Fairfax Financial Stock: Catastrophe Losses Pose A Challenge (OTCMKTS: FRFHF)

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Canadian Money

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Investment Thesis: Rising demand for Property & Casualty insurance in the face of higher inflation could be a potential growth engine for Fairfax. However, catastrophic losses and potentially higher future payouts remain risk factors.

The Property & Casualty market as a whole has seen significant growth in the past few years – as businesses attempt to insure against potential closures as seen through the pandemic, along with extreme weather events further fueling the demand for such insurance.

To this end, Fairfax Financial Holdings (OTCPK: FRFHF) has seen a significant rebound in growth since 2020:

Fairfax Financial Holdings <span class =

investing.com

With that being said, the Property & Casualty insurance market might face some threats from inflation going forward. Since property prices tend to rise with inflation, this means that an insurance company will need to pay higher claims in the future, and may not be able to collect sufficient premiums today to cover the increased costs.

In this article, I investigate the prospects for Fairfax Financial Holdings going forward in terms of mitigating such industry pressures, as well as investigating the Canadian property market specifically and how inflation could impact Fairfax’s business going forward.

Combined Ratio

One of the key metrics for measuring the profitability of an insurance company is the combined ratiowhich takes the ratio of claims and other expenses paid over premiums collected.

The lower the ratio, the better – as it indicates that the company is maximizing the amount of premiums collected relative to claims that it must pay out.

Here is a graph detailing the historical fluctuations in the combined ratio (consolidated) for Fairfax since Q1 2015. Note that the quarterly ratios were provided in the interim reports from Q1 to Q3, and thus the ratio for the full year was used in place of a quarterly ratio for Q4.

Fairfax Financial Holdings (<a src =

Figures sourced from annual and interim reports – graph generated by author

On the whole, the combined ratio fluctuated between 90 and 100 – with the exception of Q3 2017, when the company saw a very high combined ratio of over 130 thanks to the effects of Hurricane Harvey, Irma, and Maria.

Over this period, the company saw an average combined ratio of 97.16 with a standard deviation of 7.51. Using a Monte Carlo simulation of 10,000 iterations – here is what the expected spread of combined ratios could be expected to look like under these parameters.

Monte Carlo simulation of combined ratios

Author’s Calculations

Under this simulation, one could expect to see a combined ratio of above 100 approximately 35% of the time.

In this regard, inflationary pressures may push the ratio higher, and this could be a risk factor for Fairfax going forward.

When comparing inflation across Canada and the United States, price growth across the latter is clearly higher than the former, with inflation in the US currently at 7.5% compared to 4.8% for Canada.

inflation trend graph: Canada vs United States

tradingeconomics.com

Recent Performance

While Fairfax made significant losses in the third quarter of 2021 due to higher combined ratios across both Odyssey Group and Brit – these combined ratios have decreased significantly in the fourth quarter as the impact of catastrophic losses has abated.

Third Quarter 2021 Results

Fairfax Q3 2021 Interim Earnings Report

Fairfax Q3 2021 Interim Earnings Report

Fourth Quarter 2021 Results

Fairfax Financial Holdings Q4 2021 Financial Results

Fairfax Financial Holdings Q4 2021 Financial Results

Let’s take a further look at the Odyssey Group – which showed an impressive decline in the combined ratio due to the effect of catastrophic losses declining.

We can see that 68% of all gross premiums written were actually for the US market:

Odyssey Group: gross premiums by geo pie chart

Odyssey Group: Financial Highlights

In addition, across gross premiums written by major class, 26% were for the Property segment with the remainder across the Specialty and Casualty sectors.

Odyssey Group: gross premiums by property class pie chart

Odyssey Group: Financial Highlights

While catastrophic losses represent 28% of Odyssey’s total property book, cat losses in 2021 were still quite substantial. However, we have seen that in the most recent quarter – limiting exposure to the property sector allowed the Odyssey Group to swiftly bring the combined ratio back to an impressive 88.1%. In addition, even when accounting for catastrophic losses in the earlier quarters of 2021, we see that net premiums earned is up by 18% from Q4 2020 across Fairfax as a whole, along with underwriting profit having seen a sharp increase to $ 470.8 million.

Fairfax Financial Holdings (<a src =

Fairfax Financial Holdings Q4 2021 Results

Looking Forward

Even though Odyssey’s exposure to Property is limited – this might prove to be somewhat of a disadvantage in an inflationary environment. While it is true that rising property prices would result in higher payouts in the future – the company could be missing out on higher demand for property insurance. This is because as property prices rise in value – demand for appropriate insurance rises.

That said, this potential risk must be weighed against minimizing exposure to catastrophic losses – which resulted in a much higher than average combined ratio back in 2017.

Looking forward, Fairfax could be in a good position to return to an underwriting profit if catastrophic losses do not repeat patterns seen in 2021. Of course, the very essence of an insurance company is to assume risk and the trajectory of this remains uncertain. However, minimizing cat losses will allow the company to maximize premium growth across other areas of its business – even if that means diversifying away from potentially higher demand for property insurance.

Consideration should also be given to Fairfax’s overall financial position. When looking at the cash to total liabilities ratio (cash being defined as holding company cash and investments), we see that this has seen a decline over the past five years – even though cash still accounted for 20% of overall total liabilities in 2020:

Cash and total liabilities figures sourced from historical annual reports - percentages and graph generated by author

Cash and total liabilities figures sourced from historical annual reports – percentages and graph generated by author

While I do not see significant concern regarding the company’s cash position, it might cause some concern if this ratio continues to fall.

Conclusion

To conclude, Fairfax has seen an overall underwriting loss earlier in the financial year as a result of catastrophic losses. However, the company’s exposure is limited and the combined ratio for the Odyssey Group showed an impressive decline in the most recent quarter.

However, inflation remains a risk factor as it could increase the cost of property claims in the future. Fairfax could have potential growth going forward as demand for property insurance increases – but a significant determinant of profitability will be the extent to which the company will be affected by catastrophic losses going forward.

Additional disclosure: This article is written on an “as is” basis and without warranty. The content represents my opinion only and in no way constitutes professional investment advice. It is the responsibility of the reader to conduct their due diligence and seek investment advice from a licensed professional before making any investment decisions. The author disclaims all liability for any actions taken based on the information contained in this article.



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