MidAmerican’s energy properties consist of the physical assets necessary and appropriate to generate, transmit, store, distribute and supply energy and consist mainly of electric generation, transmission and distribution facilities and gas distribution plants, natural gas pipelines, storage facilities, compressor stations and meter stations, along with the related rights-of-way. A majority of these properties are pledged or encumbered to support or otherwise provide the security for the related project or subsidiary debt. MidAmerican or its affiliates owns or has interests in, the following types of electricity generating plants at December 31, 2006:
Facility Net Capacity megawatts (MW) represents either: 1) PacifiCorp - the total capability of a generating unit as based by actual operating experience or test experience, less power generated and used for auxiliaries and other station uses, and is determined using average annual temperatures; 2) MidAmerican Energy - the total plant accredited net generating capacity from the summer of 2006 (except for wind-powered generation facilities, which are nameplate ratings) where MW may vary depending on operating conditions and plant design; or 3) CalEnergy - the contract capacity for most facilities.
As of December 31, 2006, MidAmerican had an estimated 241.7 million tons of recoverable coal reserves in mines owned or leased in Wyoming, Utah and Colorado based on the most recent engineering studies. Coal reserve estimates are subject to adjustment as a result of the development of additional engineering and geological data, new mining technology and changes in regulation and economic factors affecting the utilization of such reserves. Collective electric transmission and distribution systems included approximately 17,900 miles of transmission lines and approximately 1,300 substations at December 31, 2006. Gas distribution facilities included approximately 22,000 miles of gas mains and service pipelines at December 31, 2006.
Kern River operates approximately 1,700 miles of natural gas pipelines consisting of a mainline section and common facilities. Kern River owns the entire mainline section, which extends from the pipeline’s point of origination near Opal, Wyoming to Daggett, California. The mainline section consists of the original approximately 700 miles of 36-inch diameter pipeline, approximately 600 miles of 36-inch diameter loop pipeline related to an expansion project and approximately 100 miles of various laterals that connect to the mainline. The common facilities consist of an approximately 200 mile section of original pipeline that extends from the point of interconnection with the mainline in Daggett to Bakersfield, California and an additional approximately 100 miles related to the expansion project. The common facilities are jointly owned by Kern River (approximately 76.8% as of December 31, 2006) and Mojave Pipeline Company, a wholly owned subsidiary of El Paso Corporation, (approximately 23.2% as of December 31, 2006) as tenants-in-common.
At December 31, 2006, Northern Electric’s and Yorkshire Electricity’s electricity distribution network (excluding service connections to consumers) on a combined basis included approximately 34,000 kilometers of overhead lines and approximately 65,000 kilometers of underground cables. Northern Electric’s and Yorkshire Electricity’s distribution facilities also included approximately 700 major substations.
On February 9, 2006, Berkshire Hathaway converted its non-voting preferred stock of MidAmerican Energy Holdings Company (“MidAmerican”) to common stock and upon conversion, owned approximately 83.4% (80.5% diluted) of the voting common stock interests. Accordingly, the 2006 Consolidated Financial Statements reflect the consolidation of the accounts of MidAmerican. During the period between 2002 and 2005, Berkshire’s investment in MidAmerican was accounted for pursuant to the equity method.
The amount of investment and derivative gains and losses for any given period has no predictive value, and variations in amount from period to period have no practical analytical value in view of the unrealized appreciation in Berkshire’s investment portfolio. After-tax investment and derivative gains were $1,709 million in 2006, $3,530 million in 2005, $2,259 million in 2004, $2,729 million in 2003 and $566 million in 2002. Investment gains in 2005 include a non-cash pre-tax gain of $5.0 billion ($3.25 billion after-tax) relating to the exchange of Gillette stock for Procter & Gamble stock.
Net earnings for the year ending December 31, 2005 includes a pre-tax underwriting loss of $3.4 billion in connection with Hurricanes Katrina, Rita and Wilma that struck the Gulf coast and Southeast regions of the United States. Such loss reduced net earnings by approximately $2.2 billion and earnings per share by $1,446.
Berkshire’s operating businesses are managed on an unusually decentralized basis. There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by Berkshire’s corporate headquarters in the day-to-day business activities of the operating businesses. Berkshire’s corporate office management participates in and is ultimately responsible for significant capital allocation decisions, investment activities and the selection of the Chief Executive to head each of the operating businesses. The business segment data (Note 20 to the 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 and reinsurance businesses are: (1) GEICO, one of the four largest auto insurers in the U.S., (2) General Re, (3) Berkshire Hathaway Reinsurance Group and (4) Berkshire Hathaway Primary Group.
Periodic underwriting results can be affected significantly by changes in estimates for unpaid losses and loss adjustment expenses, including amounts established for occurrences in prior years. See the Critical Accounting Policies section of this discussion for information concerning the loss reserve estimation process. In addition, the timing and amount of catastrophe losses can produce significant volatility in periodic underwriting results. During the third quarter of 2005, Hurricanes Katrina and Rita struck the Gulf Coast region of the United States producing the largest catastrophe losses for any quarter in the history of the property/casualty insurance industry. In the fourth quarter of 2005, Hurricane Wilma struck the Southeast U.S. Estimated pre-tax losses from these events of $3.4 billion were recorded in 2005. In contrast, there were no major hurricanes in 2006.
A key marketing strategy followed by all of these businesses is the maintenance of extraordinary capital strength. Statutory surplus of Berkshire’s insurance businesses was approximately $59 billion at December 31, 2006. This superior capital strength creates opportunities, especially with respect to reinsurance activities, to negotiate and enter into insurance and reinsurance contracts specially designed to meet unique needs of insurance and reinsurance buyers. Additional information regarding Berkshire’s insurance and reinsurance operations follows.
Net of losses of $200 million from Hurricanes Katrina, Rita and Wilma.
Losses and loss adjustment expenses in 2006 were $7,749 million, an increase of 8.7% over 2005. The loss ratio declined to 70.1% in 2006 compared to 70.6% in 2005 and 71.3% in 2004 primarily due to decreasing claim frequencies across all markets and most coverage types. In 2006, claims frequencies for physical damage coverages decreased in the two to five percent range from 2005 while frequencies for injury coverages decreased in the two to five percent range. Injury severity in 2006 increased in the two to five percent range over 2005 while physical damage severity increased in the four to seven percent range. Incurred losses from catastrophe events were approximately $54 million in 2006, $227 million in 2005 (primarily from the hurricanes in the third and fourth quarters) and $71 million in 2004.
Underwriting expenses in 2006 were $1,992 million, an increase of 13.7% over 2005, which increased 10.5% over 2004. The increase in expenses in 2006 reflected higher advertising costs as well as incremental underwriting and policy issuance costs associated with new business sales.
Premiums written declined in 2006 from amounts written in 2005 which declined from amounts written in 2004. The declines in North America were attributable to significant reductions in finite risk business and to a lesser extent lower casualty treaty volume. International premiums written in 2006 were essentially unchanged from 2005. In local currencies, international premiums written increased 2% over 2005 primarily due to increased volume of property business at Faraday offset by a significant reduction in finite risk business. The overall comparative declines in written premiums in the past three years reflected continued underwriting discipline by rejecting transactions where pricing is deemed inadequate with respect to the risk.
Approximately half of the comparative declines in the North American premiums earned in 2006 and 2005 versus the previous year were attributable to policy cancellations and non-renewals exceeding new contracts as well as a slight impact from rate changes. The remainder of the comparative declines were primarily due to the significant decreases in finite risk business. In local currencies, 2006 international premiums earned declined 3.5% from 2005, which declined 12.3% compared with 2004. Similar to North America, the decline in premiums earned in the international segment over the past three years generally reflects reductions in premium volume due to the non-renewal of unprofitable business and the decrease in finite risk business.
The North American business produced an underwriting gain of $127 million in 2006 compared with an underwriting loss of $307 million in 2005 and an underwriting gain of $11 million in 2004. Underwriting results in 2006 included $348 million in underwriting gains from property business partially offset by $221 million in underwriting losses from casualty/workers’ compensation business and includes legal and estimated settlement costs associated with the ongoing regulatory investigations of the finite risk business. The property business produced underwriting gains of $209 million for the 2006 accident year, and $139 million from favorable run-off of prior year property losses. The current accident year results benefited from a lack of catastrophe losses. The underwriting losses from casualty/workers’ compensation business in 2006 included (1) $137 million in discount accretion and deferred charge amortization, (2) increases in prior years’ workers’ compensation reserves of $103 million arising from the continuing escalation of medical utilization and cost inflation and (3) increases in asbestos and environmental reserves of $58 million. These losses were somewhat offset by net decreases in prior years’ reserves for other casualty coverages.
The International property/casualty businesses produced an underwriting gain of $246 million in 2006 compared with underwriting losses of $138 million and $93 million in 2005 and 2004, respectively. Underwriting results for 2006 benefited from $360 million of net gains in property and aviation lines of business and the lack of catastrophe losses. Partially offsetting these gains were $114 million in net losses in casualty business, including costs associated with the finite risk business regulatory investigations. Underwriting results for both 2005 and 2004 included catastrophe losses from the U.S. hurricanes of $205 million and $110 million, respectively. Additionally, 2005 results included $29 million in losses from windstorm Erwin. Underwriting results for each of the last three years benefited from favorable results of the aviation and non-catastrophe property businesses. The International property and casualty underwriting results included gains associated with prior accident years of $235 million in 2006 compared with gains of $108 million in 2005 and losses of $102 million in 2004. Prior years’ losses in 2004 were primarily in motor excess, workers’ compensation and other casualty lines and increases for operations placed in run-off.
Premiums earned in 2006 increased 3.0% over 2005, which increased 13.9% over 2004. Adjusting for the effects of foreign currency, premiums earned increased 2.3% in 2006 and 14.2% in 2005. The increase in premiums earned in 2006 was primarily from European life business and in 2005 was primarily due to an increase in both North American and European life business.
The global life/health operations produced underwriting gains of $153 million in 2006, $111 million in 2005 and $85 million in 2004. Both the U.S. and international life/health operations were profitable in each of the past three years primarily due to favorable mortality; however, most of the gains were earned in the international life business. Additionally, included in the underwriting results for 2006, 2005 and 2004 were $31 million, $66 million and $46 million, respectively, of net losses attributable to reserve increases on certain U.S. health business in run-off.
The Berkshire Hathaway Reinsurance Group (“BHRG”) underwrites excess-of-loss reinsurance and quota share coverages for insurers and reinsurers worldwide. BHRG’s business includes catastrophe excess-of-loss reinsurance and excess direct and facultative reinsurance for large or otherwise unusual discrete property risks referred to as individual risk. Retroactive reinsurance policies provide indemnification of losses and loss adjustment expenses with respect to past loss events. Other multi-line refers to other business written on both a quota-share and excess basis, participations in and contracts with Lloyd’s syndicates, as well as aviation business and workers’ compensation programs. The timing and amount of catastrophe losses can produce extraordinary volatility in the periodic underwriting results of the BHRG, and, in particular, in the catastrophe and individual risk business. The pre-tax probable maximum loss from a single event is currently estimated to be approximately $6 billion. BHRG’s pre-tax underwriting results are summarized below. Amounts are in millions.
Retroactive policies normally provide very large, but limited, indemnification of unpaid losses and loss adjustment expenses with respect to past loss events that are expected to be paid over long periods of time. The underwriting losses from retroactive reinsurance are primarily attributed to the amortization of deferred charges established on retroactive reinsurance contracts written in previous years. The deferred charges, which represent the difference between the premium and the estimated ultimate claim reserves, are amortized over the expected claim payment period using the interest method. The amortization charges are recorded as losses incurred and, therefore, generate underwriting losses. The level of amortization in a given period is based upon estimates of the timing and amount of future loss payments. To the extent there are changes in these estimates, deferred charge balances are adjusted on a retrospective basis via a cumulative adjustment.
Investment income consists of interest and dividends earned on cash equivalents and fixed maturity and equity investments of Berkshire’s insurance businesses. Pre-tax investment income earned in 2006 by Berkshire’s insurance businesses increased $836 million (24%) over 2005, which increased $656 million (23%) over 2004. The increase in 2006 reflects higher short-term interest rates in the United States and increased dividends as compared to 2005. The increase in investment income in 2005 primarily reflects higher short-term interest rates in the United States as compared to 2004.
Fixed maturity investments as of December 31, 2006 were as follows. Dollar amounts are in millions.
All U.S. government obligations are rated AAA by the major rating agencies and 96% of all state, municipal and political subdivisions, foreign government obligations and mortgage-backed securities were rated AA or higher. Non-investment grade securities represent securities that are rated below BBB- or Baa3.
Net of minority interests and includes interest earned by Berkshire (net of related income taxes). Also includes additional income tax charges of $49 million and $15 million in 2005 and 2004, respectively, related to Berkshire’s accounting for MidAmerican under the equity method.
Berkshire’s 2005 and 2004 Consolidated Financial Statements reflect Berkshire’s share of MidAmerican’s net earnings as determined under the equity method. In 2006, MidAmerican’s revenues and expenses are consolidated in Berkshire’s financial statements. For comparative purposes, revenues and earnings of MidAmerican for 2005 and 2004 are provided in the table above. Revenues and earnings of the utilities and energy businesses are, to some extent, seasonal depending on weather-induced demand. Revenues from U.S. electricity sales are generally higher in the summer when air conditioning use is greatest and revenues from gas sales and pipelines are generally higher in the winter when heating needs are higher. Real estate brokerage revenues tend to be highest in the second and third quarters.
Energy Company (“MEC”) of $3,519 million increased $319 million (10%) as compared to 2005. Major factors giving rise to MEC’s revenue increase were a change in strategy related to certain end use natural gas contracts that resulted in revenues and costs being recorded on a gross rather than net basis and higher wholesale electricity sales due to both price and volume increases. Somewhat offsetting these increases were lower natural gas sales due to mild temperatures in 2006. EBIT of MEC increased $60 million (21%) as compared to 2005. About 2/3 of the increase was due to improved margins on regulated electricity sales.
EBIT from other activities of $226 million in 2006 increased $111 million as compared to 2005. Most of this increase arose from a gain on the sale of a security that was received in connection with a bankruptcy claim award as well as from sales of other investments. In 2004, EBIT includes an impairment charge of $579 million related to the discontinuance of the operations of MidAmerican’s mineral extraction facility.
Shaw Industries (“Shaw”) is the world’s largest manufacturer of tufted broadloom carpets and is a full-service flooring company. Shaw’s revenues of $5,834 million in 2006 increased $111 million (2%) and pre-tax earnings of $594 million in 2006 increased $109 million (22%) as compared to 2005. The increase in revenues reflected a 7% increase in average selling price for carpet, partially offset by a 6% reduction in square yards sold. The comparative decline in 2006 square yards sold versus 2005 accelerated during the third and fourth quarters, which is attributed to a slowing of single-family housing construction and the acceleration of customer purchases during the second half of 2005 in anticipation of price increases. The increase in pre-tax earnings was primarily generated in the first six months of the year and was mainly attributable to a reduction in manufacturing
cost per unit deriving from the integration of carpet backing and nylon-fiber manufacturing operations acquired by Shaw in the fourth quarter of 2005. These two acquisitions allow Shaw to internally produce most of its carpet backing needs and to secure a more stable raw material source. As a result of the continued slowdown in housing construction activity, the decline in volume is expected to continue at least during the first half of 2007.
Berkshire’s other manufacturing businesses include a wide array of businesses. Included in this group are several manufacturers of building products (Acme Building Brands, Benjamin Moore, Johns Manville and MiTek) and apparel (Fruit of the Loom, Garan, Russell Corporation, Fechheimers, Justin Brands and the H.H. Brown Shoe Group). Also included in this group are Forest River, a leading manufacturer of leisure vehicles that was acquired on August 31, 2005 and the Iscar Metalworking Companies (“IMC”), an industry leader in the metal cutting tools business with operations worldwide that was acquired on July 5, 2006. Additionally, there are numerous other manufacturers of consumer and commercial products in this diverse group.
Revenues from this group of manufacturing businesses of $11,988 million in 2006 increased $2,728 million (29%) and pre-tax earnings of $1,756 million in 2006 increased $421 million (32%) as compared to 2005. The acquisitions of Forest River in August 2005, IMC in July 2006 and Russell Corporation in August 2006 account for a substantial portion of these increases. Revenues from other manufacturing businesses of $9,260 million in 2005 increased $1,108 million (14%) and pre-tax earnings increased $175 million (15%) as compared to 2004. The aforementioned acquisition of Forest River accounted for a significant portion of the increase. Additionally, the building products group of businesses reported significant increases in revenues and pre-tax earnings in both 2006 and 2005 as compared to the prior year. However, due to the continued slowdown in housing construction activity in the United States, earnings of the building products businesses are expected to be negatively impacted in 2007 as compared to 2006.
Revenues from the service businesses of $5,811 million in 2006 increased $1,083 million (23%) and pre-tax earnings of $658 million in 2006 increased $329 million (100%) as compared to 2005. The largest portion of these increases arose from greatly improved comparative operating results at NetJets where revenues increased $759 million over 2005. NetJets generated pre-tax earnings of $143 million in 2006 as compared to a pre-tax loss of $80 million in 2005 reflecting a 23% increase in flight operations and management service revenues and increased fractional aircraft sales. In 2006, occupied flight hours increased 19% and average hourly rates increased as well. The number of aircraft managed within the NetJets program over the past twelve months increased 13%. The improvement in operating results at NetJets also reflected a substantial decline in subcontracted flights that are necessary to meet peak customer demand, which resulted in a $77 million improvement in pre-tax earnings. Comparative results in 2006 also benefited from the inclusion of Business Wire which was acquired in February 2006 as well as comparative increases in revenues and earnings for FlightSafety.
Revenues from the retailing group of $3,111 million in 2005 increased $175 million (6%) and pre-tax earnings of $257 million in 2005 increased $42 million (20%) in 2005 as compared to 2004. Same store sales as well as new stores opened at R.C. Willey and Jordan’s and increased earnings at See’s contributed to these favorable comparative results.
A summary of revenues and pre-tax earnings from Berkshire’s finance and financial products businesses follows. Amounts are in millions.
Investment gains or losses are recognized upon the sales of investments or as otherwise required under GAAP. The timing of realized gains or losses from sales can have a material effect on periodic earnings. However, such gains or losses usually have little, if any, impact on total shareholders’ equity because most equity and fixed maturity investments are carried at fair value, with the unrealized gain or loss included as a component of other comprehensive income. Other-than-temporary impairment losses represent the adjustment of cost to fair value when, as required by GAAP, management concludes that an investment’s decline in value below cost is other than temporary. The impairment loss represents a non-cash charge to earnings.
For many years, Berkshire held an investment in common stock of The Gillette Company (“Gillette”). On October 1, 2005, The Procter & Gamble Company (“PG”) completed its acquisition of Gillette and issued 0.975 shares of its common stock for each outstanding share of Gillette common stock. Berkshire recognized a non-cash pre-tax investment gain of approximately $5 billion upon the exchange of the Gillette shares for PG shares. Berkshire’s management does not regard the gain that was recorded, as required by GAAP, as meaningful. Berkshire intends to hold the shares of PG just as it held the Gillette shares. The gain recognized for financial reporting purposes is deferred for income tax purposes. The transaction essentially had no effect on Berkshire’s consolidated shareholders’ equity because the gain included in earnings in the fourth quarter of 2005 was accompanied by a corresponding reduction of unrealized investment gains included in accumulated other comprehensive income.
In 2004 and 2005, life settlement investments were carried at the cash surrender value pursuant to FASB Technical Bulletin (“FTB”) 85-4 “Accounting for Purchases of Life Insurance.” The excess of the cash paid to purchase these contracts over the cash surrender value at the date of purchase was recognized as a loss immediately and periodic maintenance costs, such as premiums necessary to keep the underlying policies in force, were charged to earnings. Effective January 1, 2006, Berkshire adopted the new accounting pronouncement FTB 85-4-1 and elected to use the investment method, whereby the aforementioned costs were capitalized. The cumulative effect of the accounting change which increased the carrying value of the contracts owned as of the adoption date was recorded, net of applicable income tax, as an increase to retained earnings of $180 million. In 2006, Berkshire disposed of most of the life settlement contracts. The excess of the proceeds over the carrying value of the contracts disposed of represents most of the gain from these contracts in 2006.
Over the past three years, Berkshire has also entered into several other derivative contracts pertaining to credit default risks of other entities as well as equity price risk associated with major equity indices. Such contracts are carried at estimated fair value and the change in estimated fair value is included in earnings in the period of the change. Other derivative contract gains in 2006 derived primarily from credit default contracts. Management attributes the gains to tightening of interest rate spreads and market perceptions that the creditworthiness of many of the underlying credit issuers has improved.
During 2006, Berkshire made several business acquisitions for aggregate cash consideration of $10.1 billion. See Note 3 to the Consolidated Financial Statements for more information concerning these acquisitions. Berkshire maintains a large amount of capital in its insurance subsidiaries for strategic purposes and in support of reserves for unpaid losses. In the United States, in particular, dividend payments by insurance companies are subject to prior approval by state regulators. For the year ending December 31, 2006, Berkshire’s insurance subsidiaries paid dividends of $7.1 billion.
Capital expenditures of the utilities and energy businesses were $2.4 billion in 2006. Capital expenditures, construction and other development costs for the year ending December 31, 2007 are forcasted to be approximately $3.0 billion. MidAmerican expects to fund these capital expenditures with cash flows from operations and the issuance of debt. MidAmerican utilizes debt to finance the construction of long-lived regulated electric and gas utility assets, including power plants, transmission and distribution assets and natural gas pipelines and may also issue debt to finance operations. Certain borrowings of its regulated utility subsidiaries are secured by the assets of those subsidiaries. As of December 31, 2006, outstanding debt of MidAmerican maturing in 2007 and 2008 was $3.6 billion, with an additional $1.7 billion due before 2012. During 2006, Berkshire made a five year commitment to provide up to $3.5 billion of additional capital to MidAmerican to permit the repayment of its debt obligations or to fund its regulated utility subsidiaries. Berkshire has not and does not intend to guarantee the repayment of debt by MidAmerican or any of its subsidiaries.
Berkshire and its subsidiaries are parties to contracts associated with ongoing business and financing activities, which will result in cash payments to counterparties in future periods. Notes payable are reflected in the Consolidated Financial Statements along with accrued but unpaid interest as of the balance sheet date. In addition, Berkshire is obligated to pay interest under debt obligations for periods subsequent to the balance sheet date. Although certain principal balances may be prepaid in advance of the maturity date, thus reducing future interest obligations, it is assumed that no principal prepayments will occur for purposes of this disclosure. Further, while short-term borrowings and repurchase agreements are currently expected to be renewed as they mature, such amounts are not assumed to renew for purposes of this disclosure.
Berkshire and subsidiaries are also parties to long-term contracts to acquire goods or services in the future, which are not currently reflected in the financial statements. Such obligations, including future minimum rentals under operating leases, will be reflected in future periods as the goods are delivered or services provided. Amounts due as of the balance sheet date for purchases where the goods and services have been received and a liability incurred are not included to the extent that such amounts are due within one year of the balance sheet date.
A summary of long-term contractual obligations as of December 31, 2006 follows. Amounts represent estimates of gross undiscounted amounts payable over time. In addition, certain losses and loss adjustment expenses for property and casualty loss reserves are ceded to others under reinsurance contracts and therefore are recoverable. Such recoverables are not reflected in the table. Amounts are in millions.
Certain accounting policies require management to make estimates and judgments concerning transactions that will be settled several years in the future. Amounts recognized in the financial statements from such estimates are necessarily based on numerous assumptions involving varying and potentially significant degrees of judgment and uncertainty. Accordingly, the amounts currently reflected in the financial statements will likely increase or decrease in the future as additional information becomes available.
Berkshire records liabilities for unpaid losses and loss adjustment expenses under property and casualty insurance and reinsurance contracts based upon estimates of the ultimate amounts payable under the contracts with respect to losses occurring on or before the balance sheet date. Depending on the type of loss being estimated, the timing and amount of loss payments are subject to a great degree of variability and are contingent, among other things, upon the timing of the claim reporting from insureds and cedants and the determination and payment of the ultimate loss amount through the loss adjustment process. A variety of techniques are used to establish and review the liabilities for unpaid losses recorded as of the balance sheet date. While techniques may vary, significant judgments and assumptions are necessary in projecting the ultimate amount payable in the future with respect to loss events that have occurred. As a result, uncertainties are imbedded in and permeate the actuarial loss reserving techniques and processes for all of Berkshire’s property and casualty insurance and reinsurance businesses.
GEICO predominantly writes private passenger auto insurance which has a relatively short claim-tail. Accordingly, the risk of estimation error is thought to be much less at GEICO than for either General Re or BHRG. The key assumptions affecting GEICO’s reserves include projections of ultimate claim counts (“frequency”) and average loss per claim (“severity”), which includes loss adjustment expenses.
