The rapid rise of interest rates since March 2021 has caused the collapse of Silicon Valley Bank (SVB) due to run on deposits and potential losses on its long-duration bond investments. As the banking crisis unfolds, investors are on high alert for SVB-style portfolios as they scrutinize the investments portfolio of banks and insurance companies,  

Unlike banks’ deposit base, insurance companies’ obligations to fund future claims are longer-term with more predictable timing. They are, therefore, not as vulnerable as banks to a liquidity crisis or a “run”. But rising rates do have earning implications. For example, an insurance company with a SVB-style long-duration bond portfolio in 2021, earning 1% or sub-1%, is missing the opportunity to invest in risk-free treasury bonds earning 3-4% in 2023, hence losing tens of millions of dollars in earnings for a billion dollar portfolio.   

Fairfax Financial Holdings Ltd. (“FFH”), a Canada-based insurance holding company, does not have this problem.   CEO Prem Watsa wrote in his annual investor letter in March 2023 that “Years of refusing to reach for yield by going long duration paid off for us in 2022, as 50% of our investment portfolio was in cash and treasury bills at the end of 2021”.  He further commented during FFH Annual Shareholder Meeting in April 2023: “…we have extended our term by buying treasury bonds in the last 2-3 months … so we are confident that we will have $1.5B in interest & dividend income in 23, 24 and 25, by buying about 80% of our fixed-income portfolio in government bonds.” FFH is trading at $698 per share with a market cap of around $16B and a book value of $752 per share. Therefore, $4.5B anticipated interest & dividend income for the next three years, equivalent to $193 per share, will be a meaningful windfall for FHH shareholders. As many other financial institutions grapple with the fall-out of rising rates, FFH management’s long-term-oriented investment principle is paying off for their shareholders. 

FFH is an insurance holding company with business in Property and Casualty Insurance and Reinsurance and associated investment management. Over the 37 years since its founding in 1985, it grew its book value by 18.5% annually. The share price of FFH grew along at 17.4% per year, resulting in 378X of any investment made at inception.  

The formula of FFH’s success is the combination of disciplined insurance underwriting and a rational investing framework. Insurance companies collect premiums upfront to cover claims in the future. This collect-now, pay-later model created the insurance float – the difference between the premium collected and claims paid out. Insurance companies get to invest the float and generate income/dividends/profit for the benefit of shareholders. Companies that manage to underwrite on a break-even or profitable basis effectively use the float for free or get paid to use it. To understand the power of free/paid float, FFH had an average annual return of 7.7% on its investment portfolio since its inception but produced an 18.5% average yearly book value return, primarily due to free/paid float from its successful insurance underwriting. This powerful compounding structure has allowed FHH shareholders to enjoy index-beating returns for nearly four decades.   Another well-known insurance company based in Omaha, NE, Berkshire Hathaway Inc., used a similar structure -combination of insurance float and rational investing -to compound book value at 19.8% per year for 57 years.  

The components of the insurance compounding machine, free float and solid investment returns, are far from a given. In 2022, the Property and Casualty industry as a whole, for example, incurred underwriting losses. We believe a good starting point for looking for an insurance company compounding machine is management.   A rational management team with an owner’s mentality and long-term focus is one of the key ingredients to make the compounding machine work. 

Disclosure: Nothing here is investment advice. Some client accounts managed by RCA held FRFHF at the publication of this blog article. That holding status might have changed since.