The amount of realized 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 realized investment gains were $2,729 million in 2003, $566 million in 2002, $923 million in 2001, $2,746 million in 2000 and $809 million in 1999.
A reconciliation of Berkshire’s Consolidated Statements of Earnings for each of the five years ending December 31, 2003 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 interest. Dollars are in millions.
The business segment data (Note 20 to Consolidated Financial Statements) should be read in conjunction with this discussion.
Berkshire engages in both primary insurance and reinsurance of property and casualty risks. Through General Re, Berkshire also reinsures life and health risks. In primary insurance activities, Berkshire subsidiaries assume defined portions of the risks of loss from persons or organizations that are directly subject to the risks. In reinsurance activities, Berkshire subsidiaries assume defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves to in their own insuring activities. Berkshire’s principal insurance businesses are: (1) GEICO, the fifth largest auto insurer in the U.S., (2) General Re, one of the four largest reinsurers in the world, (3) Berkshire Hathaway Reinsurance Group (“BHRG”) and (4) Berkshire Hathaway Primary Group. Berkshire’s management views insurance businesses as possessing two distinct operations - underwriting and investing. Accordingly, Berkshire evaluates performance of underwriting operations without any allocation of investment income.
A significant marketing strategy followed by all these businesses is the maintenance of extraordinary capital strength. Statutory surplus of Berkshire’s insurance businesses totaled approximately $40.7 billion at December 31, 2003. 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 sophisticated insurance and reinsurance buyers. Additional information regarding Berkshire’s insurance and reinsurance operations follows.
Premiums earned in 2003 were $7,784 million, an increase of 16.7% over 2002, following an increase of 10.1% in 2002 over 2001. The growth in premiums earned in 2003 reflects a 10.9% increase in voluntary auto policies-in-force during the past year and average premium rate increases of about two percent. During 2003, policies-in-force increased 8.2% in the preferred risk auto line and 21.4% in the standard and nonstandard auto lines. Voluntary auto new business sales in 2003 increased 20.3% compared to 2002. Voluntary auto policies-in-force at December 31, 2003 were 531,000 higher than at December 31, 2002 and reflect strong growth in the standard and nonstandard lines during the last twelve months.
General Re conducts a reinsurance business, which offers reinsurance coverage of essentially all types of property, casualty, life and health risks in the United States and worldwide. General Re’s principal reinsurance operations are internally comprised of: (1) North American property/casualty, (2) international property/casualty, which principally consists of business written through 89% owned Cologne Re, (3) London-market property/casualty through the Faraday operations, and (4) global life/health.
General Re’s consolidated underwriting results in 2003 reflect significant improvements over the past two years and are attributed to rate increases, better coverage terms and the absence of large property losses, partially offset by increases in prior accident years’ loss estimates. Underwriting results in both 2002 and 2001 included significant charges from increases in loss reserve estimates established for claims occurring in prior years. Additionally, underwriting results for 2001 were severely impacted by losses from the September 11th terrorist attack. General Re strives to generate long-term pre-tax underwriting gains in essentially all of its product lines. Underwriting performance is not evaluated based upon market share and underwriters are instructed to reject inadequately priced risks. Over the past three years, General Re has taken significant underwriting actions to better align premium rates with coverage terms. Information with respect to each of General Re’s underwriting units is presented below.
Premiums earned in 2003 declined from 2002 premium levels by $416 million (10.5%). The decline in premiums earned reflects a net reduction from cancellations/non-renewals in excess of new contracts (estimated at $761 million), partially offset by rate increases across all lines of business (estimated at $345 million). Premiums earned in 2002 were essentially unchanged compared to 2001 as rate increases (approximately $800 million) across most lines of business were offset by reductions from cancellations in excess of new business. Premiums earned in 2001 included $400 million from one retroactive reinsurance contract and a large quota share agreement. No such contracts were written in 2002 or 2003.
