Effective January 1, 2002, Berkshire adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” SFAS No. 142 changed the accounting for goodwill from a model that required amortization of goodwill, supplemented by impairment tests, to an accounting model that is based solely upon impairment tests.
Accordingly, Berkshire’s reportable business segments are organized in a manner that reflects how Berkshire’s top management views those business activities. Certain businesses have been grouped based upon similar products or product lines, marketing, selling and distribution characteristics even though those businesses are operated by separate local management. There are approximately 40 separate reporting units.
The business segment data (Note 21 to Consolidated Financial Statements) should be read in conjunction with this discussion.
GEICO provides primarily private passenger automobile coverages to insureds in 49 states and the District of Columbia. GEICO policies are marketed mainly by direct response methods in which customers apply for coverage directly to the company over the telephone, through the mail or via the Internet. This is a significant element in GEICO’s strategy to be a low cost insurer. In addition, GEICO strives to provide excellent service to customers, with the goal of establishing long-term customer relationships.
During 2004, policies-in-force increased 8.8% in the preferred risk markets and 21.6% in the standard and nonstandard markets. Voluntary auto new business sales in 2004 increased 14.9% compared to 2003. Voluntary auto policies-in-force at December 31, 2004 were 635,000 higher than at December 31, 2003 and reflect strong growth in the standard and nonstandard lines.
Losses and loss adjustment expenses in 2004 totaled $6,360 million, an increase of 6.8% over 2003. The loss ratio declined to 71.3% in 2004 compared to 76.5% in 2003 and 77.0% in 2002 primarily due to decreasing claim frequencies across all markets and most coverage types. In 2004, claims frequencies for physical damage coverages have decreased in the two to four percent range from 2003 while frequencies for bodily injury coverages decreased in the three to five percent range. Bodily injury severity in 2004 increased in the two to four percent range over 2003 while physical damage severity has increased in the three to six percent range. Incurred losses from catastrophe events totaled approximately $71 million in 2004 (primarily from the hurricanes in the third quarter) compared to $57 million in 2003.
North American property/casualty premiums written in 2004 declined 20.1% from 2003 and 2003 premiums written declined 13.5% compared to 2002. International property and casualty premiums written in 2004 decreased 23.7% from 2003, which increased 3.6% over 2002. The declines in 2004 reflect reductions in the amounts of business accepted over the past two years, offset in part by higher rates. Underwriting performance is not evaluated based upon market share and underwriters are instructed to reject inadequately priced risks. Management expects written premiums to continue to decline during 2005, primarily due to maintaining underwriting discipline in an increasingly price-competitive property/casualty market.
The decline in premiums earned in 2004 from North American operations was attributed to cancellations/non-renewals over new contracts (estimated at $697 million), partially offset by renewal rate increases and changes in renewal terms and conditions across all lines of business (estimated at $158 million). The decline in premiums earned in 2003 from 2002 reflected cancellations/non-renewals exceeding new contracts (estimated at $761 million), partially offset by rate increases across all lines (estimated at $345 million). The decline in international premiums earned in 2004 versus 2003 reflected the reductions of premium volume partially offset by a lower value of the U.S. dollar. In local currencies, 2004 premiums earned declined 29.1% compared with 2003, which, in turn, declined 5.5% in 2003 versus 2002.
The North American property/casualty business produced a pre-tax underwriting gain of $11 million in 2004 compared with a gain of $67 million in 2003, and a loss of $1,019 million in 2002. The $11 million net underwriting gain in 2004 was comprised of current accident year gains of $166 million, partially offset by $155 million in prior accident year losses. Current accident year results included approximately $120 million of catastrophe losses from the four hurricanes that struck the Southeast United States in the third quarter. Despite these losses, current accident year underwriting results benefited from the favorable effects of re-pricing efforts and improved coverage terms and conditions implemented over the past three years and a one time reduction of $70 million in pension expense during the third quarter, resulting from the curtailment of certain benefits at the end of 2005. Underwriting results for 2003 included net underwriting gains for the current accident year of $200 million compared to $66 million in 2002. The current accident year results in 2003 and 2002 reflected re-pricing efforts and unusually low amounts of large individual and catastrophe-related property losses. In both 2003 and 2002, the current accident year gains were reduced or eliminated by additional losses ($133 million in 2003 and $1,085 million in 2002) established for prior accident years’ loss occurrences.
