Fitch Comments on Fairfax’s Rating Watch

November 11, 2004

Fitch Ratings commented that Fairfax Financial Holdings Limited’s ratings and Rating Watch Negative status are unaffected by its recent disclosures via its third-quarter 2004 financial filings and investor conference held on Nov. 8, 2004.

Fitch said it “recognizes the positive credit implications afforded by Fairfax’s forthcoming $300 million stock offering, which is expected to increase holding company cash and investments to over $600 million, provide flexibility to further term out holding company debt maturities, and/or help offset unexpected costs/shortfalls in parental dividends/tax-sharing payments. Also, a recently proposed commutation of several reinsurance transactions will lessen the liquidity strain on Fairfax’s subsidiary, nSpire Re Limited, and free up potentially needed intercompany reinsurance capacity.”

However, Fitch said it “continues to believe that Fairfax’s long-term credit fundamentals remain weak and that management continues to face challenges with liquidity issues despite substantial funds generated via capital market access or realized gains in recent years.”

The controversy between Fitch and Fairfax is not a new one. Last September the rating agency placed Fairfax and its rated subsidiaries and affiliates on Ratings Watch Negative and reiterated its negative outlook (See IJ Web site Sept.1).

The action drew a response from Fairfax, who issued a press release which said that although the company “maintains relationships with four major ratings agencies,” and provides them with additional information,” it “does not maintain a relationship with Fitch Ratings.” The company added that it had “not met with Fitch or provided information to Fitch since the spring of 2003 and since that time has requested Fitch to withdraw its ratings on Fairfax.”

Fitch so far hasn’t complied with the request, and in the more recent announcement it reiterated its concerns about Fairfax. They are summarized as follows:
— Financial leverage remains high; based on U.S. GAAP balance sheet adjustments, Fairfax’s pro forma debt to total capital ratio is 45 percent at Sept. 30, 2004, including the proposed equity issuance;
— Fixed-charge coverage as measured by EBIT-to-interest costs remains negative for the nine months ending Sept. 30, 2004;
— Operating earnings remain unfavorable due in part to losses related to run-off operations. In the past few years, the primary source of earnings for Fairfax has been realized gains on invested assets, implying a low quality of reported earnings.
— Reinsurance utilization and credit exposure to reinsurers is high, as recoverables were 277 percent of reported shareholders’ equity at Sept. 30, 2004.
— Deteriorating market pricing in the U.S. casualty segment may lead to a continued need to tap alternate sources to parental dividends and earnings retention to service subsidiary and holding company obligations.
— Loss reserves have developed unfavorably in the past few years, and uncertainty remains regarding reserve adequacy.
— Fairfax apparently is now unable to take advantage of its corporate credit facility due to stricter financial convents effective mid-2004.
— Based on Fairfax’s competitive position in the U.S. market, Fitch believes the company is more vulnerable to commercial lines price softening and a shifting market preference toward higher rated insurers than peers.

Fitch also said it “believes that a number of management actions, while providing short-term benefits, have further limited flexibility. Furthermore, the very need to take these actions is a reflection of the challenges management faces in maintaining organizational viability, including:
— The change in provider of roughly $200 million of capital to Advent Capital (Holdings) PLC from nSpire Re to Odyssey Re Holdings Corp., which may have allowed for nSpire Re to fund Fairfax’s indemnification of its runoff subsidiary TIG Insurance Company against losses related to Kingsmead;
— Increased usage of intercompany guarantees that raises the potential liquidity requirements at Fairfax to fund either direct indemnifications or support subsidiary indemnifications;
— Effective movement of letters of credit from Fairfax’s secured corporate facility to a new secured facility that Fitch believes may provide inferior claims paying capacity, compared with its replacement, and raises concerns regarding the potential for ‘double pledging’ of assets effectively securing the facility;
— Extensive utilization of internal and external income smoothing/capital enhancing financial reinsurance has negatively affected investment income and creates difficulty in understanding and interpreting financial results.
— Sales of minority stakes in profitable operating segments have decreased available operating cash flow.
— The company’s investment strategy that has produced large reported realized investment gains, while enhancing capitalization of operating subsidiaries, has also diminished future investment income.
— The proposed unwinding of sizable finite reinsurance agreements among TIG, nSpire Re, and outside parties may in part be prompted by a need to ‘free up’ capacity at nSpire Re to potentially absorb future loss reserve development among other Fairfax entities, such as Crum & Forster.
— The sale of common stock below book value is highly unusual and may reflect a continued need to maintain significant holding company cash to offset unpredictable/limited parental cash flow from subsidiaries despite improvement in core operating earnings.

Fitch did indicate that it would “consider Fairfax’s Rating Watch following the completion of the proposed common stock offering and reinsurance commutations and after a review of year-end results and disclosures by Fairfax.” But it also indicated that it ” remains concerned by the level and quality of public disclosures by the company and will consider withdrawing the ratings if it is determined that the company’s year-end 2004 disclosures do not allow for a reasonable assessment of the level or direction of Fairfax’s credit worthiness.”

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