The North American property/casualty business produced a pre-tax underwriting gain of $67 million in 2003, compared with losses of $1,019 million and $2,843 million in 2002 and 2001, respectively. The 2003 underwriting gain consisted of $200 million in current accident year gains, partially offset by $133 million in prior accident year losses. The favorable effects of re-pricing efforts and improved contract terms and conditions implemented over the past three years contributed to the net gain. In addition, underwriting results for 2003 were favorably impacted by the absence of major catastrophes and other large individual property losses ($20 million or greater), a condition that is unusual and should not be expected to occur regularly in the future.
The prior accident years’ losses of $133 million recorded in 2003 included $99 million related to discount accretion on workers’ compensation reserves and deferred charge amortization on retroactive reinsurance contracts, reserve increases of $153 million for casualty claims, (primarily in the workers’ compensation, directors and officers, and errors and omissions lines), and reserve decreases of $119 million for property claims.
For statutory and GAAP reporting purposes workers’ compensation loss reserves are discounted at 1.0% per annum for claims occurring after 2002 and at 4.5% for claims occurring before 2003. The lower discount rate for 2003 claims was approved by General Re’s state insurance regulators and reflects the lower interest rate environment that now exists. The lower discount rate effectively reduced 2003 underwriting gains by approximately $74 million.
Underwriting results for 2002 included $1,085 million in prior year loss reserve adjustments, offset by net gains of $66 million with respect to the 2002 accident year. Results for 2002 included $990 million in increased loss estimates related to casualty lines of business (general liability, workers’ compensation, medical malpractice, auto liability and professional liability coverages), principally related to the 1997 through 2000 accident years. The 2002 prior years’ loss reserve adjustment was net of a $115 million reduction in reserves established in connection with the September 11th terrorist attack, primarily due to decreased loss estimates for certain claims. The underwriting loss in 2001 included $923 million in prior years’ loss reserve adjustments, approximately $1.54 billion of net losses from the September 11th terrorist attack, as well as $87 million of losses from other catastrophes (principally Tropical Storm Allison) and other large individual property losses.
Due to the long-tail nature of casualty business, a very high degree of estimation is involved in establishing loss reserves for current accident year casualty occurrences. Thus, the ultimate level of underwriting gain or loss with respect to the 2003 accident year will not be fully known for many years. North American property/casualty loss reserves were $15.5 billion ($14.3 billion net of reinsurance) at December 31, 2003 and $16.2 billion ($14.9 billion net of reinsurance) at December 31, 2002. About 52% of this amount at December 31, 2003 represents estimates of IBNR losses.
Although loss reserve levels are now believed to be adequate, there can be no guarantees. A relatively small change in the estimate of net reserves can produce large changes in annual underwriting results. For instance, a one percentage point change in net loss reserves at year end 2003 would produce a pre-tax underwriting gain or loss of $143 million, or roughly 4% of premiums earned in 2003. 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.
The international property/casualty operations produced a pre-tax underwriting gain of $38 million during 2003, compared with pre-tax underwriting losses of $315 million and $568 million for 2002 and 2001, respectively. The net underwriting gain for 2003 included $69 million of gains in the current underwriting year, which reflected rate increases and the absence of large property losses, and losses of $31 million from increases to reserves for prior years’ loss occurrences. Results for 2002 included $240 million of net increases to prior years’ loss reserves, and approximately $107 million in catastrophe and other large individual property losses, principally European flood
Underwriting results for the global life/health operations produced a pre-tax underwriting gain of $58 million in 2003, compared with underwriting losses of $55 million and $82 million in 2002 and 2001, respectively. While both the U.S. and international life/health segments were profitable in 2003, most of the gains were earned in the international life segment. The underwriting losses for 2002 and 2001 were principally due to increased reserves on run-off business in the U.S. life/health operations. Underwriting results for 2001 also include $19 million of net losses related to the September 11th terrorist attack.
The Berkshire Hathaway Reinsurance Group (“BHRG”) underwrites excess-of-loss and quota-share reinsurance coverages for insurers and reinsurers around the world. BHRG is believed to be one of the leaders in providing catastrophe excess-of-loss reinsurance and writing coverages for large or otherwise unusual discrete commercial property risks on a direct and facultative reinsurance basis, referred to as individual risk business. BHRG’s underwriting results are summarized in the table below.