In 2004, the $155 million charge related to prior accident year loss occurrences consisted of $729 million of increases in casualty and workers’ compensation reserves, $110 million related to discount accretion on workers’ compensation reserves and deferred charge amortization on retroactive reinsurance coverages, offset by $307 million of reserve reductions for prior year property losses and $377 million of gains associated with contract commutations and settlements. The aforementioned increases in workers’ compensation reserves in 2004 reflected escalating medical utilization and inflation, and casualty reserve increases related primarily to losses under financial institutions errors and omissions and directors and officers’ lines of business and asbestos and environmental mass tort exposures. The decrease in property reserves in 2004 was primarily due to reductions in estimated World Trade Center losses.
As previously stated, underwriting results in 2003 and 2002 included $133 million and $1,085 million, respectively, in losses related to prior accident years, which included $99 million and $95 million, respectively, from discount accretion on workers’ compensation reserves and deferred charge amortization on retroactive reinsurance contracts. In 2002, reserve increases also included $990 million in increased loss estimates mostly related to casualty lines of business (general liability, workers’ compensation, medical malpractice, auto liability and professional liability coverages), principally for the 1997 through 2000 accident years, partially offset by $115 million of reserve reductions related to reduced estimates for certain World Trade Center claims.
International property/casualty businesses produced a pre-tax underwriting loss of $93 million in 2004 compared with a gain of $20 million in 2003, and a loss of $319 million in 2002. Underwriting results in 2004 include $110 million of catastrophe losses from the third quarter hurricanes. In 2003, losses from catastrophes and large individual property losses were minimal and in 2002 totaled $124 million, primarily from flood and storm losses in Europe. Underwriting results for each of the last three years benefited from favorable results of the aviation business and relatively low non-catastrophe property losses. Underwriting results of the international businesses have improved overall over the last two years as a result of re-pricing efforts and more disciplined underwriting. Underwriting results of the international property and casualty businesses included losses from prior years’ loss occurrences of $102 million in 2004, $104 million in 2003 and $320 million in 2002.
Life and health premiums earned in 2004 increased $168 million (9.1%) over 2003, which decreased by $39 million (2.1%) compared with 2002. Adjusting for the effects of foreign currency exchange, premiums earned increased 3.7% in 2004 and declined 9.6% in 2003. The increase in premiums earned is due in part to the strengthening of foreign currencies and an increase in European life business. The decline in 2003 was primarily due to decreases in the group and individual health businesses in the U.S. life/health operations.
The Berkshire Hathaway Reinsurance Group (“BHRG”) underwrites excess-of-loss reinsurance and quota-share coverages for insurers and reinsurers around the world. BHRG’s business includes catastrophe excess-of-loss reinsurance, 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 reinsurance refers to other contracts that are written on both a quota-share and excess basis, and include participations in and contracts with Lloyd’s syndicates. Amounts in the table below are in millions.
Retroactive reinsurance contracts indemnify ceding companies for losses arising under insurance or reinsurance contracts written in the past, often many years ago. While contract terms vary, losses under the contracts are subject to a very large aggregate dollar limit, occasionally exceeding $1 billion under a single contract. Generally, it is also anticipated, although not assured, that claims under retroactive contracts will be paid over long time periods. These contracts do not produce an immediate underwriting loss for financial reporting purposes. The excess of the estimated ultimate claims payable over the premiums received is established as a deferred charge which is subsequently amortized over the expected claim settlement periods. Such amortization is included as a component of losses incurred.
Underwriting losses from retroactive reinsurance are primarily attributed to the amortization of deferred charges established on retroactive reinsurance contracts. 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 timing and amount of expected future losses are re-estimated periodically. Deferred charge balances are adjusted accordingly on a retrospective basis via a cumulative adjustment.
Gross loss reserves established under retroactive reinsurance totaled approximately $10 billion as of December 31, 2004 and losses paid during the year totaled approximately $860 million. Unamortized deferred charges at December 31, 2004 totaled approximately $2.45 billion compared to approximately $2.85 billion as of December 31, 2003. Management believes that these charges are reasonable relative to the large amount of float generated from these policies. Income generated from the investment of float is reflected in investment income and investment gains.
A comparison of revenues and pre-tax earnings between 2004, 2003 and 2002 for the non-insurance businesses follows. Dollars are in millions.
