Net earnings for the year ending December 31, 2005 includes pre-tax underwriting losses of $3.4 billion in connection with Hurricanes Katrina, Rita and Wilma that struck the Gulf coast and Southeast regions of the United States. Such loss reduced net earnings by approximately $2.2 billion and earnings per share by $1,446. Net earnings for the year ending December 31, 2001 includes pre-tax underwriting losses of $2.4 billion in connection with the September 11th terrorist attack. Such loss reduced net earnings by approximately $1.5 billion and earnings per share by $982.
A reconciliation of Berkshire’s Consolidated Statements of Earnings for each of the five years ending December 31, 2005 from amounts reported to amounts exclusive of goodwill amortization is shown below. Goodwill amortization for the year ending December 31, 2001 includes $78 million related to Berkshire’s equity method investment in MidAmerican Energy Holdings Company.
A key marketing strategy followed by all these businesses is the maintenance of extraordinary capital strength. Statutory surplus of Berkshire’s insurance businesses totaled approximately $52 billion at December 31, 2005. This superior capital strength creates opportunities, especially with respect to reinsurance activities, to negotiate and enter into insurance and reinsurance contracts specially designed to meet unique needs of insurance and reinsurance buyers. Additional information regarding Berkshire’s insurance and reinsurance operations follows.
During 2005, policies-in-force increased 12.9% in the preferred risk markets and 10.7% in the standard and nonstandard markets. Voluntary auto new business sales in 2005 increased 14.0% compared to 2004. Voluntary auto policies-in-force at December 31, 2005 were 745,000 higher than at December 31, 2004.
Losses and loss adjustment expenses in 2005 totaled $7,128 million, an increase of 12.1% over 2004. The loss ratio declined to 70.6% in 2005 compared to 71.3% in 2004 and 76.5% in 2003 primarily due to decreasing claim frequencies across all markets and most coverage types. In 2005, claims frequencies for physical damage coverages decreased in the two to five percent range from 2004 while frequencies for injury coverages decreased in the five to seven percent range. Injury severity in 2005 increased in the three to five percent range over 2004 while physical damage severity has increased in the five to eight percent range. Incurred losses from catastrophe events totaled approximately $227 million in 2005 (primarily from the hurricanes in the third and fourth quarters) compared to $71 million in 2004.
Underwriting expenses in 2005 totaled $1,752 million, an increase of 10.5% over 2004, which increased 15.1% over 2003. Policy acquisition expenses in 2005 increased 20.1% over 2004, reflecting increased advertising, underwriting and policy issuance costs associated with the new business sales. Other underwriting expenses for 2005 decreased slightly from 2004.
The International property/casualty businesses produced pre-tax underwriting losses of $138 million in 2005 and $93 million in 2004 compared with a gain of $20 million in 2003. Underwriting results included catastrophe losses from U.S. hurricanes of $205 million in 2005 and $110 million in 2004. Additionally, results in 2005 included $29 million in losses from Windstorm Erwin. Losses from catastrophes and large individual property losses were minimal in 2003. Underwriting results for each of the last three years benefited from favorable results of the aviation business and relatively small non-catastrophe property losses. The International property and casualty underwriting results included gains from prior years’ loss occurrences of $108 million in 2005, compared with losses of $102 million in 2004 and $104 million in 2003. Prior years’ losses in 2004 and 2003 were primarily in motor excess, workers’ compensation and other casualty lines and also reflect reserve increases for operations placed in run-off.
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.
Premiums earned in 2005 increased 13.9% over 2004, which increased 9.1% over 2003. Adjusting for the effects of foreign currency exchange rates, premiums earned increased 14.2% in 2005 and 3.7% in 2004. The increase in 2005 premiums earned reflected increases in both North American and European life business. In 2004, the increase was attributable, in part, to the strengthening of foreign currencies and an increase in European life business.
The Berkshire Hathaway Reinsurance Group (“BHRG”) underwrites excess-of-loss reinsurance and quota-share coverages for insurers and reinsurers world-wide. BHRG’s business includes catastrophe excess-of-loss reinsurance and excess direct and facultative reinsurance for large or otherwise unusual discrete property risks referred to as individual risk. Retroactive reinsurance policies provide indemnification of losses and loss adjustment expenses with respect to past loss events. Other multi-line refers to other business written on both a quota-share and excess basis, and includes participations in and contracts with Lloyd’s syndicates. In addition, during the past twelve months BHRG has written increased amounts of aviation business and workers’ compensation insurance. Amounts are in millions.
Underwriting results from catastrophe and individual risk business in 2005 included estimated losses of approximately $2.4 billion from Hurricanes Katrina, Rita and Wilma. In 2004, underwriting results from catastrophe and individual risk business included estimated catastrophe losses of $790 million 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 due to the lack of catastrophic or otherwise large loss events. The timing and magnitude of losses may produce extraordinary volatility in periodic underwriting results of BHRG’s catastrophe and individual risk business. Management accepts such volatility, however, provided that the long-term prospect of achieving underwriting profits is reasonable. BHRG generally does not cede catastrophe and individual risks to other reinsurers.