During the second half of 2001, opportunities for BHRG to write catastrophe and individual risk business increased significantly, particularly subsequent to September 11th. Contracts written may provide exceptionally large limits of indemnification, often several hundred million dollars and occasionally in excess of $1 billion, and may 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 $1.2 billion in 2003 and $1.5 billion in 2002. 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.
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. The net underwriting loss in 2001 included about $410 million from the September 11th terrorist attack. Losses related to the September 11th terrorist attack were reduced by about $85 million in 2002, as payments to settle claims under certain policies were below original estimates. Although very large underwriting gains were achieved in 2003 and 2002, a single loss event could have easily eliminated those gains. The pre-tax maximum probable loss from a single event at December 31, 2003 is estimated to be approximately $6.7 billion resulting from potential risk of loss from a major earthquake in California.
Collectively, Berkshire’s other primary insurance businesses produced earned premiums of $1,034 million in 2003, $712 million in 2002, and $501 million in 2001. The increases in premiums earned during the past two years were largely attributed to increased volume at USIC and the NICO Primary Group. Net underwriting gains of Berkshire’s other primary insurance businesses totaled $74 million in 2003, $32 million in 2002, and $30 million in 2001. The improvement in year-to-year comparative underwriting results was due to the aforementioned increases in premiums and reasonably good claim experience.
Following is a summary of the net investment income of Berkshire’s insurance operations for the past three years. Dollars are in millions.
Invested assets of insurance businesses increased during 2003 by $14.5 billion to $93.5 billion at December 31, 2003 following an increase of $7 billion during 2002. The increase in invested assets during 2003 was primarily the result of the market price appreciation of Berkshire’s major equity investments and high-yield fixed maturity investments, as well as strong operating cash flow.
Berkshire’s apparel manufacturing and distribution businesses have grown significantly during the last two years as a result of the acquisitions of Fruit of the Loom on April 30, 2002 and Garan on September 4, 2002. During 2003 these two businesses generated combined revenues of $1,459 million and pre-tax earnings of $260 million. From their respective acquisition dates, these two businesses generated combined revenues of $957 million and pre-tax earnings of $190 million in 2002. On a comparative full year basis, total apparel group revenues in 2003 declined 5% from 2002 and pre-tax earnings in 2003 declined 11% as compared to 2002. Pre-tax losses in 2001 from the apparel businesses included operating losses and a restructuring charge at Dexter.
Each of Berkshire’s building products businesses manufactures and distributes products and services for the residential and commercial construction and home improvement markets. Revenues of the building products group totaled $3,846 million in 2003 compared to $3,702 million in 2002. Each of the building products businesses generated higher revenues in 2003 as compared to 2002 and benefited from the strong housing market and relatively low interest rates. Pre-tax earnings of the building products businesses in 2003 were $559 million compared to $516 million in 2002.
A variety of finance and financial products businesses are included in this segment. These businesses invest in various types of fixed-income securities (BH Finance), make commercial loans (Berkshire Hathaway Credit Corporation and Berkadia LLC), issue and service installment loan contracts with respect to manufactured housing (Clayton Homes, through its subsidiary Vanderbilt Mortgage, acquired August 7, 2003), lease trailers and shipping containers used in product transportation and lease furniture (XTRA and CORT) and offer for sale annuities and similar type products (Berkshire Hathaway Life). This group also includes General Re Securities (“GRS”), a dealer in derivative contracts. These businesses generally issue debt or interest bearing obligations to finance asset acquisitions.