* In 2004, Berkshire adopted the provisions of EITF 00-21(“Accounting for Revenue Arrangements with Multiple Deliverables”). As a result, for consolidated reporting purposes, the method of recognizing revenue related to NetJets’ fractional aircraft sales was changed. Management continues to evaluate the results of NetJets under the prior revenue recognition criteria and thus has shown revenues and pre-tax earnings for the flight services segment using the prior revenue recognition method. The prior revenue recognition method results in the revenues and pre-tax earnings in this table being $902 million greater and $74 million greater than the amounts reported in Berkshire’s consolidated financial statements.
Apparel revenues in 2004 totaled $2,200 million, an increase of $125 million (6%) over 2003. Increased sales by Fruit of the Loom (“FOL”) accounted for essentially all of the increase, as unit sales increased 14%, offset partially by lower net selling prices. FOL generated approximately 60% of total apparel group revenues in 2004. Pre-tax earnings of apparel businesses totaled $325 million in 2004, an increase of 12% over 2003. About half of the increase in pre-tax earnings was generated by FOL due to the aforementioned unit sales increase, although lower net selling prices and higher cotton costs resulted in a decrease in FOL’s gross margin rate. In addition, increased earnings were achieved in the footwear businesses (HH Brown and Justin) and children’s apparel (Garan), which benefited from increased sales as well as expense controls. The increases in sales and pre-tax earnings in 2003 over 2002 were due largely to acquisitions of FOL (April 2002) and Garan (September 2002).
Building products revenues in 2004 totaled $4,337 million, an increase of $491 million (13%) over 2003. Increased sales volume was generated in all significant product lines in 2004, including insulation and roofing products (11%), paint (8%), brick and masonry (4%) and steel connector plates and truss components (38%), which also reflected higher selling prices. Favorable housing construction markets in the U.S. continued in 2004, which benefited the group as a whole.
Pre-tax earnings of the building products group in 2004 exceeded earnings in 2003 by $84 million (15%), reflecting increased pre-tax earnings from insulation products and connector plate/truss components. In addition, the results for 2003 of the insulation business included a loss of $21 million from a fire at a pipe insulation plant. (Eliminating the impact of the fire loss reduces the earnings increase to about 11%). Over the past year, certain production costs (such as steel, petroleum-based materials, and energy, such as natural gas) have risen significantly. For instance, the cost of steel (used in manufacturing connector plates and trusses) has risen about 100% over the past year. Also, average prices for natural gas (used in manufacturing fiberglass and bricks) and gasoline (delivery costs) have risen significantly over the past year. Such rapid increases produced declines in profit margins, which accelerated during the last half of 2004. Revenues and pre-tax earnings of the building products group in 2003 and 2002 benefited from the favorable residential housing construction markets.
Revenues generated by the finance and financial products group in 2004 totaled $3,774 million, an increase of 24% over 2003. Revenues in 2004 include Clayton Homes for the full year. Clayton was acquired by Berkshire on August 7, 2003 and its results are included in Berkshire’s consolidated financial statements beginning as of that date. See Note 2 to the Consolidated Financial Statements for information regarding this acquisition. Clayton generated total revenues of approximately $2,024 million in 2004 compared to $512 million in 2003.
Excluding Clayton, finance revenues in 2004 declined $783 million from 2003. Life insurance annuity premiums of $700 million were earned in the last half of 2003 from a few sizable transactions. Annuity premiums generated in 2004 were nominal. The comparative declines in 2004 revenues also reflect lower interest income, resulting from lower amounts of invested assets associated with leveraged investing activities, including reduced interest from Berkadia’s loan to FINOVA, and higher proportions of low-yielding short-term investments to total invested assets. Somewhat offsetting the decline was the fact that Value Capital was consolidated during the first half of 2004. See Note 15 to the Consolidated Financial Statements for additional information regarding Value Capital.
Pre-tax earnings from finance and financial products businesses, excluding investment gains/losses, in 2004 were $584 million, a decrease of $35 million (6%) from 2003. Pre-tax earnings reflect the inclusion of Clayton for the full year of 2004 as well as much improved earnings from leasing businesses (CORT and XTRA). In 2004, the leasing businesses generated pre-tax earnings of $92 million compared to $34 million in 2003. In addition, the net loss from the run-off of General Re’s finance business was reduced by $55 million in 2004.
