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EXHIBIT 1

 


Table of Contents

(FAIRFAX LOGO)
 
2008 Annual Report


 

 
 


Table of Contents

 
2008 Annual Report
 
 
Five Year Financial Highlights
 
                                         
    (in US$ millions except share and per share data or as otherwise indicated)  
    2008     2007     2006     2005     2004  
 
Revenue
    7,975.4       7,483.7       6,803.7       5,900.5       5,829.7  
Net earnings (loss)
    1,473.8       1,095.8       227.5       (446.6 )     53.1  
Total assets
    27,305.4       27,941.8       26,576.5       27,542.0       26,271.2  
Common shareholders’ equity
    4,866.3       4,063.5       2,662.4       2,448.2       2,605.7  
Common shares outstanding – year-end (millions)
    17.5       17.7       17.7       17.8       16.0  
Increase (decrease) in book value per share
    21.0 %     53.2 %     9.2 %     (15.5 %)     (0.6 %)
Per share
                                       
Diluted net earnings (loss)
    79.53       58.38       11.92       (27.75 )     3.11  
Common shareholders’ equity
    278.28       230.01       150.16       137.50       162.76  
Dividends paid
    5.00       2.75       1.40       1.40       1.40  
Market prices
                                       
TSX – Cdn$
                                       
High
    390.00       311.87       241.00       218.50       250.00  
Low
    221.94       195.25       100.00       158.29       147.71  
Close
    390.00       287.00       231.67       168.00       202.24  
NYSE – US$
                                       
High
    355.48       310.34       209.00       179.90       187.20  
Low
    210.50       169.41       88.87       126.73       116.00  
Close
    313.41       286.13       198.50       143.36       168.50  
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
 
Corporate Profile
 
Fairfax Financial Holdings Limited is a financial services holding company whose corporate objective is to build long term shareholder value by achieving a high rate of compound growth in book value per share over the long term. The company has been under present management since September 1985.
 
Canadian insurance
 
Northbridge Financial, based in Toronto, provides property and casualty insurance products through its Commonwealth, Federated, Lombard and Markel subsidiaries, primarily in the Canadian market as well as in selected U.S. markets. It is one of the largest commercial property and casualty insurers in Canada based on gross premiums written. In 2008, Northbridge’s net premiums written were Cdn$1,166.4 million. At year-end, the company had shareholders’ equity of Cdn$1,383.6 million and there were 1,590 employees.
 
U.S. insurance
 
Crum & Forster (C&F), based in Morristown, New Jersey, is a national commercial property and casualty insurance company in the United States writing a broad range of commercial coverages. Its subsidiary Seneca Insurance provides property and casualty insurance to small businesses and certain specialty coverages. Since January 1, 2006, the specialty niche property and casualty and accident and health insurance business formerly carried on by Fairmont Insurance is being carried on as the Fairmont Specialty division of C&F. In 2008, C&F’s net premiums written were US$878.2 million. At year-end, the company had statutory surplus of US$1,410.6 million (shareholders’ equity of US$1,166.4 million on a US GAAP basis) and there were 1,266 employees.
 
Asian insurance
 
First Capital, based in Singapore, writes property and casualty insurance primarily to Singapore markets. In 2008, First Capital’s net premiums written were SGD90.2 million (approximately SGD1.4 = US$1). At year-end, the company had shareholders’ equity of SGD187.9 million and there were 68 employees.
 
Falcon Insurance, based in Hong Kong, writes property and casualty insurance to niche markets in Hong Kong. In 2008, Falcon’s net premiums written were HK$176.7 million (approximately HK$7.8 = US$1). At year-end, the company had shareholders’ equity of HK$305.8 million and there were 93 employees.
 
Reinsurance
 
OdysseyRe, based in Stamford, Connecticut, underwrites treaty and facultative reinsurance as well as specialty insurance business, with principal locations in the United States, Toronto, London, Paris, Singapore and Latin America. In 2008, OdysseyRe’s net premiums written were US$2,030.8 million. At year-end, the company had statutory surplus of US$2,951.3 million (shareholders’ equity of US$2,827.7 million on a US GAAP basis) and there were 698 employees.
 
Group Re primarily constitutes the participation by CRC (Bermuda) and Wentworth (based in Barbados) in the reinsurance of Fairfax’s subsidiaries by quota share or through participation in those subsidiaries’ third party reinsurance programs on the same terms and pricing as the third party reinsurers. Since 2004, Group Re has also written third party business. In 2008, its net premiums written were US$185.5 million. At year-end, these companies had combined shareholders’ equity of US$268.1 million.
 
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Runoff
 
The runoff business comprises the U.S. runoff group and the European runoff group. The U.S. runoff group consists of the company resulting from the December 2002 merger of TIG and International Insurance and the Fairmont legal entities placed in runoff on January 1, 2006. At year-end, the merged U.S. company had shareholders’ equity of US$1,229.5 million (statutory surplus of US$674.0 million). The European runoff group consists of RiverStone Insurance UK and nSpire Re. At year-end, this group had combined shareholders’ equity (including amounts related to nSpire Re’s financing of Fairfax’s U.S. insurance and reinsurance companies) of US$985.3 million.
 
The Resolution Group (TRG) and the RiverStone Group (run by TRG management) manage runoff under the RiverStone name. At year-end, TRG/RiverStone had 117 employees in the U.S., located primarily in Manchester, New Hampshire, and 58 employees in its offices in the United Kingdom.
 
Other
 
Hamblin Watsa Investment Counsel, founded in 1984 and based in Toronto, provides investment management to the insurance, reinsurance and runoff subsidiaries of Fairfax.
 
Notes:
 
(1) All companies are wholly owned except for OdysseyRe (70.4%-owned at December 31, 2008). Northbridge Financial became wholly owned in February 2009.
 
(2) The foregoing lists all of Fairfax’s operating subsidiaries (other than wholly-owned Polish Re, acquired in early 2009). The Fairfax corporate structure also includes a 26.0% interest in ICICI Lombard (an Indian property and casualty insurance company), a 24.9% interest in Falcon Thailand, an approximate 20% interest in Arab Orient Insurance (a Jordanian company), an approximate 20% interest in Alliance Insurance (a Dubai, U. A. E. company), and investments in Advent (66.6%), Cunningham Lindsey (45.7%) and Ridley (67.9%). The other companies in the Fairfax corporate structure, principally investment or intermediate holding companies (including companies located in various jurisdictions outside North America), are not part of these operating groups; these other companies had no insurance, reinsurance, runoff or other operations.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
 
To Our Shareholders:
 
While 2007 was a record year for us, 2008 was even better! We earned approximately $1.5 billion1 after tax or $79.53 per diluted share. Book value grew by 21.0% to $278.28 per share (excluding the $5.00 per share dividend paid in 2008) and we ended the year with over $1.5 billion in cash and marketable securities at the holding company level. We were net cash at the holding company level, as our cash and marketable securities exceeded holding company debt and other obligations.
 
Since we began 23 years ago, book value has compounded by 25% while our common stock price has followed at 23% per year. The last two years have made up significantly for the biblical seven lean years that you have suffered. In the seven lean years (1999-2005), we made no money on a cumulative basis. In the three years since (2006-2008), we have earned $2.8 billion after tax and book value per share has more than doubled. While we are pleased that our forecast of “the seven lean years are over” did come true, we much prefer the Noah principle, “Forecasting doesn’t count, building an ark does”!
 
The results for our major subsidiaries are shown below:
 
                         
                Return on
 
          Net
    Average
 
    Combined
    Earnings
    Shareholders’
 
    Ratio     after Tax     Equity  
 
Northbridge
    107.3%       45.7       3.6%  
Crum & Forster (US GAAP)
    114.6%       332.8       27.1%  
OdysseyRe (US GAAP)
    101.2%       549.0       20.5%  
 
Excluding the effect of foreign currency movements, the impact of an unusual reinsurance commutation and lawsuit settlement at Crum & Forster, and catastrophe losses related to Hurricanes Ike – the third costliest hurricane in U.S. history – and Gustav, the combined ratios of Northbridge, Crum & Forster and OdysseyRe (the latter two on a US GAAP basis) were 100.1%, 97.0% and 93.7% respectively, and Fairfax’s consolidated combined ratio (on a Canadian GAAP basis) was 96.2%. Overall, these were extraordinary results, both absolute and relative to the industry, especially given the investment environment. Northbridge’s results were mediocre because of charges recorded on investments for other than temporary impairments and mark-to-market losses, the gains on Canadian Federal Government bonds being less than on U.S. Federal Government bonds, and higher combined ratios.
 
The table below shows our major subsidiaries’ growth in book value over the past seven years (per share for Northbridge and OdysseyRe), adjusted by including distributions to shareholders.
 
         
    2001 – 2008
 
    Annual Compound
 
    Growth Rate  
 
Northbridge
    19.2%  
Crum & Forster (US GAAP)
    18.9%  
OdysseyRe (US GAAP)
    21.2%  
 
Our investment team has produced exceptional returns in many of the years over the past 23 – but none like in 2008! The investment environment in 2008 was brutal as the 1 in 50 or 1 in 100 year storm in the financial markets that we feared arrived in the fall. All major stock markets worldwide were down about 50% and all corporate and non-Federal Government bond spreads widened to historically high levels. There were very few places to hide, let alone prosper! Fortunately, after many years of caution, we were perfectly positioned with a cash and government bond position of approximately 75% of our investment portfolio, our stock positions fully hedged, and our large holdings of credit default swaps. The total return (including unrealized gains) in our investment portfolios, including our CDS position and hedges, was 16.4%. Total interest and dividend income and net investment gains in 2008 (including at the holding company) were $3.3 billion after recording almost $1 billion in other than temporary impairments and over $500 million of mark-to-market losses (primarily on convertible bonds). Interest and dividend income dropped in 2008 from $761 million to $626 million because of the collapse in short term interest rates, but total net investment
 
 
1Amounts in this letter are in U.S. dollars unless specified otherwise. Numbers in the tables in this letter are in U.S. dollars and $millions except as otherwise indicated.
 
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gains increased to $2.7 billion – again, after the $1.5 billion of impairment and mark-to-market charges mentioned above – from $1.6 billion in 2007. These are exceptional results and no other company in the industry has even come close to matching them! A standing ovation for our investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami, Sam Mitchell, Paul Rivett, Frances Burke and Enza La Selva.
 
Our performance in 2008 did not go unnoticed by the rating agencies. A.M. Best upgraded Crum & Forster to an “A” rating after upgrading Northbridge to an “A” rating and Fairfax to an investment grade rating in 2007. DBRS upgraded Fairfax to investment grade in 2008 and Standard & Poor’s followed early in 2009. By the way, we do not know of another publicly traded financial institution, of any size, that has survived after being downgraded to non-investment grade status.
 
In November of 2008, after the stock markets had dropped 50% from their highs, we decided to remove the equity hedges on our portfolio investments. Also, as the yield on long (30-year) U.S. Treasuries began to drop below 3%, we sold almost all our U.S. Treasuries (at year-end we had only $985 million left, compared to $6.4 billion on December 31, 2007), having realized net gains of $583 million in 2008 on sales of U.S. Treasuries. Both the equity hedges and the U.S. Treasuries have done an outstanding job in protecting our capital. Our U.S. Treasury bond position was to a large extent replaced by $4.1 billion in U.S. state, municipal and other tax-exempt bonds (of which $3.6 billion carry a Berkshire Hathaway guarantee) with an average yield (at purchase) of approximately 5.79% per annum. During the fourth quarter of 2008, we also increased our cash and short term investments by $752 million and invested an additional $2.3 billion in common stocks. The annualized pre-tax equivalent interest and dividend income has increased significantly for our company by virtue of our significant holdings of tax-exempt bonds and as we have taken advantage of the significant widening in corporate and non-Federal Government spreads.
 
In previous annual reports, we have discussed the holding of some common stock positions for the very long term. Last year we identified Johnson & Johnson as one name and said that Mr. Market may give us more opportunities in the future. As shown in the table below, at the end of 2008 we had taken advantage of the major decline in stock prices to purchase additional positions in outstanding companies with excellent long term track records which we contemplate holding for the long term.
 
                                 
    Shares Owned     Cost per Share     Amount Invested     Market Value  
 
Johnson & Johnson
    7,585,000     $ 60.68       460.3       453.4  
Kraft Foods
    10,723,571       26.61       285.4       287.6  
Wells Fargo Bank
    3,515,100       21.93       77.1       103.6  
 
Late in the fourth quarter of 2008, after receiving a $350 million dividend from Crum & Forster, we decided to take Northbridge private at a fair price for all minority shareholders. Our Cdn$39.00 per share offer was unanimously recommended by the Independent Committee of the Board of Northbridge, which had retained Scotia Capital as its financial advisor. As many of you will remember, we took Northbridge public in 2003 at Cdn$15.00 per share. At Cdn$39.00 per share, in the approximately five and a half years that Northbridge was public, Northbridge minority shareholders earned a 20%+ compound annual rate of return, including dividends (versus 5% for the TSX 300). We took Northbridge public at 1.2x book value and private at 1.3x book value, in an environment where the whole P&C industry (including us) was selling at approximately book value. Northbridge had never traded at Cdn$39.00 per share before. You can see why we considered the offer a fair price for Northbridge’s minority shareholders.
 
As you know, necessity is often the mother of invention – by taking Northbridge public in 2003, we created the largest commercial lines P&C company in Canada from four relatively small companies. Under Mark Ram’s leadership (Mark has been with us since he graduated from the Ivey Business School in 1991), we are very excited about Northbridge’s long term prospects.
 
