Street Capitalist: Event Driven Value Investments

For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.

Today, Gregory Zuckerman has a wonderful article on Fairfax Financial in the Wall Street Journal:

As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Firm Makes Bold Bet on Falling Prices (WSJ)

With The Greatest Trade Ever and The Big Short, investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.

Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.

So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.

What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).

A lot of investors are fixated on BP plc (NYSE:BP) and Transocean (NYSE:RIG) because they are in the headlines so much. I think that part of the reason stems from the fact that investors like to be involved in the things they read about. There is a certain level of excitement.

I saw this same behavior during the financial crisis. Most people end up becoming obsessed with certain stocks just because they are constantly in the news. I can see the appeal, it gives you something that you can bring up in conversations with your friends. But often, it is not really prudent investing.

BP and RIG both face liabilities that are extremely difficult to estimate. BP has already agreed to pay for the costs of the cleanup, but as long as the oil keeps leaking, the costs will continue to rise. Credit Suisse analysts have come out saying that the costs may reach $37B or 9 times the cost of the Exxon Valdez spill. That is up from $10B a few weeks ago. With the public outraged and Attorney General investigating BP for possible criminal charges, there is a lot of uncertainty here. I just don’t think any one investor can truly figure out the risks in a situation like this with any accuracy.

Now, that is not to say there aren’t opportunities out there stemming from the oil spill.

Here are a few companies that I am researching right now. I still have a lot to read, but some of these look very interesting at current prices and all have been affected by the spill in one way or another. The benefit though is that they lack the headline risk and may ultimately be safer investments:

1. Ensco (NYSE:ESV)

Ensco is an offshore contract drilling company. As of February 15, 2010, Ensco’s offshore rig fleet included 42 jackup rigs, four ultra-deepwater semisubmersible rigs and one barge rig. Additionally, it had four ultra-deepwater semisubmersible rigs under construction. Ensco’s operations are concentrated in the regions of Asia Pacific, which includes Asia, the Middle East and Australia, Europe and Africa, and North and South America. It operates under four segments: Deepwater, Asia Pacific, Europe and Africa, and North and South America. Each of the four operating segments provides one service, contract drilling. Ensco engages in the drilling of offshore oil and natural gas wells by providing its drilling rigs and crews under contracts with international, government-owned and independent oil and gas companies.

At current prices, Ensco looks pretty cheap. Yes, a moratorium on offshore drilling would undoubtedly cause them to take a bit of a hit. But, think about it this way. You are getting a company that has been clobbered almost as bad as BP and RIG (about a 4% difference month-to-date).

However, you are also getting a company without the headline risk, substantial operations abroad to make up for any lost revenues during the drilling moratorium, and a clean balance sheet with $1B in net cash. If there really is a 6 month drilling moratorium, you can bet that some of the more leveraged players will be in for some pain. Plus, drilling rig premiums are going up, putting even more pressure on them. This might create some good bargains for a company like Ensco which could come in and buy rigs on the cheap from financially squeezed competitors.

The biggest risk with a company like Ensco is that its earnings could go down if the price of oil declines. With the risk of China’s economy slowing down, this is a possibility, but I think that in the long run the BRIC countries are here to stay and will ultimately drive energy prices higher.

Ensco looks pretty nice at around 7x earnings, 1x book, $1B in net cash, and a 4% dividend yield.

2. Tidewater (NYSE:TDW)

Tidewater Inc. provides offshore supply vessels and marine support services to the offshore energy industry through the operation of offshore marine service vessels. As of March 31, 2008, the Company had a total of 430 vessels, of which 10 were operated through joint ventures, 61 were stacked and 11 vessels withdrawn from service.

Tidewater is another company I started to look at. Again, these guys lack the headline risk, but still operate in the same industry and might take a hit from the moratorium. They operate shipping vessels for the O&G industry. A decline in drilling activity and energy prices would negatively impact their business.

On the plus side, TDW has a great record of capital allocation. When activity slows down, they have proven themselves to be incredibly adept at selling under-utilized vessels to companies in non-competing industries at prices in excess of cost.

Tidewater trades at 8.3x earnings, 88% of book value, and has a clean balance sheet with a 3% debt to equity ratio when you net out cash.

