Markel Financial, a specialty underwriter of trucking insurance in Canada, looked as though it may fail by 1985. The three-decade-old company had underpriced its policies and it caught up with it in 1984 when it lost C$4.8 million – about two-thirds of its beginning capital. Prem Watsa and other Canadian investors gambled that the company was sound and could be a profitable investment with a capital increase and better pricing. They were right. Markel Financial turned a profit of C$5.6 million in 1986 and C$10.1 million in 1987. After a couple of years of control, Watsa changed the name of the holding company formed from Markel Financial as Fairfax Financial.
Watsa was trained as a Chemical Engineer in India before following his brother to Canada. After getting his MBA at the Richard Ivey School of Business, he was introduced to value investing, a system of principles pioneered by Benjamin Graham and championed by Warren Buffett. Building the new Fairfax Financial Holdings on those principles and Watsa’s shrewd business sense has allowed it to become one of the most important investors in Canada and more recently an insurance powerhouse with premiums written across the globe, despite an intentionally low profile that is only occasionally interrupted from acolytes of the value investing philosophy. And while Fairfax’s track record of achieving a high rate of return on its investments is well known, its decentralized and global insurance operations are less so.
The acquisitions started small, but they were frequent. In 1987, Watsa added Canadian insurers Shand, Morahan & Company, Otter Dorcester, and Sphere Reinsurance to Markel Financial. Fairfax’s subsequent acquisitions were later folded into these earlier ones to form Northbridge Financial. According to the Insurance Bureau of Canada, Northbridge is now the twelfth largest Canadian insurer, with about 2.5% of the total market. Those acquisitions included Federated Insurance for C$29 million, Commonwealth Insurance for C$58 million, and Lombard Insurance for C$155 million.
In 1998, Watsa agreed to purchase specialty insurer Crum & Forster from Xerox for $565 million and began directly writing policies in the United States. Like in Canada, a slew of bolt-on acquisitions enlarged Crum & Forster’s size. Seneca Insurance for $65 million in 2000, Old Lyme Insurance in 2002 for $43 million, workers’ comp insurer Zenith National for $1.3 billion in 2010, commercial insurer First Mercury in 2011 for $294 million, pet insurer Hartville in 2013 for $34 million, environmental liability insurer American Safety in 2013 for $317 million, and pet insurer PetHealth for $88 million in 2014.
A value investing strategic approach meant that the insurers being acquired by Fairfax were done so at low multiples of book value – often below their tangible worth. That approach worked well in some situations, but in others became disastrous. Insurers purchased in 1998 including Crum & Forster and TIG soon presented enormous problems because of under-reserving by the previous owners. Just when Fairfax was building back up its reserves to an appropriate level, the terrorist attacks of September 11, 2001 happened – a blow to almost every large insurer in the world.
It seems to have left a permanent impression on Watsa’s thinking. After a period of time with little acquisition activity, the insurers that Fairfax have purchased more recently are of a much higher quality than those purchased prior to 1998, in particular Zenith National, which was purchased for a 35% premium to book value in 2010 and is an extremely high quality underwriter of workers’ compensation insurance. Fairfax also has gone from operating primarily in the United States and Canada to writing premiums and gathering float across the world.
Another decision in 1998 that seemed small at the time has come to have a profound effect on Fairfax: Falcon Insurance was started in Hong Kong with Kenneth Kwok at the helm. The business has proven to be extremely valuable to the company and is now entrenched among corporate customers where it operates. Before long, another insurer was purchased in Singapore and Fairfax beginning building a foundation of flows of premiums from around the world.
Success in life, and particularly competitive endeavors like business, are rarely the result of formulas. Guiding principles that include purchasing assets for less than you conservatively believe they are worth and running them in a decentralized manner are fine principles, but the success comes in learning how to apply them. For many years, the way these principles were applied resulted in a swelling of assets, but rather poor performance from the insurance companies when compared to competitors.
The underwriting history of the company could be considered as four episodes: 1986-1997, when early successes and acquisitions, along with a manageable scope of business, propelled the company towards solid results; 1998-2005, when the purchase of under-reserved insurers combined with terrorism and Hurrican Katrina to severely penalize results; 2006-2011, when reserves were back at an appropriate level and underwriting results stabilized; and 2012 to today, when Fairfax’s insurance businesses have produced world class results.
The previous five years have all produced underwriting profits and it has been the only one of the four periods shown above at which aggregate underwriting results were below zero, meaning Fairfax was paid by its policyholders to hold insurance float. It was also the best period relative to long-term interest rates in the company’s history, despite interest rates remaining at anemic levels.
One could attribute this improvement to luck. Indeed, luck plays a large role in period to period insurance results. But, the larger story is simply one of the impact that learning can have on on-going performance. There appears to be little question that while Prem Watsa has had a natural talent in investing and economics, like anyone else he had to learn about business and accumulate wisdom with time. The purchase of TIG appeared to be a fantastic deal at less than book value. But, someone who more clearly understands the insurance business can see why it may be true that Zenith National is better deal at a premium to its tangible worth.
Watsa has also found his “General Grant” in Andy Barnard, who now runs the insurance operations. Decentralization can be a good business strategy in many industries, and it can also work well in insurance. Fairfax has largely stayed true to its principle of keeping its businesses decentralized. But Barnard, who came from Odyssey Re, clearly was talented and Watsa knew enough to modify his working premise by placing Barnard in charge of the insurance businesses. While not mandating details to insurance heads from headquarters, this approach better allows for institutionalized learning and will surface problems sooner when they appear.
Watsa never abandoned his guiding principles. But, his success in more recent years has been owed as much to his adaptability in refining his thought process and criteria as it is in staying true to the past. Not only have insurance results been spectacular for five years now, but Fairfax has a world class insurance operation that few people appreciate the quality of.
The Toronto-based company is now gathering float from every continent in the world and through primary and reinsurance business lines. More impressively, the vast majority of these entities, whether Fairfax controls them or has a minority stake, is underwriting well.
Fairfax’s deal for Swiss insurer Allied World should close later this year. Fairfax is paying nearly $5 billion, which is equal to 1.35x book value for an insurer that has averaged combined ratios around 90% in the past. The template of getting good assets at fair prices appears to still be intact, and combining the two organizations has the potential to further solidify Fairfax’s quality.
Surprisingly, Fairfax’s investment portfolio has produced subpar returns of late, the value-creating part of the company that it has been known for. Before the financial crisis, Watsa made what could be considered the best investment of his life by betting against the stock market and making billions. But, after the worldwide economic recovery, he has proved cautious. Perhaps too cautious. Derivatives meant to protect the company from deflation appear as though they will expire worthless and hedges against the company’s equity portfolio have meant that it has not participated in the strong returns of equities from around the world. Over the previous decade, Fairfax’s equity portfolio has produced essentially no return, while the S&P 500 has compounded at 7%. With global equities selling at nosebleed valuations, it would be dangerous to think that Watsa has lost his investing ability now, even if he has been very early in his caution.
Investors it seems may have given up on Fairfax with investment returns lagging and the Allied World deal set to close shortly. At just 1.17x its accounting book value, it is far cheaper than many of its peers. If those investors pay attention to the company in the next few years, they just might learn something.