Pre-tax earnings of the finance group in 2003, which exclude realized investment gains, declined $107 million (14.7%) from 2002. Much of the
GRS had a pre-tax loss in 2003 of $99 million versus a loss of $173 million in 2002. GRS’s operation has been in run-off since January 2002. During the run-off period, GRS has limited new business to certain risk management transactions and is unwinding existing asset and liability positions in an orderly manner. Since the run-off commenced, approximately two-thirds of GRS’s open trades have been terminated. It is expected that the run-off will take at least several more years to complete. The pre-tax losses in the last two years reflect related run-off costs as well as net transaction and position losses. Additional losses will almost certainly be incurred over time in connection with the run-off. The timing and amounts of such losses is uncertain.
This segment includes FlightSafety, a leading provider of high technology training to operators of aircraft and ships and NetJets, the world’s leading provider of fractional ownership programs for general aviation aircraft. FlightSafety’s worldwide clients include corporations, regional airlines, the military and government agencies. The decline in revenues was split between FlightSafety (about $96 million) and NetJets (about $310 million). A decline in FlightSafety training revenues accounted for most of that businesses revenue decline. The decline in training revenues was due to a decline in regional airline training somewhat offset by increased U.S. Government training revenues. The decline in revenues at NetJets was due to a reduction of revenues from sales of aircraft of $514 million partially offset by increased flight services and other revenues of about $204 million. Pre-tax earnings from these businesses was $72 million in 2003 as compared to $225 million in 2002. The results for 2002 include a gain of $60 million from the sale of a partnership interest to Boeing and the results for 2003 include the recognition of pre-tax charges of $69 million related to write downs of certain simulators and aircraft inventory. Excluding the aforementioned gain and write downs, “normal earnings” from these businesses were $141 million in 2003 versus $165 million in 2002. The reduction in combined “normal” pre-tax earnings from these businesses is due to reduced “normal” pre-tax earnings at FlightSafety of $34 million somewhat offset by improved results at NetJets where its pre-tax loss before write downs was $9 million in 2003 versus about $19 million in 2002. The corporate aviation business has slowed significantly in the past few years which has hurt FlightSafety’s results. NetJets continues to be the leader in the fractional ownership field.
On May 23, 2003, Berkshire acquired McLane Company, Inc. from Wal-Mart Stores, Inc. Results of McLane’s business operations are included in Berkshire’s consolidated results beginning on that date. McLane’s revenues were $13,743 million and pre-tax earnings totaled $150 million for the period from May 23 to December 31. Approximately 35% of McLane’s revenues derived from sales to Wal-Mart Stores, Inc. McLane’s business is marked by high sales volume and low profit margins. For its most recently completed fiscal year prior to the acquisition, McLane’s sales and pre-tax earnings totaled approximately $21.9 billion and $220 million, respectively. See Note 2 to the Consolidated Financial Statements for information regarding the acquisition and McLane’s business.
Shaw is a leading manufacturer and distributor of carpet and rugs for residential and commercial use. Shaw also provides installation services and offers hardwood floor and other floor coverings. Berkshire acquired 87.3% of the common stock of Shaw in January 2001 and the remainder of the outstanding stock in January 2002. Shaw’s revenues in 2003 of $4,660 million increased by $326 million (7.5%) over 2002, and 2002 revenues increased 8.0% over 2001. The increase in 2003 revenues reflects a 6.1% increase in carpet sales revenues as well as increased sales of hard floor surfaces. Shaw’s revenues in 2003 also include the results from Dixie Group, a carpet and rug manufacturer acquired in November. In 2003, Shaw’s pre-tax earnings totaled $436 million, an increase of $12 million (2.8%) over 2002. Shaw’s operating results in 2003 benefited from increased sales and lower borrowing costs.
Purchase-accounting adjustments reflect the after-tax effect on net earnings with respect to the amortization of fair value adjustments to certain assets and liabilities recorded at various business acquisition dates. Prior to 2002, this amount also included goodwill amortization. Effective January 1, 2002, Berkshire ceased amortizing goodwill of previously acquired businesses in accordance with the provisions of SFAS No. 142.
Realized investment gains and losses have been a recurring element in Berkshire’s net earnings for many years. Such amounts are recorded when investments are: (1) sold or disposed; (2) impaired; or (3) marked-to-market with a corresponding gain or loss included in earnings. Such amounts also include realized and unrealized gains or losses associated with certain derivatives contracts. Realized investment gains may fluctuate significantly from period to period, resulting in a meaningful effect on reported net earnings. However, the amount of realized gains in a given period has no practical analytical value, given the magnitude of unrealized gains existing in Berkshire’s consolidated investment portfolio.
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 annually each May 15 from 2004 through 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, 2003.
Assets of the finance and financial products businesses totaled $28.3 billion at December 31, 2003 and $34.1 billion at December 31, 2002. The overall decline reflects a $6 billion decline in assets of BH Finance as a result of the liquidation of certain fixed income investments, FINOVA loan prepayments totaling $1.65 billion and a decline in assets of GRS, which is in run-off. The outstanding loan to FINOVA as of December 31, 2003 and corresponding borrowing from Fleet (each $525 million) were fully repaid in February 2004.
Berkshire and its subsidiaries have contractual obligations associated with ongoing business and financing activities, which will result in cash payments in future periods. Certain of those obligations, such as notes payable and other borrowings and related interest payments, are reflected in the Consolidated Financial Statements. In addition, Berkshire and subsidiaries have entered into long-term contracts to acquire goods or services in the future, which are not currently reflected in the financial statements and will be reflected in future periods as the goods are delivered or services provided. A summary of contractual obligations follows. Amounts are in millions.
In applying certain accounting policies, Berkshire’s management is required to make estimates and judgments regarding transactions that have occurred and ultimately will be settled several years in the future. Amounts recognized in the financial statements from such estimates are necessarily based on assumptions about numerous factors involving varying, and possibly significant, degrees of judgment and uncertainty. Accordingly, the amounts currently recorded in the financial statements may prove, with the benefit of hindsight, to be inaccurate. The balance sheet items most significantly affected by these estimates are property and casualty insurance and reinsurance related liabilities.
Reserves for unpaid losses and loss adjustment expenses are established by policy type (or line) or individual coverage within the policy type. Reserves may consist of individual case estimates, supplemental case estimates, development estimates and incurred-but-not-reported (“IBNR”) claim estimates. Once reported, certain casualty claims may take years to settle, especially if legal action is involved. Liabilities may also reflect implicit or explicit assumptions regarding the potential effects of future economic and social inflation, judicial decisions, law changes, and recent trends in such factors.
Berkshire uses a variety of techniques as tools in establishing and evaluating aggregate reserve amounts. Techniques used vary within each business depending upon the availability of reliable information. Statistical techniques may include detailed analysis of historical amounts of losses incurred or paid, claim frequency and severity data, average paid or incurred loss data, closed claim data, paid or incurred loss ratios or other measurements. Statistical techniques are more reliable when a sufficient volume of historical loss information exists. Significant changes to policy terms or coverages or in volumes of business written (and, therefore, loss exposures), or changes in the insurance laws or legal environment can cause historical statistical data to be less reliable in projecting the ultimate amount of losses as of the balance sheet date. Statistical analysis may be based
A summary of Berkshire’s consolidated liabilities for unpaid property and casualty losses are in the table below. The amount of losses recorded in each of the past two years relating to prior years’ loss occurrences is expressed as a percentage of total net premiums earned as well as a percentage of the net reserve balance established as of the beginning of the year. Dollars are in millions.
Berkshire’s consolidated financial position reflects large amounts of invested assets, including assets of its finance and financial products businesses. A substantial portion of these assets are carried at fair values based upon current market quotations and, when not available, based upon fair value pricing models. 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.
The table below summarizes Berkshire’s equity price risks as of December 31, 2003 and 2002 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.
Berkshire’s derivatives risks are concentrated in the operations of General Re Securities (“GRS”), a dealer in various types of derivative instruments in conjunction with offering risk management products to its clients. Effective January 2002, GRS commenced the run-off of its business. It is expected that the run-off will take several years to complete. Since January 2002, approximately two-thirds of GRS’s contracts have been terminated. GRS manages its market risk from derivatives by estimating the effect on operating results of potential changes in market variables over time, based on historical market volatility, correlation data and informed judgment. GRS’s weekly maximum aggregate market risk target was $15 million in 2003 and weekly losses exceeded that amount on two occasions. In addition to these daily and weekly assessments of risk, GRS prepares periodic stress tests to assess its exposure to extreme movements in various market risk factors. The estimated average expected weekly market risk, as calculated using the methodology described over one week intervals was $5 million in 2003 and $4 million in 2002.
duration of the contracts is generally less than twelve months. The aggregate notional value of such contracts at December 31, 2003 was approximately $11 billion. Unrealized gains from these contracts totaled approximately $630 million at December 31, 2003.
Investors are cautioned that certain statements contained in this document, as well as some statements by the Company in periodic press releases and some oral statements of Company officials during presentations about the Company, are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”). Forward-looking statements include statements which are predictive in nature, which depend upon or refer to future events or conditions, which include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” or similar expressions. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible future Company actions, which may be provided by management are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about the Company, economic and market factors and the industries in which the Company does business, among other things. These statements are not guaranties of future performance and the Company has no specific intention to update these statements.
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, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.
As described in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets”, effective January 1, 2002.
Average shares outstanding include average Class A common shares and average Class B common shares determined on an equivalent Class A common stock basis. Net earnings per common share shown above represents net earnings per equivalent Class A common share. Net earnings per Class B common share is equal to one-thirtieth (1/30) of such amount or $177 per share for 2003, $93 per share for 2002, and $17 per share for 2001.
The accompanying Consolidated Financial Statements include the accounts of Berkshire consolidated with the accounts of all of its subsidiaries and affiliates in which Berkshire holds a controlling financial interest as of the financial statement date. Normally control reflects ownership of a majority of the voting interests. Other factors considered in determining whether control is held include whether Berkshire provides significant financial support as a result of its authority to purchase or sell assets or make other operating decisions that significantly affect the entity’s results of operations and whether Berkshire bears a majority of the financial risks.
Intercompany accounts and transactions have been eliminated. Certain amounts in 2002 and 2001 have been reclassified to conform with the current year presentation.
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.
judgement, the decline in value is other-than-temporary, the cost of the investment is written down to fair value with a corresponding charge to earnings. Factors considered in determining whether an impairment exists include: the financial condition, business prospects and creditworthiness of the issuer, the length of time that the asset’s fair value has been less than cost, and Berkshire’s ability and intent to hold such investments until the fair value recovers.
Berkshire utilizes the equity method of accounting with respect to investments where it exercises significant influence, but not control, over the policies of the investee. A voting interest of at least 20% and no greater than 50% is normally a prerequisite for utilizing the equity method. However Berkshire may apply the equity method with less than 20% voting interests based upon the facts and circumstances including representation on the Board of Directors, contractual veto or approval rights, participation in policy making processes and the existence or absence of other significant owners. Berkshire applies the equity method to investments in common stock and investments in preferred stock when such preferred stock possesses substantially identical subordinated interests to common stock. Berkshire accounts for investments in unconsolidated limited partnerships under the equity method.
In applying the equity method, investments are recorded at cost and subsequently increased or decreased by the proportionate share of 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 additional 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.
Goodwill of acquired businesses represents the difference between purchase cost and the fair value of net assets of 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, and was reviewed for impairment if conditions were identified that indicated possible impairment.
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.
In December 2003, the FASB issued a revision to Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which was originally issued in January 2003. FIN 46, as revised, provides guidance on the consolidation of certain entities when control exists through other than voting (or similar) interests and was effective immediately with respect to entities created after January 31, 2003. For certain special purpose entities created prior to February 1, 2003, FIN 46, as revised, became effective for financial statements issued after December 15, 2003. FIN 46, as revised, is effective for all other entities created prior to February 1, 2003 beginning with financial statements for reporting periods ending after March 15, 2004.
FIN 46, as revised, requires consolidation by the majority holder of expected residual gains and losses of the activities of a variable interest entity (“VIE”). Berkshire is a limited partner in Value Capital L.P. (“Value Capital”), whose objective is to achieve income and capital growth from investment and arbitrage of fixed maturity securities. See Note 10. Neither Berkshire nor any of its subsidiaries possess any management authority over Value Capital and possess no voting or similar rights. Berkshire conducts no business activities with Value Capital. Berkshire does not guaranty or provide any financial support with respect to the obligations of Value Capital beyond its direct equity investment.
On January 8, 2001, Berkshire acquired approximately 87.3% of the common stock of Shaw for $19 per share, or $2.1 billion in the aggregate and in January 2002, Berkshire acquired the remaining shares in exchange for 4,505 shares of Berkshire Class A common stock and 7,063 shares of Berkshire Class B common stock. The aggregate market value of Berkshire stock issued was approximately $324 million. Shaw is the world’s largest manufacturer of tufted broadloom carpet and rugs for residential and commercial applications throughout the U.S. Shaw markets its residential and commercial products under a variety of brand names.
On March 14, 2000, Berkshire acquired 900,942 shares of common stock and 34,563,395 shares of convertible preferred stock of MidAmerican Energy Holdings Company (“MidAmerican”) for $35.05 per share, or approximately $1.24 billion in the aggregate. During March 2002, Berkshire acquired 6,700,000 additional shares of the convertible preferred stock for $402 million. Such investments currently give Berkshire about a 9.9% voting interest and an 83.7% economic interest in the equity of MidAmerican (80.5% on a diluted basis). Since March 2000, Berkshire and certain of its subsidiaries also acquired approximately $1,728 million of 11% non-transferable trust preferred securities, of which $150 million were redeemed in August 2003. Mr. Walter Scott, Jr., a member of Berkshire’s Board of Directors, controls approximately 88% of the voting interest in MidAmerican.
While the convertible preferred stock does not vote generally with the common stock in the election of directors, the convertible preferred stock gives Berkshire the right to elect 20% of MidAmerican’s Board of Directors. The convertible preferred stock is convertible into common stock only upon the occurrence of specified events, including modification or elimination of the Public Utility Holding Company Act of 1935 so that holding company registration would not be triggered by conversion. Additionally, the prior approval of the holders of convertible preferred stock is required for certain fundamental transactions by MidAmerican. Such transactions include, among others: a) significant asset sales or dispositions; b) merger transactions; c) significant business acquisitions or capital expenditures; d) issuances or repurchases of equity securities; and e) the removal or appointment of the Chief Executive Officer. Through the investments in common and convertible preferred stock of MidAmerican, Berkshire has the ability to exercise significant influence on the operations of MidAmerican.
Condensed consolidated balance sheets of MidAmerican are as follows. Amounts are in millions.
Shown below are the amortized cost and estimated fair values of securities with fixed maturities at December 31, 2003, 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.
Data with respect to investments in equity securities are shown below. Amounts are in millions.
(2) Net of unrealized losses of $65 million and $406 million as of December 31, 2003 and 2002, respectively.
Net realized 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 2003 and 2002 include no periodic amortization of goodwill. In 2001, goodwill amortization, net of tax, was $636 million (or $416 per equivalent Class A share). Such amount included $78 million related to Berkshire’s equity method investment in MidAmerican. A reconciliation of the change in the carrying value of goodwill for 2003 and 2002 is as follows (in millions).
At December 31, 2003, Berkshire subsidiaries accepted collateral with a fair value of $1,220 million to secure unrealized gains on derivatives. Of the securities held as collateral, approximately $31 million were repledged as of December 31, 2003. At December 31, 2003, securities with a fair value of approximately $441 million (which includes $31 million of repledged securities as described above) were pledged against derivative liabilities with a fair value of $733 million. Contractual terms with counterparties often require additional collateral to be posted immediately in the event of a decline in the financial rating of the counterparty or its guarantor.
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, 2003 approximated $3,439 million. The following table presents derivatives portfolios by counterparty credit quality and maturity at December 31, 2003. 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 unrealized gains on financial instrument contracts in gain positions, net of any unrealized 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.
Liquidity risk can arise from funding the portfolio of open transactions. Movements in underlying market variables affect both future cash flows related to the transactions and collateral required to cover the value of open positions.
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. Through December 31, 2003, Berkshire accounted for its limited partnership investment pursuant to the equity method. At December 31, 2003, the carrying value of $634 million (including Berkshire’s share of accumulated undistributed earnings of $204 million) is included as a component of other assets of finance and financial products businesses. In January of 2004, Berkshire received a cash distribution of $30 million from Value Capital. As a limited partner, Berkshire’s exposure to loss is limited to the carrying value of its investment. Beginning in 2004, Berkshire will consolidate Value Capital in connection with the adoption of FIN 46, as revised. See Note 1 (r) for additional information.
Berkshire’s insurance subsidiaries are exposed to environmental, asbestos and other latent injury claims arising from insurance and reinsurance contracts. Loss reserve estimates for environmental and asbestos exposures include case basis reserves, which also reflect reserves for legal and other loss adjustment expenses and IBNR reserves. IBNR reserves are determined based upon Berkshire’s historic general liability exposure base and policy language, previous environmental and loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.
The liabilities for environmental, asbestos, and latent injury claims and claims expenses net of reinsurance recoverables were approximately $5.5 billion at December 31, 2003 and $6.6 billion at December 31, 2002. These liabilities include $4.4 billion at December 31, 2003 and $5.4 billion at December 31, 2002, of liabilities assumed under
retroactive reinsurance contracts written by the Berkshire Hathaway Reinsurance Group. The decline in these liabilities over the last twelve months was primarily attributed to commutations of certain contracts in 2003. Claim liabilities arising from the retroactive contracts are subject to aggregate policy limits. Thus, Berkshire’s exposure to environmental and latent injury claims under these contracts is, likewise, limited. Claims paid or reserved under these policies were approximately 86% of aggregate policy limits as of the end of 2003.
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 securities with fixed maturities 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 as compared to 40 years under GAAP for periods ending December 31, 2001 and prior. As of January 1, 2002, under GAAP, goodwill is only subject to tests for impairment.
The estimated fair values of Berkshire’s financial instruments as of December 31, 2003 and 2002, are as follows (in millions).
Considerable judgment is necessarily required in interpreting market data used to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value.
The increase (decrease) in minimum liabilities included in other comprehensive income for each year are as follows (in millions). Such amounts do not include Berkshire’s share of changes in minimum liabilities of MidAmerican.
The accumulated benefit obligation is the actuarial present value of benefits earned based on service and compensation prior to the valuation date. The projected benefit obligation is the actuarial present value of benefits earned based upon service and compensation prior to the valuation date and includes assumptions regarding future compensation levels when benefits are based on those amounts. Information regarding accumulated and projected benefit obligations and plan assets are as follows (in millions).
Information related to Berkshire’s reportable business operating segments is shown below. Berkshire’s reportable segments are reported in a manner consistent with the way management evaluates the businesses. As such, insurance underwriting activities are evaluated separately from investment activities. Realized investment gains are not considered relevant in evaluating investment performance on an annual basis. Amortization of purchase accounting adjustments is not considered by management in evaluating the results of the business segments.
Manufacturing and distribution of a variety of building materials and related products and services
Consolidated sales and service revenues in 2003, 2002 and 2001 totaled $32.1 billion, $17.0 billion and $14.5 billion respectively. Over 90% of such amounts in each year were in the United States with the remainder primarily in Canada and Europe. In 2003, consolidated sales and service revenues included $5.5 billion of sales to Wal-Mart Stores, Inc. which were primarily related to McLane’s wholesale distribution business that Berkshire acquired in May 2003.
(1) Includes realized investment gains, which, for any given period have 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 realized investment gains for the periods presented above are as follows: