Reserve Concerns Impact Fairfax Shares

"We have not been accorded access to management to verify the general accuracy of our findings and conclusions. This is a clear corporate policy," he stated.

Despite Mr. Gwynn's assertion, however, Fairfax shares began to fall the following day and went into a sharp decline after the weekend when news of the report spread. On Monday, January 20, the company stock fell more than 40 percent to a seven-year low of $57 per share before recovering to close down some 15 percent.

Fairfax has also been listed on the New York Stock Exchange since last December, but its shares in the United States were spared the price volatility on January 20 since the market was closed for Martin Luther King Day.

The stock's late recovery on the Toronto Stock Exchange that day came after Fairfax chairman and chief executive officer Prem Watsa assured investors and characterized Morgan Keegan's findings on loss reserve deficiencies as "totally wrong" and having "no validity whatsoever."

"From the beginning, our reserves have been reviewed by company actuaries, by an actuary at Fairfax and by one or more independent actuaries, and have been subject to regulatory review," Mr. Watsa stated.

Fairfax shares gained more ground when on January 30, Morgan Keegan lowered its estimate of the reserve deficiency for Fairfax's TIG Insurance Group to $1.0 billion from a previous estimate of $3.1 billion, while keeping its assessment of $1.9 billion in reserve deficiencies for other areas of the company.

Commenting on the revised estimate, Jim Auden, senior director at New York-based Fitch Ratings, noted that it remains difficult to estimate reserve deficiencies at Fairfax.

"Looking at the numbers, you can come up with a lot of different estimates. We stated in the past that one of our concerns for Fairfax is the reserve adequacy of its U.S. commercial lines. It reported a lot of reserve increases in the last few years, and I think the company obviously has the best information on reserves. Only time will tell what the true number is," Mr. Auden told National Underwriter.

But even if analysts' estimates for reserve deficiencies are overblown, the company is hardly out of hot water yet. Its stock has been on a downward path in the last few years after reaching $600 a share in 1999. It is also being scrutinized by rating agencies after announcing last December that it is restructuring TIG, its money-losing U.S. subsidiary.

"In terms of the summary, TIG is very simply discontinuing its remaining program business and separating its discontinued business from its ongoing business. The best part of TIG continues to go forward," said Mr. Watsa during the December conference call.

To describe the size of the business discontinued, Mr. Watsa noted that on Sept. 30, 2002, the total premiums written by TIG was $722 million and that the discontinued program business would make up 56 percent. Earlier in 2002, Fairfax had already discontinued 33 percent of the business.

"Why did we discontinue the business? The program business was not working. We have tried it now for the better part of four years and there is no way for us to make the combined ratio of below 100. So with some sense of disappointment, we have decided to discontinue the program business," Mr. Watsa said.

"Fairfax had a lot of troubles. TIG has been losing money and they just put it into runoff," said Mr. Auden, whose rating agency downgraded the company's senior debt rating one notch to "double-B," while keeping its outlook to "negative."

"Specifically, Fairfax will place TIG Insurance Company and most of its subsidiaries into runoff, strengthen TIG's loss reserves by $200 million, and purchase a $300 million adverse loss development cover," he noted.

Additionally, Fairfax will acquire additional shares of TRG, a jointly owned business with Xerox Corp., for $425 million payable over a 15-year period, and merge TIG with TRG's International Insurance Co. subsidiary.

Mr. Auden said that although the proposed restructuring alleviates some concerns regarding the event risk related to 2003 debt maturities and Fairfax's weak financial flexibility, he expects an increase in financial leverage related to the Xerox purchase agreement.

Furthermore, there are other ongoing concerns, including Fairfax's dependence on investment gains and asset sales to achieve profitability and holding-company cash targets, as well as significant exposures to reinsurance recoverables, he said.

Standard & Poor's in New York is another rating agency that took action after Fairfax's December announcement by revising its outlook to "negative" from "stable." Its senior debt rating remains at "double-B-plus."

Matthew Coyle, director at S&P, told National Underwriter that he remains concerned about Fairfax's quality of earnings as well as its liquidity.

"We will continue to monitor the company's progress in underwriting, reserving and liquidity management. To the extent management can demonstrate a sustainable track record of improvement in these areas, we will maintain its current ratings and possibly reconsider its 'negative' outlook," Mr. Coyle said. "Conversely, a material deterioration in these areas would likely result in a downgrade."

Analysts will also be keeping a close watch on the company's next major disclosure: its fourth-quarter report, which is due out this week. "We will wait and see how its fourth-quarter earnings come out," Mr. Auden said.

Reproduced from National Underwriter Edition, February 10, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.