The physical properties used by the Registrant and its significant business segments are summarized below:
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 summary follows of underwriting results from Berkshire’s insurance businesses for the past three years. Dollars are in millions.
GEICO provides primarily private passenger automobile coverages to insureds in 48 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.
Losses and loss adjustment expenses incurred increased 15.9% to $5,955 million in 2003, following an increase of 6.1% in 2002 over 2001. The loss ratio for property and casualty insurance, which measures the portion of premiums earned that is paid or reserved for losses and related claims handling expenses, was 76.5% in 2003 compared to 77.0% in 2002 and 79.9% in 2001. Claims frequencies in 2003 for physical damage and bodily injury coverages have decreased in the two to five percent range from 2002 despite more weather related losses in 2003 resulting from winter snowstorms, spring hailstorms and Hurricane Isabel. Bodily injury severity has increased in the six to eight percent range over 2002 while physical damage severity has increased in the two to three percent range. Incurred losses from catastrophe events for 2003 totaled approximately $57 million compared to $20 million in 2002 and $47 million in 2001.
Underwriting expenses increased 23.3% to $1,377 million in 2003 over 2002, which follows an increase of 12.0% in 2002 over 2001. Policy acquisition expenses increased 18.7% in 2003 to $731 million reflecting increased advertising and increased staffing to handle the growth in policies-in-force. Other operating expenses were $646 million in 2003, up from $501 million in 2002 and reflect higher salary, profit sharing and other employee benefit expenses.
General Re’s pre-tax underwriting results for the past three years are summarized below. Dollars are in millions.
General Re’s North American property/casualty operations underwrite predominantly excess reinsurance across essentially all lines of property and casualty business. Excess reinsurance provides indemnification of losses above a stated retention on either an individual claim basis or in the aggregate across all claims in a portfolio. Reinsurance contracts are written on both a treaty (group of risks) and facultative (individual risk) basis.
Management believes the revised estimates in 2003 on prior years’ casualty loss reserves were primarily due to escalating medical inflation and utilization that adversely affect workers’ compensation and other casualty lines; and an increased frequency in corporate bankruptcies, scandals and accounting restatements which increased losses under errors and omissions and directors and officers coverages. Otherwise, reported casualty losses for prior years were generally consistent with management estimates. In addition to the above listed factors, revised estimates in 2002 and 2001 for prior years’ loss reserves were due to (1) an increase in claim severity, which has a leveraged effect on excess of loss coverages provided by General Re by producing a disproportionate increase in claims exceeding General Re’s attachment point; (2) broadened coverage terms under General Re’s reinsurance contracts during 1997 through 2000; (3) increased ceding companies’ reserve inadequacies, likely arising from broadened terms and conditions, as well as previously unrecognized premium inadequacies; and (4) increased primary company insolvencies, which changed historical claim reporting patterns. See the discussion regarding “Critical Accounting Policies” for information about the processes used in estimating loss reserves.
In addition, General Re continuously estimates its liabilities and related reinsurance recoverables for environmental and asbestos claims and claim expenses. Most liabilities for such claims arise from exposures in North America. Environmental and asbestos exposures do not lend themselves to traditional methods of loss development determination and therefore reserves related to these exposures may be considered less reliable than reserves for standard lines of business (e.g., automobile). The estimate for environmental and asbestos losses is composed of four parts: known claims, development on known claims, incurred but not reported (“IBNR”) losses and direct excess coverage litigation expenses. At December 31, 2003, environmental and asbestos loss reserves for North America were $1,050 million ($890 million net of reinsurance). As of December 31, 2002 such amounts totaled $1,161 million ($1,008 million net of reinsurance). The changing legal environment concerning asbestos and environmental claims has made quantification of potential exposures very difficult. Future changes to the legal environment may precipitate significant changes in reserves.
