Chevy Chase, MD, New York, Georgia, Texas, California, Florida and Virginia
Omaha, NE, Wayne, PA and 10 other locations in the U.S. and U.K.
199 locations in 34 U.S. states and the District of Columbia
The amount of investment gains and losses for any given period has no predictive value, and variations in amount from period to period have no practical analytical value, particularly in view of the unrealized appreciation now existing in Berkshire’s consolidated investment portfolio. After-tax investment gains were $2,259 million in 2004, $2,729 million in 2003, $566 million in 2002, $923 million in 2001 and $2,746 million in 2000.
A reconciliation of Berkshire’s Consolidated Statements of Earnings for each of the five years ending December 31, 2004 from amounts reported to amounts exclusive of goodwill amortization is shown below. Goodwill amortization for the years ending December 31, 2001 and 2000 includes $78 million and $65 million, respectively, related to Berkshire’s equity method investment in MidAmerican Energy Holdings Company.
Net earnings for each of the past three years are disaggregated in the table that follows. Amounts are after deducting income taxes and minority interests. Dollars are in millions.
Berkshire’s operating businesses are managed on a decentralized basis. There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing 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.
Berkshire engages in both primary insurance and reinsurance of property and casualty risks. Through General Re, Berkshire also reinsures life and health risks. In primary insurance activities, Berkshire subsidiaries assume defined portions of the risks of loss from persons or organizations that are directly subject to the risks. In reinsurance activities, Berkshire subsidiaries assume defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves to in their own insuring activities. Berkshire’s principal insurance businesses are: (1) GEICO, one of the five largest auto insurers in the U.S., (2) General Re, one of the four largest reinsurers in the world, (3) Berkshire Hathaway Reinsurance Group (“BHRG”) and (4) Berkshire Hathaway Primary Group. Berkshire’s management views insurance businesses as possessing two distinct operations - underwriting and investing. Accordingly, Berkshire evaluates performance of underwriting operations without any allocation of investment income.
Underwriting expenses in 2004 totaled $1,585 million, an increase of 15.1% over 2003, which increased 23.3% over 2002. Policy acquisition expenses in 2004 increased 21.5% over 2003 to $889 million reflecting increased advertising and other costs associated with the increase in policies-in-force. Other operating expenses for 2004 were $696 million, an increase of 7.7% over 2003. The increase in other expenses was due to higher salary, profit sharing and other employee benefit expenses.
General Re conducts a reinsurance business offering property and casualty and life and health coverages to clients worldwide. In North America, property and casualty reinsurance is written on a direct basis through General Reinsurance Corporation. Internationally, property and casualty reinsurance is written on a direct basis through 91% owned Cologne Re (based in Germany) and other wholly-owned affiliates as well as through brokers with respect to Faraday in London. Life and health reinsurance is written for clients worldwide through Cologne Re. General Re’s pre-tax underwriting results are summarized for the past three years in the following table. Amounts are in millions.
Although loss reserve levels are now believed to be adequate, there are no guarantees. A relatively small change in the estimate of net reserves can produce large changes in annual underwriting results. In addition, the timing and magnitude of catastrophe and large individual property losses are expected to continue to contribute to volatile periodic underwriting results in the future. See “Critical Accounting Policies” for additional information concerning loss reserves.
Underwriting results for the global life/health operations produced pre-tax underwriting gains of $85 million in 2004 and $58 million in 2003, compared with an underwriting loss of $55 million in 2002. While both the U.S. and international life/health operations were profitable in both 2004 and 2003, most of the gains were earned in the international life business. The underwriting losses for 2002 were principally due to increased reserves on run-off business in the U.S. life/health operations.
Catastrophe and individual risk contracts may provide exceptionally large limits of indemnification, often several hundred million dollars and occasionally in excess of $1 billion, and cover catastrophe risks (such as hurricanes, earthquakes or other natural disasters) or other property risks (such as aviation and aerospace, commercial multi-peril or terrorism). Catastrophe and individual business written totaled about $1.5 billion in 2004 and $1.2 billion in 2003. The level of business written in future periods will vary, perhaps materially, based upon market conditions and management’s assessment of the adequacy of premium rates. Premiums written in 2004 included $165 million to reinstate coverages as a result of the third quarter hurricane losses.
In 2004, underwriting results from catastrophe and individual risk business included estimated catastrophe losses of $790 million, primarily from four hurricanes that struck the U.S. and Caribbean during the third quarter. The catastrophe and individual risk business produced substantial underwriting gains in 2003 and 2002 due to the lack of catastrophic or otherwise large loss events. However, catastrophic losses (such as the recent hurricane losses) are anticipated to occur over time, which could exceed the gains earned in recent years. The pre-tax maximum probable loss from a single event at December 31, 2004 is estimated to be $5 billion resulting from potential risk of loss from a major earthquake in California. BHRG, as a matter of general practice, does not cede catastrophe and individual risks to other reinsurers. The timing and magnitude of such losses may produce extraordinary volatility in periodic underwriting results. Nevertheless, Berkshire’s management remains willing to accept such volatility provided there is a reasonable prospect of long-term underwriting profitability.
Premiums earned in 2004 from traditional multi-line reinsurance decreased $510 million (19.8%) compared to 2003. The comparative decrease was primarily due to declines in quota-share participations (including Lloyd’s) and the termination of a major quota-share contract in mid-2003. Several contracts were not renewed or were curtailed in 2004 so further premium declines are anticipated in 2005. Pre-tax underwriting results in 2004 included losses of approximately $175 million arising from the third quarter hurricanes affecting the United States and Caribbean. However, these losses were more than offset by increased underwriting gains in aviation coverages and approximately $160 million in gains from the commutations of several reinsurance contracts in 2004. Underwriting gains in 2003 reflected low amounts of property and aviation losses. There were no significant commutations in 2003.
Berkshire’s primary insurance group consists of a wide variety of smaller insurance businesses that principally write liability coverages for commercial accounts. These businesses include: National Indemnity Company’s primary group operation (“NICO Primary Group”), a writer of motor vehicle and general liability coverages; U.S. Investment Corporation (“USIC”),
whose subsidiaries underwrite specialty insurance coverages; a group of companies referred to internally as “Homestate” operations, providers of standard multi-line insurance; and Central States Indemnity Company, a provider of credit and disability insurance to individuals nationwide through financial institutions.
Collectively, Berkshire’s other primary insurance businesses produced earned premiums of $1,211 million in 2004, $1,034 million in 2003, and $712 million in 2002. The increases in premiums earned during the past two years were largely attributed to increased volume of USIC and the NICO Primary Group. Net underwriting gains of Berkshire’s other primary insurance businesses totaled $161 million in 2004, $74 million in 2003 and $32 million in 2002. The improvement in year-to-year comparative underwriting results was due to the aforementioned increases in premiums and better-than-expected claim experience.
In the second half of 2004, short-term interest rates in the United States increased, which should result in increased earnings from such investments in 2005 periods when compared to 2004 periods. Management continues to seek to invest cash balances into long-term instruments, including business acquisitions. However, absent such opportunities, investment income may remain relatively low. Berkshire’s management believes that this current strategy, while potentially hurting current earnings, is appropriate in preserving capital and maintaining flexibility to make significant acquisitions when opportunities arise.
Fixed maturity investments as of December 31, 2004 were as follows. Dollar amounts are in millions.
All U.S. government obligations are rated AAA by the major rating agencies and about 95% of all state, municipal and political subdivisions, foreign government obligations and mortgage-backed securities were rated AA or higher by the major rating agencies. Non-investment grade securities represent securities that are rated below BBB- or Baa3. Fair value reflects quoted market prices where available or, if not available, prices obtained from independent pricing services.
Invested assets derive from shareholder capital and reinvested earnings as well as net liabilities assumed under insurance contracts or “float.” The major components of float are unpaid losses, unearned premiums and other liabilities to policyholders less premiums and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float totaled $46.1 billion at December 31, 2004, $44.2 billion at December 31, 2003 and $41.2 billion at December 31, 2002. The cost of float, as represented by the ratio of pre-tax underwriting gain or loss to average float, was negative for 2004 and 2003, as Berkshire’s insurance businesses generated pre-tax underwriting gains.
Pre-tax earnings from leveraged investing activities declined approximately $163 million in 2004 as a result of comparatively lower amounts of invested assets. In addition, pre-tax earnings for 2004 of the life/annuity insurance business declined approximately $142 million as a result of higher allocations of investments in cash and cash equivalents, a significant reduction in the early redemption of fixed-income securities purchased at a discount and adverse changes in mortality assumptions.
Operating results of the flight services business have improved gradually since 2003. These businesses were adversely affected by the attack on the World Trade Center and the deterioration in the U.S. economy that followed. Revenues and pre-tax earnings of this segment in 2003 declined in comparison with 2002.
On May 23, 2003, Berkshire acquired McLane Company, Inc., a distributor of grocery and food products to retailers, convenience stores and restaurants. See Note 2 to the Consolidated Financial Statements for additional information regarding the McLane acquisition. Results of McLane’s business operations are included in Berkshire’s consolidated results beginning on that date. McLane’s revenues in 2004 totaled $23.4 billion and for the full year 2003 totaled about $22 billion. Pre-tax earnings totaled $228 million in 2004 and $225 million for the full year 2003. The comparative year-to-date increases in sales reflect the addition of new customers since Berkshire’s acquisition and growth in the food service business. In 2004, approximately 33% of McLane’s annual revenues derived from sales to Wal-Mart Stores, Inc. McLane’s business is marked by high sales volume and very thin profit margins.
Berkshire’s principal retail operations consist of home furnishings and jewelry retailers. Total revenues attributed to retail operations were $2.60 billion in 2004 and $2.31 billion in 2003. Same store sales in 2004 increased 2.4% from 2003. Pre-tax earnings of the retail group totaled $163 million in 2004 compared to $165 million in 2003. The increase in sales was substantially offset by higher costs associated with new home furnishings stores, including increased salaries and benefits, depreciation, and distribution costs.
Floor covering sales generated by Shaw Industries totaled $5.17 billion in 2004, an increase of $514 million (11%) over 2003. The increase in revenues was driven by an approximate 9% increase in square yards of carpet sold, higher net selling prices and increased hard surface and rug sales. Sales in 2004 include those of two businesses acquired by Shaw (Georgia Tufters and the North Georgia operations of the Dixie Group) in 2003, which contributed sales of $240 million in 2004 and $50 million in 2003. Pre-tax earnings in 2004 totaled $466 million, an increase of $30 million (7%) over 2003. During 2004, petroleum-based raw material costs increased on several occasions. Production cost inflation was driven by higher petroleum-based raw material and energy related costs. Sales price increases have lagged raw material supplier price increases resulting in a decline in gross sales margins during 2004. Further margin declines in 2005 are possible.
Gains and losses from foreign currency contracts arise as the value of the U.S. dollar changes against certain foreign currencies. Small changes in certain foreign currency exchange rates can produce material changes in the fair value of these contracts given the large net notional value of Berkshire’s open contracts ($21.4 billion as of December 31, 2004) and consequently, may produce exceptional volatility in reported earnings in a given period.
Berkshire’s balance sheet continues to reflect significant liquidity and a strong capital base. Consolidated shareholders’ equity at December 31, 2004 totaled $85.9 billion. Consolidated cash and invested assets, excluding assets of finance and financial products businesses, totaled approximately $102.9 billion at December 31, 2004 (including cash and cash equivalents of $40.0 billion) and $95.6 billion at December 31, 2003 (including $31.3 billion in cash and cash equivalents).
In May 2002, Berkshire issued the SQUARZ securities, which consist of $400 million par amount of senior notes due in November 2007 together with warrants to purchase 4,464 Class A equivalent shares of Berkshire common stock, which expire in May 2007. A warrant premium is payable to Berkshire at an annual rate of 3.75% and interest is payable to note holders at a rate of 3.00%. Each warrant provides the holder the right to purchase either 0.1116 shares of Class A or 3.348 shares of Class B stock for $10,000. In addition, holders of the senior notes have the option to require Berkshire to repurchase the senior notes at par on May 15, 2005 and 2006, provided that the holders also surrender a corresponding amount of warrants for cancellation. All warrants and senior notes were outstanding as of December 31, 2004.
Assets of the finance and financial products businesses totaled $30.1 billion as of December 31, 2004, compared to $49.0 billion at June 30, 2004 and $28.3 billion at December 31, 2003. Liabilities totaled $20.4 billion as of December 31, 2004 compared to $42.2 billion at June 30, 2004 and $22.0 billion at December 31, 2003. As discussed in Note 15 to the Consolidated Financial Statements, Berkshire consolidated the accounts of Value Capital, L.P. beginning as of January 1, 2004, and as a result of a reduction of its ownership interest in the partnership, discontinued consolidation effective July 1, 2004. As of June 30, 2004, Value Capital’s assets and liabilities totaled $24.1 billion and $23.4 billion, respectively.
Notes payable and other borrowings of Berkshire’s finance and financial products businesses totaled $5.4 billion at December 31, 2004 and $4.9 billion at December 31, 2003. During 2004, Berkshire Hathaway Finance Corporation (“BHFC”) issued a total of $1.6 billion par amount of medium term notes due from 2007 through 2014. The proceeds of these issues were used to finance originated and acquired loans of Clayton. These medium term notes are guaranteed by Berkshire. On January 4, 2005, BHFC issued an additional $3.75 billion par amount of medium term notes to finance Clayton’s December 30, 2004 loan portfolio acquisition discussed above. In February 2004, the remaining balance of Berkadia’s bank borrowing ($525 million) was repaid upon the collection of the final $525 million loan to FINOVA and in the second quarter GRS repaid debt of approximately $550 million.
A summary of long-term contractual obligations as of December 31, 2004 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 potential recoverables are not reflected in the table. Amounts are in millions.
Contractual obligations for unpaid losses and loss adjustment expenses arising under property and casualty insurance contracts are estimates. The timing and amount of such payments is contingent upon the ultimate outcome of claim settlements that will occur over many years. The amounts presented in the preceding table are based upon past claim settlement activities. The timing and amount of such payments are subject to significant estimation error. The factors affecting the ultimate amount of claims are discussed in the following section regarding Berkshire’s critical accounting policies. Accordingly, the actual timing and amount of payments may differ materially from the amounts shown in the table.
A summary of Berkshire’s consolidated liabilities for unpaid property and casualty losses is presented in the table below. Except for certain workers’ compensation reserves, liabilities for unpaid property and casualty reserves are reflected in the Consolidated Balance Sheets without discounting for time value, regardless of the length of the claim-tail. Dollars are in millions.
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 related to losses occurring on or before the balance sheet date. Depending on the type of loss being estimated, the timing and amount of property and casualty 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 of any balance sheet date, claims that have occurred have not all been reported, and if reported may not have been settled. The time period between the occurrence date and payment date of a loss is referred to as the “claim-tail.” Property claims usually have fairly short claim-tails and, absent litigation, are reported and settled within no more than a few years after
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 (55%), and (3) incurred-but-not-reported (“IBNR”) reserves (25%). 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, jurisdiction of loss, reporting date and occurrence date, among other factors. A brief discussion of each component follows.
Claim 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.
General Re’s unpaid losses and loss adjustment expenses as of December 31, 2004 are summarized below. Amounts are in millions.
General Re’s process of establishing loss reserve estimates is based upon a ground-up approach, beginning with case estimates and supplemented by additional case reserves (“ACR’s”) and IBNR reserves. Critical judgments in the establishment of these loss reserves involve the establishment of ACR’s by claim examiners, the expectation of ultimate loss ratios, which drive IBNR reserve amounts and the case reserve reporting trends compared to the expected loss reporting patterns. Actuaries do not routinely calculate loss reserve ranges, because it is currently believed that the mathematics of determining ranges has not been sufficiently developed and the myriad of assumptions required, render such resulting range to be unreliable. In addition, counts of claims or average amount per claim are not utilized because clients do not consistently provide reliable data in sufficient detail.
General Re claim examiners establish case reserve estimates based on the facts and circumstances of the claims and the terms and provisions of the insurance and reinsurance contracts. For reinsurance claims, claim examiners receive notices from client companies in a manner that reflects the terms of the reinsurance contracts. Contract terms governing claim reporting are generally based on the client’s view of the case loss (e.g., claims with reserves greater than one-half the retention) or injury type (e.g., any claim arising from a fatality). Some reinsurance contracts permit claims to be reported on a bulk basis. Bulk reporting provisions generally apply to quota-share reinsurance contracts.
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 called loss triangles, which are the primary basis for IBNR reserve calculations. North American operations presently review over 300 reserve cells and the international operations presently review about 900 reserve cells.
Loss triangles are used to determine the expected case loss emergence patterns and, in conjunction with expected loss ratios by accident year, are further used to determine IBNR reserves. Certain calculations are performed and form the basis for estimating the expected loss emergence pattern. The determination of the expected loss emergence pattern is not strictly a mechanical process. In instances where the historical loss data is insufficient, estimation formulas are used along with reliance on other loss triangles and judgment. Factors affecting loss development triangles include but are not limited to the following: changing client claims practices, changes in claim examiners use of ACR’s or the frequency of client company claim reviews, changes in the mix of policy terms and coverage (such as client loss retention levels and occurrence and aggregate policy limits), changes in loss trends and changes in legal trends that result in unanticipated losses, as well as other sources of statistical variability. These items influence the selection of the expected loss emergence patterns.
In certain reserve cells (excess directors and officers and errors and omissions) IBNR reserves are based on estimated ultimate losses, without consideration of expected emergence patterns. These cells typically involve a spike in loss activity arising from recent industry developments making it difficult to select an expected loss emergence pattern as has been experienced from the recent wave of corporate scandals that have caused an increase in reported losses. Overall industry-wide loss experience data and informed judgment are used when internal loss data is of limited reliability, such as in setting the estimates for asbestos and hazardous waste claims. Unpaid environmental, asbestos and mass tort reserves at December 31, 2004 were approximately $1.6 billion gross and $1.3 billion net of reinsurance. Such reserves were approximately $1.2 billion gross and $1.0 billion net of reinsurance as of December 31, 2003. Claims paid attributable to such losses were about $70 million in 2004.
As of December 31, 2004, 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 above a contractual retention are indemnified as well as contracts that indemnify all losses paid by the counterparty after the effective date. Retroactive losses paid in 2004 totaled $860 million. The classification “reported case reserves” has no practical analytical value with respect to retroactive policies since the amount is derived from reports in bulk from ceding companies, who may have inconsistent definitions of “case reserves.” Reserves are reviewed and established in the aggregate including provisions for IBNR reserves.
BHRG’s liabilities for environmental, asbestos, and latent injury losses and loss adjustment expenses are presently believed to be concentrated within retroactive reinsurance contracts. Reserves for such losses were approximately $4.2 billion at December 31, 2004 and $4.4 billion at December 31, 2003. Claims paid in 2004 attributable to such losses were approximately $334 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.
Berkshire records as assets deferred charges with respect to liabilities assumed under retroactive reinsurance contracts. At the inception of these contracts the deferred charges represent the difference between the consideration received and the estimated ultimate liability for unpaid losses. No net gain or loss is recognized at the inception of the contract. Deferred charges are amortized using the interest method over an estimate of the ultimate claim payment period and are reflected in earnings as a component of losses and loss expenses. The deferred charge balances are adjusted periodically to reflect new projections of the amount and timing of loss payments. Adjustments to these assumptions are applied retrospectively from the inception of the contract. Unamortized deferred charges totaled $2.7 billion at December 31, 2004. Significant changes in either the timing or ultimate amount of loss payments may have a significant effect on unamortized deferred charges and the amount of periodic amortization.
Berkshire’s Consolidated Balance Sheet as of December 31, 2004 includes goodwill of acquired businesses of approximately $23 billion. These amounts have been recorded as a result of Berkshire’s numerous prior business acquisitions accounted for under the purchase method. Prior to 2002, goodwill from each acquisition was generally amortized as a charge to earnings over periods not exceeding 40 years. Under SFAS No. 142, which was adopted by Berkshire as of January 1, 2002, periodic amortization ceased, in favor of an impairment-only accounting model.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include periodically determining or reviewing the estimated fair value of Berkshire’s reporting units. Under SFAS No. 142, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating a reporting unit’s fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted projected 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.
Berkshire’s consolidated financial position reflects large amounts of invested assets. A substantial portion of these assets are carried at fair values based upon current market quotations and, when not available, based upon fair value pricing models. Certain fixed maturity securities Berkshire owns are not actively traded in the markets. Further, Berkshire’s finance businesses maintain significant balances of finance receivables, which are carried at amortized cost. Considerable judgment is required in determining the assumptions used in certain pricing models, including interest rate, loan prepayment speed, credit risk and liquidity risk assumptions. Significant changes in these assumptions can have a significant effect on carrying values.
Information concerning recently issued accounting pronouncements which are not yet effective is included in Note 1(r) to the Consolidated Financial Statements. As indicated in Note 1(r) to the Consolidated Financial Statements, Berkshire does not expect any of the recently issued accounting pronouncements to have a material effect on its financial statements.
Berkshire’s Consolidated Balance Sheets include a substantial amount of assets and liabilities whose fair values are subject to market risks. Berkshire’s significant market risks are primarily associated with interest rates and equity prices and to a lesser degree derivatives. The following sections address the significant market risks associated with Berkshire’s business activities.
Berkshire’s management prefers to invest in equity securities or to acquire entire businesses based upon the principles discussed in the following section on equity price risk. When unable to do so, management may alternatively invest in bonds, loans or other interest rate sensitive instruments. Berkshire’s strategy is to acquire securities that are attractively priced in relation to the perceived credit risk. Management recognizes and accepts that losses may occur. Berkshire has historically utilized a modest level of corporate borrowings and debt. Further, Berkshire strives to maintain the highest credit ratings so that the cost of debt is minimized. Berkshire utilizes derivative products to manage interest rate risks to a very limited degree.
* Excludes General Re Securities - See Derivatives Dealer Risk section for discussion of risks associated with this business.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears below.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Berkshire Hathaway Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
Held-to-maturity investments are carried at amortized cost, reflecting Berkshire’s intent and ability to hold the securities to maturity. Available-for-sale securities are stated at fair value with net unrealized gains or losses reported as a component of accumulated other comprehensive income.
Berkshire utilizes the equity method of accounting with respect to investments where it exercises significant influence, but not control, over the policies of the investee. A voting interest of at least 20% and no greater than 50% is normally a prerequisite for utilizing the equity method. However Berkshire may apply the equity method with less than 20% voting interests based upon the facts and circumstances including representation on the Board of Directors, contractual veto or approval rights, participation in policy making processes and the existence or absence of other significant owners. Berkshire applies the equity method to investments in common stock and other investments when such other investments possess substantially identical subordinated interests to common stock.
Berkshire carries derivative contracts at estimated fair value. Derivatives are classified as trading account assets or trading account liabilities in the accompanying Consolidated Balance Sheets and reflect reductions permitted under master netting agreements with counterparties. The fair values of these instruments represent the present value of expected future cash flows under the contracts, which are a function of underlying interest rates, currency rates, security values, related volatility, the creditworthiness of counterparties and duration of the contracts. Future changes in these factors or a combination thereof may affect the fair value of these instruments. With minor exception, derivative contracts are not designated as hedges for accounting purposes. Changes in the fair value of such contracts are included in the Consolidated Statements of Earnings.
Inventories are stated at the lower of cost or market. Cost with respect to manufactured goods includes raw materials, direct and indirect labor and factory overhead. As of December 31, 2004, approximately 61% of the total inventory cost was determined using the last-in-first-out (“LIFO”) method, 29% using the first-in-first-out (“FIFO”) method, with the remainder using the specific identification method. With respect to inventories carried at LIFO cost, the aggregate difference in value between LIFO cost and cost determined under FIFO methods was $115 million and $23 million as of December 31, 2004 and December 31, 2003, respectively.
Insurance premiums for prospective property/casualty insurance and reinsurance and health reinsurance policies are earned in proportion to the level of insurance protection provided. In most cases, premiums are recognized as revenues ratably over the term of the contract with unearned premiums computed on a monthly or daily pro rata basis. Premium adjustments on contracts and audit premiums are based on estimates made over the contract period. Premiums for retroactive reinsurance policies are earned at the inception of the contracts. Premiums for life reinsurance contracts are earned when due. Premiums earned are stated net of amounts ceded to reinsurers. Premiums are estimated with respect to certain reinsurance contracts where premiums are based upon reports from ceding companies that are contractually reported after the balance sheet date.
The estimated liabilities of workers’ compensation claims assumed under reinsurance contracts are carried in the Consolidated Balance Sheets at discounted amounts. Discounted amounts are based upon an annual discount rate of 4.5% for claims arising prior to 2003 and 1% for claims arising after 2002. The lower rate for post-2002 claims reflects the lower interest rate environment prevailing in the United States. The discount rates are the same rates used under statutory accounting principles. The periodic discount accretion is included in the Consolidated Statements of Earnings as a component of losses and loss adjustment expenses.
The excess of estimated liabilities for claims and claim costs over the consideration received with respect to retroactive property and casualty reinsurance contracts that provide for indemnification of insurance risk is established as a deferred charge at inception of such contracts. The deferred charges are subsequently amortized using the interest method over the expected claim settlement periods. The periodic amortization charges are reflected in the accompanying Consolidated Statements of Earnings as losses and loss adjustment expenses.
Certain costs of acquiring insurance premiums are deferred, subject to ultimate recoverability, and charged to income as the premiums are earned. Acquisition costs consist of commissions, premium taxes, advertising and other underwriting costs. The recoverability of premium acquisition costs, generally, reflects anticipation of investment income. The unamortized balances of deferred premium acquisition costs are included in other assets and were $1,371 million and $1,278 million at December 31, 2004 and 2003, respectively.
The accounts of foreign-based subsidiaries are measured in most instances using the local currency as the functional currency. Revenues and expenses of these businesses are translated into U.S. dollars at the average exchange rate for the period. Assets and liabilities are translated at the exchange rate as of the end of the reporting period. Gains or losses from translating the financial statements of foreign-based operations are included in shareholders’ equity as a component of accumulated other comprehensive income. Unrealized gains or losses associated with available-for-sale securities are included as a component of other comprehensive income. Gains and losses arising from other transactions denominated in a foreign currency are included in the Consolidated Statements of Earnings.
Deferred income taxes are calculated under the liability method. Deferred tax assets and liabilities are recorded based on differences between the financial statement and tax bases of assets and liabilities at the enacted tax rates. Changes in deferred income tax assets and liabilities that are associated with components of other comprehensive income, primarily unrealized investment gains, are charged or credited directly to other comprehensive income. Otherwise, changes in deferred income tax assets and liabilities are included as a component of income tax expense.
In March 2004 the Emerging Issues Task Force (“EITF”) ratified additional provisions of Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The provisions of EITF 03-01 ratified in March 2004: (a) define impairments of debt and equity securities accounted for under SFAS 115, (b) provide criteria to be used by management in judging whether or not impairments are other-than-temporary, and (c) provide guidance on determining the amount of an impairment loss. These additional provisions were originally scheduled to be applied prospectively beginning July 1, 2004. Subsequently, the effective date for applying items (b) and (c) above was postponed in order to consider implementation issues. The postponed provisions are expected to become effective during 2005. The adoption of the additional provisions of EITF 03-01 is not expected to have a material effect on Berkshire’s financial statements.
Berkshire’s long-held acquisition strategy is to purchase businesses with consistent earning power, good returns on equity, able and honest management and at sensible prices. Businesses with these characteristics typically have market values that exceed net asset value, thus producing goodwill for accounting purposes. During 2003 and 2002, Berkshire acquired several businesses which are described in the following paragraphs.
On May 23, 2003, Berkshire acquired McLane Company, Inc. (“McLane”), from Wal-Mart Stores, Inc. for cash consideration of approximately $1.5 billion. McLane is one of the nation’s largest wholesale distributors of groceries and nonfood items to convenience stores, wholesale clubs, mass merchandisers, quick service restaurants, theaters and others.
On September 4, 2002, Berkshire acquired all of the outstanding common stock of Garan. Garan is a leading manufacturer of children’s, women’s, and men’s apparel bearing the private labels of its customers as well as several of its own trademarks, including GARANIMALS.
Through its subsidiaries, MidAmerican owns a combined electric and natural gas utility company in the United States, two natural gas pipeline companies in the United States, two electricity distribution companies in the United Kingdom, a diversified portfolio of domestic and international electric power projects and the second largest residential real estate brokerage firm in the United States.
Condensed consolidated balance sheets of MidAmerican are as follows (in millions).
(a) Primarily relates to securities whose amortized cost has exceeded fair value for less than twelve months.
Shown below are the amortized cost and estimated fair values of securities with fixed maturities at December 31, 2004, 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.
Common shares of American Express Company (“AXP”) owned by Berkshire and its subsidiaries possessed approximately 12% of the voting rights of all AXP shares outstanding at December 31, 2004. The shares are held subject to various agreements which, generally, prohibit Berkshire from (i) unilaterally seeking representation on the Board of Directors of AXP and (ii) possessing 17% or more of the aggregate voting securities of AXP. Berkshire has entered into an agreement with AXP which will remain effective so long as Berkshire owns 5% or more of AXP’s voting securities. The agreement obligates Berkshire, so long as Kenneth Chenault is chief executive officer of AXP, to vote its shares in accordance with the recommendations of AXP’s Board of Directors. Additionally, subject to certain exceptions, Berkshire has agreed not to sell AXP common shares to any person who owns 5% or more of AXP voting securities or seeks to control AXP, without the consent of AXP.
Net of unrealized losses of $65 million as of December 31, 2003. There were no unrealized losses at December 31, 2004.
Net gains are reflected in the Consolidated Statements of Earnings as follows.
Effective January 1, 2002, Berkshire adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” SFAS 142 changed the accounting for goodwill from a model that required amortization of goodwill, supplemented by impairment tests, to an accounting model that is based solely upon impairment tests. Thus, Berkshire’s Consolidated Statements of Earnings for 2004, 2003 and 2002 include no periodic amortization of goodwill. A reconciliation of the change in the carrying value of goodwill for 2004 and 2003 is as follows (in millions).
A summary of the fair value and gross notional value of open derivatives contracts follows. Amounts are in millions.
Berkshire utilizes derivatives in order to manage economic risks of its businesses as well as to assume specified amounts of market or credit risk from others. Beginning in 2002, Berkshire began to enter into foreign currency forward
contracts with the objective of partially hedging corporate-wide adverse risk from the decline in the value of the U.S. Dollar. In addition, Berkshire, through its subsidiary General Re Securities (“GRS”) operates as a dealer in various types of derivative instruments, such as swaps, forwards, futures and options, which are used by clients to manage economic risks arising from interest rate, foreign exchange rate, or market price movements. In January 2002, GRS commenced a long-term run-off of its operations. The run-off is expected to occur over a number of years during which GRS will limit its new business and will unwind its existing asset and liability positions in an orderly manner. General Re Corporation, the parent of GRS, has guaranteed the obligations of GRS.
Assuming non-performance by all counterparties on all contracts potentially subject to a loss, the maximum potential loss, based on the cost of replacement, net of collateral held, at market rates prevailing at December 31, 2004 approximated $2,226 million. The following table presents derivatives portfolios by counterparty credit quality and maturity at December 31, 2004. The amounts shown under gross exposure in the table are before consideration of netting arrangements and collateral held by Berkshire affiliates. Net fair value shown in the table represents contracts in gain positions, net of any loss owed to these counterparties on offsetting positions. Net exposure shown in the table that follows is net fair value less collateral held. Amounts are in millions.
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, particularly with respect to certain casualty or liability claims, which are typically reported over long periods of time and subject to changing legal and litigation trends. This delay in claim reporting is exacerbated in reinsurance of liability or casualty claims as claim reporting by ceding companies is further delayed by contract terms.
Certain workers’ compensation reserves are discounted. Net discounted liabilities at December 31, 2004 and 2003 were $2,280 million and $2,211 million, respectively, and are net of discounts totaling $2,611 million and $2,435 million. Periodic accretions of these discounts are also a component of prior years losses incurred. The accretion of discounted liabilities was approximately $87 million in 2004, $85 million in 2003 and $81 million in 2002.
Notes payable and other borrowings of Berkshire and its subsidiaries are summarized below. Amounts are in millions.
$3.75 billion par amount of senior notes consisting of $1.5 billion par of 4.125% notes due 2010, $1.0 billion par of 4.85% notes due 2015, and $1.25 billion par of floating rate notes due 2008. Aggregate proceeds of $3,733 million were used to finance a loan portfolio acquisition on December 30, 2004 by Clayton Homes.
Generally, Berkshire’s guarantee of a subsidiary’s debt obligation is an absolute, unconditional and irrevocable guarantee for the full and prompt payment when due of all present and future payment obligations of the issuer.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2004 and 2003 are shown below (in millions).
Value Capital L.P., (“Value Capital”), a limited partnership, commenced operations in 1998. A wholly owned Berkshire subsidiary is a limited partner in Value Capital. The partnership’s objective is to achieve income and capital growth from investments and arbitrage in fixed income investments. Profits and losses (after fees to the general partner) are allocated to the partners based upon each partner’s investment. As a limited partner Berkshire’s exposure to loss is limited to the carrying value of its investment. Berkshire does not guarantee any of Value Capital’s liabilities and has no control over decisions made by the management of Value Capital or those of its general partner.
Since June 30, 2004, Value Capital accepted investments from new limited partners unrelated to Berkshire and Value Capital redeemed $125 million of Berkshire’s investment in December 2004 as permitted under the partnership agreement. As a result, Berkshire’s economic interest in Value Capital declined from approximately 90% at June 30, 2004 to approximately 62% as of December 31, 2004.
The estimated fair values of Berkshire’s financial instruments as of December 31, 2004 and 2003, are as follows (in millions).
Certain Berkshire subsidiaries individually sponsor defined benefit pension plans covering their employees. Benefits under the plans are generally based on years of service and compensation, although benefits under certain plans are based on years of service and fixed benefit rates. Funding policies are generally to contribute amounts required to meet regulatory requirements plus additional amounts determined by management based on actuarial valuations. The measurement date for the pension plans is predominantly December 31.
During the third quarter of 2004 a Berkshire subsidiary amended its defined benefit plan to freeze benefits as of the end of 2005. Such an event is considered a curtailment and the curtailment gain included in the table above represents the elimination of projected plan benefits beyond the end of 2005 and the recognition of unamortized prior service costs and actuarial losses as of the amendment date.
The increase (decrease) in minimum liabilities included in other comprehensive income were $41 million in 2004, $(3) million in 2003, and $263 million in 2002. Such amounts include Berkshire’s share of changes in minimum liabilities of MidAmerican.
Pension plan assets are generally invested with the long-term objective of earning sufficient amounts to cover expected benefit obligations, while assuming a prudent level of risk. There are no target investment allocation percentages with respect to individual or categories of investments. Allocations may change rapidly as a result of changing market conditions and investment opportunities. The expected rates of return on plan assets reflect Berkshire’s subjective assessment of expected invested asset returns over a period of several years. Berkshire does not give significant consideration to past investment returns when establishing assumptions for expected long-term rates of returns on plan assets. Actual experience will differ from the assumed rates, in particular over quarterly or annual periods as a result of market volatility and changes in the mix of assets.
The funded status of the plans as of December 31, 2004 and 2003 is as follows (in millions).
Weighted average assumptions used in determining projected benefit obligations were as follows. These rates are substantially the same as the weighted average rates used in determining the net periodic pension expense.
Berkshire’s reportable business segments are organized in a manner that reflects how management views those business activities. Certain businesses have been grouped together for segment reporting based upon similar products or product lines, marketing, selling and distribution characteristics, even though those business units are operated under separate local management. There are approximately 40 separate business units.
BH Finance, Clayton Homes, XTRA, CORT, Berkshire Hathaway Life and General Re Securities (“Finance and financial products”)
Nebraska Furniture Mart, R.C. Willey Home Furnishings, Star Furniture Company, Jordan’s Furniture, Borsheim’s, Helzberg Diamond Shops and Ben Bridge Jeweler (“Retail”)
General Reinsurance and four of its current and former employees, along with numerous other defendants, also have been sued in several civil actions related to ROA, including actions brought by the Virginia Commissioner of Insurance, as Deputy Receiver of ROA, and the Tennessee Commissioner of Insurance, as Liquidator for three Tennessee risk retention groups. Plaintiffs assert various claims, including fraud and conspiracy, against General Reinsurance and others. General Reinsurance intends to deny the allegations but Berkshire cannot at this time predict the outcome of these actions, is unable to estimate a range of possible loss, if any, and cannot predict whether or not that outcome will have a material adverse effect on Berkshire’s results of operations for at least the quarterly period when these actions are resolved.
In December 2004, General Re received a request from the U.S. Securities and Exchange Commission (“SEC”) for documents and information relating to non-traditional products. In January 2005, General Re also received a subpoena for the same documents and information from both the SEC and the New York State Attorney General. The subpoenas apply to General Re and its affiliates, including Berkshire Hathaway Inc., as well as Berkshire’s other insurance subsidiaries. General Re, Berkshire and certain of its other insurance subsidiaries have been cooperating fully with the SEC and the New York State Attorney General, including by providing them with information relating to
The Liquidator of both FAI Insurance Limited and HIH Insurance Limited has advised two subsidiaries of General Reinsurance, General Reinsurance Australia (“GRA”) and Kolnische Ruckversicherungs-Gessellschaft (“KR”), of claims it intends to assert arising from insurance transactions GRA entered into with FAI in May and June 1998. The Liquidator contends, among other things, that GRA and KR engaged in deceptive conduct that assisted FAI in improperly accounting for such transactions as reinsurance, and that such deception was a causal factor that led to the insolvency of HIH. GRA and KR do not know whether the Liquidator will pursue these or other claims, and Berkshire cannot predict the outcome of any such action and is unable to estimate a range of possible loss, if any, and cannot predict whether or not that outcome will have a material adverse effect on Berkshire’s results of operations for at least the quarterly period when such action, if any, is resolved.
The Company leases certain manufacturing, warehouse, retail and office facilities as well as certain equipment. Total rent expense for all leases was $422 million, $384 million and $312 million in 2004, 2003 and 2002 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.
Several of the Company’s subsidiaries have made long-term commitments to purchase goods and services used in their businesses. The most significant of these relate to NetJets’ commitments to purchase up to 340 aircraft through 2014. Commitments under all such subsidiary arrangements are approximately $3.1 billion in 2005, $1.2 billion in 2006, $1.1 billion in 2007, $990 million in 2008, $514 million in 2009 and $867 million after 2009.