In the past year, we have had significant share repurchases in the group. Fairfax repurchased 1.07 million shares at an average price of $264.39 per share (total cost of $282 million), more than offsetting the 0.9 million shares issued on the conversion of the $189 million of 5% convertible debentures that we called for redemption in early 2008. Northbridge repurchased 2.3 million shares at an average price of Cdn$29.04 per share in 2008, while OdysseyRe repurchased 9.5 million shares at an average price of $37.06 per share after repurchasing 2.6 million shares at an average price of $35.83 per share in 2007. Fairfax also retired Cdn$50 million of preferred shares in 2008.
 
We think that Fairfax has developed two significant strengths over the past 23 years. One, our worldwide investment management capabilities, has been evident, especially in a year like 2008. The other is our P&C insurance and
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
reinsurance operating skills. From humble beginnings in Canada (remember Markel Insurance with $10 million in premiums in 1985!), by the end of 2007 we had insurance operations in Canada, the U.S., India, Singapore, Hong Kong and Thailand and reinsurance operations worldwide.
 
In 2008, we expanded into Eastern Europe through the 100% purchase of Polish Re (we closed this purchase in January 2009), and into the Middle East through the purchase of an approximate 20% interest in two of the finest companies in the region: Arab Orient Insurance in Jordan and Alliance Insurance in Dubai. All three companies are focused on underwriting profit with good reserving. We welcome Marek Czerski and all the employees at Polish Re to the Fairfax family and we look forward to working with Mr. Karim Kabariti (Chairman and CEO of Arab Orient’s controlling shareholder, Kuwait Jordan Bank) and Isam Abdelkhaliq, CEO of Arab Orient, and with Sheik Ahmed Bin Saeed Al Maktoum (Chairman of both Alliance and the Emirates Group) and Wisam Al Haimus, CEO of Alliance.
 
At this time, I must share with you the record of an outstanding manager that we have been fortunate to attract to Fairfax, Mr. Athappan from Singapore. I first met Mr. Athappan about 15 years ago when he was managing a P&C company called India International. Mr. Athappan took over managing India International, an Indian Government owned company, in 1988 with approximately SGD14 million in shareholders’ equity. Until he joined us in 2006, Mr. Athappan grew that SGD14 million to SGD238 million – with no new capital and having paid SGD28 million in dividends to his shareholder. During this time period, India International had an average combined ratio of less than 90%, almost never had a combined ratio in excess of 100%, and always practised excellent reserving. About 13 years ago, when real estate prices were very high, Mr. Athappan sold his house and rented, even though the house was owned by the company!! Mr. Athappan is an outstanding investor and is intuitively value oriented. Since he began managing First Capital in 2002, shareholders’ equity has increased from SGD58 million to SGD188 million and the company has made an underwriting profit every year with excellent reserving. With regard to 2007, by which time net premiums written had risen from SGD14 million to SGD90 million, First Capital was ranked fourth in premiums written in Singapore but first in underwriting profit. This is our goal for all our companies – to be first in underwriting profit, not in premiums written. You can see why we are excited about Fairfax Asia’s prospects as Mr. Athappan puts his stamp on all our Asian operations!
 
As I mentioned to you last year, in 2008 Doug Libby succeeded Nick Antonopoulos at Crum & Forster and Gobi Athappan became the Managing Director of Falcon upon Kenneth Kwok’s retirement. Late in the year, Nick Bentley took over from Dennis Gibbs and now manages all of our runoff operations worldwide. All of these “successions” have been from inside the company, were well planned and are going very well.
 
Dennis Gibbs retires in March 2009 and will continue with us as a consultant. Dennis joined us when we acquired TRG in 1999 and over the past 10 years, Dennis and TRG handled any significant downside risk in the insurance/reinsurance business exceptionally well. Dennis’ first assignment, and the only lawsuit we had ever initiated, was the Horace Holman lawsuit in London in 2000. Four and a half years later, we won that lawsuit hands down. When we put TIG in runoff in 2002, Dennis masterfully executed the merger of TIG and IIC within four months and in the next few years significantly reduced the size of the runoff in terms of claims outstanding. Over a period of years, this runoff, which is one of the larger runoffs in the U.S., has proceeded smoothly and successfully and we were able to retrieve most of our OdysseyRe shares from TIG. Dennis also was responsible for getting our European runoff under control and, finally, for picking his successor Nick Bentley. Dennis has done an outstanding job for us and has been a pleasure to work with. We look forward to working with Dennis in the future, as we are sure another opportunity or problem will surface again.
 
Our partnership with Chuck Davis and Stone Point in the ownership of Cunningham Lindsey is going well and recently, on Stone Point’s recommendation, Cunningham Lindsey purchased the operations of GAB Robins (excluding the U.S. and U.K.). We invested $49 million to maintain our ownership interest in the company. Brad Martin continues to monitor our investment in Cunningham Lindsey.
 
We have positions in two other companies which are only investments, even though the fact that we own over 50% of those companies requires that they be consolidated on our financial statements. In November 2008 we paid $68 million to purchase 67.9% of the shares of Ridley Inc., one of North America’s leading commercial animal nutrition companies, and during 2008 we purchased $25.6 million of additional shares of Advent, bringing our ownership of that company to 66.6%.
 
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The Insurance Cycle
 
The P&C industry changed dramatically in 2008. Mainly because of investment problems, the industry lost almost 10% of its $540 billion of capital. Many of the industry’s leading lights are on the ropes. If these companies are consumed by a credit event or if the rating agencies lose patience, the current soft insurance market could become hard quickly. If this happens, our companies have the management and capital to expand, as they have in the past in these circumstances. If current conditions continue, count on us shrinking our business further.
 
Insurance and Reinsurance Operations
 
                                 
                      Net Premiums
 
    Combined Ratio
    Written
 
    Year Ended December 31,     % Change in
 
    2008     2007     2006     2008  
 
Northbridge
    107.3 %     92.3 %     98.0 %     10.3 %
Crum & Forster
    117.6 %     93.5 %     92.3 %     (20.2 %)
Fairfax Asia
    92.1 %     70.4 %     78.4 %     22.7 %
OdysseyRe
    103.5 %     95.5 %     96.5 %     (2.8 %)
Other reinsurance
    150.0 %     95.6 %     95.7 %     (10.0 %)
                                 
Consolidated
    110.1 %     94.0 %     95.5 %     (3.7 %)
 
On the surface, we reported some ugly combined ratios for 2008. However (don’t smile!), if you exclude from our 2008 combined ratios three major unusual items – foreign exchange translation losses on claims reserves, a commutation of a reinsurance contract and a lawsuit settlement at Crum & Forster, and losses from Hurricanes Ike, the third most costly hurricane in U.S. history, and Gustav – our combined ratios were not that bad – 100.1%, 99.3%, 94.7% and 96.2% (all on a Canadian GAAP basis) at Northbridge, Crum & Forster, OdysseyRe and Fairfax consolidated respectively – and we maintained conservative reserving.
 
All of our insurance and reinsurance companies remained well capitalized in 2008. Following is the statutory capital for our three major companies, which reflects the significant share buybacks at Northbridge and OdysseyRe and a special $350 million dividend payout by Crum & Forster as well as the ordinary course dividend payments by Crum & Forster, Northbridge and OdysseyRe.
 
                         
                Net
 
                Premiums/
 
    Net Premiums
    Statutory
    Statutory
 
    Written     Surplus     Surplus  
 
Northbridge
    1,099.5       1,120.8 (1)     1.0  
Crum & Forster
    878.2       1,410.6       0.6  
OdysseyRe
    2,030.8       2,951.3       0.7  
 
(1)  Canadian GAAP shareholders’ equity
 
We have updated the float table for our operating companies that we showed you last year.
 
                                 
                      Average Long
 
                Benefit
    Term Canada
 
    Underwriting
          (Cost)
    Treasury Bond
 
Year   Profit (Loss)     Average Float     of Float     Yield  
 
1986
    2.5       21.6       11.6 %     9.6 %
  ↕
                               
2004
    147.4       5,898.7       2.5 %     5.2 %
2005
    (437.5 )     7,323.9       (6.0 %)     4.4 %
2006
    212.6       8,212.9       2.6 %     4.3 %
2007
    281.3       8,617.7       3.3 %     4.3 %
2008
    (457.7 )     8,917.8       (5.1 %)     4.1 %
Weighted average since inception
                    (2.8 %)     5.1 %
Fairfax weighted average financing differential since inception: 2.3%
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
Float is the sum of loss reserves, including loss adjustment expense reserves, and unearned premium reserves, less accounts receivable, reinsurance recoverables and deferred premium acquisition costs. As the table shows, the average float from our operating companies increased 3.5% (1.6% excluding Advent) in 2008 at a cost of 5.1% (3.9% excluding Advent). Excluding foreign exchange gains and losses, the float had a cost of 3.0%. Our long term goal is to increase the float at no cost. This, combined with our ability to invest the float well over the long term, is why we could achieve our long term objective of 15% per annum compounding of book value per share over time. The table below shows you the breakdown of our year-end float for the past five years.
                                                         
                            Total
             
                            Insurance
             
    Canadian
    U.S.
    Asian
          and
             
    Insurance     Insurance     Insurance     Reinsurance     Reinsurance     Runoff     Total  
 
2004
    1,404.2       1,657.1       119.7       3,498.7       6,679.7       741.3       7,421.0  
2005
    1,461.8       1,884.9       120.2       4,501.1       7,968.0       788.6       8,756.6  
2006
    1,586.0       1,853.8       85.4       4,932.6       8,457.8       2,061.0       10,518.8  
2007
    1,887.4       1,812.8       86.9       4,990.4       8,777.5       1,770.5       10,548.0  
2008
    1,739.1       2,125.1       68.9       5,125.0       9,058.1       1,783.8       10,841.9  
 
Insurance and reinsurance float increased in 2008 by $281 million, primarily due to the increase in float from the consolidation of Advent and the commutation of a significant reinsurance treaty by Crum & Forster. The Canadian insurance float would have increased if the effect of foreign exchange movements were excluded. Runoff float increased in 2008 by $13 million, primarily due to the transfer of nSpire Re’s Group Re reserves to runoff.
 
The table below shows the sources of our net earnings. This table, like various others in this letter, is set out in a format which we have consistently used and we believe assists you in understanding Fairfax.
 
                 
    2008     2007  
 
Underwriting
               
Insurance – Canada (Northbridge)
    (78.7 )     78.0  
                    – U.S. (Crum & Forster)
    (177.2 )     77.0  
                    – Asia (Fairfax Asia)
    6.7       20.3  
Reinsurance – OdysseyRe
    (73.5 )     94.7  
                         – Other
    (135.0 )     11.3  
                 
Underwriting income (loss)
    (457.7 )     281.3  
Interest and dividends
    476.1       604.4  
                 
Operating income
    18.4       885.7  
Net gains on investments
    1,558.6       984.0  
Runoff
    392.6       187.6  
Other
    1.4       25.4  
Interest expense
    (158.6 )     (209.5 )
Corporate overhead and other
    631.9       287.2  
                 
Pre-tax income
    2,444.3       2,160.4  
Income taxes
    (755.6 )     (711.1 )
Non-controlling interests
    (214.9 )     (353.5 )
                 
Net earnings
    1,473.8       1,095.8  
                 
 
The table shows the results from our insurance and reinsurance (underwriting and interest and dividends), runoff, and non-insurance operations (Other shows the pre-tax income before interest and other of Cunningham Lindsey in 2007 and Ridley in 2008). Net gains on investments other than at runoff and the holding company are shown separately to help you understand the composition of our earnings. The underwriting loss in 2008 was significant due to the adverse effect of foreign exchange ($189 million), an unusual reinsurance commutation and lawsuit
 
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settlement at Crum & Forster ($110 million) and Hurricanes Ike and Gustav ($326 million). Also, the consolidation of Advent accounted for $112 million of the $135 million underwriting loss at Reinsurance – Other. Interest and dividends decreased mainly due to much lower short term rates. Net investment gains at our operating companies increased significantly in 2008 to record levels. Runoff also had another record year due to record investment gains. Corporate overhead and other was a very significant positive because of substantial net investment gains and investment income from our holding company’s investment portfolio. Pre-tax income and net earnings were also at record levels.
 
Reserving
 
At the end of 2008, our reserves are in excellent shape. Our reserve position has probably never been better in the past 10 years and all our companies are now at the Northbridge standard. Please also note the accident year triangles shown in the MD&A.
 
Financial Position
 
             
    December 31,
    2008   2007
 
Holding company cash, short term investments and marketable securities,
net of short sale and derivative obligations
    1,555.0     963.4
             
Holding company debt
    869.6     1,063.2
Subsidiary debt
    910.2     915.0
Other long term obligations – holding company
    187.7     192.6
             
Total debt
    1,967.5     2,170.8
             
Net debt
    412.5     1,207.4
             
Common shareholders’ equity
    4,866.3     4,121.4
Preferred equity
    102.5     136.6
Non-controlling interests
    1,382.8     1,585.0
             
Total equity and non-controlling interests
    6,351.6     5,843.0
             
Net debt/total equity and non-controlling interests
    6.5%     20.7%
Net debt/net total capital
    6.1%     17.1%
Total debt/total capital
    23.7%     27.1%
Interest coverage
    16.4x      11.3x 
 
At the end of 2008, cash and marketable securities at the holding company level ($1.56 billion) exceeded holding company debt and other long term obligations ($1.06 billion in aggregate), so we were net cash of $498 million at the holding company level. Including subsidiary debt of $910 million (which contained $115 million of debt of Advent and Ridley as a result of our being required to consolidate these investments), net debt was $413 million. Holding company indebtedness decreased by $134 million in 2008 due to the conversion of our 5% convertible debentures and by $62 million due to our redemption at maturity of our outstanding 6.875% notes. The company also redeemed $34 million of its preferred shares in 2008 for cash consideration of $48 million. Our debt/equity and debt/capital ratios dropped significantly again in 2008, to levels well within investment grade standards.
 