Premiums earned in 2003 increased $105 million (5.9%) from 2002 amounts, reflecting the increase in values of most foreign currencies relative to the U.S. dollar. In local currencies, premiums earned declined 8.1% in 2003 versus 2002. The decrease in premiums earned was primarily due to the non-renewal of unprofitable business in Continental Europe, the United Kingdom, Latin America and Australia. In local currencies, premiums earned in 2002 declined 2.1% from 2001, primarily due to a substantial decline in premiums in Argentina, the non-renewal of under-performing business in Continental Europe and parts of Asia, partially offset by increases in the United Kingdom and Australia.
losses in August and European storm Jeanette in October. The underwriting loss of $568 million in 2001 included $247 million of net losses related to the September 11th terrorist attack and $143 million resulting from other large individual property losses.
London-market business is written through Faraday Holdings Limited (“Faraday”). Faraday owns the managing agent of Syndicate 435 at Lloyd’s of London and provides capacity and participates in the results of Syndicate 435. Through Faraday, General Re’s participation in Syndicate 435 was 100% in 2003. Also included in the London-market segment are Cologne Re’s UK and Continental Europe broker-market subsidiaries.
Premiums earned in the London-market operations increased $95 million (11.1%) in 2003 as compared to 2002. Premiums earned in 2002 increased $280 million (48.7%) over 2001 amounts. In local currencies, premiums earned in 2003 were unchanged from 2002 and increased 41.9% in 2002 over 2001. In 2003, premiums earned from Cologne Re’s Continental Europe broker-market subsidiary, which was placed in run-off, declined but were offset by increases in earned premiums in Faraday Syndicate 435. Premiums earned in 2002 increased primarily due to the increased participation in Faraday Syndicate 435 from 60.6% in 2001 to 96.7% in 2002.
London-market operations produced a pre-tax underwriting loss of $18 million in 2003, compared with pre-tax underwriting losses of $4 million and $178 million in 2002 and 2001, respectively. The underwriting loss in 2003 included $73 million of reserve increases related to prior years’ loss events. These losses occurred primarily in casualty lines. In 2003, underwriting gains were earned in property and aviation lines, reflecting more selective underwriting and a lack of catastrophes and other large losses. Underwriting results in 2002 were adversely impacted by $80 million of increases in prior years’ casualty loss reserve estimates and $17 million of European flood losses. Offsetting these amounts were gains in property business. The London-market underwriting loss in 2001 included $66 million of losses from the September 11th terrorist attack as well as relatively high property losses.
At December 31, 2003, the Faraday operations had gross loss reserves of $1.9 billion, ($1.7 billion net of reinsurance) compared to $1.7 billion in gross reserves at December 31, 2002 ($1.3 billion net of reinsurance). The increase in reserves during 2003 was primarily due to changes in foreign currency rates.
General Re’s global life/health affiliates reinsure such risks worldwide. Premiums earned in 2003 decreased by $39 million (2.1%) compared with 2002. Premiums earned in 2002 for the global life/health operations declined $102 million (5.1%) from 2001. Adjusting for the effects of foreign currency exchange, premiums earned declined 9.6% in 2003, and 6.7% in 2002. The decline in 2003 was primarily due to decreases in the group and individual health businesses in the U.S. life/health operations.
Retroactive reinsurance contracts indemnify ceding companies for losses arising under insurance or reinsurance contracts written in the past, usually 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 and essentially represents the net underwriting losses from this business in each of the past three years. In addition, underwriting results in 2003 included a net gain of $41 million from the commutation of contracts written in prior years in exchange for commutation payments of $710 million.
Retroactive reinsurance contracts are expected to generate significant underwriting losses over time due to the amortization of deferred charges. This business is accepted due to the exceptionally large amounts of float generated, which totaled about $7.7 billion at December 31, 2003. Unamortized deferred charges under BHRG retroactive reinsurance contracts were $2.8 billion at December 31, 2003 and $3.2 billion as of December 31, 2002.
share arrangement, BHRG essentially participates proportionately in the premiums and claims of the business written by the ceding company. BHRG was willing to enter into these new contracts because it believed the level of rate adequacy in certain property/casualty markets was much improved in relation to past years. BHRG’s participation in the Lloyd’s business declined in 2003 as the availability of other sources of capacity for Lloyd’s syndicates increased.