Flight service revenues increased $813 million (33%) over 2003. Over 90% of the revenue increase resulted from the NetJets business where flight operations revenue increased just under $400 million and revenues from aircraft sales increased about $360 million. The increase in flight operations revenue was primarily due to higher usage, a larger percentage of hours being on larger aircraft and a slight rate increase. Sales of fractional aircraft increased due to an approximately 10% increase in aircraft sold and a higher percentage of sales being large cabin aircraft which carry a higher sales price. In 2004, revenues from FlightSafety increased about $57 million (10% over the prior year). Increased revenues from simulator sales represent about 65% of the increase with increased training revenues accounting for the remainder. Increased training revenues in 2004 were attributed to a 13% increase in simulator usage, primarily from corporate aviation and regional airline customers, offset by reduced revenues from government customers.
Pre-tax earnings of flight services businesses totaled $191 million in 2004, an increase of $119 million as compared to 2003. About half of this increase is due to reduced write downs of certain simulators and aircraft inventory. During 2003, such write downs were about $69 million and during 2004 they were about $12 million. Pre-tax earnings from FlightSafety’s training business, excluding asset write downs, increased about $33 million due to the aforementioned revenue increases. Pre-tax earnings from NetJets’ flight operations business, excluding asset write downs, improved by about $25 million.
Earnings from MidAmerican represent Berkshire’s share of MidAmerican’s net earnings, as determined under the equity method. In 2004, Berkshire’s share of MidAmerican’s net earnings was $237 million versus $429 million in 2003. During the third quarter of 2004, MidAmerican recorded 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. In the fourth quarter of 2004, MidAmerican realized a gain of $44 million (Berkshire’s share was about $33 million) from the realization of certain Enron-related bankruptcy claims. Ignoring the effect to these two non-recurring events Berkshire’s share of MidAmerican’s 2004 net earnings was $459 million, which reflects improved results at most of MidAmerican’s major operating units. See Note 3 to the Consolidated Financial Statements for additional information regarding MidAmerican.
Investment gains and losses arise when investments are sold and foreign currency forward contracts are marked-to-market with a corresponding gain or loss included in earnings. Investment gains and losses also arise in connection with investments by Berkshire in life settlement contracts. Investment losses can also arise when available-for-sale or held-to-maturity securities are deemed to be other-than-temporarily impaired (“OTTI”). A summary of investment gains and losses follows. Dollar amounts are in millions.
Prior to January 1, 2004, Berkshire accounted for investments in life settlement contracts on the cost basis. Therefore, the cost of the investment included the initial purchase price plus periodic maintenance costs. Beginning in 2004, as a result of obtaining information which suggested that the SEC believed that a different accounting method should be used, these investments are being accounted for under FASB Technical Bulletin (“FTB”) 85-4 “Accounting for Purchases of Life Insurance.” Under FTB 85-4, the carrying value of each contract at purchase and at the end of each reporting period is equal to the cash surrender value of the contract. Cash paid to purchase these contracts that is in excess of the cash surrender value at the date of purchase is recognized as a loss immediately and periodic maintenance costs, such as premiums necessary to keep the underlying policy in force, are charged to earnings immediately. The life insurance benefits are payable to the Company. The loss during 2004 included $73 million related to life settlement contracts held at December 31, 2003. Despite the accounting loss recorded for these contracts, management views these contracts to have a current value no less than the cost paid for the policies plus any subsequent maintenance costs and believes these contracts will produce satisfactory earnings.
Berkshire’s consolidated notes payable and other borrowings, excluding borrowings of finance businesses, totaled $3.5 billion at December 31, 2004 and $4.2 billion at December 31, 2003. During 2004, commercial paper and short-term borrowings of subsidiaries declined $388 million, primarily from repayments arising from operating cash flow of NetJets and Shaw. Additionally, investment contract balances of $226 million were repaid during 2004.
Berkshire believes that it currently maintains sufficient liquidity to cover its existing contractual obligations and provide for contingent liquidity.
Berkshire and its subsidiaries are parties to contracts associated with ongoing business and financing activities, which will result in cash payments to counterparties in future periods. Notes payable and securities sold under agreements to repurchase are reflected in the Consolidated Financial Statements along with accrued but unpaid interest as of the balance sheet date. In addition, Berkshire will be obligated to pay interest under debt obligations for periods subsequent to the balance sheet date. Although certain principal balances may be prepaid in advance of the maturity date, which could reduce future interest obligations, it is assumed that no principal prepayments will occur for purposes of this disclosure. Further, while short-term borrowings and repurchase agreements are currently expected to be renewed as they mature, such amounts are not assumed to renew for purposes of this disclosure.
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. The loss and loss 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.
For most liability coverages, case reserves alone are an insufficient measure of the ultimate cost due in part to the longer claim-tail, the greater chance of protracted litigation and the incompleteness of facts available at the time the claim is first reported. Therefore, additional case development reserve estimates are established, usually as a percentage of the case reserve. In general, case development factors are selected by historical statistical analysis, which includes incurred case loss analysis for groups of claims from period-to-period projected to future dates and amounts (or age-to-age techniques) when substantially all of the claims are expected to be settled. Case development factors are reviewed and revised periodically based upon trends in loss development patterns.
For unreported claims, IBNR reserve estimates are calculated by first projecting the ultimate number of claims expected (reported and unreported) for each significant coverage by using historical quarterly and monthly claim counts, to develop age-to-age projections of the ultimate counts by accident quarter. Reported claims are subtracted from the ultimate claim projections to produce an estimate of the number of unreported claims. The number of unreported claims is multiplied by an estimate of the average cost per unreported claim to produce the IBNR reserve amount. Actuarial techniques are difficult to apply reliably in certain situations, such as to new legal precedents, class action suits, long-term claimants from personal injury protection coverages or recent catastrophes. Consequently, supplemental IBNR reserves for these types of events may be established.
For each of its major coverages, GEICO tests the adequacy of the total loss reserves using one or more actuarial projections based on claim closure models, paid loss triangles and incurred loss triangles. Each type of projection analyzes loss occurrence data for claims occurring in a given period over intervals of time until substantially all of the expected claims have been settled.
GEICO’s exposure to highly uncertain losses is believed to be limited to certain commercial excess umbrella policies written during a period from 1981 to 1984. Remaining reserves associated with such exposure is currently a relatively insignificant component of GEICO’s total reserves (3%) and there is little if any apparent asbestos or environmental liability exposure. Related claim activity over the past year was insignificant.
IBNR reserves are estimated by reserve cell, by accident year, using the expected loss emergence pattern and the expected loss ratios. The expected loss emergence patterns and expected loss ratios are the critical IBNR reserving assumptions and are generally updated every year-end. Once the year-end IBNR reserves are determined, actuaries calculate expected case loss emergence for the upcoming calendar year. This calculation does not involve new assumptions and uses the prior year-end expected loss emergence patterns and expected loss ratios. The expected losses are then allocated into interim estimates that are compared to actual reported losses in the subsequent year. This comparison provides a test of the adequacy of prior year-end IBNR reserves and forms the basis for possibly changing IBNR reserve assumptions during the course of the year.
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, maximum unpaid losses under retroactive policies approximated $12.2 billion as of December 31, 2004. Management cannot reasonably estimate the low-end of the retroactive reserve range given the nature of the liabilities assumed.
BHRG’s other property and casualty loss reserves derive from catastrophe, individual risk and multi-line reinsurance policies. Reserve amounts are based upon loss estimates reported by ceding companies and IBNR reserves, which are primarily a function of reported losses from ceding companies and anticipated loss ratios established on an individual contract basis supplemented by management’s judgment of the impact on each contract of major catastrophe events as they become known. Anticipated loss ratios are based upon management’s judgment considering the type of business covered, analysis of each ceding company’s loss history and evaluation of that portion of the underlying contracts underwritten by each ceding company, which are in turn ceded to BHRG. A range of reserve amounts as a result of changes in underlying assumptions is not prepared.
The carrying values of investments subject to equity price risks are based on quoted market prices or management’s estimates of fair value as of the balance sheet dates. Market prices are subject to fluctuation and, consequently, the amount realized in the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from perceived changes in the underlying economic characteristics of the investee, the relative price of alternative investments and general market conditions. Furthermore, amounts realized in the sale of a particular security may be affected by the relative quantity of the security being sold.
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 and 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 six months. The aggregate notional value of such contracts, which are spread among 12 currencies at December 31, 2004, was approximately $21.4 billion compared to about $12.0 billion as of December 31, 2003. The fair value asset of these contracts totaled approximately $1,761 million at December 31, 2004 and $630 million at December 31, 2003.
Berkshire monitors the currency positions daily for each currency. The following table summarizes the outstanding foreign currency forward contracts as of December 31, 2004 and 2003 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 therefore, actual results may differ. Dollars are in millions.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2004 of the Company and our report dated March 3, 2005 expressed an unqualified opinion on those financial statements.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2003, 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, 2004. 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.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 3, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
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 $158 per share for 2004, $177 per share for 2003 and $93 per share for 2002.
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 21. Berkshire consummated a number of business acquisitions over the past three years which are discussed in Note 2.
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 will 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 and assumptions used in preparing the Consolidated Financial Statements.
Derivative instruments include interest rate, currency and credit swaps and options, interest rate caps and floors and futures and forward contracts.
Cash collateral received from or paid to counterparties to secure trading account 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.
Effective January 1, 2002, Berkshire adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” SFAS No. 142 eliminated the periodic amortization of goodwill in favor of an accounting model that is based solely upon impairment tests. Goodwill is reviewed for impairment using a variety of methods at least annually, and impairments, if any, are charged to earnings. Annual impairment tests are performed in the fourth quarter.
Provisions for losses and loss adjustment expenses are reported in the accompanying Consolidated Statements of Earnings after deducting amounts recovered and estimates of amounts recoverable under reinsurance contracts. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify policyholders with respect to the underlying insurance and reinsurance contracts.
In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3 (“Accounting for Certain Loans or Debt Securities Acquired in a Transfer”) (“SOP 03-3”), which specifies the accounting and disclosure requirements for loans or debt securities purchased in a transfer where it is probable that the investor will be unable to collect all contractually required amounts due as a result of deteriorated credit quality of the issuer. SOP 03-3 also addresses post-acquisition income recognition with respect to such loans and debt securities. SOP 03-3 is effective for loans or debt securities acquired in years beginning after December 15, 2004. For loans acquired in years beginning before December 15, 2004, the provisions of SOP 03-3 related to changes in expected cash flows are to be applied prospectively. The adoption of SOP 03-3 is not expected to have a material effect on Berkshire’s financial statements.
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (“SFAS 151”), “Inventory Costs an amendment of ARB No. 43, Chapter 4.” SFAS 151 discusses the general principles applicable to the pricing of inventory. This Statement amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS 151 is not expected to have a material effect on Berkshire’s financial statements.
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.
The results of operations for each of the entities acquired are included in Berkshire’s consolidated results of operations from the effective date of each acquisition. The following table sets forth certain unaudited consolidated earnings data for 2003, as if each of the acquisitions discussed above were consummated on the same terms at the beginning of each year. Dollars are in millions, except per share amounts.
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). As of December 31, 2004, Berkshire and certain of its subsidiaries also owned $1,478 million of MidAmerican’s 11% non-transferable trust preferred securities. 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, it does give 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.
Berkshire’s equity in earnings from MidAmerican includes Berkshire’s proportionate share (83.7% in 2004) of MidAmerican’s undistributed net earnings reduced by deferred taxes on such undistributed earnings in accordance with SFAS 109, reflecting Berkshire’s expectation that such deferred taxes will be payable as a consequence of dividends from MidAmerican. However, no dividends from MidAmerican are likely for some time. It is possible that when, and if, a dividend is paid MidAmerican will then be eligible for inclusion in Berkshire’s consolidated tax return and a tax on the dividend would not be due. Berkshire’s share of MidAmerican’s interest expense (after-tax) on Berkshire’s investments in MidAmerican’s trust preferred (debt) securities has been eliminated.
MidAmerican, through its subsidiaries, owns the rights to proprietary processes for the extraction of zinc, manganese, silica, and other elements in the geothermal brine and fluids utilized in energy production at certain geothermal energy generation facilities. Mineral extraction facilities were installed near the energy generation sites (“the Project”). During 2004, MidAmerican’s management assessed the long-term economic viability of the Project in light of current cash flow and operating losses and continuing efforts to increase production. MidAmerican’s management evaluated estimates of projected cash flows for the Project, including the expected impact of planned improvements to the mineral extraction processes and also began exploring other operating alternatives, such as establishing strategic partnerships.