Retroactive policies normally provide very large, but limited, indemnification of unpaid losses and loss adjustment expenses with respect to past loss events, which are generally expected to be paid over long periods of time. The underwriting losses from retroactive reinsurance are primarily attributed to the amortization of deferred charges established on retroactive reinsurance contracts written in previous years. The deferred charges, which represent the difference between the policy premium and the estimated ultimate claim reserves, are amortized over the expected claim payment period using the interest method. The amortization charges are recorded as losses incurred and, therefore, produce underwriting losses. The level of amortization in a given period is based upon estimates of the timing and amount of future loss payments. While contract terms vary, losses under retroactive contracts are generally subject to a very large aggregate dollar limit occasionally exceeding $1 billion under a single contract. The expected amount and timing of future loss payments is reviewed periodically. To the extent there are changes in these estimates, deferred charge balances are adjusted on a retrospective basis via a cumulative adjustment.
Underwriting losses in 2005 from retroactive contracts are net of a pre-tax gain of approximately $46 million related to the final settlement of remaining unpaid losses under a certain retroactive reinsurance agreement. In addition, estimates of unpaid losses were reviewed during the fourth quarter of 2005 which resulted in a net reduction of $75 million in loss reserves. Also, rates of deferred charge amortization on certain contracts were decreased due to slower than expected loss payments. During 2004 the estimated timing of future loss payments with respect to one large contract was accelerated which produced an incremental pre-tax amortization charge of approximately $100 million.
Premiums earned in 2005 from other multi-line reinsurance increased approximately $226 million over 2004. In 2005, increased premiums were earned from new workers’ compensation and ongoing aviation programs and were partially offset by declines in quota-share contracts. Premiums earned in 2004 from traditional multi-line reinsurance decreased $510 million 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.
The pre-tax maximum probable loss from a single event at December 31, 2005 is estimated to be $6 billion resulting from potential risk of loss from a major earthquake in California.
Collectively, Berkshire’s other primary insurance businesses produced earned premiums of $1,498 million in 2005, $1,211 million in 2004, and $1,034 million in 2003. Premiums earned in 2005 by Med Pro accounted for most of the increase in total premiums earned by the group compared with 2004. The increase in premiums earned in 2004 compared to 2003 was largely attributed to increased volume of USIC and the NICO Primary Group. Net underwriting gains of Berkshire’s other primary insurance businesses totaled $235 million in 2005, $161 million in 2004, and $74 million in 2003. The underwriting gain in 2005 reflected a decrease in loss reserve estimates for pre-2005 loss events in auto and general liability business, improved results of Homestate, USIC and CSI operations, partially offset by losses incurred from increases in medical malpractice reserves.
Investment income consists of interest and dividends earned on cash equivalents and fixed maturity and equity investments of Berkshire’s insurance businesses. Pre-tax investment income earned in 2005 by Berkshire’s insurance businesses exceeded amounts earned in 2004 by $656 million (23.2%). The increase in investment income in 2005 primarily reflects higher short-term interest rates in the United States in 2005 as compared to 2004. Investment income in 2004 declined 12.4% from 2003, reflecting relatively lower short-term interest rates and lower amounts of interest earned from high yield corporate bonds.
A summary of investments held in Berkshire’s insurance businesses follows. Dollar amounts are in millions.
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 approximately $49.3 billion at December 31, 2005, $46.1 billion at December 31, 2004 and $44.2 billion at December 31, 2003. The cost of float, as represented by the ratio of pre-tax underwriting gain or loss to average float, was negative for the last three years, as Berkshire’s insurance businesses generated pre-tax underwriting gains in each year.
Apparel revenues in 2005 increased $86 million (4%) over 2004 and revenues in 2004 increased $125 million (6%) over 2003. Sales of clothing products (Fruit of the Loom (“FOL”), Garan and Fechheimer) totaled $1,754 million in 2005 an increase of $60 million (3.5%) over 2004, which was primarily attributed to a 3% increase in unit volume and changes in the sales mix of FOL products. Footwear (HH Brown Shoe Group and Justin) sales in 2005 increased $26 million (5.3%) over 2004. Increased sales were generated in Western boots and women’s casual shoes. Increased sales by FOL accounted for essentially all of the increases in 2004 over 2003, as unit sales increased 14%, partially offset by lower net selling prices. Sales to a few major retailers account for about 45% of apparel revenues. Loss or curtailment of sales to a major customer could have a material adverse impact on revenues and pre-tax earnings of the apparel segment.
Other finance revenues in 2005 and 2004 are primarily derived from interest income from other loans and fixed income investments and the operations of General Re Securities (“GRS”) which is being run-off. In 2003, other finance revenues included life insurance annuity premiums of $700 million arising from a few sizable transactions. Annuity premiums generated in 2005 and 2004 were nominal. Other finance revenues in 2004 also included $282 million from the consolidation of Value Capital L.P. (“VC”) during the first six months. As a result of a significant decline in the percentage of Berkshire’s economic interest in VC, Berkshire ceased consolidation of VC effective July 1, 2004 and thereafter accounted for its investment in VC pursuant to the equity method.
Pre-tax earnings from other finance activities in 2005 were $233 million, a decrease of $67 million from 2004. Berkshire’s investment in VC produced a pre-tax loss in 2005 of $33 million compared to a pre-tax gain of $30 million in 2004. GRS generated pre-tax losses of $104 million in 2005 and $44 million in 2004. The increase in GRS losses was due to higher losses from unwinding derivative positions. In 2005, pre-tax earnings attributed to the life insurance/annuity business exceeded 2004 by $68 million as a result of higher short-term interest rates and the absence of adverse effects from changes to mortality estimates pertaining to annuity contracts.
Pre-tax earnings from other finance activities in 2004 declined approximately $251 million from 2003 primarily as a result of comparatively lower amounts of invested assets. In addition, pre-tax earnings for 2004 were negatively impacted by higher allocations of investments in low-yielding cash and cash equivalents, a significant reduction in the early redemptions of fixed-income securities purchased at a discount and adverse effects from changes in mortality assumptions.
Flight service revenues in 2005 increased $416 million (13%) over 2004, which, in turn, increased $813 million (33%) over 2003. In 2005, revenues of the training business (FlightSafety) and the fractional ownership business (NetJets) each increased 13% over revenues in 2004. In 2005, the increase in training revenue was primarily due to increased simulator usage and increased demand, primarily in the corporate aviation and regional airline markets. The fractional ownership program revenue increase in 2005 over 2004 reflected an 18% increase in flight operations and management service fees. The increase in flight operations revenue primarily resulted from a 7% increase in occupied flight hours, rate increases and a higher mix of larger cabin aircraft usage, which generate higher revenues. Over 90% of the revenue increase in 2004 over 2003 resulted from the NetJets business where flight operations revenue increased just under $400 million and revenues from aircraft sales increased about $360 million. NetJets and FlightSafety continue to be leaders in the aircraft fractional ownership and training markets.
On May 23, 2003, Berkshire acquired McLane Company, Inc., (“McLane”) a distributor of grocery and food products to retailers, convenience stores and restaurants. Results of McLane’s business operations are included in Berkshire’s consolidated results beginning on that date. McLane’s revenues in 2005 totaled $24.1 billion compared to $23.4 billion in 2004 and approximately $22.0 billion for the full year of 2003. Sales of grocery products increased about 5% in 2005 and were partially offset by lower sales to foodservice customers. McLane’s business is marked by high sales volume and very low profit margins.
Total revenues attributed to retail operations were $2,601 million in 2004, an increase of $290 million (13%) over 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.
Revenues generated by Shaw Industries in 2004 increased $514 million (11%) over 2003 due to a 9% increase in square yards of carpet sold, higher net selling prices and increased hard surface and rug sales. In addition, sales in 2004 include two businesses acquired by Shaw in 2003 (Georgia Tufters and the North Georgia operations of the Dixie Group). These acquisitions 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. Sales price increases lagged raw material supplier price increases resulting in a decline in gross margins during 2004 as compared to 2003.
Earnings from MidAmerican represent Berkshire’s share of MidAmerican’s net earnings as determined under the equity method. In 2005, Berkshire’s share of MidAmerican’s net earnings was $523 million versus $237 million in 2004. MidAmerican’s 2004 results include an after-tax charge of $340 million (of which Berkshire’s share was about $255 million) to write down certain assets of an operation that was shut down in the third quarter and a gain of $44 million (Berkshire’s share was about $33 million) from the realization of certain Enron-related bankruptcy claims. In 2005, MidAmerican benefited from favorable comparative results at most of its domestic businesses and from gains on sales of certain non-strategic assets and investments. These improvements were partially offset by lower earnings from the U.K. electricity business. Ignoring the effect of the aforementioned two non-recurring events, Berkshire’s share of MidAmerican’s 2004 net earnings was $459 million, which, when compared with 2003 results, reflects improved results at most of MidAmerican’s major operating units. See Note 2 to the Consolidated Financial Statements for additional information regarding MidAmerican.
A summary of investment and derivative gains and losses follows. Dollar amounts are in millions.
The other-than-temporary impairment losses reflected in the table above represent the adjustment of cost to fair value when, as required by GAAP, management concludes that the investment’s decline in value below cost is other than temporary. The impairment loss represents a non-cash charge to earnings. See Note 1(d) to the Consolidated Financial Statements for a summary of the factors considered in the judgment process. Gains and losses from the ultimate sale of securities in which other-than-temporary impairments were previously recorded are included in sales of investments.
Berkshire’s balance sheet continues to reflect significant liquidity and a strong capital base. Consolidated shareholders’ equity at December 31, 2005 totaled $91.5 billion. Consolidated cash and invested assets, excluding assets of finance and financial products businesses, totaled approximately $115.6 billion at December 31, 2005 (including cash and cash equivalents of $40.5 billion) and $102.9 billion at December 31, 2004 (including $40.0 billion in cash and cash equivalents). Berkshire’s invested assets are held predominantly in its insurance businesses.
On June 30, 2005, Berkshire acquired Med Pro from an affiliate of General Electric Company. Med Pro is a primary medical malpractice insurer. On August 31, 2005, Berkshire acquired Forest River, Inc., a manufacturer of recreational vehicles sold in the United States and Canada. In addition, a few other smaller add on acquisitions were completed by Berkshire subsidiaries during 2005. Aggregate consideration paid for all acquisitions in 2005 was approximately $2.4 billion.
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, 2006, provided that the holders also surrender a corresponding amount of warrants for cancellation. To date, no warrants have been exercised and $64 million par of notes have been redeemed.
Total assets of the finance and financial products businesses totaled $24.5 billion as of December 31, 2005, and $31.0 billion at December 31, 2004. Liabilities totaled $20.3 billion as of December 31, 2005, and $20.4 billion at December 31, 2004. During 2005, significant declines in investments in fixed maturity securities ($5.0 billion) resulted from sales and disposals and were offset by a decline ($4.6 billion) in securities sold under repurchase agreements. A $3.4 billion decline in derivative contract assets was the result of a large reduction in derivative contracts outstanding, including the ongoing run-off of the remaining positions of GRS. The asset reductions were partially offset by declines in liabilities to counterparties for funds held as collateral. Derivative contract liabilities increased slightly in 2005 as declines in liabilities due to the run-off of GRS were offset by increases in liabilities established with respect to other derivative positions of another Berkshire subsidiary.
Cash and cash equivalents of finance and financial products businesses totaled $4.2 billion as of December 31, 2005 and $3.4 billion as of December 31, 2004. During 2004, manufactured housing loans of Clayton increased approximately $5.0 billion to $7.5 billion as of December 31, 2004 and as of December 31, 2005 further increased to $9.6 billion. The increases were primarily attributed to loan portfolio acquisitions during 2004 and 2005. Prior to its acquisition by Berkshire in August 2003, Clayton securitized and sold a significant portion of its installment loans through special purpose entities. In early 2003, Clayton discontinued its loan securitizations and sales.
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 are contingent upon the ultimate outcome of claim settlements that will occur over many years. The amounts presented in the following table have been estimated 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 losses (referred to in this section as “gross unpaid losses”) are reflected in the Consolidated Balance Sheets without discounting for time value, regardless of the length of the claim-tail. Dollars are in millions.
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 occurrence. Casualty losses usually have very long claim-tails, occasionally extending for decades. Casualty claims are more susceptible to litigation and can be significantly affected by changing contract interpretations and the legal environment which contributes to extended claim-tails. Claim-tails for reinsurers may be further extended due to delayed reporting by ceding insurers or reinsurers due to contractual provisions or reporting practices. Loss and loss adjustment expense reserves include provisions for those claims that have been reported (referred to as “case reserves”) and for those claims that have not been reported, referred to as incurred but not yet reported (“IBNR”) reserves.
Expected loss ratios are selected by reserve cell, by accident year, based upon reviewing indicated ultimate loss ratios predicted from aggregated pricing statistics. Indicated ultimate loss ratios are calculated using the selected loss emergence pattern, reported losses and earned premium. If the selected emergence pattern is not accurate, then the indicated ultimate loss ratios will not be correct and this can influence the selected loss ratios and hence the IBNR reserve. As with selected loss emergence patterns, selecting expected loss ratios is not a strictly mechanical process and judgment is used in the analysis of indicated ultimate loss ratios and department pricing loss ratios.
BHRG’s unpaid losses and loss adjustment expenses as of December 31, 2005 are summarized as follows. Amounts are in millions.
As of December 31, 2005, BHRG’s gross loss reserves related to retroactive reinsurance policies were attributed to casualty losses. Retroactive policies include excess-of-loss contracts, in which losses (relating to past loss events) above a contractual retention are indemnified or contracts that indemnify all losses paid by the counterparty after the policy effective date. Retroactive losses paid in 2005 totaled $969 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.
In establishing retroactive reinsurance reserves, historical aggregate loss payment patterns are analyzed and projected into the future under various scenarios. The claim-tail is expected to be very long for many policies and may last several decades. Management attributes judgmental probability factors to these aggregate loss payment scenarios and an expectancy outcome is determined. Due to contractual limits of indemnification, the maximum losses payable under retroactive policies are approximately $11.5 billion as of December 31, 2005.
Berkshire’s Consolidated Balance Sheet as of December 31, 2005 includes goodwill of acquired businesses of approximately $23.6 billion. A significant amount of judgment is required in performing goodwill impairment tests. Such tests include periodically determining or reviewing the estimated fair value of Berkshire’s reporting units. There are several methods of estimating a reporting unit’s fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted projected future net earnings and multiples of earnings. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of goodwill. The excess of the recorded amount of goodwill over the implied value is then charged to earnings as an impairment loss.
Berkshire’s preferred strategy is to hold equity investments for very long periods of time. Thus, Berkshire’s management is not troubled by short term equity price volatility with respect to its investments provided that the underlying business, economic and management characteristics of the investees remain favorable. Berkshire strives to maintain above average levels of shareholder capital to provide a margin of safety against short-term equity price volatility.
The table which follows summarizes Berkshire’s equity price risk as of December 31, 2005 and 2004 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 is also subject to equity price risk with respect to certain long duration equity index put contracts. Berkshire’s maximum exposure with respect to such contracts is approximately $14 billion at December 31, 2005. These contracts generally expire 15 to 20 years from inception. Outstanding contracts at December 31, 2005, have been written on four major equity indexes including three foreign. Berkshire’s potential exposure with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration. Thus, if the overall value at December 31, 2005 of the underlying indices decline 30%, Berkshire would incur a pre-tax loss of approximately $900 million.
Berkshire’s market risks associated with changes in foreign currency exchange rates are concentrated primarily in a portfolio of short duration foreign currency forward contracts. Generally, these contracts provide that Berkshire receive certain foreign currencies and pay U.S. dollars at specified exchange rates at specified future dates. Management entered into these contracts as a partial economic hedge of the adverse effect from a decline in the value of the U.S. dollar on its net U.S. dollar-based assets. The value of these contracts changes daily due primarily to changes in the spot exchange rates and to a lesser degree, interest rates and time value. The average duration of the contracts is approximately one and a half months. The aggregate notional value of such contracts, in nine currencies at December 31, 2005, was approximately $13.8 billion compared to about $21.4 billion as of December 31, 2004. Berkshire monitors the currency positions daily.
The following table summarizes the outstanding foreign currency forward contracts as of December 31, 2005 and 2004 and shows the estimated changes in values of the contracts assuming changes in the underlying exchange rates applied immediately and uniformly across all currencies. The changes in value do not necessarily reflect the best or worst case results and actual results may differ. Dollars are in millions.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of earnings, cash flows and changes in shareholders’ equity and comprehensive income for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
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 $185 per share for 2005, $158 per share for 2004 and $177 per share for 2003.
Berkshire Hathaway Inc. (“Berkshire” or “Company”) is a holding company owning subsidiaries engaged in a number of diverse business activities. The most important of these are property and casualty insurance businesses conducted on both a primary and reinsurance basis. Further information regarding these businesses and Berkshire’s other reportable business segments is contained in Note 20. Berkshire consummated a number of business acquisitions over the past three years which are discussed in Note 3.
The preparation of the Consolidated Financial Statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the period. In particular, estimates of unpaid losses and loss adjustment expenses and related recoverables under reinsurance for property and casualty insurance are subject to considerable estimation error due to the inherent uncertainty in projecting ultimate claim amounts that can be reported and settled over a period of many years. In addition, estimates and assumptions associated with the amortization of deferred charges reinsurance assumed, the determination of fair value of certain invested assets and related impairments, and the determination of goodwill impairments require considerable judgment by management. Actual results may differ from the estimates used in preparing the Consolidated Financial Statements.
Berkshire’s management determines the appropriate classifications of investments in fixed maturity securities and equity securities at the acquisition date and re-evaluates the classifications at each balance sheet date. Berkshire’s investments in fixed maturity and equity securities are primarily classified as available-for-sale, except for certain securities held by finance businesses which are classified as held-to-maturity.
Allowances for estimated losses from uncollectible loans are recorded when it is probable that the counterparty will be unable to pay all amounts due according to the terms of the loan. Allowances are provided on aggregations of consumer loans with similar characteristics and terms based upon historical loss and recovery experience, delinquency rates, and current economic conditions. Provisions for loan losses are included in the Consolidated Statements of Earnings.
The preponderance of derivative contracts outstanding at December 31, 2005 and 2004 are not designated as hedging instruments for financial reporting purposes. Accordingly, changes in the fair value of such contracts are included in the Consolidated Statements of Earnings as derivative gains/losses.
Derivative contracts may provide for Berkshire or the counterparty to post collateral as security against the fair value of open or unsettled contracts. Cash collateral received from or paid to counterparties to secure derivative contract assets or liabilities is included in liabilities or assets of finance and financial products businesses in the Consolidated Balance Sheets. Securities received from counterparties as collateral are not recorded as assets and securities delivered to counterparties as collateral continue to be reflected as assets in the Consolidated Balance Sheets.
Inventories consist of manufactured goods and purchased goods acquired for resale. Manufactured inventory costs include raw materials, direct and indirect labor and factory overhead. Inventories are stated at the lower of cost or market. As of December 31, 2005, approximately 59% of the total inventory cost was determined using the last-in-first-out (“LIFO”) method, 36% 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 $237 million and $115 million as of December 31, 2005 and 2004, respectively.
Goodwill represents the difference between purchase cost and the fair value of net assets acquired in business acquisitions. Goodwill is tested for impairment using a variety of methods at least annually and impairments, if any, are charged to earnings. Key assumptions used in the testing include, but are not limited to, the use of an appropriate discount rate and estimated future cash flows. In estimating cash flows, the Company incorporates current market information as well as historical factors. During 2005 and 2004, the Company did not record any goodwill impairments.
Premiums earned are stated net of amounts ceded to reinsurers. Premiums are estimated with respect to certain reinsurance contracts written during the period where reports from ceding companies for the period are not contractually due until after the balance sheet date. For policies containing experience rating provisions, premiums are based upon estimated loss experience under the contract.
Changes to the expected timing and estimated amount of loss payments produce changes in the unamortized deferred charge balance. Such changes in estimates are accounted for retrospectively with the net effect included in amortization expense in the period of the change.
Berkshire’s investment in MidAmerican Energy Holdings Company (“MidAmerican”) as of December 31, 2005 and 2004, which was accounted for pursuant to the equity method, is summarized below. Dollar amounts are in millions.
MidAmerican owns a combined electric and natural gas utility company in the United States, two interstate 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.
Through its investments in MidAmerican common and convertible preferred stock, at December 31, 2005, Berkshire possessed 9.7% of the voting rights and 83.4% (80.5% diluted) of the economic rights in MidAmerican. Each share of convertible preferred stock was convertible into a share of common stock only upon the occurrence of specified events, including the elimination of the Public Utility Holding Company Act of 1935 (“PUHCA”). Walter Scott, Jr., a member of Berkshire’s Board of Directors, controlled approximately 86% of the voting interest in MidAmerican at December 31, 2005.
During the three year period ending December 31, 2005, Berkshire possessed the ability to exercise significant influence on the operations of MidAmerican through its investments in common and convertible preferred stock of MidAmerican. The convertible preferred stock, although generally non-voting, was substantially an identical subordinate interest to a share of common stock and economically equivalent to common stock. Therefore, during this period, Berkshire accounted for its investments in MidAmerican pursuant to the equity method.
On September 10, 2004, MidAmerican’s management decided to cease operations of mineral extraction facilities installed near certain geothermal energy generation sites (“the Project”), at which proprietary processes were used to extract zinc from geothermal brine and fluids. MidAmerican’s management concluded that the Project could not become commercially viable. Consequently, a non-cash impairment charge of approximately $340 million, after tax, was required to write-down assets of the Project, rights to quantities of extractable minerals, and allocated goodwill to estimated net realizable value.
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. During the last three years, 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 August 7, 2003, Berkshire acquired all the outstanding common stock of Clayton Homes, Inc. (“Clayton”) for cash consideration of approximately $1.7 billion in the aggregate. Clayton is a vertically integrated manufactured housing company which at the time of the acquisition had 20 manufacturing plants, 306 company owned stores, 535 independent retailers, 89 manufactured housing communities and financial services operations that provide mortgage services and insurance protection.
In May 2005, MidAmerican (See Note 2) reached a definitive agreement with Scottish Power plc to acquire its subsidiary, PacifiCorp, a regulated electric utility providing service to customers in six Western states for approximately $5.1 billion in cash. It is currently expected that MidAmerican will issue $3.4 billion of additional capital stock to Berkshire (the additional MidAmerican capital stock to be acquired for purposes of funding the PacifiCorp acquisition is in addition to Berkshire’s equity commitment described in Note 2) which will increase Berkshire’s ownership percentage of MidAmerican to approximately 88.6% (86.5% diluted). The proceeds from the issuance of the capital stock along with proceeds from the planned issuance by MidAmerican of $1.7 billion of long-term debt or other securities will be used to fund the purchase. The acquisition is subject to customary closing conditions and is expected to close in March 2006.
Subsequent to December 31, 2005, Berkshire agreed to acquire Business Wire, a leading global distributor of corporate news, multimedia and regulatory filings and to acquire an 81% interest in Applied Underwriters, an industry leader in integrated workers’ compensation solutions. The Business Wire acquisition closed on February 28, 2006 and the acquisition of Applied Underwriters is expected to close prior to May 1, 2006.
Investments in securities with fixed maturities as of December 31, 2005 and 2004 are shown below (in millions).
The amortized cost and estimated fair values of securities with fixed maturities at December 31, 2005, are summarized below by contractual maturity dates. Actual maturities will differ from contractual maturities because issuers of certain of the securities retain early call or prepayment rights. Amounts are in millions.
Berkshire utilizes derivatives in order to manage certain economic risks of its businesses as well as to assume specified amounts of market and credit risk from others. The contracts summarized in the preceding table, with limited exceptions, are not designated as hedges for financial reporting purposes. Changes in the fair values of derivative assets and derivative liabilities that do not qualify as hedges are reported in the Consolidated Statements of Earnings as derivative gains/losses. In 2002, Berkshire began to enter into foreign currency forward contracts with the objective of partially managing corporate-wide adverse risk from the decline in the value of the U.S. Dollar. Berkshire has also written equity index options and credit default swap contracts during the last two years.
Since January 2002, the operations of General Re Securities (“GRS”) have been in run-off. As of December 31, 2005, approximately 95% of GRS’s derivative risks (as measured by the gross notional value) that existed as of the commencement of the run-off have been liquidated. The run-off is expected to continue over several more years, however, management believes that the remaining exposures are not material.
Master netting agreements are utilized to manage counterparty credit risk, where gains and losses are netted across other contracts with that counterparty. In addition, Berkshire may receive cash or securities from counterparties as collateral. Likewise, Berkshire may be required to post cash or securities as collateral with counterparties under similar circumstances. At December 31, 2005, Berkshire held collateral with a fair value of $422 million, including cash of $379 million to secure open contract assets. At December 31, 2005, Berkshire posted collateral with a fair value of approximately $853 million (which includes $487 million in cash) with counterparties as security on contract liabilities. Berkshire may be required to post collateral to cover derivative liabilities in the event of a downgrade of its credit rating below specified levels. Assuming non-performance by all counterparties on all contracts potentially subject to a credit loss, the maximum potential receivable loss, net of collateral held, at December 31, 2005 approximated $379 million.
Certain workers’ compensation reserves are discounted. Net discounted liabilities at December 31, 2005 and 2004 were $2,434 million and $2,280 million, respectively, and are net of discounts totaling $2,798 million and $2,611 million. Periodic accretions of these discounts are also a component of prior years losses incurred. The accretion of discounted liabilities was approximately $92 million in 2005, $87 million in 2004 and $85 million in 2003.
Berkshire monitors evolving case law and its effect on environmental and latent injury claims. Changing government regulations, newly identified toxins, newly reported claims, new theories of liability, new contract interpretations and other factors could result in significant increases in these liabilities. Such development could be material to Berkshire’s results of operations. It is not possible to reliably estimate the amount of additional net loss, or the range of net loss, that is reasonably possible.
Investment agreements represent numerous individual borrowing arrangements under which Berkshire is required to periodically pay interest over the contract terms. The weighted average interest rate on amounts outstanding as of December 31, 2005 was 3.3%. Under certain conditions, principal amounts may be redeemed without premium prior to the contractual maturity date at the option of the counterparties.
In May 2002, Berkshire issued 40,000 SQUARZ securities for net proceeds of $398 million. Each SQUARZ security consists of a $10,000 par amount senior note due in November 2007 together with a warrant, which expires in May 2007. Interest is payable at a rate of 3.00% per annum. In May 2005, $64 million par amount of senior notes were tendered at the option of the holders for redemption at par, and a corresponding amount of warrants were cancelled. In addition, holders of the senior notes have the option to require Berkshire to repurchase the senior notes at par on May 15, 2006, provided that the holders also surrender a corresponding amount of warrants for cancellation. Also, the warrants may be exercised to purchase either 0.1116 shares of Class A common stock (effectively at $89,606 per share) or 3.3480 shares (effectively at $2,987 per share) of Class B common stock for $10,000. A warrant premium is payable to Berkshire at an annual rate of 3.75%.
The liability for income taxes as of December 31, 2005 and 2004 as reflected in the accompanying Consolidated Balance Sheets is as follows (in millions).
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 are shown below (in millions).
Deferred income taxes have not been established with respect to undistributed earnings of certain foreign subsidiaries. Such earnings are expected to remain reinvested indefinitely and totaled approximately $512 million as of December 31, 2005. Upon distribution as dividends or otherwise, such amounts would be subject to taxation in the United States as well as foreign countries. However, U.S. tax liabilities could be offset, in whole or in part, by tax credits allowable from taxes paid to foreign jurisdictions. Determination of the potential net tax due is impracticable due to the complexities of hypothetical calculations involving uncertain timing and amounts of taxable income and the effects of multiple taxing jurisdictions.
Berkshire and its subsidiaries’ income tax returns are continuously under audit by U.S. Federal and various local and international taxing authorities. Berkshire’s consolidated U.S. Federal income tax return liabilities have been settled with the Internal Revenue Service through 1998. Berkshire is also involved in income tax litigation in the U.S. with respect to certain issues in Federal income tax returns dating back to 1988, in which a favorable ruling from the U.S. District Court was received in the fourth quarter of 2005. On February 16, 2006, the U.S. Government appealed this ruling to the United States Court of Appeals. Although the ultimate resolution of these matters remains uncertain, Berkshire does not currently believe that the impact of potential audit adjustments will have a material effect on its Consolidated Financial Statements.
Payments of dividends by insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, insurance subsidiaries may pay up to approximately $6.7 billion as ordinary dividends during 2006.
The estimated fair values of Berkshire’s financial instruments as of December 31, 2005 and 2004, are as follows (in millions).
Changes in issued and outstanding Berkshire common stock during the three years ended December 31, 2005 are shown in the table below.
Each share of Class B common stock has dividend and distribution rights equal to one-thirtieth (1/30) of such rights of a Class A share. Accordingly, on an equivalent Class A common stock basis there are 1,540,723 shares outstanding as of December 31, 2005 and 1,538,756 shares as of December 31, 2004.
Each share of Class A common stock is convertible, at the option of the holder, into thirty shares of Class B common stock. Class B common stock is not convertible into Class A common stock. Each share of Class B common stock possesses voting rights equivalent to one-two-hundredth (1/200) of the voting rights of a share of Class A common stock. Class A and Class B common shares vote together as a single class.
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 is shown in the table that follows (in millions).
Many Berkshire subsidiaries sponsor defined contribution retirement plans, such as 401(k) or profit sharing plans. Employee contributions to the plans are subject to regulatory limitations and the specific plan provisions. Berkshire subsidiaries may match these contributions up to levels specified in the plans, and may make additional discretionary contributions as determined by management. The total expenses related to employer contributions for these plans were $395 million, $338 million and $242 million for the years ended December 31, 2005, 2004 and 2003, respectively.
A summary of supplemental cash flow information for each of the three years ending December 31, 2005 is presented in the following table (in millions).
Retail sales of home furnishings, appliances, electronics, fine jewelry and gifts
Other businesses not specifically identified consist of: Scott Fetzer, a diversified manufacturer and distributor of commercial and industrial products; Buffalo News, a newspaper publisher in Western New York; International Dairy Queen, which licenses and services a system of about 6,000 Dairy Queen stores; See’s Candies, a manufacturer and distributor of boxed chocolates and other confectionery products; Larson-Juhl, which designs, manufactures, and distributes custom picture framing products; CTB International, a manufacturer of equipment and systems for the poultry, hog, egg production and grain industries; The Pampered Chef, a direct seller of kitchen tools and Forest River, a leading manufacturer of leisure vehicles.
Investment and derivative gains/losses exclude derivative losses of GRS (see Note 11) of $86 million, $25 million and $46 million in 2005, 2004 and 2003, respectively. The GRS derivative losses have been included in the results of the finance and financial products segment.
