TORONTO--Fairfax Financial Holdings Ltd. last week said it will restate previous earnings following an accounting review related to a soon-to-be commuted $1 billion reinsurance contract with Swiss Reinsurance Co.

The move, which is expected to reduce Fairfax's shareholders' equity by up to $240 million, drew mixed reviews from rating agencies.

In addition, Fairfax's Stamford, Conn.-based Odyssey Re Holdings Corp. subsidiary said it would once more restate its financial results for the years 2001 through 2005, and for the first quarter of 2006, to correct the accounting treatment of certain equity and convertible bond investment securities, according to a company statement. Odyssey's latest restatement--which does not impact shareholders' equity--will be the second earnings restatement in under a year for the reinsurer. Odyssey, amid regulatory probes into the use of finite insurance products, in April made five years' worth of finite-insurance related restatements that cut shareholders' equity by $35 million (BI, April 10).

Fairfax said it discovered the errors leading to its restatement while reviewing the accounting impact of a proposed commutation of a $1 billion reinsurance contract purchased from Swiss Re in 1999. The contract, referred to as "corporate adverse development coverage," was used to protect the Fairfax group of companies from adverse development on reserves and uncollectible reinsurance for accident years 1998 and prior, Greg Taylor, Fairfax's chief financial officer, said during a conference call with analysts.

Commutation clauses are sometimes included in reinsurance agreements to provide for the valuation, payment and complete discharge of all obligations--including future obligations between the parties for reinsurance losses incurred--between a ceding company and a reinsurer.

Under the commutation, expected to take place in early August, approximately $585 million of funds withheld in trust under the Swiss Re contract would be paid to Fairfax's Irish reinsurance subsidiary, nSpire Re Ltd., to fund claims payments and operating expenses.

"The commutation of Swiss Re will significantly decrease the drag from European runoff as well as the cash demands on holding company cash," V. Prem Watsa, Fairfax's chief executive officer, said during the conference call. Fairfax currently has over $500 million in holding company cash, Mr. Watsa noted.

Under Canadian accounting rules, the move will result in a noncash pretax loss of about $415 million in the third quarter, Fairfax said, while under U.S. rules, the noncash loss will be approximately $16 million.

Estimated impact

Although the restated amounts have not been finalized, Fairfax said it estimates the impact of the restatement--which the company expects to complete by the end of August--will be a decrease in shareholders' equity of as of March 31 of between $225 million and $240 million.

"This is a very embarrassing moment for us at Fairfax," Mr. Watsa said. "Prior to Odyssey Re's restatement, we had never had one at Fairfax or at subsidiaries."

"We take very seriously our obligation to provide accurate financial results, and our management team, having identified the 2001 and prior reconciliation differences, acted diligently to quantify the difference and promptly disclose our findings." Mr. Watsa said.

The accounting problems that were uncovered have since been remedied, Fairfax said in a statement.

According to a spokesman for Fairfax, "There is no relationship between the announced restatement and the industrywide inquiry by regulators into the use of finite reinsurance policies."

Rating agencies had mixed reaction to news of the restatement.

New York-based Standard & Poor's Corp. placed under review a variety of financial strength and credit ratings for Fairfax and related entities, due primarily to Fairfax's delayed filing of second-quarter financial statements stemming from of its restatement.

Oldwick, N.J.-based A.M. Best Co. Inc., meanwhile, did not make any rating changes to Fairfax and its subsidiaries, and it noted that it views the company's decision to commute the Swiss Re contract as a positive step.

"There are many reasons why the unwinding of this contract is economically beneficial," said Joyce Sharaf, assistant vp and managing senior financial analyst at Best. "The positives more than outweigh the negatives."

"European runoff has been a significant drain on Fairfax's holding company and now, that cash drain on the holding company will be eliminated through at least 2007."

She added that, "Every year, there is an interest rate on the funds held on the contract that Fairfax has to pay, and now they don't have to pay that, which is some savings."

"The biggest negative in commuting the contract is that they do take an economic hit in the third quarter, but there are benefits to be gained going forward, especially with regard to investment income and holding company cash," Ms. Sharaf said.