might be right. But please consider:

 

1) You don’t want to compare returns in the midst of a spectacular secular bull, with returns in the midst of a secular bear.

 

2) Sincerely, I think OdysseyRe is among the best underwriters today.

 

3) Mr. Watsa + Mr. Barnard don’t have really to be as good as Mr. Buffett + Mr. Jain, otherwise we would be expecting 20%-25% returns, instead of 15%.

 

4) With all due respect for BRK and all Mr. Buffett has accomplished, in 1993 they certainly weren’t what they are today: net operating earnings were $477.7 million, of which $321.3 were Net Investment Income and $20.1 million came from underwriting. Operating businesses earned: Dexter $28.8 million, Commercial & Consumer Finance $14.1 million, Fechheimer $6.9 million, Kirby $25 million, Nebraska Forniture Mart $10.4 million, Scott Fetzer $23.8 million, See’s $24.4 million, World Book $13.5 million. BVPS increased 14.3% and BRK’s net worth increased by $1.5 billion, which means that stock investments (increase in value + sales) contributed more or less $1 billion… It is clear to me that in 1993 BRK still counted on insurance and investing for most of its increase in net worth.

 

5) Please, also note that as good as those other operating businesses truly were, they almost count for nothing in today’s BRK.

 

Listen, what I see in FFH is at least two bright and trustworthy people at the helm of a vehicle that could eventually follow in the footsteps of BRK. They have the brains and they have the right mean to achieve such a goal… This being said, I am certainly not saying they will succeed! Nobody of course can be sure about it.

 

Gio

 

 

Gio, you basically made my case for me.  At a similar size BRK was pulling in well over 100 million per year from wholly owneds.  The insurers under Buffett have always done better than FFHs insurers over time.  FFh has done very well with low probability, high payout situations.  Original Mungerville mentioned the nearly 1 b in bond gains they booked in the short days.  All of that money went to paying for bad insurance underwriting. 

 

The underwriting has improved to the point where it is not much of a drag now. 

 

So the big questions going forward I am asking:

 

1) Is it worth keeping the insurance operations.  Should they expand or focus these operations as per Markel, BErk.

 

2) The lack of stable cash flow is handicapping them now.  They cant get the ratings up to AIG, or BRK levels until this is remedied.  Lumpy doesn't work well.  Because they aren't a double AA insurer they cant Get the best clients and the best combined ratios. 

 

3) Buffett could point his the rating agencies to his incoming cash flow from dividends, and operating companies.  FFh cant do this because the wholly owneds are weak as compared to Sees, Furniture Mart, or now Mid-american.  I see no sign of a desire to move up the quality curve so far. 

 

4) So we are left with middling insurers, weak operating companies, and some low probability high payout bets. 

 

5) If there is a massive insurance event who will come out of it better: FFh or BRK.  if there is another recession who will come out better off: FFH or BRK.  BRK on both counts. 

 

I am kind of all over the place on this, but it explains why I don't believe FFH will do better than 15%, or even as good as 15% going forward.  I have spent 15 years listening to these arguments and have yet to see them consistently write insurance to a significant profit, across most units.