Includes investment and derivative gains/losses, which, for any given period have no predictive value, and variations in amount from period to period have no practical analytical value, particularly in view of the unrealized appreciation now existing in Berkshire’s consolidated investment portfolio. Net earnings in the third quarter of 2005 include a pre-tax underwriting loss of $3.0 billion ($1.95 billion after-tax) related to Hurricanes Katrina and Rita which struck the Gulf coast region of the United States. Net earnings in the fourth quarter of 2005 include a non-cash pre-tax gain of $5.0 billion ($3.25 billion after-tax) which arose from the exchange of Gillette common stock for Procter & Gamble common stock (see Note 6). After-tax investment and derivative gains/losses for the periods presented above are as follows (in millions):
General Reinsurance is continuing to cooperate fully with the EDVA U.S. Attorney and the Department of Justice in Washington (the “DOJ”) in their ongoing investigation regarding ROA and, in part, its transactions with General Reinsurance. The EDVA U.S. Attorney and the DOJ have continued to request additional information from General Reinsurance regarding ROA and its affiliate, First Virginia Reinsurance, Ltd. (“FVR”) and General Reinsurance’s transactions with ROA and FVR. The EDVA U.S. Attorney and the DOJ have also interviewed a number of current and former officers and employees of General Re and General Reinsurance. In August 2005, the EDVA U.S. Attorney issued an additional subpoena to General Reinsurance regarding General Reinsurance’s transactions with ROA and FVR. One of the individuals originally subpoenaed in October 2003 has been informed by the EDVA U.S. Attorney that this individual is a target of the EDVA U.S. Attorney’s investigation. General Reinsurance has also been sued in a number of civil actions related to ROA, as described below.
In September 2005, Ronald Ferguson, Joseph Brandon, the Chief Executive Officer of General Re, Christopher Garand, a former Senior Vice President of General Reinsurance, and Robert Graham, a former Senior Vice President and Assistant General Counsel of General Reinsurance, each received a “Wells” notice from the SEC. In addition to Messrs. Houldsworth, Napier, Brandon, Ferguson, Garand and Graham, Elizabeth Monrad, the former Chief Financial Officer of General Re, also received a “Wells” notice from the SEC in May 2005 in connection with its investigation.
Various state insurance departments have issued subpoenas or otherwise requested that General Reinsurance, NICO and their affiliates provide documents and information relating to non-traditional products. The Office of the Connecticut Attorney General has also issued a subpoena to General Reinsurance for information relating to non-traditional products. General Reinsurance, NICO and their affiliates have been cooperating fully with these subpoenas and requests.
CRD is also providing information to and cooperating fully with the Irish Financial Services Regulatory Authority in its inquiries regarding the activities of CRD. The Office of the Director of Corporate Enforcement in Ireland is conducting a preliminary evaluation in relation to CRD concerning, in particular, transactions between CRD and AIG. CRD is cooperating fully with this preliminary evaluation.
General Reinsurance’s subsidiary, Kolnische Ruckversicherungs-Gesellschaft AG (“Cologne Re”), is also cooperating fully with requests for information from the German Federal Financial Supervisory Authority regarding the activities of Cologne Re relating to “finite reinsurance” and regarding transactions between Cologne Re or its subsidiaries, including CRD, and AIG. General Reinsurance is also providing information to and cooperating fully with the Office of the Superintendent of Financial Institutions Canada in its inquiries regarding the activities of General Re and its affiliates relating to “finite reinsurance.”
General Reinsurance and four of its current and former employees, along with numerous other defendants, have been sued in a number of civil actions related to ROA. Plaintiffs assert various claims in these civil actions, including breach of contract, unjust enrichment, fraud and conspiracy, against General Reinsurance and others, arising from various reinsurance coverages General Reinsurance provided to ROA and related entities.
In December 2003, the Liquidators of both FAI Insurance Limited (“FAI”) and HIH Insurance Limited (“HIH”) advised GRA and Cologne Re that they intended to assert claims arising from insurance transactions GRA entered into with FAI in May and June 1998. In August 2004, the Liquidators filed claims in the Supreme Court of New South Wales in order to avoid the expiration of a statute of limitations for certain plaintiffs, but neither GRA nor Cologne Re have been served with legal process by the Liquidators. The focus of the Liquidators’ allegations against GRA and Cologne Re are the 1998 transactions GRA entered into with FAI (which was acquired by HIH in 1999). The Liquidators contend, among other things, that GRA and Cologne Re engaged in deceptive conduct that assisted FAI in improperly accounting for such transactions as reinsurance, and that such deception led to HIH’s acquisition of FAI and caused various losses to FAI and HIH.
purchasers through bid-rigging and contingent commission arrangements. Berkshire, General Re and General Reinsurance were not parties to the original, transferred cases. On August 1, 2005, the named plaintiffs-fourteen businesses, two municipalities, and three individuals-filed their First Consolidated Amended Commercial Class Action Complaint, and Berkshire, General Re and General Reinsurance (along with a large number of insurance companies and insurance brokers) were named as defendants in the Amended Complaint. The plaintiffs claim that all defendants engaged in a pattern of racketeering activity, in violation of RICO, and that they conspired to restrain trade. They further allege that the broker defendants breached fiduciary duties to the plaintiffs, that the insurer defendants aided and abetted that breach, and that all defendants were unjustly enriched in the process. Plaintiffs seek treble damages in an unspecified amount, together with interest and attorneys fees and expenses. They also seek a declaratory judgment of wrongdoing as well as an injunction against future anticompetitive practices. On November 29, 2005, General Re, General Reinsurance and Berkshire, together with the other defendants, filed motions to dismiss the complaint. On February 1, 2006, plaintiffs filed a motion for leave to file a Second Consolidated Amended Complaint. Among other things, plaintiffs seek leave to add numerous new defendants, including several additional Berkshire subsidiaries including, among others, NICO. Berkshire opposed the motion for leave to amend, and the Court has denied the motion without prejudice to plaintiffs’ renewing it following a ruling on defendants’ motion to dismiss the First Consolidated Amended Complaint.