Investments
 
The table below shows the time-weighted compound annual returns (including hedging) achieved by Hamblin Watsa Investment Counsel (Fairfax’s wholly-owned investment manager) on stocks and bonds managed by it during the past 15 years for our companies, compared to the benchmark index in each case.
 
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
                         
    5 Years     10 Years     15 Years  
 
Common stocks (with equity hedging)
    12.2 %     19.1 %     16.1 %
S&P 500
    (2.2 %)     (1.4 %)     6.5 %
                         
Bonds
    9.6 %     9.3 %     9.4 %
Merrill Lynch U.S. corporate (1-10 year) index
    1.6 %     4.4 %     5.4 %
 
2008 was another very good year for Hamblin Watsa’s investment results, even excluding our CDS position which is not included in the results shown above. These results are due to Hamblin Watsa’s outstanding investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami, Sam Mitchell, Paul Rivett, Frances Burke and Enza La Selva.
 
As I said earlier, the return that our investment team produced in 2008 was the best since we began in 1985 – 23 years ago! All of the investment risks that we worried about and have written to you about for at least the past five years simultaneously reared their ugly head as the 1 in 50 or 1 in 100 year storm in the financial markets landed in the fall of 2008. All the major stock markets worldwide were down about 50% and all corporate and non-Federal Government bond spreads widened to historically high levels. Risk was back with a vengeance and, as Grant’s Interest Rate Observer wrote back in 1996, “the return of one’s money, the humblest investment attribute in good times, is always prized in bad times”.
 
Long U.S. Treasury yields declined to 2.5% – a low not seen since 1954 – and 3-month T-Bills were yielding close to 0% for much of the fourth quarter of 2008. All parts of the U.S. economy and financial markets began to deleverage at the same time, led by financial institutions, hedge funds, businesses and individuals. Mutual fund redemptions began worldwide and the risk in common stock investing was exposed as stock markets declined viciously in the fourth quarter of 2008 and have continued to decline in 2009. Comparing levels at the end of 2008 and the end of 1998, most U.S. and worldwide stock market indices had not provided any return for the past 10 years. For example, the S&P 500 had a compound annual return of minus 3.0% (excluding dividend reinvestment) over the past 10 years. Of course, for the investor in late 2008, the returns in the future may be very different from the past.
 
Last year, I quoted Hyman Minsky who said that history shows that “stability causes instability”. He said that prolonged periods of prosperity lead to leveraged financial structures that cause instability – and did we see that in spades in 2008!! With SIVs, CDOs, CDOs squared, among many other structures, leverage on leverage was exposed in 2008. Private equity firms that could do no wrong in 2005/2006 were down 90% from their IPO price in 2007. While Madoff may be the biggest Ponzi scheme yet unearthed, what Mr. Minsky calls Ponzi financial structures, where interest and principal cannot be financed by internal operations, are being unmasked daily in the financial markets. Structured investments based upon consumer debt that we warned you about for some time took a real beating in 2008, as 47% of the original AAA ratings on U.S. residential mortgage-backed and various other asset-backed securities issued between 2005 and 2007 were downgraded. In fact, as of January 9, 2009, over 13% of those securities which had originally been rated as AAA had been downgraded to CCC+ or lower!
 
Last year, we quoted Ben Graham who said that only 1 in 100 of the investors who were invested in the stock market in 1925 survived the crash of 1929-32. Our experience has been the same. As shown in the table below, we incurred a significant cost annually from 2003 through 2006 because of our equity hedging and CDS exposures. Not shown, of course, is the cost of not reaching for yield in the same time period.
 
                                                 
Net investment gains (losses)   2008     2007     2006     2005     2004     2003  
 
Equity hedges
    2,079.6       143.0       (158.7 )     (53.1 )     (75.1 )      
Credit default swaps
    1,290.5       1,145.0       (83.5 )     (101.6 )     (13.7 )     (12.5 )
                                                 
Total
    3,370.1       1,288.0       (242.2 )     (154.7 )     (88.8 )     (12.5 )
                                                 
 
We had to endure years of pain before harvesting the gains in 2007 and 2008.
 
We think this recession is going to be long and deep and the only comparable data points are the debt deflation that the U.S. experienced in the 1930s and Japan experienced from 1989 to the present time. While the U.S. government has initiated a massive stimulus program and is providing up to $2 trillion for its Financial Stability Program, the effect of these programs will be diminished by the enormous deleveraging going on by businesses and individuals: government in the U.S. only accounts for less than 20% of GNP while the private sector accounts for more than 80%. The situation will have to be monitored carefully over the next few years. Of course, many of these negatives are being
 
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discounted in the stock market and credit markets as stock prices are down more than 50% and credit spreads are at record levels. We have not had as many opportunities in both markets in our investing career and we are busy!
 
In 2008, gross gains on investments totaled $4.2 billion. After other than temporary impairment losses of almost $1 billion and over $500 million of mark-to-market losses (primarily on convertible bonds), net gains on investments were $2.7 billion. Net gains from fixed income securities were $274 million (including gains from U.S. Treasuries of $583 million) and credit default swap gains were $1.3 billion, while net gains from common stocks were $21 million and from equity hedges were $2.1 billion.
 
Our net unrealized gains (losses) by asset class at year-end were as follows:
 
                 
    2008     2007  
 
Bonds
    123.5       76.2  
Preferred stocks
    (2.7 )     (0.9 )
Common stocks
    (198.5 )     300.9  
Investments, at equity
    356.0       77.7  
                 
      278.3       453.9  
                 
 
Our common stock portfolio, which reflects our long term value oriented investment philosophy, is broken down by country as follows (at market value). We have never had more common stock investments in the United States.
 
         
    2008  
 
United States
    2,975.1  
Canada
    560.3  
Other
    705.8  
         
      4,241.2  
         
 
For the first time in more than a decade, we are very excited about the long term prospects of our common stock investments and believe that these investments have been purchased at prices well below their intrinsic values. This, of course, does not mean stock prices cannot go lower! Mark-to-market gains or losses on these investments will make our book value more volatile, but in the next five years, these investments should be a major reason for our success.
 
Miscellaneous
 
Given our results for 2008, our record holding company cash and marketable securities position and our strong and conservative balance sheet, we paid a dividend of $8 per share (an extra $6 per share in excess of our nominal $2 per share). Our shareholders were pleased!
 
In 2008, Fairfax and its subsidiaries made over $11 million in charitable donations, benefitting a variety of charities, principally in North America. As we said last year, in a free enterprise world, customers, employees, shareholders and communities do benefit from the success of an individual business. However, we forgot to mention governments, as for 2008 Fairfax will pay income taxes of $1.1 billion to all governments where we do business. The $1.1 billion is approximately 20% of our market value at the end of 2008.
 
Paul Murray has decided not to stand for re-election to our Board at this year’s shareholders’ meeting. Paul has a long history with Fairfax: he was one of the original investors in 1985 and he joined our Board to chair our Audit Committee upon Robbert Hartog’s retirement in 2005. As the beneficiary of Paul’s experience and quiet insight, we are grateful for his service and advice over many years and we wish Paul well in his retirement.
 
The future is always uncertain but it is particularly so as I write this letter to you. However, I am confident about the long term prospects of our company because of the outstanding calibre of our management team – the Presidents, officers and investment principals. This is not a large group – only about 40 strong – but it is a highly unusual group of men and women with great integrity, team spirit and no egos. On average, they have been with the company 13 years. We have come a long way in the past 23 years, from $12 million in revenue and $8 million in shareholders’ equity in 1985 to $8 billion in revenue and approximately $5 billion in shareholders’ equity in 2008. Over that time period, book value per share has increased more than 180 times and our stock price 120 times. I am really thankful for the past, but because of our management team and our bedrock guiding principles (again reproduced for you in Appendix A), I am excited about the future.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
We will very much look forward to seeing you at our annual meeting in Toronto at 9:30 a.m. on Wednesday, April 15, 2009 in the John W.H. Bassett Theatre, Room 102, Metro Toronto Convention Centre, 255 Front Street West. Our Presidents, the Fairfax officers and the Hamblin Watsa principals will all be there to answer any and all of your questions.
 
I would like to thank the Board and the management and employees of all our companies for their outstanding efforts during 2008. We would also like to thank you, our long term shareholders, who have supported us loyally for many, many years. We look forward to continuing to build shareholder value for you over the long term.
 
March 6, 2009
 
-s- V. P. Watsa
V. Prem Watsa
Chairman and Chief Executive Officer
 
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Management’s Responsibility for the Financial Statements
 
The preparation and presentation of the accompanying consolidated financial statements, Management’s Discussion and Analysis (“MD&A”) and all financial information are the responsibility of management and have been approved by the Board of Directors.
 
The consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles. Financial statements, by nature, are not precise since they include certain amounts based upon estimates and judgments. When alternative methods exist, management has chosen those it deems to be the most appropriate in the circumstances.
 
We, as Fairfax’s Chief Executive Officer and Chief Financial Officer, will certify Fairfax’s annual disclosure document filed with the SEC (Form 40-F) in accordance with the United States Sarbanes-Oxley Act of 2002.
 
The Board of Directors is responsible for ensuring that management fulfills its responsibilities for financial reporting and is ultimately responsible for reviewing and approving the consolidated financial statements. The Board carries out this responsibility principally through its Audit Committee which is independent from management.
 
The Audit Committee is appointed by the Board of Directors and reviews the consolidated financial statements and MD&A; considers the report of the external auditors; assesses the adequacy of the internal controls of the company, including management’s assessment described below; examines the fees and expenses for audit services; and recommends to the Board the independent auditors for appointment by the shareholders. The independent auditors have full and free access to the Audit Committee and meet with it to discuss their audit work, Fairfax’s internal control over financial reporting and financial reporting matters. The Audit Committee reports its findings to the Board for consideration when approving the consolidated financial statements for issuance to the shareholders and management’s assessment of the internal control over financial reporting.
 
Management’s Report on Internal Control over Financial Reporting
 
Management is responsible for establishing and maintaining adequate internal control over financial reporting.
 
Management has assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2008 using criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of December 31, 2008.
 
The effectiveness of the company’s internal control over financial reporting as of December 31, 2008 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in its report which appears herein.
 
March 6, 2009
 
     
-s- V. Prem Watsa   -s- Greg Taylor
V. Prem Watsa   Greg Taylor
Chairman and Chief Executive Officer   Vice President and Chief Financial Officer
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
 
Independent Auditors’ Report
 
To the Shareholders of Fairfax Financial Holdings Limited
 
We have completed integrated audits of the consolidated financial statements of Fairfax Financial Holdings Limited (the “Company”) as at December 31, 2008 and 2007 and for the three years ended December 31, 2008, and an audit of its internal control over financial reporting as at December 31, 2008. Our opinions, based on our audits, are presented below.
 
Consolidated financial statements
 
We have audited the accompanying consolidated balance sheets of the Company as at December 31, 2008 and 2007, and the related consolidated statements of earnings, comprehensive income, shareholders’ equity and cash flows for each of the years in the three year period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits of the Company’s consolidated financial statements as at December 31, 2008 and 2007 and for each of the years in the three year period ended December 31, 2008 in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A financial statement audit also includes assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as at December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2008 in accordance with Canadian generally accepted accounting principles.
 
As discussed in Note 2 to the consolidated financial statements, the Company adopted new accounting standards related to financial instruments on January 1, 2007.
 
Internal control over financial reporting
 
We have also audited the Company’s internal control over financial reporting as at December 31, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting on page 13. Our responsibility is to express an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
 
We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally
 
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accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as at December 31, 2008 based on criteria established in Internal Control – Integrated Framework issued by the COSO.
 
-s- of Toronto
 
Chartered Accountants, Licensed Public Accountants
Toronto, Ontario
 
March 6, 2009
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
 
Valuation Actuary’s Report
 
I have reviewed management’s valuation, including management’s selection of appropriate assumptions and methods, of the policy liabilities of the subsidiary insurance and reinsurance companies of Fairfax Financial Holdings Limited in its consolidated balance sheet as at December 31, 2008 and their change as reflected in its consolidated statement of earnings for the year then ended, in accordance with Canadian accepted actuarial practice.
 
In my opinion, management’s valuation is appropriate, except as noted in the following paragraph, and the consolidated financial statements fairly present its results.
 
Under Canadian accepted actuarial practice, the valuation of policy liabilities reflects the time value of money. Management has chosen not to reflect the time value of money in its valuation of the policy liabilities.
 
-s- Richard Gauthier
 
Richard Gauthier, FCIA, FCAS
PricewaterhouseCoopers LLP
Toronto, Canada
March 6, 2009
 
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Consolidated Financial Statements
 
Consolidated Balance Sheets
as at December 31, 2008 and 2007
 
                 
    2008     2007  
    (US$ millions)  
 
Assets
               
Holding company cash, short term investments and marketable securities (including assets pledged for short sale and derivative obligations – $19.7; 2007 – nil)
    1,564.2       971.8  
Accounts receivable and other
    1,688.7       1,906.9  
Recoverable from reinsurers (including recoverables on paid losses – $298.9; 2007 – $371.8)
    4,234.2       5,038.5  
                 
      7,487.1       7,917.2  
                 
Portfolio investments
               
Subsidiary cash and short term investments (cost $5,492.3; 2007 – $3,218.8)
    5,508.5       3,218.1  
Bonds (cost $8,302.1; 2007 – $9,971.7)
    8,425.8       10,049.9  
Preferred stocks (cost $41.2; 2007 – $20.8)
    38.2       19.9  
Common stocks (cost $3,964.1; 2007- $2,314.9)
    3,816.9       2,617.5  
Investments, at equity (fair value $575.3; 2007 – $485.7)
    219.3       408.0  
Derivatives and other invested assets (cost $157.3; 2007 – $339.7)
    398.0       979.6  
Assets pledged for short sale and derivative obligations (cost $8.3; 2007 – $1,800.9)
    8.3       1,798.7  
                 
      18,415.0       19,091.7  
                 
Deferred premium acquisition costs
    321.9       371.1  
Future income taxes
    699.4       344.3  
Premises and equipment
    133.1       53.8  
Goodwill and intangible assets
    123.2       89.4  
Other assets
    125.7       74.3  
                 
      27,305.4       27,941.8  
                 
 
 
See accompanying notes.
 
Signed on behalf of the Board
 
 
     
-s- V. P. Watsa
Director
  -s- V. P. Watsa
Director
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
                 
    2008     2007  
    (US$ millions)  
 
Liabilities
               
Subsidiary indebtedness
    21.1        
Accounts payable and accrued liabilities
    1,326.5       1,232.6  
Income taxes payable
    656.3       68.9  
Short sale and derivative obligations (including at the holding company – $9.2; 2007 – $8.4)
    29.4       1,062.8  
Funds withheld payable to reinsurers
    355.1       362.6  
                 
      2,388.4       2,726.9  
                 
Provision for claims
    14,728.4       15,048.1  
Unearned premiums
    1,890.6       2,153.0  
Long term debt – holding company borrowings
    869.6       1,063.2  
Long term debt – subsidiary company borrowings
    889.1       915.0  
Other long term obligations – holding company
    187.7       192.6  
                 
      18,565.4       19,371.9  
                 
Non-controlling interests
    1,382.8       1,585.0  
                 
Contingencies (note 13)
               
Shareholders’ Equity
               
Common stock
    2,124.9       2,067.4  
Other paid in capital
          57.9  
Treasury stock, at cost
    (22.7 )     (22.6 )
Preferred stock
    102.5       136.6  
Retained earnings
    2,871.9       1,658.2  
Accumulated other comprehensive income (loss)
    (107.8 )     360.5  
                 
      4,968.8       4,258.0  
                 
      27,305.4       27,941.8  
                 
 
See accompanying notes.
 
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Consolidated Statements of Earnings
for the years ended December 31, 2008, 2007 and 2006
 
                         
    2008     2007     2006  
    (US$ millions except
 
    per share amounts)  
 
Revenue
                       
Gross premiums written
    5,061.4       5,214.5       5,486.6  
                         
Net premiums written
    4,332.2       4,498.4       4,789.7  
                         
Net premiums earned
    4,529.1       4,648.8       4,850.6  
Interest and dividends
    626.4       761.0       746.5  
Net gains on investments
    2,720.5       1,639.4       765.6  
Net gain on secondary offering
                69.7  
Other
    99.4       434.5       371.3  
                         
      7,975.4       7,483.7       6,803.7  
                         
Expenses
                       
Losses on claims
    3,720.9       3,132.0       3,822.4  
Operating expenses
    823.8       820.0       757.9  
Commissions, net
    729.8       760.3       780.7  
Interest expense
    158.6       209.5       210.4  
Other costs and expenses
    98.0       401.5       353.7  
                         
      5,531.1       5,323.3       5,925.1  
                         
Earnings from operations before income taxes
    2,444.3       2,160.4       878.6  
Provision for income taxes
    755.6       711.1       485.6  
                         
Net earnings before non-controlling interests
    1,688.7       1,449.3       393.0  
Non-controlling interests
    (214.9 )     (353.5 )     (165.5 )
                         
Net earnings
    1,473.8       1,095.8       227.5  
                         
Net earnings per share
  $ 80.38     $ 61.20     $ 12.17  
Net earnings per diluted share
  $ 79.53     $ 58.38     $ 11.92  
Cash dividends paid per share
  $ 5.00     $ 2.75     $ 1.40  
Shares outstanding (000) (weighted average)
    18,037       17,700       17,763  
 
 
See accompanying notes.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
Consolidated Statements of Comprehensive Income
for the years ended December 31, 2008, 2007 and 2006
 
                         
    2008     2007     2006  
    (US$ millions)  
 
Net earnings
    1,473.8       1,095.8       227.5  
                         
Other comprehensive income (loss), net of income taxes
                       
Change in net unrealized gains and losses on available for sale securities(1)
    (548.0 )     293.0        
Reclassification of net realized (gains) losses to earnings(2)
    248.6       (95.4 )      
Change in unrealized foreign currency translation gains and losses(3)
    (186.6 )     114.9       31.9  
Reclassification of foreign currency translation (gains) losses on disposition of investee company
    24.9       (13.7 )      
Changes in gains and losses on hedges of net investment in foreign subsidiary(4)
    (7.2 )            
                         
Other comprehensive income (loss)
    (468.3 )     298.8       31.9  
                         
Comprehensive income
    1,005.5       1,394.6       259.4  
                         
 
(1) Net of income tax recovery of $213.4 (2007 – income tax expense of $142.2).
 
(2) Net of income tax expense of $86.1 (2007 – income tax recovery of $35.3).
 
(3) Net of income tax expense of $45.3 (2007 – income tax recovery of $7.6; 2006 – income tax recovery of $9.5).
 
(4) Net of income tax recovery of $2.8 (2007 and 2006 – nil).
 
See accompanying notes.
 
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Consolidated Statements of Shareholders’ Equity
for the years ended December 31, 2008, 2007 and 2006
 
                         
    2008     2007     2006  
    (US$ millions)  
 
Common stock –
                       
Subordinate voting shares – beginning of year
    2,063.6       2,068.1       2,075.8  
Issuances on conversion of convertible senior debentures
    192.3              
Purchases for cancellation
    (134.8 )     (4.5 )     (7.7 )
                         
Subordinate voting shares – end of year
    2,121.1       2,063.6       2,068.1  
Multiple voting shares – beginning and end of year
    3.8       3.8       3.8  
                         
Common stock
    2,124.9       2,067.4       2,071.9  
                         
Other paid in capital – beginning of year
    57.9       57.9       59.4  
Conversion of convertible senior debentures
    (57.9 )            
Purchases of convertible senior debentures
                (1.5 )
                         
Other paid in capital – end of year
          57.9       57.9  
                         
Treasury shares (at cost) – beginning of year
    (22.6 )     (18.3 )     (17.3 )
Net acquisitions
    (0.1 )     (4.3 )     (1.0 )
                         
Treasury shares (at cost) – end of year
    (22.7 )     (22.6 )     (18.3 )
                         
Preferred stock –
                       
Series A – beginning of year
    51.2       51.2       51.2  
Purchases for cancellation
    (12.8 )            
                         
Series A – end of year
    38.4       51.2       51.2  
                         
Series B – beginning of year
    85.4       85.4       85.4  
Purchases for cancellation
    (21.3 )            
                         
Series B – end of year
    64.1       85.4       85.4  
                         
Preferred stock
    102.5       136.6       136.6  
                         
Retained earnings – beginning of year
    1,658.2       596.6       405.6  
Transition adjustment – financial instruments
          29.8        
Net earnings for the year
    1,473.8       1,095.8       227.5  
Excess over stated value of common shares purchased for cancellation
    (147.2 )     (2.5 )      
Excess over stated value of preferred shares purchased for cancellation
    (13.9 )            
Common share dividends
    (88.9 )     (49.0 )     (25.1 )
Preferred share dividends
    (10.1 )     (12.5 )     (11.4 )
                         
Retained earnings – end of year
    2,871.9       1,658.2       596.6  
                         
Accumulated other comprehensive income (loss) – beginning of year
    360.5       12.2       (19.7 )
Transition adjustment – financial instruments
          49.5        
Other comprehensive income (loss)
    (468.3 )     298.8       31.9  
                         
Accumulated other comprehensive income (loss) – end of year
    (107.8 )     360.5       12.2  
                         
Retained earnings and accumulated other comprehensive income
    2,764.1       2,018.7       608.8  
                         
Total shareholders’ equity
    4,968.8       4,258.0       2,856.9  
                         
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
                         
    2008     2007     2006  
 
Number of shares outstanding
                       
Common stock –
                       
Subordinate voting shares – beginning of year
    16,918,020       16,981,970       17,056,856  
Issuances on conversion of convertible senior debentures
    886,888              
Purchases for cancellation
    (1,066,601 )     (38,600 )     (67,800 )
Net treasury shares acquired
    (252 )     (25,350 )     (7,086 )
                         
Subordinate voting shares – end of year
    16,738,055       16,918,020       16,981,970  
Multiple voting shares – beginning and end of year
    1,548,000       1,548,000       1,548,000  
Interest in shares held through ownership interest in shareholder – beginning and end of year
    (799,230 )     (799,230 )     (799,230 )
                         
Common stock effectively outstanding – end of year
    17,486,825       17,666,790       17,730,740  
                         
Preferred stock –
                       
Series A – beginning of year
    3,000,000       3,000,000       3,000,000  
Purchases for cancellation
    (750,000 )            
                         
Series A – end of year
    2,250,000       3,000,000       3,000,000  
                         
Series B – beginning of year
    5,000,000       5,000,000       5,000,000  
Purchases for cancellation
    (1,250,000 )            
                         
Series B – end of year
    3,750,000       5,000,000       5,000,000  
                         
 
 
See accompanying notes.
 
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Consolidated Statements of Cash Flows
for the years ended December 31, 2008, 2007 and 2006
 
                         
    2008     2007     2006  
    (US$ millions)  
 
Operating activities
                       
Earnings before non-controlling interests
    1,688.7       1,449.3       393.0  
Amortization
    22.4       27.0       24.9  
Bond discount amortization
    (3.9 )     (17.6 )     (67.9 )
(Earnings) loss on investments, at equity
    49.4       (7.7 )     (78.0 )
Future income taxes
    (342.9 )     323.5       375.2  
Loss on significant commutations
    84.2             412.6  
Net gains on investments
                (835.3 )
Net (gains) losses on available for sale securities
    334.7       (130.7 )      
Other net gains on investments
    (3,055.2 )     (1,508.7 )      
                         
      (1,222.6 )     135.1       224.5  
Changes in:
                       
Provision for claims
    186.6       (981.6 )     (741.2 )
Unearned premiums
    (200.0 )     (172.4 )     (274.6 )
Accounts receivable and other
    292.1       19.9       555.6  
Recoverable from reinsurers
    582.5       665.2       1,154.2  
Funds withheld payable to reinsurers
    (25.6 )     (28.3 )     (97.5 )
Accounts payable and accrued liabilities
    (158.0 )     69.3       21.0  
Income taxes payable
    614.0       67.8       1.1  
Other
    50.9       (19.8 )     62.0  
                         
Cash provided by (used in) operating activities
    119.9       (244.8 )     905.1  
                         
Investing activities
                       
Investments – purchases
                (3,971.3 )
 – sales
                3,999.2  
Net sales of assets and liabilities classified as held for trading
    3,157.3       482.6        
Net sales (purchases) of securities designated as held for trading
    (3,814.6 )     40.9        
Available for sale securities – purchases
    (6,333.0 )     (3,693.5 )      
 – sales
    9,233.7       2,273.8        
Net purchases of available for sale short term investments
    (1,762.9 )     (1,538.4 )      
Net decrease (increase) in restricted cash and cash equivalents
    196.3       (107.9 )     8.0  
Net sales of marketable securities
                51.3  
Net sales (purchases) of investments, at equity
    (54.2 )     381.3       (2.8 )
Net sales of other invested assets
          7.6        
Net purchases of premises and equipment and intangible assets
    (23.7 )     (18.0 )     (13.2 )
Net proceeds on secondary offerings
                337.6  
Proceeds on partial disposition of investee company
          60.0        
Sale (purchase) of subsidiaries, net of cash acquired
    (11.0 )     1.8        
                         
Cash provided by (used in) investing activities
    587.9       (2,109.8 )     408.8  
                         
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
                         
    2008     2007     2006  
    (US$ millions)  
 
Financing activities
                       
Subsidiary indebtedness
                       
Issuances
          6.9       4.3  
Repayment
    (13.2 )     (73.4 )      
Long term debt – holding company
                       
Repayment
    (62.1 )     (107.8 )     (115.7 )
Debt issuance costs
          (15.0 )      
Long term debt – subsidiary companies
                       
Issuances
    3.3       330.0       140.0  
Repayment
    (118.6 )     (295.7 )     (59.3 )
Debt issuance costs
          (23.4 )      
Other long term obligations – holding company – repayment
    (4.9 )     (4.5 )     (43.7 )
Repurchase of subsidiary securities
    (419.5 )     (121.5 )      
Repurchase of subordinate voting shares
    (282.0 )     (7.0 )     (7.7 )
Repurchase of preferred shares
    (48.0 )            
Purchase of shares for treasury
    (0.2 )     (4.4 )     (2.1 )
Common share dividends
    (88.9 )     (49.0 )     (25.1 )
Preferred share dividends
    (10.1 )     (12.5 )     (11.4 )
Dividends paid to non-controlling interests
    (25.6 )     (27.3 )     (22.1 )
                         
Cash provided by (used in) financing activities
    (1,069.8 )     (404.6 )     (142.8 )
                         
Foreign currency translation
    (224.8 )     107.9       2.3  
                         
Increase (decrease) in cash and cash equivalents
    (586.8 )     (2,651.3 )     1,173.4  
Cash and cash equivalents – beginning of year
    3,112.5       5,763.8       4,590.4  
                         
Cash and cash equivalents – end of year
    2,525.7       3,112.5       5,763.8  
                         
 
 
See accompanying notes.
 
Cash and cash equivalents are included in the consolidated balance sheet as follows:
 
                         
    December 31,  
    2008     2007     2006  
    (US$ millions)  
 
Holding company cash and short term investments
    293.8       31.3       540.2  
Subsidiary cash and short term investments
    2,338.8       2,164.8       4,602.7  
Subsidiary cash and short term investments pledged for short sale and derivative obligations
    8.3       1,244.2       829.3  
                         
      2,640.9       3,440.3       5,972.2  
Subsidiary restricted cash and short term investments
    (115.2 )     (327.8 )     (208.4 )
                         
      2,525.7       3,112.5       5,763.8  
                         
 
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Notes to Consolidated Financial Statements
for the years ended December 31, 2008, 2007 and 2006
(in US$ and $millions except per share amounts and as otherwise indicated)
 
1.   Business Operations
Fairfax Financial Holdings Limited (“the company” or “Fairfax”) is a financial services holding company which, through its subsidiaries, is principally engaged in property and casualty insurance and reinsurance and the associated investment management.
 
2.   Summary of Significant Accounting Policies
The preparation of consolidated financial statements in accordance with Canadian generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods covered by the financial statements. The principal financial statement components subject to measurement uncertainty include other-than-temporary declines in the value of investments (note 3), the provision for claims (note 5), the allowance for unrecoverable reinsurance (note 7) and contingencies (note 13). Actual results may differ from the estimates used in preparing the consolidated financial statements.
 
Principles of consolidation
The consolidated financial statements include the accounts of the company and all of its subsidiaries at December 31, 2008:
 
Canadian Insurance
 
Northbridge Financial Corporation
(Northbridge)
 
U.S. Insurance
 
Crum & Forster Holdings Corp.
(Crum & Forster)
 
Asian Insurance
 
Fairfax Asia consists of:
 
Falcon Insurance Company Limited (Falcon)
 
First Capital Insurance Limited (First Capital)
 
ICICI Lombard General Insurance
Company Limited
(26.0% equity accounted interest) (ICICI Lombard)
 
Reinsurance
 
Odyssey Re Holdings Corp. (OdysseyRe)
 
Advent Capital (Holdings) PLC (Advent)
 
Group Re, which underwrites business in:
 
CRC (Bermuda) Reinsurance Limited (CRC (Bermuda))
 
Wentworth Insurance Company Ltd. (Wentworth)
 
Runoff
 
TIG Insurance Company (TIG)
 
Fairmont Specialty Group (Fairmont)
 
RiverStone Insurance (UK) Limited
(RiverStone (UK))
 
RiverStone Managing Agency
 
Syndicate 3500
 
nSpire Re Limited (nSpire Re)
 
Other
 
Hamblin Watsa Investment Counsel Ltd.
(Hamblin Watsa)
(investment management)
 
Ridley Inc. (Ridley) (animal nutrition)
 
 
All subsidiaries are wholly-owned except for OdysseyRe with a 70.4% interest (2007 – 61.0%; 2006 – 59.6%), Northbridge with a 63.6% interest (prior to its privatization in 2009 – refer to note 17) (2007 – 60.2%; 2006 – 59.2%), Advent with a 66.6% interest (2007 and 2006 – 44.5%) and Ridley with a 67.9% interest (2007 and 2006 – nil). Prior to the company acquiring control of Advent on September 11, 2008 pursuant to the transaction described in note 17, the company recorded its investment in Advent on the equity basis of accounting.
 
The company has investments in ICICI Lombard with a 26.0% interest (2007 and 2006 – 26.0%), Falcon Insurance PLC (“Falcon Thailand”) with a 24.9% interest (2007 – 24.9%; 2006 – nil) and the Cunningham Lindsey Group Limited operating companies (“the Cunningham Lindsey operating companies”) with a 45.7% interest (2007 –
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
44.6%; 2006 – nil)) which are recorded on the equity basis of accounting. The company consolidated its 100.0% interest (2007 – 100.0%; 2006 – 81.0%) in the Cunningham Lindsey Group Inc. holding company (“Cunningham Lindsey”) until its sole asset being a 45.7% (2007 – 44.6%; 2006 – nil) interest in the Cunningham Lindsey operating companies was distributed upon liquidation into the ultimate parent company on December 5, 2008.
 
Investments
Financial assets are classified as held for trading, available for sale, held to maturity or loans and receivables. Financial liabilities are classified as held for trading or as other financial liabilities. Derivatives are classified as held for trading. The company’s management determines the appropriate classifications of investments in fixed income and equity securities at their acquisition date.
 
Held for trading – Held for trading financial assets and liabilities are purchased or incurred with the intention of generating profits in the near term (“classified as held for trading”) or are voluntarily so designated by the company (“designated as held for trading”). On initial recognition, the company generally designates financial instruments with embedded derivatives, as held for trading under the fair value option. Financial liabilities classified as held for trading comprise obligations related to securities sold but not yet purchased. Financial assets and liabilities and derivatives classified or designated as held for trading are carried at fair value in the consolidated balance sheet with realized and unrealized gains and losses recorded in net gains (losses) on investments in the consolidated statement of earnings and as an operating activity in the consolidated statement of cash flows. Dividends and interest earned net of interest incurred are included in the consolidated statement of earnings in interest and dividends and as an operating activity in the consolidated statement of cash flows in accounts receivable and other except for interest income from mortgage backed securities. Interest from mortgage backed securities is included in net gains (losses) on investments in the consolidated statement of earnings as these securities were acquired in a distressed market and as an operating activity in the consolidated statement of cash flows.
 
Available for sale – Non-derivative financial assets are classified as available for sale when they are intended to be held for long term profitability and are other than those classified as loans and receivables, held to maturity or held for trading. Except for equity securities that do not have quoted market values in an active market, which are carried at cost, these assets are carried at fair value with changes in unrealized gains and losses, including the foreign exchange component thereof, recorded in other comprehensive income (loss) (net of tax) until realized or impaired, at which time the cumulative gain or loss is reclassified to net gains (losses) on investments in the consolidated statement of earnings and as an operating activity in the consolidated statement of cash flows. The amount of gains or losses on securities reclassified out of accumulated other comprehensive income (loss) into net earnings is determined based on average cost. Interest and dividend income from available for sale securities, including amortization of premiums and accretion of discounts calculated using the effective interest method, are recorded in the consolidated statement of earnings in interest and dividends and as an operating activity in the consolidated statement of cash flows in accounts receivable and other and in bond discount amortization.
 
Held to maturity – Non-derivative financial assets that have a fixed maturity date, other than loans and receivables, for which the company has the intent and ability to hold to maturity or redemption are classified as held to maturity and reported at amortized cost. The company has not designated any financial assets as held to maturity.
 
Other than temporary impairments – At each reporting date, and more frequently when conditions warrant, management evaluates all available for sale (and if applicable, held to maturity) securities with unrealized losses to determine whether those unrealized losses are other than temporary and should be recognized in net earnings rather than accumulated other comprehensive income (loss). This determination is based on consideration of several factors including: (i) the length of time and extent to which the fair value has been less than its amortized cost; (ii) the severity of the impairment; (iii) the cause of the impairment and the financial condition and near-term prospects of the issuer; and (iv) the company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery of fair value. If management’s assessment indicates that the impairment in value is other than temporary, or the company does not have the intent or ability to hold the security until its fair value recovers, the security is written down to its fair value at the balance sheet date, and a loss is recognized in net gains (losses) on investments in the consolidated statement of earnings. Prior to January 1, 2007, when there was a decline in value of an investment that was determined to be other than temporary, such investments were written down to net realizable value with the charge recorded in net gain (losses) on investments in the consolidated statement of earnings.
 
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Pricing – For traded securities, which comprise the majority of the company’s investment portfolio, quoted market value based on bid prices is considered to be fair value except for securities sold but not yet purchased which are recorded at ask price. For securities where market quotes are unavailable, the company uses estimation techniques to determine fair value including discounted cash flows, internal models that utilize observable market data to the extent possible or appropriate and comparisons with other securities that are substantially the same. The fair values of third party managed investment funds are based on the net asset values as advised by the funds. Short term investments comprise securities due to mature within one year from the date of purchase and are carried at fair value.
 
Recognition – The company accounts for the purchase and sale of securities using trade date accounting for purposes of both the consolidated balance sheet and the consolidated statement of earnings. Transactions pending settlement are reflected in the consolidated balance sheet in accounts receivable and other or in accounts payable and accrued liabilities.
 
Transaction costs related to financial assets and liabilities classified or designated as held for trading are expensed as incurred. Transaction costs related to available for sale financial assets and long term debt are capitalized to the cost of the asset or netted against the liability on initial recognition and are recorded in other comprehensive income (loss) or amortized in the consolidated statement of earnings, respectively.
 
Other – The equity method is used to account for investments in entities including corporations, limited partnerships and trusts in which the company is deemed to exercise significant influence. These investments are reported in investments, at equity in the consolidated balance sheet, with the company’s share of earnings (losses) including writedowns to reflect other than temporary impairment in the value of these investments reported in interest and dividends. Gains and losses realized on dispositions of equity method investments are included in net gains (losses) on investments. The company’s proportionate share of the other comprehensive income (loss) of its equity method investments is recorded in the corresponding line in the company’s consolidated statement of comprehensive income.
 
Derivative financial instruments
The company uses derivatives to mitigate financial risks arising principally from its investment holdings and recoverables. Derivatives that are not specifically designated or that do not meet the requirements for hedge accounting are carried at fair value on the consolidated balance sheet and changes in fair value are recorded in net gains (losses) on investments in the consolidated statement of earnings. All derivatives are monitored by the company for effectiveness in achieving their risk management objectives. The determination of fair value for the company’s derivative financial instruments where quoted market prices in active markets are unavailable is described in note 3. As at December 31, 2008, a consolidated subsidiary of the company whose functional currency is the pound sterling designated $56.3 of long term U.S. dollar debt to hedge its $56.3 U.S. dollar net investment in a self-sustaining foreign operation. During 2007 and 2006, the company did not designate any financial assets or liabilities (including derivatives) as accounting hedges.
 
Cash collateral received from or paid to counterparties as security for derivative contract assets or liabilities respectively is included in liabilities or assets in the consolidated balance sheet. Securities received from counterparties as collateral are not recorded as assets. Securities delivered to counterparties as collateral continue to be reflected as assets in the consolidated balance sheet as assets pledged for short sale and derivative obligations.
 
Cash and cash equivalents
Cash and cash equivalents consist of holding company and subsidiary cash and short term investments that are readily convertible into cash and have maturities of three months or less when purchased and exclude cash and short term investments that are restricted.
 
Loans and receivables and other financial liabilities
Loans and receivables and other financial liabilities are initially recognized at fair value and subsequently measured at amortized cost using the effective interest rate method. At each balance sheet date, the company assesses whether there is any objective evidence of impairment of financial assets classified as loans and receivables. A provision for impairment is established when such evidence provides reasonable assurance based on current information and events, that it is probable that the company will not collect all amounts due according to their original terms.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
Insurance contracts
Revenue recognition – Premiums written are deferred as unearned premiums and recognized as revenue, net of premiums ceded, on a pro rata basis over the terms of the underlying policies. Certain reinsurance premiums are estimated at the individual contract level, based on historical patterns and experience from the ceding companies for contracts where reports from ceding companies for the period are not contractually due until after the balance sheet date. The cost of reinsurance purchased by the company (premiums ceded) is included in recoverable from reinsurers and is amortized over the contract period in proportion to the amount of insurance protection provided.
 
Provision for claims Provisions for claims represent estimated claim and claim settlement costs of property and casualty insurance and reinsurance contracts with respect to losses that have occurred as of the balance sheet date. The provisions for loss and loss adjustment expenses are recorded at the estimated ultimate payment amounts, except that amounts arising from certain workers’ compensation business are discounted as discussed below. For insurance business, the provisions for claims are established by the case method as claims are reported. For reinsurance business, the provision for claims is based on reports and individual case estimates received from ceding companies. The estimates are regularly reviewed and updated as additional information becomes known and any resulting adjustments are included in the consolidated statement of net earnings in the period the adjustment is made. A provision is also made for management’s calculation of factors affecting the future development of claims including claims incurred but not reported (IBNR). The company utilizes generally accepted actuarial methodologies to determine provisions for claims on the basis of historical experience and the volume of business currently in force. Provisions for claims are reported in the consolidated statement of earnings after deducting amounts recoverable under reinsurance contracts.
 
The estimated liabilities for workers’ compensation claims that are determined to be fixed or determinable are carried in the consolidated balance sheet at discounted amounts. The company uses tabular reserving for such liabilities with standard mortality assumptions, and discounts such reserves using interest rates of 3.5% to 5.0%. The periodic discount accretion is included in the consolidated statement of earnings as a component of losses on claims.
 
Reinsurance – The company presents third party reinsurance balances in the consolidated balance sheet on a gross basis to indicate the extent of credit risk related to third party reinsurance and its obligations to policyholders. Net premiums earned and losses on claims are recorded in the consolidated statement of earnings net of amounts ceded to, and recoverable from, reinsurers. Unearned premiums are reported before reduction for business ceded to reinsurers and the reinsurers’ portion is classified with recoverable from reinsurers in the consolidated balance sheet along with the estimates of the reinsurers’ shares of provision for claims determined on a basis consistent with the related claims liabilities. Reinsurance contracts do not relieve the ceding company of its obligations to policyholders with respect to the underlying insurance and reinsurance contracts.
 
In order to control the company’s exposure to loss from adverse development of reserves or reinsurance recoverables on pre-acquisition reserves of companies acquired or from future adverse development on long tail latent or other potentially volatile claims, and to protect capital, the company has for certain acquisitions obtained vendor indemnities or purchased excess of loss reinsurance protection from reinsurers. For excess of loss reinsurance treaties (other than vendor indemnities), the company generally pays the reinsurer a premium as losses from adverse development are ceded under the treaty. The company records the premium charge (earned premiums ceded to reinsurers), commissions earned on ceded reinsurance premiums and the related reinsurance recovery (claims incurred ceded to reinsurers) in its consolidated statement of earnings in the period in which the adverse development is incurred and ceded to the reinsurer.
 
The company’s credit risk on reinsurance recoverables is analyzed by Riverstone. The Company’s reinsurance security department at Riverstone analyzes the recoverables of the company and is responsible for setting appropriate provisions for reinsurers suffering financial difficulties.
 
The provision for uncollectible reinsurance balances represents management’s estimate of specific credit-related losses, provisions for disputed and litigated balances, as well as losses that have been incurred but are not yet identifiable by individual reinsurer. The process for determining the provision involves quantitative and qualitative assessments using current and historical credit information and current market information. The process inherently requires the use of certain assumptions and judgements including: (i) assessing the probability of impairment (ii) estimating ultimate recovery rates of impaired reinsurers and, (iii) effects from potential offsets or collateral arrangements.
 
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Changes in these assumptions or using other reasonable judgements can materially affect the provision level and thereby our net earnings.
 
Provisions for uncollectible reinsurance are recorded in the consolidated statement of earnings in the period in which the company determines that it is unlikely that the full amount or disputed amounts due from reinsurers are not collectible. When the probability of collection is remote either through liquidation of the reinsurer or settlement of the reinsurance balance, the uncollectible balance is written off from the provision account against the reinsurance balance.
 
Deferred premium acquisition costs – Certain costs of acquiring insurance premiums, consisting of brokers’ commissions and premium taxes are deferred and charged to income as the related premiums are earned. Deferred acquisition costs are limited to their estimated realizable value based on the related unearned premium, which considers anticipated losses and loss adjustment expenses and estimated remaining costs of servicing the business based on historical experience. The ultimate recoverability of deferred premium acquisition costs is determined without regard to investment income.
 
Business combinations, goodwill and other intangible assets
All business combinations are accounted for using the purchase method whereby the results of acquired companies are included only from the date of acquisition and divestitures are included up to the date of disposal. Identifiable intangible assets are recognized separately from goodwill and are included in goodwill and intangibles assets in the consolidated balance sheet. Goodwill represents the excess of the price paid for the business acquired over the fair value of the net identifiable assets acquired, and is assigned to the operating units of a reporting segment which is also defined by GAAP as the level of reporting at which goodwill is tested for impairment.
 
Goodwill is evaluated for impairment annually or more often if events or circumstances indicate there may be an impairment. If the carrying value of a reporting segment, including the allocated goodwill, exceeds its fair value, the amount of the goodwill impairment is measured as the excess of the carrying amount of the reporting segment’s allocated goodwill over the implied fair value of the goodwill, based on the fair value of the assets and liabilities of the reporting segment. Any goodwill impairment is charged to the consolidated statement of earnings in the period in which the impairment is identified. The estimate of fair value required for the impairment test is sensitive to the cash flow projections and the discount rate used in the valuation.
 
Income taxes
Future income taxes are calculated under the liability method. Future income taxes assets and liabilities are based on differences between the financial statement and tax bases of assets and liabilities at the current substantively enacted tax rates. Changes in future income tax assets and liabilities that are associated with components of other comprehensive income (loss) (primarily unrealized investment gains and losses) are charged or credited directly to other comprehensive income (loss). Otherwise, changes in future income taxes assets and liabilities are included in the provision for income taxes. Changes in future income taxes assets and liabilities attributable to changes in substantively enacted tax rates are charged or credited to provision for income tax expense in the period of enactment. A valuation allowance is established if it is more likely than not, all or some portion of, the benefits related to a future taxes asset will not be realized.
 
Pensions
For defined benefit pension and other retirement benefit plans, the benefit obligations, net of the fair value of plan assets adjusted for unrecognized items consisting of prior service costs, transitional assets and obligations and net actuarial gains and losses are accrued in the consolidated balance sheet. For each plan, the company has adopted the following policies:
 
  (i)  Actuarial valuations of benefit liabilities for pension and post retirement benefit plans are performed as at December 31 of each year for all benefit plans using the projected benefit method prorated on service, based on management’s assumptions on the discount rate, rate of compensation increase, retirement age, mortality and the trend in the health care cost rate. The discount rate is determined by management with reference to market conditions at year end. Other assumptions are determined with reference to long-term expectations.
 
  (ii)  Expected return on plan assets is calculated based on the fair value of those assets.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
 
  (iii)  Actuarial gains (losses) arise from the difference between the actual long term rate of return and the expected long term rate of return on plan assets for that period or from changes in actuarial assumptions used to determine the benefit obligation. Only gains or losses in excess of 10% of the greater of the benefit obligations or the fair value of plan assets are amortized over the average remaining service period of active employees.
 
  (iv)  Prior service costs arising from plan amendments are amortized on a straight line basis over the average remaining service period of employees active at the date of amendment.
 
  (v)  When a restructuring of a benefit plan gives rise to both a curtailment and a settlement of obligations, the curtailment is accounted for prior to the settlement.
 
Translation of foreign currencies
Foreign currency transactions are translated into the functional currency of the company and its subsidiaries using the exchange rates prevailing at the dates of the transactions. Foreign exchange gains and losses resulting from the settlement of such transactions and from the translation at year-end exchange rates of monetary assets and liabilities are recognized in the consolidated statement of earnings except for unrealized foreign exchange gains and losses arising on monetary investments classified as available for sale. These unrealized gains and losses are recorded in other comprehensive income (loss) until realized, at which time the cumulative gain or loss is reclassified to net gains (losses) on investments in the consolidated statement of earnings.
 
Unrealized gains or losses arising as a result of the translation of the company’s foreign self-sustaining operations along with the effective portion of any hedges are reported as a component of other comprehensive income (loss) on an after-tax basis. Upon disposal or reduction of an interest in such investments, related accumulated net translation gains or losses are included in the consolidated statement of earnings.
 
Comprehensive income (loss)
Comprehensive income (loss) consists of net earnings and other comprehensive income (loss) and includes all changes in equity during a period, except for those resulting from investments by owners and distributions to owners. Unrealized gains and losses on financial assets classified as available for sale, unrealized foreign currency translation amounts arising from self-sustaining foreign operations, and changes in the fair value of the effective portion of cash flow hedging instruments on hedges of net investments in self-sustaining foreign operations are recorded in the consolidated statement of comprehensive income and included in accumulated other comprehensive income (loss) until recognized in the consolidated statement of earnings. Accumulated other comprehensive income (net of income taxes) is included on the consolidated balance sheet as a separate component of shareholders’ equity.
 
Animal nutrition products
Revenues from the sale of animal nutrition products are recognized when the price is fixed or determinable, collection is reasonably assured and the product has been shipped to the customer from the plant or facility. These revenues are recorded in Revenue – Other in the consolidated statement of earnings.
 
Inventories of $58.5 (2007 – nil) are included in Other assets in the consolidated balance sheet and are measured at the lower of cost or net realizable value on a first-in, first-out basis. Inventories are written down to net realizable value when the cost of inventories is estimated to be greater than the anticipated selling price.
 
Non-controlling interest
Non-controlling interest included $86.3 (2007 – $89.4) of non-cumulative Series A and Series B preferred shares issued by OdysseyRe which pay dividends at a rate of 8.125% per annum on Series A preferred shares and at a floating rate on Series B preferred shares.
 
Comparative figures
Certain prior year comparative figures have been reclassified to be consistent with the current year’s presentation.
 
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Change in accounting policies
Current year
In October 2008, amendments were made to Canadian Institute of Chartered Accountants (“CICA”) Handbook Section 3855, Financial Instruments – Recognition and Measurement and Section 3862, Financial Instruments – Disclosure. These amendments permit companies to reclassify certain investments in debt or equity securities from the classification that requires fair value changes to be recognized immediately in net earnings to the available for sale classification; provided strict criteria are met. No such reclassifications have been effected by the company.
 
Prior year
Commencing January 1, 2007, the company adopted five new accounting standards that were issued by the Accounting Standards Board (“AcSB”) of the CICA: CICA Handbook Section 1530, Comprehensive Income; Section 3251, Equity; Section 3855, Financial Instruments – Recognition and Measurement; Section 3861, Financial Instruments – Disclosure and Presentation; and Section 3865, Hedges.
 
The main requirements of the standards and the related accounting policies subsequently adopted by the company are discussed throughout the investment policy note. The period ended prior to January 1, 2007 has not been restated as a result of implementing the new accounting standards, except that unrealized foreign currency translation gains or losses on net investments in self-sustaining operations were reclassified to accumulated other comprehensive income (loss). As a result of these changes, the company recorded net increases of $29.8 and $49.5 to the opening balances of retained earnings and accumulated other comprehensive income on January 1, 2007 respectively, principally to recognize the majority of the company’s investment portfolio at fair value. Unamortized debt issue costs of $28.2 were reclassified from other assets to long term debt.
 
The company’s financial assets and liabilities, other than for recoverable from reinsurers and provision for claims, are recorded in the consolidated balance sheet at fair value on initial recognition and subsequently are accounted for based on their classification as described in the relevant accounting policy note. Prior to the adoption of these accounting standards, the majority of the company’s financial assets and liabilities were recorded at cost or amortized cost. The methods used by the company in determining the fair value of financial instruments were unchanged as a result of implementing these new accounting standards.
 
On October 1, 2007, the company prospectively adopted three new accounting standards that were issued by the CICA: CICA Handbook Section 1535, Capital Disclosures; Section 3862 Financial Instruments – Disclosures; and Section 3863, Financial Instruments – Presentation. Section 1535 requires the disclosure of information on the company’s capital resources and how they are managed. Sections 3862 and 3863 enhance the disclosure requirements for financial instruments (the presentation requirements remain unchanged) by expanding the disclosure of information on the nature and extent of risks arising from financial instruments and how those risks are managed. The company adopted Section 3862 and Section 3863 to replace Section 3861 – Financial Instruments – Disclosure and Presentation which was adopted on January 1, 2007.
 
Accounting pronouncements to be adopted in the future
Goodwill and intangible assets
In November 2007, the AcSB issued CICA Handbook Section 3064, Goodwill and Intangible Assets, which replaced Section 3062, Goodwill and Other Intangible Assets and Section 3450, Research and Development Costs. Section 3064 establishes standards for the recognition, measurement and disclosure of goodwill and intangible assets. Requirements pertaining to goodwill are unchanged from the previous Section 3062. Section 3064 is effective for the company on January 1, 2009. The adoption of this standard is not expected to have a significant impact on the company’s consolidated financial position or results of operations.
 
Business combinations and non-controlling interest
In January 2009, the AcSB issued Handbook Section 1582, Business Combinations, Section 1601, Consolidated Financial Statements and Section 1602, Non-Controlling Interests, which replaces Section 1581, Business Combinations and Section 1600, Consolidated Financial Statements. Section 1582 retains the fundamental requirements of Section 1581 to identify an acquirer and to use the acquisition method of accounting for each business combination. This new standard requires: measurement of share consideration issued at fair value at the acquisition date; recognition of contingent consideration at fair value at the date of acquisition with subsequent changes in fair value generally reflected in net earnings; and the acquirer to expense acquisition-related costs as incurred. A non-
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
controlling interest may be measured at fair value or at the proportionate share of identifiable net assets. Under current Canadian GAAP, a non-controlling interest is recorded at the proportionate share of the carrying value of the acquiree. Section 1602 provides guidance on the treatment of a non-controlling interest after acquisition in a business combination. This new standard requires: a non-controlling interest to be presented clearly in equity, but separately from the parent’s equity; the amount of consolidated net income attributable to the parent and to a non-controlling interest be clearly identified and presented on the consolidated statement of income; and accounting for changes in ownership interests of a subsidiary that do not result in a loss of control as an equity transaction. Section 1601 carries forward existing guidance on aspects of the preparation of consolidated financial statements subsequent to the acquisition date other than that pertaining to a non-controlling interest.
 
These three new sections apply to the company’s consolidated financial statements effective January 1, 2011 with earlier adoption permitted. The company is currently evaluating the impact of adopting these three new sections on its consolidated financial position and results of operations.
 
International Financial Reporting Standards (“IFRS”)
In February 2008, the AcSB confirmed that Canadian GAAP for publicly accountable enterprises will be converged with IFRS effective in calendar year 2011. IFRS uses a conceptual framework similar to Canadian GAAP, but there are significant differences in recognition, measurement and disclosures. The company will change over to IFRS for its interim and annual financial statements beginning on January 1, 2011 and is currently evaluating the impact of adopting IFRS on its financial position and results of operations.
 
3.   Cash and Investments
 
Cash and short term investments, marketable securities, portfolio investments and short sale and derivative contracts by financial instrument classification are shown in the table below:
 
                                                                                 
    December 31, 2008     December 31, 2007  
    Classified
    Designated
    Classified
                Classified
    Designated
    Classified
             
    as
    as
    as
          Total
    as
    as
    as
          Total
 
    held for
    held for
    available
          carrying
    held for
    held for
    available
          carrying
 
    trading     trading     for sale     Other     value     trading     trading     for sale     Other     value  
Holding company:
                                                                               
Cash and short term investments
    275.4             521.1             796.5       31.3             413.0             444.3  
Assets pledged for short sale and derivative obligations – cash and short term investments
    18.4             1.3             19.7                                
Bonds
          216.6       12.2             228.8             17.6       12.2             29.8  
Preferred stocks
                12.1             12.1                                
Common stocks
                424.3             424.3                   235.0             235.0  
Derivatives
    82.8                         82.8       262.7                         262.7  
                                                                                 
      376.6       216.6       971.0             1,564.2       294.0       17.6       660.2             971.8  
Short sale and derivative obligations
    (9.2 )                       (9.2 )     (8.4 )                       (8.4 )
                                                                                 
      367.4       216.6       971.0             1,555.0       285.6       17.6       660.2             963.4  
                                                                                 
Portfolio investments:
                                                                               
Cash and short term investments
    2,338.8       355.2       2,814.5             5,508.5       2,164.8             1,053.3             3,218.1  
Bonds
          4,463.3       3,962.5             8,425.8             1,215.9       8,834.0             10,049.9  
Preferred stocks
                38.2             38.2                   19.9             19.9  
Common stocks
          80.7       3,736.2             3,816.9                   2,617.5             2,617.5  
Investments, at equity
                      219.3       219.3                         408.0       408.0  
Derivatives
    372.7                         372.7       950.7                         950.7  
Other invested assets
                      25.3       25.3                         28.9       28.9  
                                                                                 
      2,711.5       4,899.2       10,551.4       244.6       18,406.7       3,115.5       1,215.9       12,524.7       436.9       17,293.0  
                                                                                 
Assets pledged for short sale and derivative obligations:
                                                                               
Cash and short term investments
    8.3                         8.3       1,244.2             121.9             1,366.1  
Bonds
                                              432.6             432.6  
                                                                                 
      8.3                         8.3       1,244.2             554.5             1,798.7  
                                                                                 
      2,719.8       4,899.2       10,551.4       244.6       18,415.0       4,359.7       1,215.9       13,079.2       436.9       19,091.7  
                                                                                 
Short sale and derivative obligations
    (20.2 )                       (20.2 )     (1,054.4 )                       (1,054.4 )
                                                                                 
      2,699.6       4,899.2       10,551.4       244.6       18,394.8       3,305.3       1,215.9       13,079.2       436.9       18,037.3  
                                                                                 
 
Restricted cash and cash equivalents of $115.2 (2007 – $327.8) are included in cash and short term investments and in assets pledged for short sale and derivative obligations in portfolio investments, with $3.9 (2007 – $221.3) pledged as collateral for derivative positions and the remainder consisting primarily of amounts pledged to the Society and Council of Lloyd’s (“Lloyd’s”) to support the underwriting capacity of subsidiaries’ Lloyd’s syndicates.
 
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In addition to the amounts disclosed in note 13, the company’s subsidiaries have pledged cash and investments of $2.3 billion (2007 – $2.2 billion) inclusive of trust funds and regulatory deposits as security for their own obligations to pay claims or make premium payments (these pledges are either direct or to support letters of credit). These pledges are in the normal course of business and are generally released when the payment obligation is fulfilled.
 
Included in investments, at equity and common stocks designated as held for trading are investments in certain limited partnerships with a carrying value of $62.2 (2007 – $186.0) and $80.7 (2007 – nil) respectively.
 
The carrying value of investments by type of issuer designated as held for trading and classified as available for sale, including gross unrealized gains and losses for available for sale investments are analyzed as follows:
 
December 31, 2008
 
                                                 
          Designated
       
    Available for sale     as held
       
    Cost or
    Gross
    Gross
          for trading     Total
 
    amortized
    unrealized
    unrealized
    Carrying
    Carrying
    carrying
 
    cost     gains     losses     value     value     value  
                                                 
Holding company:
                                               
Short term investments:(1)
                                               
Canadian government
    136.7             (1.4 )     135.3             135.3  
U.S. treasury
    387.1                   387.1             387.1  
                                                 
      523.8             (1.4 )     522.4             522.4  
                                                 
Bonds:
                                               
U.S. treasury
    12.0                   12.0             12.0  
U.S. states and municipalities
                            88.0       88.0  
Corporate and other
    0.4             (0.2 )     0.2       109.7       109.9  
Mortgage backed securities
                            18.9       18.9  
                                                 
      12.4             (0.2 )     12.2       216.6       228.8  
                                                 
Preferred stocks:
                                               
Canadian
    11.8       0.3             12.1             12.1  
                                                 
      11.8       0.3             12.1             12.1  
                                                 
Common stocks:
                                               
Canadian
    58.4             (11.1 )     47.3             47.3  
U.S.
    397.2       12.4       (56.8 )     352.8             352.8  
Other
    20.0       4.2             24.2             24.2  
                                                 
      475.6       16.6       (67.9 )     424.3             424.3  
                                                 
Portfolio investment:
                                               
Short term investments:
                                               
Canadian government
    196.9             (0.1 )     196.8       2.8       199.6  
U.S. treasury
    2,307.9             (3.4 )     2,304.5       255.8       2,560.3  
Other government
    297.1       16.1             313.2       96.6       409.8  
                                                 
      2,801.9       16.1       (3.5 )     2,814.5       355.2       3,169.7  
                                                 
Bonds:
                                               
Canadian government
    928.1       57.0             985.1       741.2       1,726.3  
U.S. treasury
    739.2       140.4             879.6       93.4       973.0  
U.S. states and municipalities
    999.7       12.7       (32.7 )     979.7       3,036.9       4,016.6  
Other government
    856.8       24.3       (66.6 )     814.5       38.9       853.4  
Corporate and other
    315.0       7.2       (18.6 )     303.6       420.1       723.7  
Mortgage backed securities
                            132.8       132.8  
                                                 
      3,838.8       241.6       (117.9 )     3,962.5       4,463.3       8,425.8  
                                                 
Preferred stocks:
                                               
Canadian
    10.2                   10.2             10.2  
U.S.
    0.6             (0.5 )     0.1             0.1  
Other
    30.4             (2.5 )     27.9             27.9  
                                                 
      41.2             (3.0 )     38.2             38.2  
                                                 
Common stocks:
                                               
Canadian
    535.8       43.6       (66.4 )     513.0             513.0  
U.S.
    2,731.1       95.8       (250.9 )     2,576.0       46.3       2,622.3  
Other
    616.5       44.2       (13.5 )     647.2       34.4       681.6  
                                                 
      3,883.4       183.6       (330.8 )     3,736.2       80.7       3,816.9  
                                                 
 
(1)  Includes $1.3 of short term investments included in assets pledged for short sale and derivative obligations.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
 
December 31, 2007
 
                                                 
          Designated
       
    Available for sale     as held
       
    Cost or
    Gross
    Gross
          for trading     Total
 
    amortized
    unrealized
    unrealized
    Carrying
    Carrying
    carrying
 
    cost     gains     losses     value     value     value  
 
Holding company:
                                               
Short term investments:
                                               
U.S. treasury
    413.0                   413.0             413.0  
                                                 
      413.0                   413.0             413.0  
                                                 
Bonds:
                                               
U.S. treasury
    12.0       0.2             12.2             12.2  
Corporate and other
                            17.6       17.6  
                                                 
      12.0       0.2             12.2       17.6       29.8  
                                                 
Common stocks:
                                               
Canadian
    30.3       3.2       (0.2 )     33.3             33.3  
U.S.
    177.4       3.7       (8.9 )     172.2             172.2  
Other
    29.1       0.4             29.5             29.5  
                                                 
      236.8       7.3       (9.1 )     235.0             235.0  
                                                 
Portfolio investment:
                                               
Short term investments:
                                               
Canadian government
    87.7       0.9             88.6             88.6  
U.S. treasury
    863.1             (1.8 )     861.3             861.3  
Other government
    103.4                   103.4             103.4  
                                                 
      1,054.2       0.9       (1.8 )     1,053.3             1,053.3  
                                                 
Bonds:
                                               
Canadian government
    1,325.0       60.3       (0.4 )     1,384.9       904.1       2,289.0  
U.S. treasury
    6,020.6       45.0       (76.3 )     5,989.3             5,989.3  
U.S. states and municipalities
    185.7       6.5       (0.3 )     191.9             191.9  
Other government
    990.1       60.0       (7.8 )     1,042.3             1,042.3  
Corporate and other
    234.4             (8.8 )     225.6       311.8       537.4  
                                                 
      8,755.8       171.8       (93.6 )     8,834.0       1,215.9       10,049.9  
                                                 
Preferred stocks:
                                               
Canadian
    12.8                   12.8             12.8  
U.S.
    2.1             (0.9 )     1.2             1.2  
Other
    5.9                   5.9             5.9  
                                                 
      20.8             (0.9 )     19.9             19.9  
                                                 
Common stocks:
                                               
Canadian
    682.7       143.5       (20.7 )     805.5             805.5  
U.S.
    1,276.5       98.4       (69.4 )     1,305.5             1,305.5  
Other
    355.7       154.7       (3.9 )     506.5             506.5  
                                                 
      2,314.9       396.6       (94.0 )     2,617.5             2,617.5  
                                                 
Assets pledged for short sale and derivative obligations:
                                               
Short term investments:
                                               
Canadian government
    53.6                   53.6             53.6  
U.S. treasury
    68.3                   68.3             68.3  
                                                 
      121.9                   121.9             121.9  
                                                 
Bonds:
                                               
Canadian government
    2.0                   2.0             2.0  
U.S. treasury
    432.8             (2.2 )     430.6             430.6  
                                                 
      434.8             (2.2 )     432.6             432.6  
                                                 
 
Bonds designated as held for trading and classified as available for sale are summarized by the earliest contractual maturity date in the table below. Actual maturities may differ from maturities shown below due to the existence of call and put features. At December 31, 2008, securities containing call and put features represented approximately $4,358.2 and $950.1, respectively (2007 – $49.5 and $1,532.9, respectively) of the total fair value of bonds in the table below.
 
 
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    December 31, 2008     December 31, 2007  
    Amortized
    Fair
    Amortized
    Fair
 
    cost     value     cost     value  
 
Due in 1 year or less
    804.7       825.7       382.1       393.6  
Due after 1 year through 5 years
    2,048.0       1,567.0       2,939.5       2,992.9  
Due after 5 years through 10 years
    5,099.5       5,235.4       2,493.6       2,542.2  
Due after 10 years
    943.6       1,026.5       4,625.4       4,583.6  
                                 
      8,895.8       8,654.6       10,440.6       10,512.3  
                                 
Effective interest rate
            5.5 %             4.2 %
                                 
 
The calculation of the effective interest rate of 5.5% in 2008 is on a pre-tax basis and does not give effect to the favourable tax treatment which the company expects to receive with respect to its bond investments of approximately $4.1 billion in U.S. states and municipalities.
 
The number of continuous months in which available for sale securities excluding short term investments had gross unrealized losses is as follows:
 
December 31, 2008
 
                                                                         
    Less than 12 Months     Greater than 12 Months     Total  
          Gross
                Gross
                Gross
       
    Fair
    unrealized
    Number of
    Fair
    unrealized
    Number of
    Fair
    unrealized
    Number of
 
    value     losses     securities     value     losses     securities     value     losses     securities  
 
Bonds:
                                                                       
U.S. states and municipalities
    541.1       (32.7 )     30         –         –         –       541.1       (32.7 )     30  
Other government
    327.1       (66.6 )     8                         327.1       (66.6 )     8  
Corporate and other
    127.7       (18.8 )     8                         127.7       (18.8 )     8  
                                                                         
      995.9       (118.1 )     46                         995.9       (118.1 )     46  
                                                                         
Preferred stocks:
                                                                       
U.S.
    0.1       (0.5 )     2                         0.1       (0.5 )     2  
Other
    27.9       (2.5 )     4                         27.9       (2.5 )     4  
                                                                         
      28.0       (3.0 )     6                         28.0       (3.0 )     6  
                                                                         
Common stocks:
                                                                       
Canadian
    303.3       (77.5 )     5                         303.3       (77.5 )     5  
U.S.
    1,214.6       (307.7 )     13                         1,214.6       (307.7 )     13  
Other
    284.3       (13.5 )     20                         284.3       (13.5 )     20  
                                                                         
      1,802.2       (398.7 )     38                         1,802.2       (398.7 )     38  
                                                                         
      2,826.1       (519.8 )     90                         2,826.1       (519.8 )     90  
                                                                         
 
December 31, 2007
 
                                                                         
    Less than 12 Months     Greater than 12 Months     Total  
          Gross
                Gross
                Gross
       
    Fair
    unrealized
    Number of
    Fair
    unrealized
    Number of
    Fair
    unrealized
    Number of
 
    value     losses     securities     value     losses     securities     value     losses     securities  
 
Bonds:
                                                                       
Canadian government
                      136.7       (0.4 )     1       136.7       (0.4 )     1  
U.S. treasury
    1,715.0       (3.9 )     10       2,255.1       (74.6 )     7       3,970.1       (78.5 )     17  
U.S. states and municipalities
    10.3       (0.1 )     4       22.4       (0.2 )     6       32.7       (0.3 )     10  
Other government
    303.8       (7.8 )     3                         303.8       (7.8 )     3  
Corporate and other
    136.6       (8.8 )     8                         136.6       (8.8 )     8  
                                                                         
      2,165.7       (20.6 )     25       2,414.2       (75.2 )     14       4,579.9       (95.8 )     39  
                                                                         
Preferred stocks:
                                                                       
U.S.
    0.5       (0.9 )     1                         0.5       (0.9 )     1  
                                                                         
Common stocks:
                                                                       
Canadian
    426.6       (20.9 )     11                         426.6       (20.9 )     11  
U.S.
    655.0       (78.3 )     8                         655.0       (78.3 )     8  
Other
    23.0       (3.9 )     17                         23.0       (3.9 )     17  
                                                                         
      1,104.6       (103.1 )     36                         1,104.6       (103.1 )     36  
                                                                         
      3,270.8       (124.6 )     62       2,414.2       (75.2 )     14       5,685.0       (199.8 )     76  
                                                                         
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
At each reporting date, and more frequently when conditions warrant, management evaluates all available for sale (and if applicable, held to maturity) securities with unrealized losses to determine whether those unrealized losses are other than temporary and should be recognized in net earnings rather than in accumulated other comprehensive income (loss). If management’s assessment indicates that the impairment in value is other than temporary, or the company does not have the intent or ability to hold the security until its fair value recovers, the security is written down to its fair value at the balance sheet date, and a loss is recognized in net gains (losses) on investments in the consolidated statement of earnings. As a result, net gains on investments include $996.4 (2007- $102.6) of provisions for other than temporary impairment related to securities with unrealized losses at December 31, 2008. After such provisions, the unrealized losses on such securities at December 31, 2008 were $398.7 (2007 – $103.1), $3.0 (2007 – $0.9) and $118.1 (2007 – $95.8) with respect to common stocks, preferred stocks and debt securities respectively.
 
As of December 31, 2008, the company had investments in bonds in or near default (where the issuer has missed payment of principal or interest or entered bankruptcy) with a fair value of $26.1 (2007 – $27.8).
 
The company is responsible for determining the fair value of its investment portfolio by utilizing market driven fair value measurements obtained from active markets where available, by considering other observable and unobservable inputs and by employing valuation techniques which make use of current market data. Considerable judgment may be required in interpreting market data used to develop the estimates of fair value. Accordingly, the estimates presented in these consolidated financial statements are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value. The company uses a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. A description of the inputs used in the valuation of financial instruments is summarized as follows:
 
  1.  Quoted prices in active markets for identical instrument – Inputs represent unadjusted quoted prices for identical instruments exchanged in active markets. The fair value of the majority of the company’s preferred and common stocks and positions in securities sold but not yet purchased (including in prior periods, the S&P 500 index based Standard and Poor’s Depository receipts (“SPDRs”) short position) are determined based on quoted prices in active markets obtained from external pricing sources.
 
  2.  Significant other observable inputs – Inputs include directly or indirectly observable inputs other than quoted prices for identical instruments exchanged in active markets. These inputs include quoted prices for similar instruments exchanged in active markets; quoted prices for identical or similar instruments exchanged in inactive markets; inputs other than quoted prices that are observable for the instruments, such as interest rates and yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates where available; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.
 
The company’s investments in government securities (including federal, state, provincial and municipal bonds), corporate securities, private placements and infrequently traded securities are priced using publicly traded, over-the-counter prices or broker-dealer quotes which are based on market observable inputs. Observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads and bids are available for these investments.
 
The fair value of derivatives such as total return swaps, equity index total return swaps and S&P index call options are based on broker-dealer quotes. To assess the reasonableness of pricing received from broker-dealers, the company compares the fair values supplied by broker-dealers to industry accepted valuation models, to observable inputs such as credit spreads and discount rates and to recent transaction prices for similar assets where available.
 
Derivative assets as at December 31, 2008 includes $415.0 (2007 - $1,119.1) related to the fair value of credit default swaps. The fair values of credit default swaps are based principally on third party broker-dealer quotes which are based on market observable inputs with current market spreads being the primary observable input. In addition, the company assesses the reasonableness of the fair values obtained from these providers by comparing these fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. The fair values of credit default swaps are subject to significant
 
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volatility arising from the potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturity.
 
The company has investments of $463.1 (2007 – $262.7) in certain private placement convertible debt which has been designated as held for trading. The fair value of this debt is determined based on industry accepted valuation models which are sensitive to certain assumptions, specifically share price volatility and credit spreads of the issuer.
 
  3.  Significant unobservable inputs – Inputs include unobservable inputs used in the measurement of financial instruments. Management is required to use its own assumptions regarding unobservable inputs as there is little, if any, market activity in these assets or liabilities or related observable inputs that can be corroborated at the measurement date. Unobservable inputs require management to make certain projections and assumptions about the information that would be used by market participants in pricing assets or liabilities. To verify pricing, the company assesses the reasonability of the fair values by comparing to industry accepted valuation models, to movements in credit spreads and to recent transaction prices for similar assets where available.
 
The extent of the company’s use of quoted market prices, internal models using observable market information as inputs and internal models without observable market information as inputs in the valuation of securities as at December 31, 2008 were as follows:
 
                                 
                Significant
       
    Total fair
          other
    Significant
 
    value asset
    Quoted
    observable
    unobservable
 
    (liability)     prices     inputs     inputs  
 
Cash and short term investments
    6,333.0       6,303.9       29.1        
Bonds
    8,654.6             8,488.0       166.6  
Preferred stocks(1)
    38.2       10.1       28.1        
Common stocks(1)
    4,064.1       3,816.7       243.6       3.8  
Derivatives and other invested assets
    480.8       39.4       441.4        
Short sale and derivative obligations
    (29.4 )     (20.2 )     (9.2 )      
                                 
Portfolio investments measured at fair value – ($)
    19,541.3       10,149.9       9,221.0       170.4  
                                 
                                                                       – (%)
    100.0 %     51.9 %     47.2 %     0.9 %
                                 
 
(1)  Excluded from these totals are available for sale investments of $12.1 and $177.1 in preferred stocks and partnership trusts respectively which are carried at cost as they do not have quoted market values in active markets.
 
The fair value of the company’s investments determined through use of internal models without observable market information as inputs (approximately 0.9% of total investment portfolio required to be measured at fair value) include mortgage backed securities that were purchased during 2008, at deep discounts to par, and had a fair value of $151.7 at December 31, 2008. These securities are valued using an internal discounted cash flow model. The cash flow model incorporates actual cash flows on the mortgage backed securities through the current period and projects the remaining cash flows from the underlying mortgages, using a number of assumptions and inputs that are based on the security specific collateral. The assumptions to which the model is sensitive include default, prepayment and recovery rates. The company assesses the reasonableness of the values of these securities by comparing to recent transaction prices for similar assets where available.
 
A net loss at December 31, 2008 of $29.2 (2007 – nil) representing the change in fair value of the company’s investments (principally mortgage backed securities purchased during 2008 at a deep discount to par) priced through the use of internal models without observable market information as inputs was recognized in the consolidated statement of earnings. The change in fair value of $29.2 was offset by the receipt of $44.9 of interest and return of capital during the period.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
A reconciliation of financial instruments measured at fair value on a recurring basis with the use of significant unobservable inputs from January 1, 2008 to December 31, 2008 follows:
 
                 
          Common
 
    Bonds     stocks  
 
Balance at January 1, 2008
    23.3       10.6  
Net gains (losses) included in the consolidated statement of earnings
    (37.4 )     7.9  
Net purchases (sales)
    180.7       (12.2 )
Transfer out of category
          (2.5 )
                 
Balance at December 31, 2008
    166.6       3.8  
                 
 
Investment Income
 
An analysis of investment income for the years ended December 31 as follows:
 
                                         
    2008  
    Classified as
    Designated as
    Classified as
             
    held for
    held for
    available
             
    trading     trading     for sale     Other     Total  
 
Interest income:
                                       
Cash and short term investments
    100.4             30.8             131.2  
Bonds
          81.9       372.7             454.6  
Derivatives and other
    14.8                   6.4       21.2  
                                         
      115.2       81.9       403.5       6.4       607.0  
                                         
Dividends:
                                       
Preferred stocks
                1.5             1.5  
Common stocks
                74.5             74.5  
                                         
                  76.0             76.0  
                                         
Losses from investments, at equity
                      (49.4 )     (49.4 )
Expenses
                        (7.2 )     (7.2 )
                                         
      115.2       81.9       479.5       (50.2 )     626.4  
                                         
Net gains (losses) on investments:
                                       
Bonds:
                                       
Gains
                651.8             651.8  
Losses
          (356.1 )     (22.0 )           (378.1 )
                                         
            (356.1 )     629.8             273.7  
                                         
Preferred stocks:
                                       
Gains
                3.0             3.0  
Losses
                             
                                         
                  3.0             3.0  
                                         
Common stocks:
                                       
Gains
                44.0             44.0  
Losses
          (20.8 )     (2.6 )           (23.4 )
                                         
            (20.8 )     41.4             20.6  
                                         
Financial instruments classified as held for trading
    3,433.6                         3,433.6  
Foreign currency gains (losses) on cash, cash equivalents and short term investments
    (75.7 )     71.8       (7.3 )           (11.2 )
Foreign currency translation loss on disposition of investee company
                      (24.9 )     (24.9 )
Other
          1.2             20.9       22.1  
Other than temporary impairments of investments
                (996.4 )           (996.4 )
                                         
      3,357.9       (303.9 )     (329.5 )     (4.0 )     2,720.5  
                                         
      3,473.1       (222.0 )     150.0       (54.2 )     3,346.9  
                                         
 
 
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    2007     2006              
    Classified as
    Designated as
    Classified as
                               
    held for
    held for
    available
                               
    trading     trading     for sale     Other     Total     Total              
 
Interest income:
                                                               
Cash and short term investments
    182.8             29.6             212.4       268.6                  
Bonds
          47.4       399.4             446.8       356.4                  
Derivatives and other
    20.8                         20.8       (14.8 )                
                                                                 
      203.6       47.4       429.0             680.0       610.2                  
                                                                 
Dividends:
                                                               
Preferred stocks
                1.2             1.2       0.7                  
Common stocks
                80.5             80.5       71.9                  
                                                                 
                  81.7             81.7       72.6                  
                                                                 
Earnings from investments, at equity
                      7.7       7.7       78.0                  
Expenses
                      (8.4 )     (8.4 )     (14.3 )                
                                                                 
      203.6       47.4       510.7       (0.7 )     761.0       746.5                  
                                                                 
Net gains (losses) on investments:
                                                               
Bonds:
                                                               
Gains
                93.7             93.7       216.3                  
Losses
          (42.0 )     (1.0 )           (43.0 )     (7.3 )                
                                                                 
            (42.0 )     92.7             50.7       209.0                  
                                                                 
Preferred stocks:
                                                               
Gains
                                  1.6                  
Losses
                                                   
                                                                 
                                    1.6                  
                                                                 
Common stocks:
                                                               
Gains
                158.2             158.2       799.4                  
Losses
                (17.7 )           (17.7 )     (4.3 )                
                                                                 
                  140.5             140.5       795.1                  
                                                                 
Investments, at equity
                      220.5       220.5                        
Financial instruments classified as held for trading
    1,274.7                         1,274.7       (251.0 )                
Foreign currency gains (losses) on cash, cash equivalents and short term investments
    24.0                         24.0       72.6                  
Repurchase of debt
                      1.8       1.8       (15.7 )                
Secondary offerings – OdysseyRe
                                  69.7                  
Other
                      40.0       40.0       (8.2 )                
Other than temporary impairments of investments
                (102.6 )     (10.2 )     (112.8 )     (37.8 )                
                                                                 
      1,298.7       (42.0 )     130.6       252.1       1,639.4       835.3                  
                                                                 
      1,502.3       5.4       641.3       251.4       2,400.4       1,581.8                  
                                                                 
 
The net losses on investments, in bonds designated as held for trading of $356.1 (2007 – $42.0) are principally unrealized losses on bonds with embedded derivatives where changes in fair value are recorded through the consolidated statement of earnings.
 
Earnings from investments, at equity includes a provision of nil (2007– $37.4; 2006 – nil) for other than temporary impairments. In 2007, the other than temporary impairment of $37.4 related to the company’s investment in Advent. Included in net gains on investments – other are dilution losses of nil (2007 – $8.0; 2006 – $8.1) and dilution gains of nil (2007 – $1.2; 2006 – $15.8), related to changes in the company’s proportional ownership in certain of its consolidated and equity accounted investments.
 
On June 13, 2007, the company and its subsidiaries completed the sale of all of their 26.1% interest in Hub International Limited (“Hub”) for cash proceeds of $41.50 per share. The sale of 10.3 million Hub shares held by the company and its subsidiaries resulted in cash proceeds of $428.5 and a net gain on investment before income taxes and non-controlling interests of $220.5.
 
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FAIRFAX FINANCIAL HOLDINGS LIMITED
 
The following table summarizes the impact of investments classified or designated as held for trading on net gains (losses) on investments included in the consolidated statement of earnings. Other is primarily comprised of warrants, foreign exchange forward contracts and futures contracts. Common stock and equity index short positions includes positions in securities sold but not yet purchased, total return swaps and equity index call options.
 
                                                 
          Designated as
 
    Classified as held for trading     held for trading  
    Common
                               
    stock and
    Credit
                         
    equity index
    default
                      Common
 
    short positions     swaps     Other     Total     Bonds     stocks  
 
For the year ended December 31, 2008
                                               
Inception-to-date realized gains (losses) on positions closed in the year
    1,989.9       1,802.9       62.5       3,855.3       (2.1 )      
Reversal of mark-to-market (gains) losses recognized in prior periods on positions closed in the year
    89.9       (750.6 )     2.9       (657.8 )     0.1        
Mark-to-market gains (losses) arising on positions remaining open at year end
    (0.2 )     238.2       (1.9 )     236.1       (354.1 )     (20.8 )
                                                 
Net gains (losses)
    2,079.6       1,290.5       63.5       3,433.6       (356.1 )     (20.8 )
                                                 
For the year ended December 31, 2007
                                               
Inception-to-date realized gains (losses) on positions closed in the year
    106.0       173.6       (1.4 )     278.2       19.1        
Reversal of mark-to-market (gains) losses recognized in prior periods on positions closed in the year
    (15.9 )     11.1       (2.1 )     (6.9 )     (12.6 )      
Mark-to-market gains (losses) arising on positions remaining open at year end
    52.9       960.3       (9.8 )     1,003.4       (48.5 )      
                                                 
Net gains (losses)
    143.0       1,145.0       (13.3 )     1,274.7