Fairfax Financial Stock: Catastrophe losses pose a challenge (OTCMKTS: FRFHF)

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

The property and casualty insurance market as a whole has seen significant growth in recent years – as businesses attempt to insure against potential closures as seen through the pandemic, as well as weather events extremes further fueling the demand for such insurance.

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

Fairfax Financial Holdings <span class=

investment.com

That being said, the property and casualty insurance market may face inflationary threats in the future. Since house prices tend to rise with inflation, this means that an insurance company will have to pay higher claims in the future and may not be able to collect enough premiums today to cover rising costs.

In this article, I explore the prospects for Fairfax Financial Holdings moving forward in terms of mitigating these industry pressures, as well as investigating the Canadian real estate market specifically and how inflation could impact Fairfax’s business in the future.

Combined report

One of the key parameters for measuring the profitability of an insurance company is the combined reportwhich takes the ratio of claims and other expenses paid to premiums collected.

The lower the ratio, the better – as it indicates that the company is maximizing the amount of premiums collected in relation to the claims it has to pay.

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

Fairfax Financial Holdings (<a href=

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

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

During this period, the company recorded 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 dispersion of ratios combined with these parameters might look like.

Monte Carlo simulation of combined ratios

Author’s calculations

Based on this simulation, one would expect to see a combined ratio above 100 about 35% of the time.

In this regard, inflationary pressures could push the ratio up, which could be a risk factor for Fairfax going forward.

When comparing inflation in Canada and the United States, price growth in the latter is significantly higher than in the former, with inflation in the United States currently at 7.5% compared to 4, 8% for Canada.

inflation trend graph: Canada vs. United States

tradingeconomics.com

Recent performances

Although Fairfax posted significant losses in the third quarter of 2021 due to higher combined ratios in Odyssey Group and Brit, these combined ratios declined significantly in the fourth quarter as the impact of catastrophic losses eased.

Third quarter 2021 results

Fairfax Q3 2021 Interim Earnings Report

Fairfax Q3 2021 Interim Earnings Report

Fourth quarter 2021 results

Fairfax Financial Holdings Fourth Quarter 2021 Financial Results

Fairfax Financial Holdings Fourth Quarter 2021 Financial Results

Let’s take a closer look at Odyssey Group – which posted an impressive drop in the combined ratio due to the effect of falling catastrophic losses.

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

Odyssey Group: gross premiums by geographic pie chart

Odyssey Group: financial highlights

In addition, of the gross written premiums by main category, 26% related to the P&C segment, the remainder being split between the Specialty and P&C segments.

Odyssey Group: pie chart of gross premiums by ownership class

Odyssey Group: financial highlights

While catastrophic losses represent 28% of Odyssey’s total property portfolio, cat losses in 2021 were still quite significant. However, we have seen that over the last quarter, limiting exposure to the real estate sector allowed the Odyssey Group to quickly bring the combined ratio down to an impressive 88.1%. Additionally, even taking into account the catastrophic losses in the first quarters of 2021, we see that net premiums earned were up 18% over the fourth quarter of 2020 across Fairfax, along with underwriting earnings that were down sharp increase to $470.8 million.

Fairfax Financial Holdings (<a href=

Fairfax Financial Holdings Q4 2021 Results

Looking forward to

Even though Odyssey’s exposure to real estate is limited, it could prove somewhat disadvantageous in an inflationary environment. While it is true that rising house prices would translate into higher payments in the future, society could be missing out on increased demand for property insurance. Indeed, as real estate prices increase in value, the demand for appropriate insurance increases.

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

Going forward, Fairfax may be in a good position to regain underwriting profit if the catastrophic losses do not recur in 2021. Of course, the essence of an insurance company is to assume risk and its trajectory remains uncertain. However, minimizing cat losses will allow the company to maximize premium growth in other areas of its business, even if it means diversifying away from potentially higher demand for property insurance.

Consideration should also be given to Fairfax’s overall financial condition. When looking at the cash to total liabilities ratio (cash being defined as the holding company’s cash and investments), we see that it has declined over the last five years – even though cash was still 20% of total total liabilities in 2020:

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

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

While I don’t see a significant concern about the company’s cash position, it could raise concerns if this ratio continues to decline.

Conclusion

To conclude, Fairfax experienced an overall underwriting loss earlier in the year due to catastrophic losses. However, the company’s exposure is limited and Odyssey Group’s combined ratio has shown an impressive decline in the last quarter.

However, inflation remains a risk factor as it could increase the cost of property claims in the future. Fairfax could have potential growth in the future as demand for property insurance grows – but an important determinant of profitability will be the extent to which the business is affected by catastrophic losses in the future.

Additional Disclosure: This article is written “as is” and without warranty. The content represents my opinion only and does not constitute professional investment advice. It is the reader’s responsibility to exercise due diligence and seek investment advice from a licensed professional before making any investment decision. The author assumes no responsibility for any action taken based on the information in this article.

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