Berkshire’s primary insurance group consists of a wide variety of smaller insurance businesses that principally write liability coverages for commercial accounts. These businesses include: National Indemnity Company’s primary group operation (“NICO Primary Group”), a writer of motor vehicle and general liability coverages; U.S. Investment Corporation (“USIC”), whose subsidiaries underwrite specialty insurance coverages; a group of companies referred to internally as “Homestate” operations, providers of standard multi-line insurance; and Central States Indemnity Company, a provider of credit and disability insurance to individuals nationwide through financial institutions.
Investment income from insurance operations in 2003 of $3,223 million increased 5.7% over 2002, which exceeded 2001 by 8.0%. The increase in 2003 investment income was due primarily to higher amounts of interest earned from high-yield corporate obligations, partially offset by the effects of lower interest rates for other fixed maturity obligations. Berkshire’s investments in high-yield corporate bonds were approximately $8 billion (at original cost) as of December 31, 2002. As of December 31, 2003 the cost of such investments declined about $1.5 billion, as a result of sales and prepayments by issuers.
The high-yield investments were primarily acquired at distressed prices. The credit risk associated with such investments is much greater than with other fixed maturity investments typically acquired by Berkshire, which are generally U.S. Government, municipal and mortgage-backed securities and short-term cash equivalents. As of December 31, 2003, approximately 65% of Berkshire’s high-yield investments were issued by companies in the energy industry. While the market prices of such investments increased significantly for all major positions during 2003, Berkshire management does not believe that the credit risks associated with the issuers of these instruments has correspondingly declined. Credit losses may eventually occur with respect to some of these investments. However, management also believes that over time these investments will produce reasonable returns in relation to credit risk.
Float represents an estimate of the amount of funds ultimately payable to policyholders that is available for investment. Total float at December 31, 2003 was approximately $44.2 billion compared to $41.2 billion at December 31, 2002 and about $35.5 billion at December 31, 2001. The cost of float, represented by the ratio of the pre-tax underwriting gain or loss over average float, was negative for 2003 due to $1.7 billion of pre-tax net underwriting gains. The cost of float in 2002 was about 1.1% as compared to 12.8% for 2001.
Since December 31, 2000, Berkshire’s numerous non-insurance business activities have increased significantly through several business acquisitions. Additional information regarding these acquisitions is contained in Note 2 to the Consolidated Financial Statements.
A summary follows of results from Berkshire’s non-insurance businesses for the past three years. Dollars are in millions.
A comparison of revenues and pre-tax earnings between 2003, 2002 and 2001 for the non-insurance businesses follows. Dollars are in millions.
comparative decline in pre-tax earnings was due to lower net interest earned by BH Finance. BH Finance’s fixed maturity investment portfolio declined about $6 billion during 2003 as a result of sales and prepayments and was offset by corresponding declines in repurchase agreement obligations.
During 2003, pre-tax earnings included about $101 million from Berkadia as compared to $115 million in 2002. Earnings of Berkadia are directly correlated with the outstanding amount of a term loan to FINOVA, which totaled $525 million at December 31, 2003 compared to $2.175 billion at December 31, 2002 and $4.9 billion at December 31, 2001. Most of Berkadia’s pre-tax earnings in 2003 were represented by the accelerated recognition in earnings of fees received in 2001 from FINOVA in connection with origination of the loan as a result of loan repayments being at a much faster rate than originally anticipated. In February 2004, the FINOVA loan was repaid in full. Thus, earnings from Berkadia in 2004 will be nominal.
Berkshire’s retailing businesses consist of four independently managed retailers of home furnishings (Nebraska Furniture Mart and its subsidiaries (“NFM”), R.C. Willey Home Furnishings (“R.C. Willey”), Star Furniture (“Star”) and Jordan’s Furniture) and three independently managed retailers of fine jewelry (Borsheim’s Jewelry, Helzberg’s Diamond Shops (“Helzberg”), and Ben Bridge Jeweler). Revenues of the retail businesses in 2003 increased $208 million (9.9%) as compared to 2002, and 2002 revenues increased 5.3% over 2001. The increase in revenues in 2003 was primarily attributed to Nebraska Furniture Mart’s new store in Kansas City, Kansas, which opened in August 2003 and R.C. Willey’s second Nevada location, which opened in May 2003. Comparative pre-tax earnings of the retail group in 2003 were relatively unchanged from 2002. Higher earnings associated with the new R.C. Willey store were offset by start-up and depreciation costs incurred in connection with NFM’s new store.
Revenues in 2003 from Berkshire’s other businesses as compared to 2002 increased $665 million to $3,040 million and pre-tax earnings increased $105 million to $486 million. Berkshire’s other non-insurance businesses consist of the results of numerous smaller businesses. The increase in revenues and pre-tax earnings of other businesses in 2003 was primarily due to the inclusion of the results of businesses acquired in 2002 from their respective acquisition dates (Larson-Juhl-February 8, 2002, The Pampered Chef and CTB International-both October 31, 2002).
Earnings from MidAmerican represent Berkshire’s share of MidAmerican’s net earnings, as determined under the equity method. Earnings from MidAmerican totaled $429 million in 2003, $359 million in 2002 and $134 million in 2001. MidAmerican’s earnings increased in 2003 due to improved results in its utility businesses, the effects of the acquisition during 2002 and the subsequent expansion during 2003 of two natural gas pipelines and increased earnings from its real estate brokerage business due to acquisitions and increased transaction volume. See Note 3 to the Consolidated Financial Statements for additional information regarding Berkshire’s investments in MidAmerican.
The Consolidated Statements of Earnings include after-tax realized investment gains of $2,729 million in 2003, $566 million in 2002 and $923 million in 2001. These gains were net of after-tax losses of $188 million in 2003, $373 million in 2002 and $161 million in 2001 related to “other-than-temporary” impairments. Management evaluates investments for impairment as of each balance sheet date. Factors considered in determining whether an impairment charge is warranted include the length of time the unrealized loss has existed, the financial condition of the investee, future business prospects and creditworthiness of the investee, and Berkshire’s ability and intent to hold the investment until the value recovers. When an impairment charge is recorded, the cost of the investment is written down to fair value through a charge to earnings. Consequently, impairment charges from essentially all of Berkshire’s “other-than-temporarily” impaired investments produced little effect on total shareholders’ equity because these investments were already carried at fair value with the difference between fair value and cost included in shareholders’ equity as a component of accumulated other comprehensive income.
After-tax realized gains also included $536 million in 2003 and $193 million in 2002 of realized and unrealized gains on foreign currency forward contracts entered into during the last two years. After-tax unrealized gains included in earnings with respect to open contracts totaled $414 million as of December 31, 2003 and $193 million at December 31, 2002. The gains in each year were due primarily to the decline in the value of the U.S. dollar against certain foreign currencies.
Berkshire’s balance sheet continues to reflect significant liquidity and a strong capital base. Consolidated shareholders’ equity at December 31, 2003 totaled $77.6 billion. Consolidated cash and invested assets, excluding assets of finance and financial products businesses, totaled approximately $95.6 billion at December 31, 2003, (including $31.3 billion in cash and cash equivalents) and totaled $80.5 billion at December 31, 2002. During 2003, the market prices of Berkshire’s holdings in equity and fixed maturity securities increased significantly and cash flow generated from operations was about $8.2 billion. During 2003, Berkshire deployed about $3.2 billion in internally generated cash for business acquisitions and during the preceding two years, cash of $7.3 billion was utilized in business acquisitions, and $1.7 billion was utilized for additional investments in MidAmerican.
Berkshire’s consolidated notes payable and other borrowings, excluding borrowings of finance businesses, totaled $4.2 billion at December 31, 2003 and $4.8 billion at December 31, 2002. During 2003, commercial paper and short-term borrowings of subsidiaries declined $642 million from prepayments arising from strong operating cash flow at Shaw and utilization of excess cash by General Re. Other borrowings consist primarily of debt of subsidiaries and investment contracts issued by Berkshire.
As of December 31, 2003, finance assets included approximately $3.8 billion in assets of Clayton, which was acquired by Berkshire in August 2003. Clayton is a leading builder of manufactured housing, provides financing and services loans to customers, and acquires other installment loan portfolios. Prior to its acquisition, Clayton securitized and sold a significant portion of its installment loans through special purpose entities. In early 2003, Clayton discontinued loan securitizations and sales. Since being acquired by Berkshire, Clayton retained loan portfolios have increased by about $1.3 billion. Loan portfolios are expected to continue to grow over time.
Notes payable and other borrowings of Berkshire’s finance and financial products businesses totaled $4.9 billion at December 31, 2003 and $4.5 billion at December 31, 2002. During the last four months of 2003, Berkshire Hathaway Finance Corporation issued a total of $2.0 billion par amount of medium term notes due from
2008 through 2013. The proceeds of these issues were used to finance new and existing loans of Clayton. The medium term notes are guaranteed by Berkshire. Additional borrowings are expected in the future as retained loan portfolios continue to increase.
Berkshire records liabilities for unpaid losses and loss adjustment expenses under property and casualty insurance and reinsurance contracts based upon estimates of the ultimate amounts payable under the contracts related to losses occurring on or before the balance sheet date. Berkshire uses a variety of techniques to establish and review the liabilities for unpaid losses recorded as of the balance sheet date. While techniques may vary, significant judgments and assumptions are necessary in projecting the ultimate amount payable in the future with respect to loss events that have occurred as of the balance sheet date.
upon internally developed loss experience, the experience of individual clients or groups of clients, or overall industry-wide experience. Reserving techniques are based more upon informed judgment when statistical data is insufficient or unavailable. Management must make judgments regardless of the techniques used.
As of any balance sheet date, all claims that have occurred have not yet been reported to Berkshire, and if reported may not have been settled. The time period between the occurrence of a loss and the time it is settled by the insurer or reinsurer is referred to as the “claim-tail.” Property claims usually have a fairly short claim-tail and, absent claim litigation, are reported and settled within no more than a few years of the balance sheet date. Casualty losses, on the other hand, can have a very long claim-tail, occasionally extending for decades. In addition, casualty claims are more susceptible to litigation and can be significantly affected by changing contract interpretations and to the legal environment, which contributes to the extended claim-tail. The claim-tail for reinsurers is further extended due to delayed reporting by ceding insurers or reinsurers due to contractual provisions or reporting practices.
The process of establishing reserves for losses assumed under reinsurance contracts requires additional estimation and judgments by management. Loss reserve estimates are based primarily on claims reported by ceding companies (such amounts generally exclude IBNR claim estimates), analysis of historical claim reporting patterns of ceding companies, and estimates of expected overall loss amounts. Techniques for estimating facultative (or individual) reinsurance losses can be similar to those techniques used by primary insurers and subject to the same caveats. In estimating losses assumed under treaty reinsurance (groups of losses), claim frequency or count analyses may not be used because such data is either not provided by ceding companies or otherwise not timely or reliable. Loss reserves established by line of business and type of coverage are regularly re-evaluated with appropriate adjustments being made to bring reserves in line with the revised estimates.
