Berkshire’s management views insurance businesses as possessing two distinct operations - underwriting and investing. Underwriting decisions are the responsibility of the unit managers; investing, with limited exceptions at GEICO and General Re’s international operations, is the responsibility of Berkshire’s Chairman and CEO, Warren E. Buffett. Accordingly, Berkshire evaluates performance of underwriting operations without any allocation of investment income.
Underwriting losses from retroactive reinsurance in 2006 are net of gains of approximately $145 million which primarily derived from contracts that were commuted or amended during the last half of 2006. Underwriting losses in 2005 from retroactive reinsurance are net of a gain of approximately $46 million related to the final settlement of remaining unpaid losses under a retroactive reinsurance agreement. In addition, estimates of unpaid losses were reviewed during the fourth quarter of 2005 which resulted in a net reduction of $75 million in loss reserves and the rates of deferred charge amortization on certain other contracts were decreased due to slower than expected loss payments. During 2004 the estimated timing of future loss payments with respect to one large contract was accelerated which produced an incremental amortization charge of approximately $100 million. Unamortized deferred charges at December 31, 2006 were approximately $1.74 billion compared to $2.13 billion at December 31, 2005. Management believes that these charges are reasonable with respect to the large amounts of float related to these policies. Float was approximately $6.5 billion at December 31, 2006.
Revenues and pre-tax earnings from manufactured housing and finance activities (Clayton Homes) increased 12% and 23%, respectively, as compared to 2005. In 2006, manufactured home sales increased $302 million as compared to 2005 which was primarily due to slightly increased sales of higher priced homes and an increase in total units sold. However, unit sales during the second half of 2006 declined as compared to 2005. Interest income from installment loans in 2006 increased $104 million as compared to 2005 due to higher average installment loan balances primarily from loan portfolio acquisitions during 2005. The balance of installment loans has stabilized after significant increases in recent years. Absent major new loan portfolio acquisitions or significant increases in loan originations, installment loan balances are expected to gradually decline as loan portfolios acquired in 2004 and 2005 are repaid. Consequently, the rate of growth in interest income may decline over the next year and amounts may eventually decline in comparison with amounts earned in 2006.
BHRG’s unpaid losses and loss adjustment expenses as of December 31, 2006 are summarized as follows. Amounts are in millions.
In general, the methodologies used to establish loss reserves vary widely and encompass many of the common methodologies employed in the actuarial field today. Certain traditional methodologies such as paid and incurred loss development techniques, incurred and paid loss Bornhuetter-Ferguson techniques and frequency and severity techniques are utilized. Additional judgments must also be employed to consider changes in contract conditions and terms as well as the incidence of litigation or legal and regulatory change.
Berkshire is also subject to equity price risk with respect to certain long duration equity index option contracts. Berkshire’s maximum exposure with respect to such contracts was approximately $21 billion and $14 billion at December 31, 2006 and 2005, respectively. These contracts generally expire 15 to 20 years from inception and they may not be settled before their respective expiration dates. The contracts have been written on four major equity indexes including three that are foreign. While Berkshire’s ultimate potential loss with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration, the change in fair value from current changes in the indices do not produce a proportional change in the estimated fair value of the contracts. Other factors (such as expected future interest rates, dividend rates and the remaining duration of the contract as well as the general market assumptions) affect the estimates of fair value reflected in the financial statements. Thus, if the underlying indices declined 30% immediately, and absent changes in other factors, Berkshire estimates that it could incur a non-cash pre-tax loss of approximately $2 billion from the change in the estimated fair value of open contracts as of December 31, 2006.
The following table summarizes the outstanding derivatives contracts as of December 31, 2006 and 2005 with foreign currency risk and shows the estimated changes in values of the contracts assuming changes in the underlying exchange rates applied immediately and uniformly across all currencies. The changes in value do not necessarily reflect the best or worst case scenarios and actual results may differ. Dollars are in millions.
The accompanying Consolidated Financial Statements include the accounts of Berkshire consolidated with the accounts of all of its subsidiaries and affiliates in which Berkshire holds a controlling financial interest as of the financial statement date. Normally a controlling financial interest reflects ownership of a majority of the voting interests. Other factors considered in determining whether a controlling financial interest is held include whether Berkshire possesses the authority to purchase or sell assets or make other operating decisions that significantly affect the entity’s results of operations and whether Berkshire bears a majority of the financial risks of the entity. Intercompany accounts and transactions have been eliminated. Certain amounts in prior year presentations have been reclassified to conform with the current year presentation.
Inventories consist of manufactured goods and purchased goods acquired for resale. Manufactured inventory costs include raw materials, direct and indirect labor and factory overhead. Inventories are stated at the lower of cost or market. As of December 31, 2006, approximately 53% of the total inventory cost was determined using the last-in-first-out (“LIFO”) method, 41% using the first-in-first-out (“FIFO”) method, with the remainder using the specific identification method. With respect to inventories carried at LIFO cost, the aggregate difference in value between LIFO cost and cost determined under FIFO methods was $263 million and $237 million as of December 31, 2006 and 2005, respectively.
Includes gross unrealized losses of $69 million related to securities that have been in an unrealized loss position for 12 months or more. Such losses are believed to be the result of general interest rate increases.
The MidAmerican goodwill represents the consolidation of Berkshire’s investment in MidAmerican as of January 1, 2006. The increase in goodwill from business acquisitions and other primarily relates to the acquisitions of PacifiCorp and IMC.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2006 and 2005 are shown below (in millions).