Omaha, NE, Salt Lake City, UT, Houston, TX, Avon, MA and 4
The business segment data (Note 18 to Consolidated Financial Statements) should be read in conjunction with this discussion.
Berkshire engages in both primary insurance and reinsurance of property and casualty risks. Through General Re, Berkshire also reinsures life and health risks. In primary insurance activities, Berkshire subsidiaries assume defined portions of the risks of loss from persons or organizations that are directly subject to the risks. In reinsurance activities, Berkshire subsidiaries assume defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves to in their own insuring activities. Berkshire’s principal insurance businesses are: (1) GEICO, the sixth largest auto insurer in the U.S., (2) General Re, one of the four largest reinsurers in the world, (3) Berkshire Hathaway Reinsurance Group (“BHRG”) and (4) Berkshire Hathaway Primary Group. Berkshire’s management views insurance businesses as possessing two distinctive operations - underwriting and investment. Accordingly, Berkshire evaluates performance of underwriting operations without any allocation of investment income.
GEICO provides primarily private passenger automobile coverages to insureds in 48 states and the District of Columbia. GEICO policies are marketed mainly by direct response methods in which customers apply for coverage directly to the company over the telephone, through the mail or via the Internet. This is a significant element in GEICO’s strategy to be a low cost insurer and, yet, provide high value to policyholders.
GEICO companies are defendants in several class action lawsuits related to the use of collision repair parts not produced by the original auto manufacturers, the calculation of “total loss” value and whether to pay diminished value as part of the settlement of certain claims. GEICO intends to vigorously defend its position on these claim settlement procedures. However, the lawsuits are in various stages of development and the ultimate outcome cannot be reasonably determined at this time.
Underwriting expenses for 2002 were $1,117 million, an increase of $120 million (12.0%) from 2001, following a decrease of $28 million in 2001 from 2000. Advertising expense was unchanged in 2002 as compared to 2001 and significantly lower than in 2000. Underwriting expenses reflect higher associate profit sharing expense than in 2001.
GEICO’s business produced outstanding underwriting results in each of the past two years reflecting favorable claims experience and the effects of rate increases taken primarily in 2000. GEICO believes its rates are adequate in nearly all states and expects additional policy growth in 2003 as competitors increase their rates.
General Re’s underwriting results were negatively impacted in both 2002 and 2001 by increases in loss reserve estimates established for claims occurring in prior years with respect to the North American property/casualty business. Additionally, underwriting results for 2001 were severely impacted by losses from the September 11th terrorist attack.
Premiums earned in 2002 were unchanged from premiums earned in 2001. Premiums earned in 2001 increased over 2000 levels by $579 million (17.1%). Premiums earned in 2002 were primarily impacted by rate increases (estimated at approximately $800 million) across most lines of business, partially offset by reductions from cancellations in excess of new business written. Premiums earned in 2001 included $400 million from one retroactive reinsurance contract and a large quota share agreement. An aggregate excess reinsurance contract produced earned premiums of $404 million in 2000. There were no such contracts written in 2002.
The adjustment of $990 million to prior year loss estimates in 2002 was from casualty lines of business and related principally to the 1997 through 2000 accident years. Increases in prior years’ general liability claims totaled about $400 million. The remainder of the increase in prior years’ reserves in 2002 was split fairly evenly among
About $386 million of the reserve increases for prior years’ claims resulted from actual reported claims exceeding expectations. This under-estimation of expected claims indicated that the level of premium rate erosion that occurred in recent years was greater than had been previously contemplated in General Re’s earlier loss reserve estimates. As a result of the higher than anticipated reported losses, General Re increased reserves for incurred but not reported (“IBNR”) claims by an additional $604 million.
IBNR reserves are largely comprised of liability and workers’ compensation exposures because these claims tend to be reported by and settled with ceding companies over long time periods. Therefore, such claims are subject to a higher degree of estimation error as a result of changes in the legal environment, jury awards, medical cost trends and general cost inflation. Based upon statistical analysis of past reporting trends, General Re estimates how much IBNR is required to cover claims that will be reported by ceding companies in future years. Subsequently, as claims are reported, amounts are measured against previous expectations, with variances (positive or negative) recognized in earnings as a component of losses and loss adjustment expenses. Significant variances are analyzed and revised judgments are made with respect to remaining IBNR reserve levels, and are also recognized in earnings.
There is considerable judgment employed in developing the estimates because of inherent delays in claim emergence and reporting by ceding companies, particularly with respect to liability claims. Normally only about 15% of ultimate excess casualty reinsurance claims are reported in the year of loss occurrence. General Re has not quantified a range of possible reserve estimates.
Among other factors, management believes the revised estimates in 2002 for prior years were due to: (a) an increase in claim severity, which has a leveraged effect on excess of loss coverages provided by General Re by producing a disproportionate increase in claims exceeding General Re’s attachment point; (b) escalating medical inflation and utilization that adversely affect workers’ compensation and other casualty lines; (c) an increased frequency in corporate bankruptcies, scandals and accounting restatements which increased losses under directors and officers coverages; (d) broadened coverage terms under General Re’s reinsurance contracts during 1997 through 2000; (e) increased ceding companies’ reserve inadequacies, likely arising from broadened terms and conditions, as well as previously unrecognized premium inadequacies; and (f) increased primary company insolvencies, which changed historical claim reporting patterns.
Due to the long-tail nature of casualty business, a very high degree of estimation is involved in establishing loss reserves for current accident year occurrences. Thus, the ultimate level of underwriting gain or loss with respect to the 2002 accident year will not be fully known for many years. North American property/casualty loss reserves were $16.2 billion ($14.9 billion net of reinsurance) at December 31, 2002 and $15.1 billion ($13.6 billion net of reinsurance) at December 31, 2001. About 50% of these amounts represent estimates of IBNR losses.
Although loss reserve levels are now believed to be adequate, there can be no guarantees. A relatively small change in the estimate of net reserves can produce large changes in annual underwriting results. For instance, a one percentage point change in net reserves at year end 2002 would produce a pre-tax underwriting gain or loss of $149 million, or roughly 4% of premiums earned in 2002. In addition, the timing and magnitude of catastrophes and large individual property losses are expected to continue to contribute to volatile periodic underwriting results in the future.
The international property/casualty operations write quota-share and excess reinsurance on risks around the world. International property/casualty business is written on a direct reinsurance basis (primarily through Cologne Re) and in the London market (through Faraday). In recent years, General Re’s largest international markets have been in Western Europe.
The direct market reinsurance operations produced an underwriting loss of $315 million for 2002. Significantly impacting 2002 results were $240 million of net losses on prior years’ loss estimates, where claims reported exceeded actuarial expectations, and approximately $107 million in catastrophe and other large individual property losses, principally European flood losses in August and European storm Jeanette in October. The underwriting loss of $568 million in 2001 included $247 million of net losses related to the September 11th terrorist attack and $143 million resulting from other large individual property losses. Large individual property losses for 2000 aggregated $80 million.
London market operations produced an underwriting loss in 2002 of $4 million, compared with an underwriting loss of $178 million in 2001. Underwriting results in 2002 benefited from improved market conditions and below normal property losses in the current accident year, but were adversely impacted by $17 million of European flood losses and $80 million of increases in prior years’ loss reserve estimates. The London market underwriting loss in 2001 included $66 million from the September 11th terrorist attack as well as relatively high property losses.
General Re’s global life/health affiliates reinsure such risks worldwide. Premiums earned in 2002 for the global life/health operations declined $102 million (5.1%) from 2001. In 2001, premiums declined $273 million from 2000, primarily due to the elimination of the one quarter reporting lag in the fourth quarter of 2000. Global life/health generated underwriting losses of $55 million in 2002, compared with $82 million in 2001, and $80 million in 2000. Underwriting results for 2001 include $19 million of net losses related to the September 11th terrorist attack. Otherwise, the poor underwriting results in 2002 and 2001 reflected losses generated from discontinued lines of the health business and in 2000 were from the international health business.
During 2002, Berkshire increased its investments in high-yield corporate bonds to approximately $8 billion at December 31, 2002. Approximately $7 billion of these investments are held by Berkshire insurance subsidiaries with the remaining portion held by finance subsidiaries. These investments were primarily acquired at distressed prices. The credit risk associated with these investments is much greater than with other fixed income investments, which are generally U.S. Government, municipal and mortgage-backed securities. Approximately $4 billion of these investments were issued by companies in the energy industry and approximately $2 billion were issued by telecommunications businesses. Berkshire believes that credit losses may eventually occur with respect to some of these investments. However, the Company also believes that over time these investments will produce reasonable returns in relation to credit risk.
Berkshire’s numerous non-insurance businesses grew significantly through the acquisition of a number of businesses subsequent to December 31, 1999. Additional information regarding these acquisitions is contained in Notes 2 and 3 of the Consolidated Financial Statements. As a result of these acquisitions, three new non-insurance business segments were formed in the last two years.
A summary follows of results from Berkshire’s non-insurance businesses for the past three years.
A comparison of revenues and pre-tax earnings between 2002, 2001 and 2000 for the non-insurance businesses follows.
The largest new segment in terms of revenue is Shaw Industries (“Shaw”), in which Berkshire acquired an 87.3% interest on January 8, 2001. In January 2002, Berkshire acquired the remaining interest in Shaw. The building products segment consists of four recently acquired businesses (MiTek Inc., acquired in July 2001; Johns Manville, acquired in February 2001; Benjamin Moore, acquired in December 2000; and Acme Building Brands, acquired in August 2000). The third new segment, apparel, consists of several businesses, including Fruit of the Loom (acquired in April 2002), Garan (acquired in September 2002), Justin Brands (acquired in August 2000) and several other businesses that have been owned by Berkshire for many years but were previously not part of a reportable segment (H.H. Brown Shoe Group and Fechheimer).
Berkshire’s apparel businesses grew significantly during 2002 as a result of the Fruit of the Loom and Garan acquisitions. From their acquisition dates, these two businesses generated combined revenues of $957 million and pre-tax earnings of $190 million. Revenues from Berkshire’s other apparel businesses declined $64 million in 2002 as compared to 2001 primarily due to lower revenues from the Dexter shoe business. Pre-tax earnings in 2002 from the other apparel businesses totaled $39 million compared to a pre-tax loss of $33 million in 2001 which included significant operating losses and a restructuring charge at Dexter.
Each of Berkshire’s building products businesses manufactures and distributes products and services for the residential and commercial construction and home improvement markets. Revenues of the building products group in 2002 totaled $3.7 billion compared to $3.3 billion in 2001. Pre-tax earnings of these businesses in 2002 were $516 million compared to $461 million in 2001.
Several finance and financial products businesses are included in this segment. Generally, these businesses invest in various types of fixed-income securities, loans, leases and other financial instruments, often utilizing leverage in the process. The most significant of these businesses are BH Finance, a business engaged in proprietary trading strategies, General Re Securities (“GRS”), a dealer in derivative contracts, Berkadia LLC, a special purpose commercial lender, and XTRA Corporation, a transportation equipment leasing business.
GRS had a pre-tax loss in 2002 of $173 million compared to earnings of $11 million in 2001. In January 2002, it was announced that GRS would commence a long-term run-off of its business. During the run-off period, GRS will limit new business to certain risk management transactions and will unwind existing asset and liability positions in an orderly manner. It is expected that the run-off will take a number of years to complete. The pre-tax loss in 2002 included a charge of $31 million for employee severance and related run-off costs as well as net transaction and position losses of $68 million. Additional losses will likely be incurred over time in connection with the run-off. The timing and amounts of such losses is uncertain.
In August 2001, Berkadia LLC commenced operation by lending $5.6 billion to FINOVA in connection with that company’s bankruptcy reorganization. The structure of this transaction and risks associated with this transaction are described in Note 11 to the Consolidated Financial Statements. This special purpose lender generated pre-tax earnings of $115 million in 2002 compared to a loss of $40 million in 2001, which included a charge of $189 million from the writedown of FINOVA common stock received in the loan transaction. Earnings of Berkadia are directly correlated with the outstanding amount of the loan to FINOVA, which declined $2.725 billion in 2002 to $2.175 billion at December 31, 2002. Consequently, Berkadia’s earnings will decline in 2003.
The Scott Fetzer companies are a group of about twenty diverse manufacturing and distribution businesses under common management. Principal businesses in this group of companies sell products under the Kirby (home cleaning systems), Campbell Hausfeld (air compressors, paint sprayers, generators and pressure washers) and World Book (encyclopedias and other educational products) names. Revenues in 2002 from Scott Fetzer’s businesses decreased $15 million (1.6%) as compared to 2001. Pre-tax earnings in 2002 were $129 million, unchanged from 2001.
Revenues in 2002 of Berkshire’s other businesses increased $495 million to $1,983 million and pre-tax earnings increased $314 million to $691 million. Pre-tax earnings from other businesses include interest on trust preferred securities issued by MidAmerican Energy as well as Berkshire’s proportionate share of MidAmerican’s net earnings related to Berkshire’s investments in common and convertible preferred stock of MidAmerican. Berkshire’s earnings from these investments totaled $435 million in 2002 and $165 million in 2001. MidAmerican’s earnings in 2002 benefited from acquisitions of two natural gas pipelines and acquisitions of three real estate brokerage businesses. The remainder of the comparative increases in revenues and operating profits was primarily due to the inclusion of the results of businesses acquired in 2002 from their respective acquisition dates (Albecca-February 8, 2002, The Pampered Chef and CTB International-both October 31, 2002).
Effective January 1, 2002, Berkshire ceased amortizing goodwill of previously acquired businesses in accordance with the provisions of SFAS No. 142. See Note 7 to the Consolidated Financial Statements for additional information related to this new accounting standard. Purchase-accounting adjustments for 2001 and 2000 included $636 million and $548 million, respectively, of after-tax goodwill amortization. These amounts include Berkshire’s share of goodwill amortization charges taken by MidAmerican, with respect to Berkshire’s investments accounted for under the equity method.
Other purchase-accounting adjustments consist primarily of the amortization of the excess of market value over historical cost of fixed maturity investments held by certain businesses at their acquisition dates. Berkshire included such excess in the cost of the investments and subsequently amortizes it over the remaining lives of the investments.
Berkshire’s balance sheet continues to reflect significant liquidity and a strong capital base. Consolidated shareholders’ equity at December 31, 2002 totaled $64.0 billion. Consolidated cash and invested assets, excluding assets of finance and financial products businesses, totaled approximately $80.8 billion at December 31, 2002 and $72.5 billion at December 31, 2001. During 2002, Berkshire deployed about $3.9 billion in internally generated cash for business acquisitions, including $1.3 billion of additional investments in MidAmerican Energy interest bearing trust preferred securities. During 2001 and 2000, additional cash of $8.5 billion was deployed in business acquisitions.
Berkshire’s consolidated borrowings under investment agreements and other debt, excluding borrowings of finance businesses, totaled $4.8 billion at December 31, 2002 and $3.5 billion at December 31, 2001. The increase in borrowings during 2002 relates to pre-acquisition debt of Albecca Inc., which was acquired in February 2002, Berkshire’s issuance of the SQUARZ securities in May 2002, a net increase in Berkshire’s borrowings under investment agreements and increases in short-term borrowing by certain Berkshire subsidiaries. Albecca’s outstanding borrowings at December 31, 2002 primarily consisted of $135 million of 10.75% senior subordinated notes, due in August 2008. The notes are redeemable beginning in August 2003 and it is Berkshire’s intention to redeem the notes at that time. The SQUARZ securities consist of $400 million par amount of senior notes due in November 2007 together with warrants to purchase Berkshire Class A or Class B common stock, which expire in May 2007. A warrant premium is payable to Berkshire at an annual rate of 3.75% and interest is payable to note holders at a rate of 3.00%.
During the second quarter of 2001, Berkshire filed a shelf registration to issue up to $700 million in new debt securities at a future date. The intended purpose of the future issuance of debt is to fund the repayment of currently outstanding borrowings of certain Berkshire subsidiaries. The timing and amount of the debt to be issued under the shelf registration has not yet been determined.
Assets of the finance and financial products businesses totaled $33.6 billion at December 31, 2002 and $41.6 billion at December 31, 2001. The overall decline reflects a decline in assets of BH Finance as a result of the liquidation of certain fixed income investments and $2.725 billion in repayments of Berkadia’s loan to FINOVA.
The following table summarizes the estimated effects of hypothetical increases and decreases in interest rates on assets and liabilities that are subject to interest rate risk. It is assumed that the changes occur immediately and uniformly to each category of instrument containing interest rate risks. The hypothetical changes in market interest rates do not reflect what could be deemed best or worst case scenarios. Variations in market interest rates could produce significant changes in the timing of repayments due to prepayment options available. For these reasons, actual results might differ from those reflected in the table. Dollars are in millions.
Excludes General Re Securities - See Financial Products Risk section for discussion of risks associated with this business.
GRS evaluates and records a fair-value adjustment to recognize counterparty credit exposure and future costs associated with administering each contract. The expected credit exposure for each trade is initially established on the trade date and is estimated through the use of a proprietary credit exposure model that is based on historical default probabilities, market volatilities and, if applicable, the legal right of setoff. These exposures are continually monitored and adjusted due to changes in the credit quality of the counterparty, changes in interest and currency rates or changes in other factors affecting credit exposure. During 2002, GRS did not experience any credit losses.
Berkshire uses a variety of techniques to establish the liabilities for unpaid claims recorded at the balance sheet date. While techniques may vary, each employs significant judgments and assumptions. Techniques may involve detailed statistical analysis of past claim reporting, settlement activity, claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience, the experience of clients or industry experience. Techniques may vary depending on the type of claim being estimated. More judgmental techniques are used in lines of business when statistical data is insufficient or unavailable. Liabilities may also reflect implicit or explicit assumptions regarding the potential effects of future economic and social inflation, judicial decisions, law changes, and recent trends in such factors.
Berkshire’s financial position reflects large amounts of invested assets, including assets of its finance and financial products businesses. A substantial portion of these assets are carried at fair values based upon current market quotations and, when not available, based upon fair value pricing models. Berkshire’s finance businesses maintain significant balances of finance receivables, which are carried at amortized cost. Considerable judgment is required in determining the assumptions used in certain pricing models, which may address interest rates, loan prepayment speeds, and creditworthiness of the issuer.
Berkshire’s Consolidated Balance Sheet as of December 31, 2002 includes goodwill of acquired businesses of approximately $22.3 billion. These amounts have been recorded as a result of Berkshire’s numerous prior business acquisitions accounted for under the purchase method. Prior to 2002, goodwill from each acquisition was generally amortized as a charge to earnings over periods not exceeding 40 years. Under SFAS No. 142, which was adopted by Berkshire as of January 1, 2002, periodic amortization ceased, in favor of an impairment-only accounting model.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include periodically determining or reviewing the estimated fair value of Berkshire’s reporting units. Under SFAS No. 142, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating reporting unit values, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of goodwill. The excess of the recorded amount of goodwill over the implied value is then charged to earnings as an impairment loss.
As described in Note 7 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets”, effective January 1, 2002.
Class B common stock has economic rights equal to one-thirtieth (1/30) of the economic rights of Class A common stock. Accordingly, on an equivalent Class A common stock basis, there are 1,534,657 shares outstanding at December 31, 2002 versus 1,528,217 shares outstanding at December 31, 2001.
Berkshire Hathaway Inc. (“Berkshire” or “Company”) is a holding company owning subsidiaries engaged in a number of diverse business activities. The most important of these are property and casualty insurance businesses conducted on both a primary and reinsurance basis. Further information regarding these businesses and Berkshire’s other reportable business segments is contained in Note 18. Berkshire initiated and/or consummated a number of business acquisitions over the past three years which are discussed in Notes 2 and 3.
The accompanying Consolidated Financial Statements include the accounts of Berkshire consolidated with the accounts of all of its subsidiaries and affiliates, including special purpose entities that Berkshire controls as of the financial statement date. Normally control reflects the ownership of majority voting interests. However, control can be attained when less than a majority voting interest is held. Factors considered in determining whether control exists include whether Berkshire provides significant financial support as a result of its authority to purchase or sell assets or make other operating decisions that significantly affect the entity’s results of operations or whether Berkshire bears a majority of the financial risks. Intercompany accounts and transactions have been eliminated. Certain amounts in 2001 and 2000 have been reclassified to conform with the current year presentation.
Berkshire’s management determines the appropriate classifications of investments in securities with fixed maturities and equity securities at the time of acquisition and re-evaluates the classifications at each balance sheet date. Berkshire’s investments in fixed maturity and equity securities are primarily classified as available-for-sale, except for certain investments which are classified as held-to-maturity. Held-to-maturity investments are carried at amortized cost, reflecting Berkshire’s intent and ability to hold the securities to maturity. Available-for-sale securities are stated at fair value with net unrealized gains or losses reported as a component of accumulated other comprehensive income.
Realized gains and losses, which arise when available-for-sale investments are sold (as determined on a specific identification basis) or other-than-temporarily impaired are included in the Consolidated Statements of Earnings. Berkshire reviews investments classified as held-to-maturity or available-for-sale as of each balance sheet date with respect to investments of an issuer carried at a net unrealized loss. If in management’s judgement, the decline in value is other-than-temporary, the cost of the investment is written down to fair value with a corresponding charge to earnings. Factors considered in determining whether an impairment exists include: the financial condition, business prospects and creditworthiness of the issuer, the length of time that the asset value has been less than cost, and Berkshire’s ability and intent to hold such investments until the fair value recovers.
Berkshire utilizes the equity method of accounting with respect to investments where it exercises significant influence, but not control, over the policies of the investee. A voting interest of at least 20% and no greater than 50% is normally a prerequisite for utilizing the equity method. However Berkshire may apply the equity method with less than 20% voting interests based upon the facts and circumstances including representation on the Board of Directors, contractual veto or approval rights, participation in policy making processes, the existence or absence of other significant owners and the expected duration of the investment. Berkshire applies the equity method to investments in common stock and investments in preferred stock when such preferred stock possesses substantially identical subordinated interests to common stock.
Certain Berkshire finance affiliates utilize derivative instruments as risk management tools. Such instruments include interest rate, currency and equity swaps and options, interest rate caps and floors, futures and forward contracts and foreign exchange contracts. Trading account assets and liabilities are marked-to-market on a daily basis and represent the estimated fair values of derivatives in net gain positions (assets) and in net loss positions (liabilities) and reflect reductions permitted under master netting agreements with counterparties. The fair values of these instruments represent the present value of expected future cash flows under the contract, which is a function of underlying interest rates, currency rates, security values, related volatility, the creditworthiness of counterparties and duration of the contract. Future changes in these factors or a combination thereof may affect the fair value of these instruments. Changes in fair value of trading account assets and liabilities during the period are included in the Consolidated Statements of Earnings. The carrying values of trading account assets and trading account liabilities reflect a net decrease of $19.1 billion at December 31, 2002 and $17.5 billion at December 31, 2001 as a result of the netting arrangements.
Securities purchased under agreements to resell (assets) and securities sold under agreements to repurchase (liabilities) are accounted for as collateralized investments and borrowings and are recorded at the contractual resale or repurchase amounts. Other investment securities owned and liabilities associated with investment securities sold but not yet purchased are carried at fair value. Loans and finance receivables are principally commercial and consumer loans, which are carried at amortized cost.
Property, plant and equipment is recorded at cost. Depreciation is provided principally on the straight-line method over estimated useful lives as follows: aircraft, simulators, training equipment and spare parts, 4 to 20 years; buildings and improvements, 10 to 40 years; machinery, equipment, furniture and fixtures, 3 to 20 years. Leasehold improvements are amortized over the life of the lease or the life of the improvement, whichever is shorter. Interest is capitalized as an integral component of cost during the construction period of simulators and facilities and is amortized over the life of the related assets.
Effective January 1, 2002, Berkshire adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” SFAS No. 142 eliminated the periodic amortization of goodwill in favor of an accounting model that is based solely upon impairment tests. Goodwill is reviewed for impairment using a variety of methods at least annually, and impairments, if any, are charged to operating earnings.
The estimated liabilities of workers’ compensation claims assumed under reinsurance contracts and liabilities assumed under structured settlement reinsurance contracts are carried in the Consolidated Balance Sheets at discounted amounts. Discounted amounts pertaining to workers’ compensation risks are based upon an annual discount rate of 4.5%, which is the same discount rate used under statutory accounting principles. The discounted amounts for structured settlement reinsurance contracts are based upon the prevailing market discount rates when the contracts were written and range from 5% to 13%. Payments under such contracts are characterized as fixed and determinable. The periodic discount accretion is included in the Consolidated Statements of Earnings as a component of losses and loss adjustment expenses.
The accounts of several foreign-based subsidiaries are measured using the local currency as the functional currency. Revenues and expenses of these businesses are translated into U.S. dollars at the average exchange rate for the period. Assets and liabilities are translated at the exchange rate as of the end of the reporting period. Gains or losses from translating the financial statements of foreign-based operations are included in shareholders’ equity as a component of accumulated other comprehensive income. Gains and losses arising from other transactions denominated in a foreign currency are included in the Consolidated Statements of Earnings.
Deferred income taxes are calculated under the liability method. Deferred tax assets and liabilities are recorded based on differences between the financial statement and tax bases of assets and liabilities at the enacted tax rates. Changes in deferred income tax assets and liabilities that are associated with components of other comprehensive income, primarily unrealized investment gains are charged or credited directly to other comprehensive income. Otherwise, changes in deferred income tax assets and liabilities are included as a component of income tax expense.
In August 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143 “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 became effective for Berkshire on January 1, 2003.
Accounting pronouncements to become effective subsequent to December 31, 2002 (Continued)
In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities,” which addresses the consolidation of certain entities (“variable interest entity”) when control exists through other than voting interests. FIN 46 requires that a variable interest entity be consolidated by the holder of the majority of the risks and rewards associated with the activities of the variable interest entity. FIN 46 is effective immediately for variable interest entities created after January 31, 2003. For variable interest entities created prior to February 1, 2003, FIN 46 is effective for the first interim period beginning after June 15, 2003, and may be applied retroactively or prospectively. Berkshire has not completed its assessment of FIN 46. However, based on a preliminary review, Berkshire believes that its investment in Value Capital L.P., currently accounted for under the equity method, will be subject to consolidation in accordance with the guidelines established by FIN 46 (see Note 9).
On October 31, 2002, Berkshire acquired all of the outstanding shares of CTB, a manufacturer of equipment and systems for the poultry, hog, egg production and grain industries.
On October 31, 2002, Berkshire acquired The Pampered Chef, LTD. The Pampered Chef is the largest branded kitchenware company and the largest direct seller of housewares in the U.S.
On January 8, 2001, Berkshire acquired approximately 87.3% of the common stock of Shaw for $19 per share, or $2.1 billion in total. Robert E. Shaw, Chairman and CEO of Shaw, Julian D. Saul, President of Shaw, certain family members and related family interests of Messrs. Shaw and Saul, and certain other Shaw directors and members of management acquired the remaining 12.7% interest. In January 2002, Berkshire acquired the remaining shares in exchange for 4,505 shares of Berkshire Class A common stock and 7,063 shares of Class B common stock. The aggregate market value of Berkshire stock issued was approximately $324 million.
On February 27, 2001, Berkshire acquired all of the outstanding shares of Johns Manville for $13 per share, or $1.8 billion in total. Johns Manville is a leading manufacturer of insulation and building products. Johns Manville manufactures and markets products for building and equipment insulation, commercial and industrial roofing systems, high-efficiency filtration media, and fibers and non-woven mats used as reinforcements in building and industrial applications.
On February 18, 2000, Wesco Financial Corporation, an 80.1% owned subsidiary of Berkshire, acquired CORT Business Services Corporation, a leading national provider of rental furniture, accessories and related services in the “rent-to-rent” segment of the furniture industry. On July 3, 2000, Berkshire acquired Ben Bridge Jeweler, a leading operator of upscale jewelry stores based in major shopping malls in the Western U.S. On August 1, 2000, Berkshire acquired Justin Industries, Inc., a leading manufacturer and producer of face brick, concrete masonry products and ceramic and marble floor and wall tile (Acme Brick) and a leading manufacturer of Western footwear under a number of brand names (Justin Brands). On August 8, 2000, Berkshire acquired U.S. Investment Corporation, the parent of the United States Liability Insurance Group, one of the premier U.S. writers of specialty insurance. On December 18, 2000, Berkshire acquired Benjamin Moore & Co., a formulator, manufacturer and retailer of a broad range of architectural and industrial coatings, available principally in the U.S. and Canada.
The results of operations for each of the entities acquired are included in Berkshire’s consolidated results of operations from the effective date of each acquisition. The following table sets forth certain unaudited consolidated earnings data for 2002 and 2001, as if each of the acquisitions discussed above were consummated on the same terms at the beginning of each year. Dollars are in millions, except per share amounts.
MidAmerican is a U.S. based global energy company whose principal businesses are regulated electric and natural gas utilities, regulated interstate natural gas transmission and electric power generation. Through its subsidiaries it owns and operates a combined electric and natural gas utility company in the U.S., two natural gas pipeline companies in the U.S., two electricity distribution companies in the United Kingdom and a diversified portfolio of domestic and international electric power projects. It also owns the second largest residential real estate brokerage firm in the U.S.
MidAmerican’s Articles of Incorporation further provide that the convertible preferred shares: a) are not mandatorily redeemable by MidAmerican or at the option of the holder; b) participate in dividends and other distributions to common shareholders as if they were common shares and otherwise possess no dividend rights; c) are convertible into common shares on a 1 for 1 basis, as adjusted for splits, combinations, reclassifications and other capital changes by MidAmerican and d) upon liquidation, except for a de minimus first priority distribution of $1 per share, share ratably with the shareholders of common stock. Further, the aforementioned dividend and distribution arrangements cannot be modified without the positive consent of the preferred shareholders. Accordingly, the convertible preferred stock is, in substance, a substantially identical subordinate interest to a share of common stock and economically equivalent to common stock. Therefore, Berkshire is accounting for its investments in common and convertible preferred stock of MidAmerican pursuant to the equity method.
Berkshire’s aggregate investments in MidAmerican are included in the Consolidated Balance Sheets as Investments in MidAmerican Energy Holdings Company, and include the common and convertible preferred stock investments accounted for pursuant to the equity method totaling $1,923 million at December 31, 2002 and $1,371 million at December 31, 2001. The 11% non-transferable trust preferred securities are classified as held-to-maturity and are carried at cost.
Investments in securities with fixed maturities as of December 31, 2002 and 2001 are shown below (in millions).
(1) Common shares of American Express Company (“AXP”) owned by Berkshire and its subsidiaries possessed approximately 11.5% of the voting rights of all AXP shares outstanding at December 31, 2002. The shares are held subject to various agreements which, generally, prohibit Berkshire from (i) unilaterally seeking representation on the Board of Directors of AXP and (ii) possessing 17% or more of the aggregate voting securities of AXP. Berkshire has entered into an agreement with AXP which will remain effective so long as Berkshire owns 5% or more of AXP’s voting securities. The agreement obligates Berkshire, so long as Kenneth Chenault is chief executive officer of AXP, to vote its shares in accordance with the recommendations of AXP’s Board of Directors. Additionally, subject to certain exceptions, Berkshire has agreed not to sell AXP common shares to any person who owns 5% or more of AXP voting securities or seeks to control AXP, without the consent of AXP.