The risk here is again, if oil prices decline, rig activity slows down which also affects Tidewater. This has already happened and net income dropped from $407M to $259M YoY. In addition, the company has taken a few small charges $37M in provisions for vessels seized by Venezuela and $11.4M to the SEC for a bribery complaint related to operations in Nigeria. I can imagine that some of these may make investors nervous, but they seem quite frequent among companies in the O&G business that operate abroad.

3. HCC Insurance (NYSE:HCC)

HCC Insurance Holdings, Inc. (HCC) provides specialized property and casualty, surety, and group life, accident and health insurance coverages and agency services to commercial customers and individuals. The Company operates its businesses in three segments: insurance company, agency and other operations. It operates primarily in the United States, the United Kingdom, Spain and Ireland. It underwrites on both a direct basis, where it insures a risk in exchange for a premium, and on a reinsurance (assumed) basis, where it insures all or a portion of another, or ceding, insurance company’s risk in exchange for all or a portion of the ceding insurance company’s premium for the risk. HCC markets its products both directly to customers and through a network of independent and affiliated brokers, producers, agents and third party administrators.

These guys are expecting to take a $30 to $40M hit from the oil spill (they did $350M pre-tax last year). They seem to be running a really tight ship when it comes to underwriting, the last 3 years have been hovering around 85% combined ratio and have a good record of book value growth (15.7% CAGR since 2001). They have the lowest expense ratio in the industry, about 5% lower than peers, a nice little advantage.

The company is trading around 90% of book, historically over the last 5 years they have traded around 1.5x.

About 95% of shares are held by institutions, with 115M shares outstanding. The company just announced a $300M stock buyback, they just finished up their last buyback program ($100M, started in 2008). I think that might add some pressure to bring the stock price up, it has traded sideways the last few years.

It looks like an opportunity to get a good insurer at a good price.

I’m always fascinated by the fact that Lloyd’s of London has survived for hundreds of years. Lloyd’s of London is a marketplace for insurance companies. Insurers come together and can come together at Lloyd’s to pool and spread risk. Lloyd’s has a great reputation for being the go to place for insuring hard to insure risks, from environmental disasters to a supermodel’s legs.

You can read more of Lloyd’s history at Wikipedia.

It really is amazing to see how far the company has come.

From this in the 19th century:

To this today:

(Flickr:theboybg)

Anyone who has followed this blog for a while knows that we are fans of Sardar Biglari and his work at Steak N Shake (now Biglari Holdings). One of Biglari’s goals is to add an insurance operation to the holding company. This would add a number of benefits to BH, namely the fact that its float could be redeployed into accretive investments.

Lawmakers in Michigan seem intent on curbing his efforts:

A bill wending its way through the Legislature aimed at protecting a small insurance company from a hostile takeover will have a chilling effect on investment and job creation in the state, an opponent said today.

Sardar Biglari, CEO of San Antonio-based Biglari Holdings, which owns 19 Steak ‘n Shake restaurants in Michigan, said the measure — which passed the Senate last month to block his company from acquiring Fremont InsuraCorp. of West Michigan — sends the wrong message to potential investors.

“This bill will send a signal that Michigan poses greater risks, greater uncertainty than other states,” said Biglari, who was in Lansing to meet with members of the House Insurance Committee, which is scheduled to take up the bill Thursday.

He said his holding company has no intention of moving the small insurer out of Michigan or of laying off its 75 employees. The only change in the works is to replace the company’s CEO, he said…

The legislation would require approval of two-thirds of outstanding shares of a company to elect director candidates who are not backed by a majority of that company’s board of directors. Biglari, who owns nearly 10 percent of Fremont InsuraCorp., said the bill would make it “nearly impossible to consummate the transaction.” He said the measure dilutes shareholder rights.

Biglari added he’s looking to acquire other businesses in Michigan and said the outcome of this legislation “will determine our level of interest.”

Cobb said the bill is narrowly tailored to block the takeover of Fremont and would affect only a couple other companies in the state.

“We don’t think it will have an effect on outside investment,” he said. “Shareholders will still have their say.”

Bill seen as roadblock to takeover of Fremont insurer

The really unfortunate thing here is that if a company in Michigan underperforms, with legislation like this in place, it will be extremely difficult to turn them around. Shareholders will have a say, but it will be weakened. Michigan should by now be well acquainted with how insulated management teams can run amok, after all, US taxpayers had to bailout their state when GM and Chrysler went bankrupt. It seems as if they haven’t quite learned the lesson yet.

A few readers have e-mailed me asking that I show how to analyze a P&C insurance company. I thought that this might actually make a good post series.

When I started out in investing, insurance companies seemed really difficult for me to analyze. I found out that insurance companies aren’t necessarily harder to analyze than any other company, but that there is a good deal of jargon to get used to.

I don’t know how good I am at teaching this kind of thing, so please use the comments section or e-mail me suggestions or issues you have with the post. Once I have finished this series, I’ll put all the parts into one big PDF, that way new investors can quickly grab the whole thing to study. My other goal is to eventually post guides for other industries; think banks, restaurants, retailers, and more.

The Income Statement

For the first part, we are going to look at the income statement. Now, I prefer to look at actual cases, so we will be analyzing Fremont Michigan Insuracorp (OTC:FMMH) for the rest of the series. I think it is useful to learn from companies like Fremont, because they are smaller and tend to have fewer moving parts. You can access the company’s latest 10K by clicking here.

One of the most confusing aspects of P&C insurance companies is how they make money. It is not as simple as just looking straight at the revenues line on an income statement. Instead, P&C insurance companies generate revenues in three ways: underwriting, investment/dividend income, realized gains.

Take a moment to look at the income statement line by line. One of the things that will stand out is how revenues are related to net income. You can see that each year, revenues grow, but net income actually decreased in 2008. This sometimes happens with insurance companies, they get a little loose with their underwriting standards and write too many policies without anticipating what they will do to the bottom line. As an investor though, you can sometimes use these periods to find an undervalued insurer. Say they had been writing policies for some kind of unprofitable line and decide to quit – that is an avenue for earnings to change.

Underwriting

When you think of the insurance, underwriting is probably what comes to mind. Underwriting is the act by which insurance companies take on risk. In exchange for that risk, they are paid premiums, usually on a fixed basis. The job of an insurance company is to take on the right kinds of risk, priced appropriately, so that they wont have to pay out too often or at rates that exceed their premiums.

This is why insurance is such a difficult business. In the past, Warren Buffett has noted that most insurance companies often relax their standards during a soft market (a time when insurance premium prices decline) and take on large volumes of risk that are priced too low. This narrows the margin of safety an insurance company has. If accidents happen at a higher rate than expected, an insurance company can easily go belly up. We’ve seen a lot of that in the past.

Premiums

Whenever you enter into a policy, say for auto insurance, you are paying a premium every month. That monthly premium allows you to get coverage by the insurance company. Now, to get to net premiums we have to go through a few steps.

In general, when Fremont writes an insurance policy, it goes under gross premiums written. But, as you can see, that does not appear on the company’s income statement. What happens is, most insurance companies will actually buy some reinsurance for a premium. Basically, this reduces the amount of total risk they are taking on because the reinsurance company will cover some of it — this practice is called ceding premiums.

Gross Premiums Written – Ceded Premiums = Net Premiums Written

Still, that does not get us to net premiums earned. To get there:

Net Premiums Written / 12*10 = Net Premiums Earned

A reader pointed out to me that the example I gave is a generalization, here is his approach which is better:

I think a more accurate equation, which inherently must involve the balance sheet, is:

Net premiums earned = net premiums written – increase in the unearned premium reserve (UEPR)

When an insurer writes a policy, it immediately posts a liability (the UEPR) against the cash received of 100% of the premium. Releases from the UEPR become earned revenue.

Simple example: insurer writes a 12 month policy on December 1, 2010 for $1200 and collects all cash upfront and purchases no reinsurance on this policy. The balance sheet would show $1200 in cash and an unearned premium reserve of $1200. Assuming premium is earned pro rata over the life of the policy, at 12/31/10, the UEPR would reduce to $1100 and earned premium (the top line revenue item) on this policy would be $100, the amount of the release.

The 2010 income statement on this one policy would be calculated as follows:

Net premiums earned = net premiums written of $1200 minus $1100 (the increase in the UEPR from 0 to $1100 at year end) = $100

What you are doing is assuming that the insurance company will have 10 months of the same result over 12 months. Insurance companies earn premiums pro rata over the life of the policy. Different policies have different lengths, auto insurance is generally shorter at 6 months while commercial lines may be 1 year in length.

Fremont appears to be growing by writing more policies. They recently announced a plan to expand beyond their local Michigan market, which might help propel growth prospects and diversify their risks out of just Michigan. For an insurer, this is a pretty good sign.

Loss and Loss Adjustment Expense

Accidents happen. If you write an insurance policy, you have to be ready for losses. These come under the Loss and Loss Adjustment Expense:

An insurance company will incur losses in two ways, paying claims and establishing a reserve. When you receive a check from the insurance company? That’s paying a claim. The loss reserve? That is a liability on an insurance company’s balance sheet. Basically, Fremont sets a pool of reserves for losses they think they will encounter. Premiums are often split between loss reserves and investments. When a claim is submitted, that amount is then paid out from the loss reserve.

Paid Claims + Reserve Charge = Expenses

Insurance comes in two forms, long tail and short tail. Short tail insurance has to be paid out more frequently, so the investment prospects are usually shorter. If you look at any great investor who has taken control of an insurance company, they tend to gravitate towards longer tail policies.

Besides paying out claims, an insurance company incurs underwriting expenses.

Commissions + Other Underwriting = Total Underwriting Expenses

Most insurance companies have to deal with agents and brokers who actually go out and acquire customers. They are paid commission fees for their work, typically a percentage of premiums. Other underwriting expenses are typically your administrative costs, technology, taxes, and office rent.

The Combined Ratio

Every industry has some go-to metric for figuring out how to compare one business to the other. For fast food it might be same store sales, for retail sales per square feet, but for insurance — I think it is the combined ratio. The combined ratio is this:

Expense Ratio + Loss Ratio = Combined Ratio.

Loss Ratio:

Losses and LAE incurred / Premiums

Expense Ratio:

Underwriting Expenses / Premiums

When looking at combined ratios, a 100% CR means the insurer is breaking even on their insurance operation. Below 100% means an underwriting profit and above 100% means an underwriting loss.

I can’t stress this enough – when you are examining an insurance company you really want one that is a profitable underwriter. This is not a business where you want to get yourself involved in a turnaround. You want a turnaround? They usually end badly. Fairfax endured 7 lean years as a result of picking up some very difficult to turnaround distressed insurance operations.

Overall, you can see that Fremont’s underwriting operation is profitable. Their combined ratios are coming down below 100% and are not abnormally low which would indicate that they are under-earning.

Investment Income

Most insurance companies will have a lag time between when they collect premiums and have to pay out claims. In between, insurance companies will usually invest at least a portion of those collected premiums. The idea is to beat the time value of money effect; a dollar today is worth more than a dollar tomorrow. Investment income is made up of the dividend and interest income that an insurance company receives from its investments.

Remember that discussion about short-tail and long-tail insurance? Well that affects how long insurance companies are able to hold on to their reserves and deploy them into investments. Short-tail insurance is paid out more frequently so their investments usually have less time to compound. The opposite is true for long-tail insurance. This is one of the reasons Berkshire Hathaway is involved in reinsurance is the face that they are able to write policies on events that may never happen or wont happen for a long time. This long-tail insurance allows them to deploy premiums into investments and compound for a longer period.

Unfortunately, the insurance market takes this into account and prices insurance policies accordingly. Many forms of long-tail insurance have higher combined ratios than short-tail risk insurance.

Within investments are two other components:

1. Realized Gains (Losses):

As I said, most insurance companies operate some kind of investment portfolio. When the company actually makes a sale on one of their investments, they will record a realized gain (or loss) depending on the price they originally paid and the price they sold for.

You’ll see that Fremont took some losses in 2008, most likely tied to the financial crisis. A number of insurance companies got into purchasing fixed income securities for yield without looking at their true nature. Some were involved in the dreaded toxic assets — I have not looked at what Fremont was selling back in 2008, but you could probably find out by accessing state insurance filings via the NAIC.

2. Unrealized Gains (Losses):

This is when the company’s investment portfolio appreciates or declines, without any sales actually occurring. Due to the mark to market laws, an insurance company might report changes in unrealized gains every quarter depending on the stock market’s performance. Keep in mind that changes in unrealized gains do not register in the income statement, rather, they are found in the balance sheet as a driver of shareholders equity via retained earnings.

Since many insurance companies use fixed income instruments to obtain dividend income, their portfolios are sensitive to changes to interest rates. If they are buying securities that are yielding close to current rates, and we see rates rise, the value of those securities will fall — forcing the insurance company to record unrealized losses.

Some insurers that are not profitable on their underwriting can still crank out a profit via investments. Fairfax Financial is well known for having this ability, it really requires a strong investment team at the helm. Unfortunately, the nature of investments is changing for some insurance companies. A recent article reported that many will cease to manage their investment portfolios in house. I like when insurers foster an in house investment operation because their incentives are often more aligned with the insurer. When you farm out your assets to Wall Street, you might get into products that require only a management fee (meaning performance does not matter) and the insurer will be taken for a stroll by Wall Street sales guys who only care about their commissions — not the well being of the insurer. I’d rather that insurance companies try to create a really good, value oriented investment operation in house. Guys like Tom Gayner and the folks at Hamblin-Watsa exemplify this best.

Conclusion

Hopefully, this has helped you understand some of the terminology and items that you will find on an insurance company’s income statement. Once you see how the income statement works, you can look at it from a variable perspective. One of Fremont’s criticisms is that their expenses could be lowered, this is a good point. If the company could reduce 2009 underwriting expenses by 5.9% net income would rise by almost 25%.

Let me know if I have been unclear in this walk through the income statement. My next post will focus on the balance sheet.

Over the last few weeks, I have spent a lot of time trying to find certain industries that appear undervalued. One area is insurance, where many insurers with good combined ratios and past performance are trading below book. I was happy to see Wilbur Ross agree in this Q&A with Fortune:

Where do you think the biggest opportunities are now?

There are deep value opportunities in insurance stocks, which were beaten down because of their exposure to the subprime crisis, annuities, and commercial real estate. I won’t name names, but some well-managed life insurance and fire and casualty companies will come through this stronger. They used to trade at one or two times book value but now trade at three-quarters book…

Mr. Distress is ready to buy (Fortune)

A quick look at Google shows us how the sector is looking for reinsurance players:

Most appear pretty cheap on the basis of book value. For the moment, it seems as if these companies are trading at discounts mainly due to market conditions. Most insurance companies are reporting that they are still in a soft market. I know that the folks at W.R. Berkley are expecting that things will start to turn. One indicator of that, to me, seems to be with the uptick in M&A activity. We saw Fairfax Financial acquire Zenith, and recently Perry Capital urged Endurance Services to find a merger partner:

PEMBROKE, Bermuda—One of the largest shareholders of Endurance Specialty Holdings Ltd. has urged the Pembroke, Bermuda-based insurer to find a merger partner.

New York-based hedge fund manager Perry Corp.—which owns 12.6% of Endurance and whose president, Richard C. Perry, is a member of its board of directors—said in a regulatory filing Monday that it expects consolidation in the Bermuda reinsurance market to accelerate in the near term.

Endurance “should undertake an evaluation of its strategic alternatives and pursue a possible merger or other strategic transaction in order to create a stronger company with a defined growth strategy,” Perry, which does business as Perry Capital L.L.C., wrote in the filing with the Securities and Exchange Commission.

In addition, Perry said recent executive appointments at Endurance will “not position the insurer to capitalize on consolidation opportunities.”

Endurance Shareholder Urges Merger (Business Insurance)

Richard Perry might also see the reinsurance sector as undervalued, which is why he thinks opportunities are ripe for Endurance Services. If that is not enough, we also saw Warren Buffett purchase stakes in Munich Re and Swiss Re. Smart, value savvy investors appear to be really interested in these companies and I think they are worth a look.

To me, the key will be to find insurance companies that are trading at low multiples with the capacity to increase policy volumes as the market improves.

(Click for full size)

I still like Fairfax given its book value growth, great management team, and current price. However, I see plenty of other opportunities worth analyzing, especially with P&C insurers. I plan on posting some work that I have been doing on insurance companies sometime this week, so be sure to look for that.

When I saw the 13F for Fairfax Financial Holdings (TSE:FFH) come out, one of the things I wondered was when Prem Watsa would do another acquisition. With Fairfax’s success over the last few years and good financial shape, I thought the company would be poised for an acquisition. Watsa has publicly said that they are not interested in straying too far out of the insurance business when it comes to acquisitions. They don’t want to build another Berkshire Hathaway.

So, I’m pretty happy to see this acquisition of Zenith National Insurance (NYSE:ZNT). Zenith is in the workers’ compensation insurance business, which means that policies are generally long tail, meaning that payouts happen over longer periods of time. To contrast, short-tail insurance usually has payouts over shorter periods of time and more frequently. This is typical when you look at the likelihood that a person will get into an accident in their car versus an injury at the workplace.

So why is acquiring long-tail insurance operations so beneficial to a company like Fairfax? For one, Zenith is well operated. Moreover, the long-tail policies enable Fairfax to increase the size of its float — which is the amount of Zenith receives in premiums that it does not have to be paid out immediately or held in reserves. That capital is often invested in securities, in Zenith’s case mostly bonds, which could potentially be redeployed into more attractive securities by smart capital allocators like the people at Fairfax. Fairfax is not the only smart investor to have acquired workers’ compensation insurance companies, Warren Buffett’s Berkshire Hathaway owns National Indemnity which has workers’ compensation operations in California.

The one stickler for the Zenith deal is the fact that Fairfax will have to issue a little equity to complete the deal but will still have about $1 billion in cash on hand after the acquisition.

Via Bloomberg:

Fairfax Financial Holdings Ltd., the Canadian insurer run by Prem Watsa, agreed to buy Zenith National Insurance Corp. for about $1.3 billion in cash, adding sales in California.

Fairfax will pay $38 a share, the Toronto-based company said today in a statement. That’s 31 percent more than Woodland Hills, California-based Zenith’s $28.91 closing price on the New York Stock Exchange yesterday. The deal is expected to be completed in the second quarter.

Watsa, 59, is betting on a rebound in a workers’ compensation market pressured by rising medical costs and falling payrolls. Like Warren Buffett at Berkshire Hathaway Inc. and Loews Corp.’s Tisch family, Watsa built his company by investing the assets of insurance operations, often in out-of- favor securities.

“Workers’ compensation is probably the softest of all lines right now,” Bob Hartwig, president of the Insurance Information Institute, said at a conference in November, using industry parlance for a market where rates are falling. “Rate accounts for the vast majority of premium reduction we have seen in workers’ compensation.”

…Zenith, run by Chairman and Chief Executive Officer Stanley Zax since 1978, said in its 2009 annual report that it has “a long-term record of outperforming the industry.” Zenith’s workers’ compensation loss ratio, a measure of how much of each dollar of premium is paid in claims, was lower than the industry average every year from 2002 to 2008, according to Zenith’s annual report.

“There will be no changes in Zenith’s strategic or operating philosophy,” Watsa said in the statement.

Watsa’s Fairfax Agrees to Buy Insurer Zenith for $1.3 Billion

Warren Buffett is pretty active with foreign insurance companies these days. Not to long ago, Berkshire Hathaway (NYSE:BRK-A) did a deal to take on some of Swiss Re’s life insurance portfolio. Now, Munich Re is reporting that he owns 3% of the company:

Release of an announcement according to Section 21 WpHG [German Securities Trading Act]
WKN 843002
ISIN DE0008430026

Warren E. Buffett, USA, informed us in accordance with Section 21, para. 1 of the German Securities Trading Act (WpHG) that his share of the voting rights in our company had exceeded the threshold of 3% on 18 January 2010 and amounted to 3.045% (6,011,029 voting rights) as per this date. Thereof 2.994% (5,911,029 voting rights) are attributable to him in accordance with Section 22, para. 1 sentence 1 item 1 of the WpHG.

Munich, 26 January 2010

The Board of Management

Notifications relating to holding of voting rights 2010 (Munich Re)

I don’t know too much about Munich Re, but for any global value guys, it is probably worth taking a look at.