Actuaries establish and evaluate unpaid loss reserves using recognized standard statistical loss development methods and techniques. The significant reserve components (and percentage of gross reserves) are: (1) average reserves (20%), (2) case and case development reserves (50%), and (3) IBNR reserves (30%). Each component of loss reserves is affected by the expected frequency and average severity of claims. Such amounts are analyzed using statistical techniques on historical claims data and adjusted when appropriate to reflect perceived changes in loss patterns. Data is analyzed by policy coverage, rated state, reporting date and occurrence date, among other factors. A brief discussion of each component follows.
Average reserve amounts are established for reported auto damage claims and new liability claims prior to the development of an individual case reserve. The average reserves are established as a reasonable estimate for incurred claims for which claims adjusters have insufficient time and information to make a specific claim estimate. It also includes a large number of minor physical damage claims that are paid within a reasonably short time after being reported. Average reserve amounts are driven by the estimated average severity per claim and the number of new claims opened. The average severity per claim amount is developed by projecting the ultimate severity for each accident quarter and weighting with both reported claims and estimated unreported claims.
Claims adjusters generally establish individual liability claim case loss and loss adjustment expense reserve estimates as soon as the specific facts and merits of each claim can be evaluated. Case reserves represent the amounts that in the judgment of the adjusters are reasonably expected to be paid in the future to completely settle the claim, including expenses. Individual case reserves are revised as more information becomes known.
For most liability coverages, case reserves alone are an insufficient measure of the ultimate cost due in part to the longer claim-tail, the greater chance of protracted litigation and the incompleteness of facts available at the time the case reserve is established. Therefore, additional case development reserve estimates are established, usually as a percentage of the case reserve. As of December 31, 2006, case development reserves averaged approximately 20% of total established case reserves. In general, case development factors are selected by a retrospective analysis of the overall adequacy of historical case reserves. Case development factors are reviewed and revised periodically.
In 2006, claim frequencies were generally lower than expected and severity increases were generally not as great as originally projected. Loss reserve estimates recorded at the end of 2005 developed downward by approximately $410 million when reevaluated at December 31, 2006 producing a corresponding increase to pre-tax earnings in 2006. These downward reserve developments represented approximately 4% of earned premiums in 2006 and approximately 7% of the prior year-end reserve amount. Reserving assumptions at December 31, 2006 were modified appropriately to reflect the most recent frequency and severity results. Future reserve development will depend on whether frequency and severity turn out to be more or less than anticipated. Within the automobile line of business the reserves with the most uncertainty are for automobile liability, due to the longer claim-tails for most of these coverages. Approximately 90% of GEICO’s reserves as of December 31, 2006 were for automobile liability, of which bodily injury (“BI”) coverage accounted for nearly 60% of the automobile liability reserves. Management believes it is reasonably possible that the average BI severity will change by at least one percentage point from the severity used. If actual BI severity changes one percentage point from what was used in establishing the reserves, the reserves would develop up or down by approximately $90 million resulting in a corresponding decrease or increase in pre-tax earnings. Many of the same economic forces that would likely cause BI severity to be different from expected would likely also cause severities for other injury coverages to differ in the same direction.
GEICO’s exposure to highly uncertain losses is believed to be limited to certain commercial excess umbrella policies written during a period from 1981 to 1984. Remaining reserves associated with such exposure are currently a relatively insignificant component of GEICO’s total reserves (less than 3%) and there is little, if any, apparent asbestos or environmental liability exposure. Related claim activity over the past year was insignificant.
General Re’s and BHRG’s property and casualty loss reserves derive primarily from assumed reinsurance. Additional uncertainties unique to loss reserving processes for reinsurance are described below. The nature, extent, timing and perceived reliability of information received from ceding companies varies widely depending on the type of coverage, the contractual reporting terms (which are affected by market conditions and practices) and other factors. Due to the lack of standardization of the terms and conditions of reinsurance contracts, the wide variability of coverage needs of individual clients and the tendency for those needs to change rapidly in response to market conditions, the ongoing economic impact of such uncertainties, in and of themselves, cannot be reliably measured.
The timing of claim reporting to reinsurers is delayed in comparison with primary insurance. In some instances there are multiple reinsurers assuming and ceding parts of an underlying risk causing multiple contractual intermediaries between General Re or BHRG and the primary insured. In these instances, the delays in reporting can be compounded. The relative impact of reporting delays on the reinsurer varies depending on the type of coverage, contractual reporting terms and other factors. Contracts covering casualty losses on a per occurrence excess basis may experience longer delays in reporting due to the length of the claim tail as regards to the underlying claim. In addition, ceding companies may not report claims to the reinsurer until it becomes reasonably possible that the reinsurer will be affected, usually determined as a function of its estimate of the claim amount as a percentage of the reinsurance contract retention. On the other hand, the timing of reporting large per occurrence excess property losses or property catastrophe losses may not vary significantly from primary insurance.
Under contracts where periodic premium and claims reports are required from ceding companies, such reports are generally required at quarterly intervals which in the U.S. range from 30 to 90 days after the end of the accounting period. In continental Europe, reinsurance reporting practices vary. Fewer clients report premiums, losses, and case reserves on a quarterly basis. In certain countries, clients report on an annual basis and generally not until 90 to 180 days after the end of the annual period. Estimates of premiums and losses are accrued based on expected results supplemented when necessary for estimates of significant known events occurring in the interim. To monitor the timing and receipt of information due, client reporting requirements are tracked. When clients miss reporting deadlines, the clients are contacted.
Premium and loss data is provided through at least one intermediary (the primary insurer), so there is a greater risk that the loss data provided is incomplete, inaccurate or outside the coverage terms. Information provided by ceding companies is reviewed for completeness and compliance with the contract terms. Reinsurance contracts generally allow for Berkshire’s reinsurance subsidiaries to have access to the cedant’s books and records as regards to the subject business and provide them the ability to conduct audits to determine the accuracy and completeness of information. Such audits are conducted when management deems it appropriate.
In the regular course of business, disputes with clients may arise concerning whether certain claims are covered under the reinsurance policies. Most disputes are resolved by the claims departments by discussing coverage aspects with the appropriate client personnel or independent outside counsel review and determination. If disputes cannot be resolved, contracts generally specify whether arbitration, litigation, or alternative dispute resolution will be invoked. There are no coverage disputes at this time for which an adverse resolution would likely have a material impact on Berkshire’s results of operations or financial condition.
General Re’s gross and net unpaid losses and loss adjustment expenses and gross reserves by major line of businesses as of December 31, 2006 are summarized below. Amounts are in millions.
The company does not routinely determine loss reserve ranges because it believes that the techniques necessary have not sufficiently developed and the myriad of assumptions required render such resulting ranges to be unreliable. In addition, counts of claims or average amounts per claim are not utilized because clients do not consistently provide reliable data in sufficient detail.
Actuaries classify all loss and premium data into segments (reserve cells) primarily based on product (e.g., treaty, facultative, and program) and line of business (e.g., auto liability, property, etc.). For each reserve cell, losses are aggregated by accident year and analyzed over time. Depending on client reporting practices, some losses and premiums are aggregated by policy year. These loss aggregations are internally called loss triangles, which serve as the primary basis for IBNR reserve calculations. Over 300 reserve cells are reviewed for North American business and approximately 900 reserve cells are reviewed with respect to international business.
IBNR reserves are estimated by reserve cell, by accident year, using the expected loss emergence patterns and the expected loss ratios. The expected loss emergence patterns and expected loss ratios are the critical IBNR reserving assumptions and are updated annually. Once the annual IBNR reserves are determined, actuaries calculate expected case loss emergence for the upcoming calendar year. This calculation does not involve new assumptions and uses the prior year-end expected loss emergence patterns and expected loss ratios. The expected losses are then allocated into interim estimates that are compared to actual reported losses in the subsequent year. This comparison provides a test of the adequacy of prior year-end IBNR reserves and forms the basis for possibly changing IBNR reserve assumptions during the course of the year.
Other casualty and general liability reported losses (excluding mass tort losses) were favorable in 2006 relative to expectations after several years of relatively higher reported losses. Casualty losses tend to be long-tail and it should not be assumed that favorable loss experience in a single year (2006) means that loss reserve amounts currently established will continue to develop favorably. For General Re’s significant other casualty and general liability reserve cells (including medical malpractice, umbrella, auto and general liability), an increase of five points in the tails of the expected emergence patterns and an increase of five percent in expected loss ratios would produce a net increase in nominal IBNR reserves and a corresponding reduction in pre-tax earnings of approximately $550 million. Management believes it is reasonably possible for the tail of the expected loss emergence patterns and expected loss ratios to increase at these rates in any of the aforementioned reserve cells. However, given the diversification in worldwide business, more likely outcomes are believed to be less than $550 million.
Property losses were lower than expected (including losses related to the World Trade Center) but the nature of property loss experience tends to be more volatile because of the effect of catastrophes and large individual property losses. In response to favorable claim developments and another year of information, estimated remaining World Trade Center losses were reduced by $62 million in 2006, producing a corresponding increase in pre-tax earnings.
As of December 31, 2006, BHRG’s gross loss reserves related to retroactive reinsurance policies were attributed to casualty losses. Retroactive policies include excess-of-loss contracts, in which losses (relating to loss events occurring before a specified date on or before the contract date) above a contractual retention are indemnified or contracts that indemnify all losses paid by the counterparty after the policy effective date. Retroactive losses paid in 2006 were $858 million, essentially all of which pertained to pre-2006 contracts. The classification “reported case reserves” has no practical analytical value with respect to retroactive policies since the amount is often derived from reports in bulk from ceding companies, who may have inconsistent definitions of “case reserves.” Reserves are reviewed and established in the aggregate by contract including provisions for IBNR reserves.
BHRG’s liabilities for environmental, asbestos, and latent injury losses and loss adjustment expenses are presently concentrated within retroactive reinsurance contracts. Reserves for such losses were approximately $3.8 billion at December 31, 2006 and $4.0 billion at December 31, 2005. Losses paid in 2006 were approximately $300 million. BHRG, as a reinsurer, does not regularly receive reliable information regarding numbers of asbestos, environmental and latent injury claims from ceding companies on a consistent basis, particularly with respect to multi-line treaty or aggregate excess of loss policies. Periodically, a ground-up analysis of the underlying loss data of the reinsured is conducted to make an estimate of ultimate reinsured losses. When detailed loss information is unavailable, estimates can only be developed by applying recent industry trends and projections to aggregate client data. Judgments in these areas necessarily include the stability of the legal and regulatory environment under which these claims will be adjudicated. The increasing number of bankruptcies of asbestos manufacturers has adversely impacted trends in recent years. Potential legal reform and legislation could also have a significant impact on establishing loss reserves for mass tort claims in the future.
Berkshire’s Consolidated Balance Sheet as of December 31, 2006 includes goodwill of acquired businesses of approximately $32.2 billion. 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. There are several methods of estimating a reporting unit’s fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted projected future net earnings and multiples of earnings. 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.
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 risk. 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.
Strategically, Berkshire strives to invest in businesses that possess excellent economics, with able and honest management and at sensible prices. Berkshire’s management prefers to invest a meaningful amount in each investee. Accordingly, Berkshire’s equity investments are generally concentrated in relatively few investees. At December 31, 2006, 54% of the total fair value of equity investments was concentrated in four investees.
The table which follows summarizes Berkshire’s equity price risk as of December 31, 2006 and 2005 and shows the effects of a hypothetical 30% increase and a 30% decrease in market prices as of those dates. The selected hypothetical change does not reflect what could be considered the best or worst case scenarios. Indeed, results could be far worse due both to the nature of equity markets and the aforementioned concentrations existing in Berkshire’s equity investment portfolio. Dollars are in millions.
Market risks associated with changes in foreign currency exchange rates are currently concentrated in a portfolio of long duration equity index option contracts on foreign equity indexes. In 2005, Berkshire also had significant exposure to foreign currency risk from a portfolio of short duration forward contracts. The aggregate notional value of forward contracts was approximately $1 billion as of December 31, 2006 compared to approximately $13.8 billion as of December 31, 2005.
Berkshire, through its ownership of MidAmerican, is subject to commodity risk. Exposures include variations in the price of wholesale electricity that is purchased and sold, fuel costs to generate electricity, and natural gas supply for regulated retail gas customers. Electricity and natural gas prices are subject to wide price swings as demand responds to, among many other items, changing weather, limited storage, transmission and transportation constraints, and lack of alternative supplies from other areas. To mitigate a portion of the risk, MidAmerican uses derivative instruments, including forwards, futures, options, swaps and other over-the-counter agreements, to effectively secure future supply or sell future production at fixed prices. The settled cost of these contracts is generally recovered from customers in regulated rates. Accordingly, the net unrealized gains and losses associated with interim price movements on such contracts are recorded as regulatory assets or liabilities. Financial results may be negatively impacted if the costs of wholesale electricity, fuel and or natural gas are higher than what is permitted to be recovered in rates. MidAmerican also uses futures, options and swap agreements to economically hedge gas and electric commodity prices for physical delivery to non-regulated customers. MidAmerican does not engage in a material amount of proprietary trading activities.
The table that follows summarizes Berkshire’s commodity risk on energy derivative contracts as of December 31, 2006 and shows the effects of a hypothetical 10% increase and a 10% decrease in forward market prices by the expected volumes for these contracts as of that date. The selected hypothetical change does not reflect what could be considered the best or worst case scenarios. Dollars are in millions.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Berkshire Hathaway Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 18 to the consolidated financial statements, as of December 31, 2006, the Company changed its accounting for pensions and other postretirement benefits to conform to Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R).
The balance at beginning of 2006 includes $358 million related to MidAmerican.
Berkshire Hathaway Inc. (“Berkshire” or “Company”) is a holding company owning subsidiaries engaged in a number of diverse business activities, including property and casualty insurance and reinsurance, utilities and energy, finance, manufacturing, retailing and services. Further information regarding these businesses and Berkshire’s reportable business segments is contained in Note 20. Berkshire consummated a number of business acquisitions over the past three years which are discussed in Note 3.
The preparation of the Consolidated Financial Statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the period. In particular, estimates of unpaid losses and loss adjustment expenses and related recoverables under reinsurance for property and casualty insurance are subject to considerable estimation error due to the inherent uncertainty in projecting ultimate claim amounts that can be reported and settled over a period of many years. In addition, estimates and assumptions associated with the amortization of deferred charges reinsurance assumed, the determination of fair value of certain invested assets and related impairments and the determination of goodwill impairments require considerable judgment by management. Actual results may differ from the estimates used in preparing the Consolidated Financial Statements.
Cash equivalents consist of funds invested in U.S. Treasury Bills, money market accounts, and in other investments with a maturity of three months or less when purchased. Cash and cash equivalents exclude amounts where availability is restricted by loan agreements or other contractual provisions. Restricted amounts are included in other assets.
Berkshire’s management determines the appropriate classifications of investments in fixed maturity and equity securities at the acquisition date 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 securities held by finance businesses which are classified as held-to-maturity.
Investment gains and losses arise when investments are sold (as determined on a specific identification basis) or are other-than-temporarily impaired. If in management’s judgment a decline in the value of an investment below cost is other than temporary, the cost of the investment is written down to fair value with a corresponding charge to earnings. Factors considered in judging whether an impairment is other than temporary include: the financial condition, business prospects and creditworthiness of the issuer, the length of time that fair value has been less than cost, the relative amount of the decline, and Berkshire’s ability and intent to hold the investment until the fair value recovers.
In applying the equity method, investments are recorded at cost and subsequently increased or decreased by Berkshire’s proportionate share of the net earnings or losses of the investee. Berkshire also records its proportionate share of other comprehensive income items of the investee as a component of its comprehensive income. Dividends or other equity distributions are recorded as a reduction of the investment. In the event that net losses of the investee have reduced the equity method investment to zero, additional net losses may be recorded if other investments in the investee are at-risk, even if Berkshire has not committed to provide financial support to the investee. Berkshire bases such additional equity method loss amounts, if any, on the change in its claim on the investee’s book value.
Berkshire carries derivative contracts at estimated fair value classified as assets or liabilities in the accompanying Consolidated Balance Sheets. Such balances reflect reductions permitted under master netting agreements with counterparties. The fair values of these instruments generally represent the present value of estimated future cash flows under the contracts, which are a function of current underlying interest rates, currency rates, security values, related volatility, counterparty creditworthiness and duration of the contracts. Changes in these factors or a combination thereof may affect the fair value of these instruments.
The changes in fair value of derivative contracts that do not qualify as hedging instruments for financial reporting purposes are included in the Consolidated Statements of Earnings as derivative gains/losses.
Property, plant and equipment is recorded at cost. The cost of major additions and betterments are capitalized, while replacements, maintenance and repairs that do not improve or extend the useful lives of the related assets are expensed as incurred. Interest over the construction period is capitalized as a component of cost of constructed assets. In addition, the cost of constructed assets of certain domestic regulated utility and energy subsidiaries that are subject to SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation” (“SFAS 71”) includes the capitalization of the estimated cost of capital in addition to interest incurred during the construction period. Also see Note 1(n).
Depreciation is provided principally on the straight-line method over estimated useful lives. Depreciation of assets of certain regulated utility and energy subsidiaries is provided over recovery periods based on composite asset class lives as mandated by regulation.
Property, plant and equipment is evaluated for impairment when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable, or the assets meet the criteria of held for sale. Upon the occurrence of a triggering event, the asset is reviewed to assess whether the estimated undiscounted cash flows expected from the use of the asset plus residual value from the ultimate disposal exceeds the carrying value of the asset. If the carrying value exceeds the estimated recoverable amounts, the asset is written down to the estimated discounted present value of the expected future cash flows from using the asset. Impairment losses are reflected in the Consolidated Statements of Earnings, except with respect to impairments of assets of certain domestic regulated utility and energy subsidiaries where losses are offset by the establishment of a regulatory asset to the extent recovery in future rates is probable.
Service revenues derive primarily from pilot training and flight operations and flight management activities. Service revenues are recognized as the services are performed. Services provided pursuant to a contract are either recognized over the contract period, or upon completion of the elements specified in the contract, depending on the terms of the contract.
Interest income from investments in bonds and loans is earned under the constant yield method and includes accrual of interest due under terms of the bond or loan agreement as well as amortization of acquisition premiums and accruable discounts. In determining the constant yield for mortgage-backed securities, anticipated counterparty prepayments are estimated and evaluated periodically. Dividends from equity securities are earned on the ex-dividend date.
Operating revenue of utilities and energy businesses resulting from the distribution and sale of natural gas and electricity to customers is recognized when the service is rendered or the energy is delivered. Amounts recognized include unbilled as well as billed amounts. Rates charged are generally subject to Federal and state regulation or established under contractual arrangements. When preliminary rates are permitted to be billed prior to final approval by the applicable regulator, certain revenue collected may be subject to refund and a provision for estimated refunds is accrued.
Changes to the expected timing and estimated amount of loss payments produce changes in the unamortized deferred charge balance. Such changes in estimates are determined retrospectively and included in insurance losses and loss adjustment expense in the period of the change.
Certain domestic energy subsidiaries prepare their financial statements in accordance with SFAS No. 71, reflecting economic effects deriving from the ability to recover certain costs from customers and the requirement to return revenues to customers in the future through the regulated rate-setting process. Accordingly, certain costs are deferred as regulatory assets and obligations are accrued as regulatory liabilities, which will be amortized over various future periods. At December 31, 2006, MidAmerican had $1,827 million in regulatory assets and $1,839 million in regulatory liabilities, which are components of other assets and other liabilities of utilities and energy businesses.
Management continually assesses whether the regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes, recent rate orders received by other regulated entities and the status of any pending or potential deregulation legislation. If future recovery of costs ceases to be probable, the amount no longer probable of recovery is charged to earnings.
Deferred income taxes are calculated under the liability method. Deferred tax assets and liabilities are based on differences between the financial statement and tax basis 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 and losses) 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. Valuation allowances have been established for certain deferred tax assets where realization is not likely.
In September 2006, the FASB issued FASB Staff Position No. AUG AIR-1, “Accounting for Planned Major Maintenance Activities” (“AUG AIR-1”). AUG AIR-1 prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in which such maintenance costs are ratably recognized by accruing a liability in periods before the maintenance is performed. This pronouncement also retains three alternative methods for accounting for planned major maintenance activities including the direct expensing method, the built-in overhaul method and the deferral method. AUG AIR-1 is effective for fiscal years beginning after December 15, 2006.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value as the price received to transfer an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date reflecting the highest and best use valuation concepts. SFAS 157 establishes a framework for measuring fair value by creating a hierarchy of fair value measurements currently required under GAAP that distinguishes market data between observable independent market inputs and unobservable market assumptions. SFAS 157 further expands disclosures about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and may be adopted earlier but only if the adoption is in the first quarter of the fiscal year.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits entities to elect to measure many financial instruments and certain other items at fair value. Upon adoption of SFAS No. 159, an entity may elect the fair value option for eligible items that exist at the adoption date. Subsequent to the initial adoption, the election of the fair value option should only be made at initial recognition of the asset or liability or upon a remeasurement event that gives rise to new-basis accounting. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value nor does it eliminate disclosure requirements included in other accounting standards. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 and may be adopted earlier but only if the adoption is in the first quarter of the fiscal year.
Berkshire is evaluating the impact that the adoption of these pronouncements will have on its consolidated financial position and currently does not anticipate that the adoption of these accounting pronouncements will have a material effect on its consolidated financial position.
MidAmerican owns a combined regulated electric and natural gas utility company in the United States (MidAmerican Energy Company), a regulated electric utility company in the United States (PacifiCorp which was acquired March 21, 2006), two interstate natural gas pipeline companies in the United States (Kern River and Northern Natural Gas), two electricity distribution companies in the United Kingdom (Northern Electric and Yorkshire Electricity), a diversified portfolio of domestic and international electric power projects and the second largest residential real estate brokerage firm in the United States (HomeServices). This group of businesses is referred to as “MidAmerican” or the “utilities and energy businesses.”
On February 9, 2006, Berkshire converted its non-voting preferred stock to common stock and upon conversion, owned approximately 83.4% (80.5% diluted) of the voting common stock interests. In conjunction with the acquisition of PacifiCorp, Berkshire acquired additional common stock of MidAmerican for $3.4 billion. Berkshire’s ownership in MidAmerican as of December 31, 2006 was 87.8% (86.6% diluted). Accordingly, the 2006 Consolidated Financial Statements reflect the consolidation of the accounts of MidAmerican. MidAmerican’s debt obligations are not guaranteed by Berkshire. However, Berkshire has made a commitment until February 28, 2011 that would allow MidAmerican to request up to $3.5 billion of capital to pay its debt obligations or to provide funding to its regulated subsidiaries.
A condensed consolidated balance sheet as of December 31, 2005 and condensed statements of earnings for the years ending December 31, 2005 and 2004 of MidAmerican are as follows (in millions).
On June 30, 2005, Berkshire acquired Medical Protective Corporation (“MedPro”) from GE Insurance Solutions. MedPro is one of the nation’s premier professional liability insurers for physicians, dentists and other primary health care providers. On August 31, 2005, Berkshire acquired Forest River, Inc., (“Forest River”) a leading manufacturer of leisure vehicles in the U.S. Forest River manufactures a complete line of motorized and towable recreational vehicles, utility trailers, buses, boats and manufactured houses. Operating results of MedPro and Forest River are consolidated with Berkshire’s results beginning as of July 1, 2005 and September 1, 2005, respectively. Inclusion of MedPro’s and Forest River’s results as of the beginning of 2004 would not have materially impacted Berkshire’s consolidated results of operations as reported. Aggregate consideration paid for all business acquisitions completed during 2005, including smaller acquisitions directed by certain Berkshire subsidiaries, was $2.4 billion.
On July 5, 2006, Berkshire acquired 80% of the Iscar Metalworking Companies (“IMC”) for cash in a transaction that valued IMC at $5 billion. IMC, headquartered in Israel, is an industry leader in the metal cutting tools business through its Iscar, TaeguTec, Ingersoll and other IMC companies. IMC provides a comprehensive range of tools for the full scope of metalworking applications. IMC’s products are manufactured through a global network of world-class, technologically advanced manufacturing facilities located in Israel, Korea, the United States, Brazil, China, Germany, India, Italy and Japan, and are sold through subsidiary offices and agents located in 61 major industrial countries worldwide. On August 2, 2006, Berkshire acquired Russell Corporation, a leading branded athletic apparel and sporting goods company for cash of approximately $600 million.
The results of operations for each of these businesses are included in Berkshire’s consolidated results from the effective date of each acquisition. The following table sets forth certain unaudited pro forma consolidated earnings data for 2006 and 2005, as if each acquisition that was completed during 2005 and 2006 was consummated on the same terms at the beginning of each year. The earnings data for 2005 also reflects the pro forma consolidation of MidAmerican. Amounts are in millions, except per share amounts.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition for PacifiCorp and IMC (in millions).
In December 2006, Berkshire agreed to acquire TTI, Inc., a privately held electronic component distributor headquartered in Fort Worth, Texas. TTI, Inc. is the largest distributor specialist of passive, interconnect electromechanical components. The acquisition is expected to be completed in the first quarter of 2007.
Allowances for uncollectible loans primarily relate to consumer installment loans. Provisions for consumer loan losses were $210 million in 2006 and $232 million in 2005. Loan charge-offs were $243 million in 2006 and $110 million in 2005. Consumer loan amounts are net of acquisition discounts of $484 million at December 31, 2006 and $579 million at December 31, 2005.
Investments in securities with fixed maturities as of December 31, 2006 and 2005 are shown below (in millions).
The amortized cost and estimated fair values of securities with fixed maturities at December 31, 2006 are summarized below by contractual maturity dates. Actual maturities will differ from contractual maturities because issuers of certain of the securities retain early call or prepayment rights. Amounts are in millions.
Gross gains from sales and other disposals of equity securities during 2005 includes a $5.0 billion gain on the exchange of The Gillette Company common shares for common shares of The Procter and Gamble Company.
The FASB issued Staff Position No. FTB 85-4-1, “Accounting for Life Settlement Contracts by Third-Party Investors” (“FTB 85-4-1”) in 2006, which provides guidance on the initial and subsequent measurement, financial statement presentation and disclosures for third-party investors in life settlement contracts. Berkshire adopted FTB 85-4-1 as of January 1, 2006, and recorded an after-tax gain of $180 million which is reflected as an increase in retained earnings. Berkshire elected to use the investment method whereby the initial transaction price plus all subsequent direct external costs paid to keep the policy in force are capitalized. Death benefits received are applied against the capitalized costs and the difference is recorded in earnings. Previously, life settlement contracts were valued at the cash surrender value of the underlying insurance policy. During the second quarter of 2006, certain life settlement contracts were disposed of for proceeds of approximately $330 million. Investments in life settlement contracts as of December 31, 2006 were insignificant.
A reconciliation of the change in the carrying value of goodwill for 2006 and 2005 is as follows (in millions).
Property, plant and equipment of insurance and other businesses is comprised of the following (in millions):
The utility generation and distribution system and interstate pipeline assets are the regulated assets of public utility and natural gas pipeline subsidiaries. At December 31, 2006 and December 31, 2005, accumulated depreciation and amortization related to regulated assets was $11.9 billion and $5.7 billion, respectively. Substantially all of the construction in progress at December 31, 2006 and December 31, 2005 related to the construction of regulated assets.
Berkshire utilizes derivatives in order to manage certain economic risks of its businesses as well as to assume specified amounts of market risk from others. The contracts summarized in the preceding table, with limited exceptions, are not designated as hedges for financial reporting purposes. Changes in the fair values of derivative assets and derivative liabilities that do not qualify as hedges are reported in the Consolidated Statements of Earnings as derivative gains/losses. Since January 2002, the operations of General Re Securities (“GRS”) have been in run-off. As of December 31, 2006, substantially all of GRS’s derivative risks (as measured by the gross notional value) that existed as of the commencement of the run-off have been liquidated.
Berkshire is also exposed to variations in the market prices of natural gas and electricity as a result of its regulated utility operations and uses derivative instruments, including forward purchases and sales, futures, swaps and options to manage these commodity price risks. Derivative instruments are recorded in the Consolidated Balance Sheets at fair value as either assets or liabilities unless they are designated as and qualify for normal purchases and normal sales exemptions under GAAP. The majority of these contracts are either probable of recovery in rates and therefore recorded as a regulatory net asset or liability or are accounted for as cash flow hedges and therefore recorded as accumulated other comprehensive income. Accordingly, amounts are generally not recognized in earnings until the contracts are settled.
Fair values and gross notional values of open derivative contracts of utilities and energy businesses as of December 31, 2006 follow (in millions).
Notional values associated with commodity and weather-related derivatives are not presented due to the unique units of measure pertinent to such contracts. Notional values for commodity and weather contracts are not stated in terms of dollars.
The balances of unpaid losses and loss adjustment expenses are based upon estimates of the ultimate claim costs associated with property and casualty claim occurrences as of the balance sheet dates including estimates for incurred but not reported (“IBNR”) claims. Considerable judgment is required to evaluate claims and establish estimated claim liabilities.
arising from retroactive contracts with exposure to claims of this nature are generally subject to aggregate policy limits. Thus, Berkshire’s exposure to environmental and latent injury claims under these contracts is, likewise, limited. 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 reliably estimate the amount of additional net loss or the range of net loss that is reasonably possible.
Commercial paper and other short-term borrowings are utilized by certain subsidiaries as part of normal operations. Weighted average interest rates as of December 31, 2006 and 2005 were 5.4% and 4.4%, respectively. Berkshire subsidiaries have approximately $4.2 billion of available unused lines of credit and commercial paper capacity to support their short-term borrowing programs and provide additional liquidity.
Operating subsidiary and project debt of utilities and energy businesses represents amounts issued by subsidiaries of MidAmerican pursuant to separate project financing agreements. All or substantially all of the assets of certain utility subsidiaries are or may be pledged or encumbered to support or otherwise provide security. These borrowing arrangements generally contain various covenants including, but not limited to, leverage ratios, interest coverage ratios and debt service coverage ratios. As of December 31, 2006, MidAmerican and its subsidiaries were in compliance with all applicable covenants.
Berkshire Hathaway Finance Corporation (“BHFC”), a wholly-owned subsidiary of Berkshire, issued senior notes at various times during the three years ending December 31, 2005. The proceeds were used in the financing of manufactured housing loan originations and portfolio acquisitions of Clayton Homes. During the fourth quarter of 2006, Clayton Homes borrowed approximately $1.3 billion whereby all principal and interest collected under certain manufactured housing loan portfolios, together with any repurchased principal on such loans will be used to pay the principal and interest on these borrowings. The expected weighted average life of the borrowings is approximately eight years. The proceeds from these borrowings which are not guaranteed by Berkshire will be used to repay certain debt of BHFC.
The liability for income taxes as of December 31, 2006 and 2005 as reflected in the accompanying Consolidated Balance Sheets is as follows (in millions).
Payments of dividends by insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, insurance subsidiaries may declare up to approximately $6.4 billion as ordinary dividends before the end of 2007.
Statutory surplus differs from the corresponding amount determined on the basis of GAAP. The major differences between statutory basis accounting and GAAP are that deferred charges reinsurance assumed, deferred policy acquisition costs, unrealized gains and losses on investments in fixed maturity securities and related deferred income taxes are recognized under GAAP but not for statutory reporting purposes. In addition, statutory accounting for goodwill of acquired businesses requires amortization of goodwill over 10 years, whereas under GAAP, goodwill is subject to periodic tests for impairment.
The estimated fair values of Berkshire’s financial instruments as of December 31, 2006 and 2005 are as follows (in millions).
In determining fair value of financial instruments, Berkshire used quoted market prices when available. For instruments where quoted market prices were not available, independent pricing services or appraisals by Berkshire’s management were used. Those
Changes in issued and outstanding Berkshire common stock during the three years ended December 31, 2006 are shown in the table below.
Each share of Class B common stock has dividend and distribution rights equal to one-thirtieth (1/30) of such rights of a Class A share. Accordingly, on an equivalent Class A common stock basis there are 1,542,649 shares outstanding as of December 31, 2006 and 1,540,723 shares as of December 31, 2005.
Benefit obligations under qualified U.S. defined benefit plans are funded through assets held in trusts and are not included as assets in Berkshire’s Consolidated Financial Statements. Pension obligations under certain non-U.S. plans and non-qualified U.S. plans are unfunded. As of December 31, 2006, projected benefit obligations of non-qualified U.S. plans and non-U.S. plans which are not funded through assets held in trusts were $569 million. A reconciliation of the changes in plan assets and a summary of plan assets held as of December 31, 2006 and 2005 is presented in the table that follows (in millions).
Benefit payments over the next ten years, which reflect expected future service as appropriate, are expected to be paid as follows (in millions): 2007 - $390; 2008 - $399; 2009 - $411; 2010 - $414; 2011 - $432; and 2012 to 2016 - $2,456.
Many Berkshire subsidiaries sponsor defined contribution retirement plans, such as 401(k) or profit sharing plans. Employee contributions to the plans are subject to regulatory limitations and the specific plan provisions. Berkshire subsidiaries may match these contributions up to levels specified in the plans, and may make additional discretionary contributions as determined by management. The total expenses related to employer contributions for these plans were $498 million, $395 million and $338 million for the years ended December 31, 2006, 2005 and 2004, respectively.
A summary of supplemental cash flow information for each of the three years ending December 31, 2006 is presented in the following table (in millions).
Underwriting excess-of-loss and quota-share reinsurance for property and casualty insurers and reinsurers
Underwriting multiple lines of property and casualty insurance policies for primarily commercial accounts
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Berkshire, General Re Corporation (“General Re”) and certain of Berkshire’s insurance subsidiaries, including General Reinsurance Corporation (“General Reinsurance”) and National Indemnity Company (“NICO”) have been continuing to cooperate fully with the U.S. Securities and Exchange Commission (“SEC”), the U.S. Department of Justice, the U.S. Attorney for the Eastern District of Virginia and the New York State Attorney General (“NYAG”) in their ongoing investigations of non-traditional products. General Re originally received subpoenas from the SEC and NYAG in January 2005. Berkshire, General Re, General Reinsurance and NICO have been providing information to the government relating to transactions between General Reinsurance or NICO (or their respective subsidiaries or affiliates) and other insurers in response to the January 2005 subpoenas and related requests and, in the case of General Reinsurance (or its subsidiaries or affiliates), in response to subpoenas from other U.S. Attorneys conducting investigations relating to certain of these transactions. In particular, Berkshire and General Re have been responding to requests from the government for information relating to certain transactions that may have been accounted for incorrectly by counterparties of General Reinsurance (or its subsidiaries or affiliates). Berkshire understands that the government is evaluating the actions of General Re and its subsidiaries, as well as those of their counterparties, to determine whether General Re or its subsidiaries conspired with others to misstate counterparty financial statements or aided and abetted such misstatements by the counterparties. The government has interviewed a number of current and former officers and employees of General Re and General Reinsurance as well as Berkshire’s Chairman and CEO, Warren E. Buffett, in connection with these investigations.
In June 2005, John Houldsworth, the former Chief Executive Officer of Cologne Reinsurance Company (Dublin) Limited (“CRD”), a subsidiary of General Re, and Richard Napier, a former Senior Vice President of General Re who had served as an account representative for the AIG account, each pleaded guilty to a federal criminal charge of conspiring with others to misstate certain AIG financial statements in connection with the AIG Transaction and entered into a partial settlement agreement with the SEC with respect to such matters. In addition, Ronald Ferguson, General Re’s former Chief Executive Officer, Elizabeth Monrad, General Re’s former Chief Financial Officer, Christopher Garand, a former General Reinsurance Senior Vice President and Robert Graham, a former General Reinsurance Senior Vice President and Assistant General Counsel - are awaiting trial in the U.S. District Court for the District of Connecticut on charges of conspiracy to violate securities laws and to commit mail fraud, securities fraud, making false statements to the SEC and mail fraud in connection with the AIG Transaction. The trial is currently set for December 2007. Each has pleaded not guilty to all charges. Each of these individuals, who had previously received a “Wells” notice in 2005 from the SEC, is also the subject of an SEC enforcement action for allegedly aiding and abetting AIG’s violations of the antifraud provisions and other provisions of the federal securities laws in connection with the AIG Transaction. The SEC case is presently stayed. Joseph Brandon, the Chief Executive Officer of General Re, also received a “Wells” notice from the SEC in 2005.
In November 2006, two subsidiaries of General Re, General Reinsurance UK Limited (“Gen Re UK”) and Kolnische Ruckversicherungs-Gesellschaft AG (“Cologne Re”), entered into a settlement agreement with the Financial Services Authority (“FSA”) with respect to the FSA’s previously disclosed investigation of the role of these entities in certain transactions that were alleged to involve no or insufficient risk transfer to be treated for accounting and regulatory purposes as reinsurance. Pursuant to the settlement agreement, Gen Re UK paid the FSA a penalty of $2.3 million.
Cologne Re is also cooperating fully with requests for information and orders to produce documents from the German Federal Financial Supervisory Authority (the “BaFin”) regarding the activities of Cologne Re relating to “finite reinsurance” and regarding transactions between Cologne Re or its subsidiaries, including CRD, and certain counterparties. In particular, Cologne Re is cooperating fully with a BaFin order to produce documents received on October 24, 2006. The order stated that it is part of the BaFin’s continuing investigation into financial reinsurance agreements and that Cologne Re, and possibly one or more of its senior executives, is suspected of violating legal provisions in regard to such agreements.
General Reinsurance is also providing information to and cooperating fully with the Office of the Superintendent of Financial Institutions Canada in its inquiries regarding the activities of General Re and its affiliates relating to “finite reinsurance.”
General Reinsurance is a defendant in In re American International Group Securities Litigation, Case No. 04-CV-8141-(LTS), United States District Court, Southern District of New York, a putative class action asserted on behalf of investors who purchased publicly-traded securities of AIG between October 1999 and March 2005. The complaint, originally filed in April 2005, asserts various claims against AIG and certain of its officers, directors, investment banks and other parties, including Messrs. Ferguson, Napier and Houldsworth (whom the Complaint defines, together with General Reinsurance, as the “General Re Defendants”). The Complaint alleges that the General Re Defendants violated Section 10(b) of the Securities Exchange Act and Rule 10b-5 in connection with the AIG Transaction. The Complaint seeks damages and other relief in unspecified amounts. General Reinsurance has answered the Complaint, denying liability and asserting various affirmative defenses. Document production has begun, but no other discovery has taken place. No trial date has been scheduled.
On July 27, 2005, General Reinsurance received a Summons and a Verified and Amended Shareholder Derivative Complaint in In re American International Group, Inc. Derivative Litigation, Case No. 04-CV-08406, United States District Court, Southern District of New York. The complaint, brought by several alleged shareholders of AIG, seeks damages, injunctive and declaratory relief against various officers and directors of AIG as well as a variety of individuals and entities with whom AIG did business, relating to a wide variety of allegedly wrongful practices by AIG. The allegations relating to General Reinsurance focus on the AIG Transaction, and the complaint purports to assert causes of action in connection with that transaction for aiding and abetting other defendants’ breaches of fiduciary duty and for unjust enrichment. The complaint does not specify the amount of damages or the nature of any other relief sought. In August 2005, General Reinsurance received a Summons and First Amended Consolidated Shareholders’ Derivative Complaint in In re American International Group, Inc. Consolidated Derivative Litigation, Case No. 769-N, Delaware Chancery Court. The claims asserted in the Delaware complaint are substantially similar to those asserted in the New York derivative complaint, except that the Delaware complaint makes clear that the plaintiffs are asserting claims against both General Reinsurance and General Re. Proceedings in both the New York derivative suit and the Delaware derivative suit are stayed until March 14, 2007.
Berkshire, General Re and General Reinsurance are defendants in this multi-district litigation, In Re: Insurance Brokerage Antitrust Litigation, MDL No. 1663 (D.N.J.), in which plaintiffs allege an industry-wide scheme on the part of commercial insurance brokers and insurance companies to defraud a purported class of insurance purchasers through bid-rigging and contingent commission arrangements. The plaintiffs claim that all defendants engaged in a pattern of racketeering activity, in violation of RICO, and that they conspired to restrain trade. They further allege that the broker defendants breached fiduciary duties to the plaintiffs, that the insurer defendants aided and abetted that breach, and that all defendants were unjustly enriched in the process. Plaintiffs seek treble damages in an unspecified amount, together with interest and attorneys fees and expenses. They also seek a declaratory judgment of wrongdoing as well as an injunction against future anticompetitive practices. In November 2006, General Re, General Reinsurance and Berkshire, together with the other defendants, filed motions to dismiss the complaint which are awaiting resolution.
Berkshire subsidiaries lease certain manufacturing, warehouse, retail and office facilities as well as certain equipment. Total rent expense for all leases was $578 million, $432 million and $422 million in 2006, 2005 and 2004, respectively. Minimum rental payments for operating leases having initial or remaining non-cancelable terms in excess of one year are as follows. Amounts are in millions.
Includes investment and derivative gains/losses, which, for any given period have no predictive value and variations in amount from period to period have no practical analytical value in view of the unrealized appreciation in Berkshire’s investment portfolio. Net earnings in the third quarter of 2005 include a pre-tax underwriting loss of $3.0 billion ($1.95 billion after-tax) related to Hurricanes Katrina and Rita which struck the Gulf coast region of the United States. Net earnings in the fourth quarter of 2005 include a non-cash pre-tax gain of $5.0 billion ($3.25 billion after-tax) which arose from the exchange of Gillette common stock for Procter & Gamble common stock. After-tax investment and derivative gains/losses for the periods presented above are as follows (in millions):