On September 10, 2004, MidAmerican’s management decided to cease operations of the Project, effective immediately. Consequently, it was concluded that a non-cash impairment charge of approximately $340 million, after tax, was required to write-off the Project, the rights to quantities of extractable minerals, and the allocated goodwill to estimated net fair value. MidAmerican incurred net after-tax losses attributed to the Project of $28 million in 2004, $27 million in 2003 and $17 million in 2002. MidAmerican expects to receive approximately $55 million in future tax benefits. Berkshire’s share of the non-cash impairment charge was $255 million after tax, and is included in equity in earnings of MidAmerican Energy Holdings Company.
Investments in securities with fixed maturities as of December 31, 2004 and 2003 are shown below (in millions).
On January 28, 2005, The Proctor and Gamble Company (“PG”) announced it had signed an agreement to acquire 100% of The Gillette Company (“Gillette”). Under the terms of the agreement, PG has agreed to issue 0.975 shares of its common stock for each outstanding share of Gillette common stock. The transaction which is subject to certain conditions is expected to close in the second half of 2005. Based upon recent trading prices of PG common stock and the number of Gillette shares owned at December 31, 2004, Berkshire anticipates that it will recognize a pre-tax investment gain of approximately $4.4 billion when the transaction closes.
Derivative instruments involve, to varying degrees, elements of market, credit, and liquidity risks. Market risks may be controlled by taking offsetting positions in either cash instruments or other derivatives. Exposures are managed on a portfolio basis and monitored continuously.
Prior accident years losses incurred in 2004 include amortization of deferred charges related to retroactive reinsurance contracts incepting prior to January 1, 2004. Amortization charges included in prior accident years losses were $451 million in 2004, $432 million in 2003 and $430 million in 2002.
Incurred losses “all prior accident years” also reflects the amount of estimation error charged or credited to earnings in each year with respect to the liabilities established as of the beginning of that year. In both 2004 and 2003, Berkshire reduced the beginning of the year loss and loss adjustment expense liability by $119 million and $37 million respectively. In 2002, Berkshire recorded a loss of $1,029 million related to prior years loss occurrences. The most significant component of losses from prior years occurrences in 2002 was reserve increases with respect to General Re’s North American and international property/casualty reinsurance businesses.
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 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 $5.6 billion at December 31, 2004 and $5.5 billion at December 31, 2003. These liabilities include $4.2 billion at December 31, 2004 and $4.4 billion at December 31, 2003, of liabilities assumed under retroactive reinsurance contracts written by the Berkshire Hathaway Reinsurance Group. 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 contracts, which may also cover losses unrelated to these exposures, were approximately 85% of aggregate policy limits as of the end of 2004.
Investment agreements represent numerous individual borrowing arrangements under which Berkshire is required to periodically pay interest over contract terms, which range from a few months to over 30 years. Interest under such contracts may be at fixed or variable rates. The weighted average interest rate on amounts outstanding as of December 31, 2004 and 2003 was 3.8% and 3.1%, respectively. Under certain conditions, principal amounts may be redeemed without premium prior to the contractual maturity date at the option of the counterparties.
Commercial paper and other short-term borrowings are obligations of certain businesses that utilize short-term borrowings as part of financing their operations. Weighted average interest rates as of December 31, 2004 and 2003 were 2.4% and 1.3% respectively. Berkshire affiliates have approximately $2.6 billion of available unused lines of credit and commercial paper capacity to support their short-term borrowing programs and, otherwise, provide additional liquidity.
On May 28, 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. 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% and interest is payable to note holders at a rate of 3.00% per annum. All debt and warrants issued in conjunction with SQUARZ securities were outstanding at December 31, 2004.
The liability for income taxes as of December 31, 2004 and 2003 as reflected in the accompanying Consolidated Balance Sheets is as follows (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 $490 million as of December 31, 2004. 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.
Prior to January 1, 2004, Berkshire accounted for its investment in Value Capital pursuant to the equity method. Effective January 1, 2004 and through June 30, 2004 Berkshire consolidated Value Capital as a result of the adoption of FIN 46 because during that period Value Capital was deemed to be a variable interest entity (“VIE”) and Berkshire was the primary beneficiary.
Consequently, Berkshire reevaluated its investment in Value Capital under FIN 46 and concluded that Value Capital was no longer a VIE. Since Berkshire possesses no voting or similar rights or other rights that could otherwise represent a controlling financial interest, Berkshire ceased consolidation of Value Capital as of July 1, 2004 and resumed accounting for the investment under the equity method. The investment in Value Capital ($503 million as of December 31, 2004 and $634 million as of December 31, 2003) is included in other assets of finance and financial products businesses in the Consolidated Balance Sheets.
Payments of dividends by insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, insurance subsidiaries may pay up to approximately $5.7 billion as ordinary dividends during 2005.
Combined shareholders’ equity of U.S. based property/casualty insurance subsidiaries determined pursuant to statutory accounting rules (Statutory Surplus as Regards Policyholders) was approximately $48 billion at December 31, 2004 and $41 billion at December 31, 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, whereas under GAAP, goodwill is subject to periodic tests for impairment.
Changes in issued and outstanding Berkshire common stock during the three years ended December 31, 2004 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 1,538,756 shares outstanding as of December 31, 2004 and 1,536,630 shares as of December 31, 2003.
The components of net periodic pension expense for each of the three years ending December 31, 2004 are as follows (in millions).
Defined benefit pension plan obligations to U.S. employees are funded through assets held in trusts and are not included as assets in Berkshire’s Consolidated Financial Statements. Pension obligations under certain non-U.S. plans and non-qualified U.S. plans are unfunded. As of December 31, 2004 and 2003, total plan assets were invested as follows:
The benefit payments, which reflect expected future service as appropriate, are expected to be paid as follows (in millions): 2005 - $146; 2006 - $151; 2007 - $158; 2008 - $169; 2009 - $174; and 2010 to 2014 - $1,133.
Most Berkshire subsidiaries also sponsor defined contribution retirement plans, such as 401(k) or profit sharing plans. The plans generally cover all employees who meet specified eligibility requirements. Employee contributions to the plans are subject to regulatory limitations and the specific plan provisions. Berkshire subsidiaries generally 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 $338 million, $242 million and $202 million for the years ended December 31, 2004, 2003 and 2002, respectively.
A summary of supplemental cash flow information for each of the three years ending December 31, 2004 is presented in the following table (in millions).
The tabular information that follows shows data of reportable segments reconciled as needed to amounts reflected in the Consolidated Financial Statements. Intersegment transactions are not eliminated in instances where management considers those transactions in assessing the results of the respective segments. In 2004, Berkshire adopted the provisions of EITF 00-21 (“Accounting for Revenue Arrangements with Multiple Deliverables”). As a result, for consolidated reporting purposes, the method of recognizing revenue related to fractional aircraft sales was changed. Management continues to evaluate the results of NetJets under the prior revenue recognition criteria and thus has shown the revenues and earnings before taxes for the Flight Services segment using the former revenue recognition method. Furthermore, Berkshire management does not consider investment gains or amortization of purchase accounting adjustments in assessing the performance of reporting units. Collectively, these items are included in reconciliations of segment amounts to consolidated amounts.
Consolidated sales and service revenues in 2004, 2003 and 2002 totaled $43.2 billion, $32.1 billion and $17.0 billion respectively. Over 90% of such amounts in each year were in the United States with the remainder primarily in Canada and Europe. In 2004, consolidated sales and service revenues included $8.5 billion of sales to Wal-Mart Stores, Inc. which were primarily related to McLane’s wholesale distribution business that Berkshire acquired in May 2003.
transactions between General Re or its subsidiaries and other insurers. Berkshire cannot at this time predict the outcome of these investigations, is unable to estimate a range of possible loss, if any, and cannot predict whether or not that outcome will have a material adverse effect on Berkshire’s results of operations for at least the quarterly period when these investigations are completed or otherwise resolved.
GEICO is a defendant in a number of class action lawsuits related to the use of certain aftermarket parts to calculate the costs of repairing claimants vehicles. GEICO intends to vigorously defend its position on these claim settlement procedures. These lawsuits are in various stages of development and Berkshire cannot at this time predict the outcome of these actions, is unable to estimate a range of possible loss, if any, and cannot predict whether or not that outcome will have a material adverse effect on Berkshire’s results of operations for at least the quarterly period when these actions are resolved.
(1) Includes 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 investment gains for the periods presented above are as follows: