Fairfax Financial 4Q15 Earnings Call Notes

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Prem Watsa

Our common stock portfolios are hedged 100%

“We have yet to significantly benefit from our hedges and our approximate $110 billion notional amount of deflation swaps, and of course, our cash position gives us great optionality. At our last annual meeting, we made the point that while we were protecting our capital on the downside, our investment portfolio could also do very well. Our common stock portfolios continued to be hedged at approximately 90%. Early in 2016, we increased the hedge to 100%.”

Deflation is a very difficult environment to make a return in

“Yes. So on the deflation swaps, deflation contracts that we put in, Dave, as I said it’s almost seven years yet to go. What we’re trying to do is protect our company from worst-case events. And deflation is the very difficult environment to make a return in. You’re seeing interest rates in Japan, tenure rates are negative. German rates are below – tenure German rates are below 0.3% like below 0.3 like 30 basis points, 10 years. So in that environment it’s very difficult to make a return and we’re trying to protect, and there’s all sorts of unintended consequences and so we’re protecting our company from that”

Pricing of derivative contracts is very volatile, really not meaningful until we sell them

“I’d say up and down and we saw the same in credit default swaps. But as looking back in our 2008 Annual Report and you can see what I said there, but in eight months from June 2007 to February 2008, the valuation of our credit default swaps went from $200 million to $2 billion, in eight months it went up 10 times. And for three or four years prior to that it did nothing. So these valuations from what we see, from where we said is, and it’s in our books, we have taken a big hit in terms of our cost. And the next important number is when we sell it. And till that time there – as you point out valuations.”

The US P&C insurance environment is soft, so our business is shrinking

“the U.S. property and casualty environment as you know it’s a soft environment. So our business broadly speaking is shrinking, Odyssey came down. We did not renew a major property account. The pricing wasn’t right. So, as we’re very focused on underwriting and are reserving very important to keep the reserving at a very good level.”

Many of our competitors have reached for yield and taken credit risk

“I’ve said for some time that we have on the left-hand side of the balance sheet there has been many of our competitors have reached the yield and have taken credit risk to get more income is one of the questions earlier, it is very difficult to get income. So they’ve gone up the credit risk. We think that’s probably not an appropriate thing to do and the spreads are very narrow.”

We buy these instruments to protect the company in a mark to market world

“Yes, so it’s a combination. We bought these hedges to protect our company, right? So it’s like the deflation swaps that we bought and Chris. And the – we’re in a mark-to-market world. So if we wanted to expand our insurance business, because prices are going up, but if the prices are going up in an environment where the stock price are coming down, spreads are widening, while our capital will be reduced significantly, and so we may not be able to take advantage of the opportunity to increase our insurance business.”

We think of it like storms

“So we protect our capital. In 2008, 2009, the last time we did that. The markets came down about 50% and we took our hedges off. We just think we’re facing an insurance business you think of it as a 150 within 100 years on like not often, but you get these storms, you get an earthquake in California sometimes or you get big wind storm in Florida. We’ve had many and we have to protect ourselves from that. So it’s just similar situation that we’re looking at. We want to protect ourselves. And we think right now with interest rates at zero for sometime and in many case, it’s going negative and a ton of debt in the system, we think that the possibilities on the downside are significant. So we want to protect our company and we have no intention of taking those hedges off soon.”

We’re well prepared for recession but if we continue to muddle through then returns will be mediocre

” if we go into recession in the next year or two, my suggestion is even I have all sorts of unintended consequences and that’s the worry we have, Tom. So our company is well structured for that. But if we muddle through like we have in the last few years, our returns are not going to be exceptional. They’re going to be mediocre. We accept that with the idea that these are very difficult times and we have to be careful.”