Effective January 1, 2002, Berkshire adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” SFAS No. 142 changed the accounting for goodwill from a model that required amortization of goodwill, supplemented by impairment tests, to an accounting model that is based solely upon impairment tests. Thus, Berkshire’s Consolidated Statement of Earnings for the year ended December 31, 2002 includes no periodic amortization of goodwill.
A reconciliation of Berkshire’s Consolidated Statements of Earnings for each of the three years ended December 31, 2002 from amounts reported to amounts exclusive of goodwill amortization is shown below. Goodwill amortization for the years ended December 31, 2001 and 2000 includes $78 million, and $65 million, respectively, related to Berkshire’s equity method investment in MidAmerican. Dollar amounts are in millions, except per share amounts.
General Re Securities (“GRS”), a wholly owned subsidiary of Berkshire, regularly utilizes derivatives in providing risk management products to clients. In January 2002, it was announced that GRS would commence a long-term run-off of its operations. The run-off is expected to occur over a number of years during which GRS will limit its new business to certain risk management transactions and will unwind its existing asset and liability positions in an orderly manner. Additional information regarding GRS’s derivative instruments follows.
The derivative financial instruments involve, to varying degrees, elements of market, credit, and liquidity risks. GRS controls market risk exposures by taking offsetting positions in either cash instruments or other derivatives. GRS manages its exposures on a portfolio basis and monitors its market risk on a daily basis across all products by calculating the effect on operating results of potential changes in market variables, which include volatility, correlation and
liquidity over a one week period. GRS has established $15 million as its value at risk limit with a 99th percentile confidence interval for potential losses over a weekly horizon.
GRS evaluates and records a fair value adjustment against trading revenue to recognize counterparty credit exposure and future costs associated with administering each contract. The fair value adjustment for counterparty credit exposures and future administrative costs on existing contracts was $95 million at December 31, 2002. Counterparty credit limits are established, and credit exposures are monitored in accordance with these limits. GRS receives cash and/or investment grade securities from certain counterparties as collateral and, where appropriate, may purchase credit insurance or enter into other transactions to mitigate its credit exposure. GRS also incorporates into contracts with certain counterparties provisions which allow the unwinding of these transactions in the event of a downgrade in credit rating or other indications of decline in creditworthiness of the counterparty.
On July 1, 1998, Value Capital L.P., (“Value Capital”) a limited partnership commenced operations. A wholly owned Berkshire subsidiary is a limited partner in Value Capital. The partnership’s objective is to achieve income and capital growth from investments and arbitrage in fixed income investments. Berkshire currently accounts for this investment pursuant to the equity method. Since inception Berkshire has contributed $430 million to the partnership and other partners, including the general partner, have contributed $20 million. Profits and losses of the partnership are allocated to the partners based upon each partner’s investment. At December 31, 2002, the carrying value of $603 million (including Berkshire’s share of accumulated earnings of $173 million) is included as a component of other assets of finance and financial products businesses. Berkshire possesses no management authority over the activities conducted by Value Capital and it does not provide any financial support of the obligations of this partnership or of the other partners. As a limited partner, Berkshire’s exposure to loss is limited to the carrying value of its investment.
Supplemental data with respect to unpaid losses and loss adjustment expenses of property/casualty insurance subsidiaries (in millions) is as follows.
Incurred losses “all prior accident years” reflects the amount of estimation error charged or credited to earnings in each year with respect to the liabilities established as of the beginning of that year. During 2002, Berkshire’s insurance subsidiaries recorded additional losses of $1,553 million in connection with claims occurring in years prior to 2002. This amount includes $1,310 million arising from General Re’s North American and international property/casualty business. The reserve increases were attributed to casualty lines of businesses.
Estimates of unpaid losses resulting from the September 11th terrorist attack were $1.9 billion as of December 31, 2002 and $2.4 billion as of December 31, 2001. Berkshire’s management believes it will take many years to resolve complicated coverage issues, which could produce a material change in the ultimate loss amount.
As previously indicated, Berkshire’s insurance subsidiaries are exposed to environmental, asbestos and other latent injury claims arising from insurance and reinsurance contracts. Loss reserve estimates for environmental and asbestos exposures include case basis reserves, which also reflect reserves for legal and other loss adjustment expenses and IBNR reserves. IBNR reserves are determined based upon Berkshire’s historic general liability exposure base and policy language, previous environmental and loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.
The liabilities for environmental, asbestos, and latent injury claims and claims expenses net of reinsurance recoverables were approximately $6.6 billion at December 31, 2002 and $6.3 billion at December 31, 2001. Approximately, $5.2 billion of year end 2002 reserves were assumed under retroactive reinsurance contracts written by the Berkshire Hathaway Reinsurance Group. Claim liabilities arising from these contracts are subject to aggregate policy limits. Thus, Berkshire’s exposure to environmental and latent injury claims under these contracts are, likewise, limited. Claims paid or reserved under these policies were approximately 85% of aggregate policy limits as of the end of 2002.
Berkshire monitors evolving case law and its effect on environmental and latent injury claims. Changing government regulations, newly identified toxins, newly reported claims, new theories of liability, new contract interpretations and other factors could result in significant increases in these liabilities. Such development could be material to Berkshire’s results of operations. It is not possible to estimate reliably the amount of additional net loss, or the range of net loss, that is reasonably possible.
Notes payable and other borrowings of Berkshire and its subsidiaries as of December 31, 2002 and 2001 are summarized below. Amounts are in millions.
Commercial paper and other short-term borrowings are obligations of certain businesses that utilize short-term borrowings as part of their day-to-day operations. Berkshire affiliates have approximately $3.6 billion available unused lines of credit to support their short-term borrowing programs and, otherwise, provide additional liquidity.
Borrowings of Berkadia LLC (“Berkadia”) relate to Berkadia’s loan to FINOVA Capital Corporation (“FNV Capital”), a subsidiary of The FINOVA Group (“FNV”). On August 21, 2001, Berkshire and Leucadia National Corporation (“Leucadia”), through Berkadia LLC, a newly formed and jointly owned entity formed for this purpose, loaned $5.6 billion on a senior secured basis (the “Berkadia Loan”) to FNV Capital, in connection with a restructuring of all of FNV Capital’s then outstanding bank debt and publicly traded debt securities. Berkadia financed the entire Berkadia Loan through a third party lending facility led by Fleet Bank (“Fleet Loan”). Both the Berkadia Loan and the Fleet Loan are due on August 20, 2006. Under the terms of the Fleet Loan, which is collateralized by the Berkadia Loan, Berkadia is obligated to use the proceeds received from principal prepayments on the Berkadia Loan to prepay the Fleet Loan. Among other things, the Fleet Loan requires that FNV maintain a minimum ratio of its consolidated assets to the outstanding Fleet Loan balance. Berkadia is required to pay down the loan to the extent such ratio is under the minimum. Berkshire provided Berkadia’s lenders with a 90% primary guaranty of the Berkadia Loan and also provided a secondary guaranty to a 10% primary guaranty provided by Leucadia. Berkshire has a 90% economic interest in both the Berkadia Loan and the Fleet Loan. Subsequent to December 31, 2002, FNV has prepaid an additional $450 million principal amount on the Berkadia Loan and Berkadia has prepaid an identical amount on the Fleet Loan.
The liability for income taxes as of December 31, 2002 and 2001 as reflected in the accompanying Consolidated Balance Sheets is as follows (in millions).
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are shown below (in millions).
Payments of dividends by insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, insurance subsidiaries may pay up to approximately $2.45 billion as ordinary dividends during 2003.
Changes in issued and outstanding Berkshire common stock during the three years ended December 31, 2002 are shown in the table below.
Each share of Class A common stock is convertible, at the option of the holder, into thirty shares of Class B common stock. Class B common stock is not convertible into Class A common stock. Each share of Class B common stock possesses voting rights equivalent to
one-two-hundredth (1/200) of the voting rights of a share of Class A common stock. Class A and Class B common shares vote together as a single class.
Certain Berkshire subsidiaries individually sponsor defined benefit pension plans covering their employees. Benefits under the plans are generally based on years of service and compensation, although benefits under certain plans are based on years of service and fixed benefit rates. Funding policies are generally to contribute amounts required to meet regulatory requirements plus additional amounts determined by management based on actuarial valuations. Most plans for U.S. employees are funded through assets held in trust. However, pension obligations under plans for non-
U.S. employees are generally unfunded. Plan assets are primarily invested in fixed income obligations of U.S. government corporations and agencies, cash equivalents and equity securities.
The components of net periodic pension expense for each of the three years ending December 31, 2002 are as follows (in millions).
Changes in the projected benefit obligations and plan assets during 2002 and 2001 are as follows (in millions).
The funded status of the plans as of December 31, 2002 and 2001 is as follows (in millions).
Certain actuarial assumptions which were being used to value the assets and obligations of these plans were revised in 2001 and 2002 to better reflect the current economic environment and, in particular, the recent decline in interest rates. The total net deficit status for plans with accumulated benefit obligations in excess of plan assets was $324 million and $195 million as of December 31, 2002 and 2001, respectively.
Weighted average assumptions used in determining projected benefit obligations were as follows.
Information related to Berkshire’s reportable business operating segments is shown below.
Proprietary investing, real estate financing, transportation equipment leasing, commercial and consumer lending and risk management products
Diversified manufacturing and distribution of various consumer and commercial products with principal brand names including Kirby and Campbell Hausfeld
Other businesses not specifically identified above consist of: Buffalo News, a daily newspaper publisher in Western New York; International Dairy Queen, which licenses and services a system of about 6,000 Dairy Queen stores; See’s Candies, a manufacturer and distributor of boxed chocolates and other confectionery products; CORT Business Services, a leading national provider of rental furniture and related services; Albecca, which designs, manufactures, and distributes high-quality custom picture framing products; CTB International, a manufacturer of equipment and systems for the poultry, hog, egg production and grain industries and The Pampered Chef, a direct seller of houseware products.
Premiums written and earned by Berkshire’s property/casualty and life/health insurance businesses during each of the three years ending December 31, 2002 are summarized below. Dollars are in millions.
*Premiums attributed to Western Europe include $2,438 million from a single reinsurance policy.