IBNR reserves are largely comprised of casualty exposures, which include workers’ compensation losses. These claims tend to be reported by and settled with ceding companies over long time periods. Therefore, such claims are subject to a higher degree of estimation error as a result of changes in the legal environment, jury awards, medical cost trends and general cost inflation. Based upon statistical analysis of past reporting trends, Berkshire estimates how much IBNR is required to cover claims that will be reported by ceding companies in future years. Subsequently, as claims are reported, amounts are measured against previous expectations, with variances (positive or negative) recognized in earnings as a component of losses and loss adjustment expenses. Significant variances between expected claims and reported claims are analyzed and considered when revising estimates for remaining IBNR reserve levels.
Due to the inherent uncertainties in the processes and judgments used in establishing reserves, and because expected losses are an input in establishing premium rates for new policies, Berkshire’s management believes it is appropriate to establish reserve levels using a reasonable level of caution, especially with respect to casualty claims.
Includes amortization of deferred charges and includes accretion of discounts on General Re workers’ compensation reserves (See Note 11 to the Consolidated Financial Statements).
In each year, General Re’s casualty reserve estimates for prior years’ losses have increased. In addition, the net reserves of BHRG’s retroactive reinsurance policies have increased each year, primarily as a consequence of amortization of deferred charges. As shown in the table, a relatively small percentage change in estimates of this magnitude will result in a material effect on reported earnings. A hypothetical 5% increase in estimated net unpaid losses at December 31, 2003, would produce a $1.9 billion charge to pre-tax earnings. Future effects from changes in these estimates will be recorded as a component of losses incurred in the period of the change.
Berkshire records deferred charges as assets on its balance sheet with respect to liabilities assumed under retroactive reinsurance contracts. At the inception of these contracts the deferred charges represent the difference between the consideration received and the estimated ultimate liability for unpaid losses. The deferred charges are amortized as a component of losses incurred using the interest method over an estimate of the ultimate claim payment period. The deferred charge balance may be adjusted periodically to reflect new projections of the amount and timing of loss payments. Adjustments to these assumptions are applied retrospectively from the inception of the contract. Unamortized deferred charges totaled $3.1 billion at December 31, 2003. Significant changes in either the timing or ultimate amount of loss payments may have a significant effect on unamortized deferred charges and the amount of periodic amortization.
Berkshire’s Consolidated Balance Sheet as of December 31, 2003 includes goodwill of acquired businesses of approximately $22.9 billion. These amounts have been recorded as a result of Berkshire’s numerous prior business acquisitions accounted for under the purchase method. Prior to 2002, goodwill from each acquisition was generally amortized as a charge to earnings over periods not exceeding 40 years. Under SFAS No. 142, which was adopted by Berkshire as of January 1, 2002, periodic amortization ceased, in favor of an impairment-only accounting model.
Berkshire’s Consolidated Balance Sheet includes a substantial amount of assets and liabilities whose fair values are subject to market risks. Berkshire’s significant market risks are primarily associated with interest rates and equity prices and to a lesser degree derivatives. The following sections address the significant market risks associated with Berkshire’s business activities.
Strategically, Berkshire strives to invest in businesses that possess excellent economics, with able and honest management and at sensible prices. Berkshire’s management prefers to invest a meaningful amount in each investee. Accordingly, Berkshire’s equity investments are concentrated in relatively few investees. At December 31, 2003, 68.9% of the total fair value of equity investments was concentrated in four investees.
Berkshire’s preferred strategy is to hold equity investments for very long periods of time. Thus, Berkshire management is not necessarily 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.
GRS evaluates and records a fair-value adjustment to recognize counterparty credit exposure and future costs associated with administering each contract. The expected credit exposure for each trade is initially established on the trade date and is estimated through the use of a proprietary credit exposure model that is based on historical default probabilities, market volatilities and, if applicable, the legal right of setoff. These exposures are continually monitored and adjusted due to changes in the credit quality of the counterparty, changes in interest and currency rates or changes in other factors affecting credit exposure.
Berkshire monitors the currency positions daily for each currency. The following table summarizes the outstanding foreign currency forward contracts as of December 31, 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.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries (the “Company”) as of December 31, 2003 and 2002, 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, 2003. 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.
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 initiated and/or consummated a number of business acquisitions over the past three years which are discussed in Note 2.
Realized gains and losses arise when investments are sold (as determined on a specific identification basis) or are other-than-temporarily impaired and are included in the Consolidated Statements of Earnings. Berkshire reviews investments classified as held-to-maturity or available-for-sale as of each balance sheet date with respect to investments of an issuer carried at a net unrealized loss. If in management’s
Loans and finance receivables consist of commercial and consumer loans originated or purchased by Berkshire’s finance and financial products businesses. Loans and finance receivables are carried at amortized cost.
Derivative contracts are predominantly used to manage economic risks associated with financial instruments of finance and financial products businesses, including other derivative contracts. In addition, Berkshire enters into derivative contracts to manage general economic risks of the Company as a whole. Derivative instruments include interest rate, currency and equity swaps and options, interest rate caps and floors, futures and forward contracts and foreign currency exchange contracts.
Berkshire carries all derivative contracts at estimated fair value. These contracts are classified as trading account assets or trading account liabilities in the accompanying Consolidated Balance Sheets and reflect reductions permitted under master netting agreements with counterparties. The fair values of these instruments represent the present value of expected future cash flows under the contract, which is a function of underlying interest rates, currency rates, security values, related volatility, the creditworthiness of counterparties and duration of the contract. Future changes in these factors or a combination thereof may affect the fair value of these instruments. Most derivative contracts entered into by Berkshire are not designated as hedges for accounting purposes. Realized and unrealized gains and losses from such contracts are included in the Consolidated Statements of Earnings.
Securities sold under agreements to repurchase are accounted for as collateralized borrowings and are recorded at the contractual repurchase amounts.
Inventories are stated at the lower of cost or market. Cost with respect to manufactured goods includes raw materials, direct and indirect labor and factory overhead. As of December 31, 2003, approximately 59% of the total inventory cost was determined using the last-in-first-out (“LIFO”) method, 28% 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 not material as of December 31, 2003 and December 31, 2002.
Insurance premiums for prospective property/casualty insurance and reinsurance and health reinsurance policies are earned in proportion to the level of insurance protection provided. In most cases, premiums are recognized as revenues ratably over their terms with unearned premiums computed on a monthly or daily pro rata basis. Premium adjustments on contracts and audit premiums are based on estimates made over the contract period. Premiums for retroactive reinsurance policies are earned at the inception of the contracts. Premiums for life reinsurance contracts are earned when due. Premiums earned are stated net of amounts ceded to reinsurers. Premiums are estimated with respect to certain reinsurance contracts where premiums are based upon reports from ceding companies for the reporting period that are contractually due after the balance sheet date.
Liabilities for unpaid losses and loss adjustment expenses represent estimated claim and claim settlement costs of property/casualty insurance and reinsurance contracts with respect to losses that have occurred as of the balance sheet date. The liabilities for losses and loss adjustment expenses are recorded at the estimated ultimate payment amounts, except that amounts arising from certain workers’ compensation reinsurance business are discounted as discussed below. Estimated ultimate payment amounts are based upon (1) individual case estimates, (2) reports of losses from ceding insurers and (3) estimates of incurred but not reported (“IBNR”) losses.
The estimated liabilities of workers’ compensation claims assumed under reinsurance contracts are carried in the Consolidated Balance Sheets at discounted amounts. Discounted amounts are based upon an annual discount rate of 4.5% for claims arising prior to 2003 and 1% for claims arising after 2002. The
The accounts of foreign-based subsidiaries are measured using the local currency as the functional currency. Revenues and expenses of these businesses are translated into U.S. dollars at the average exchange rate for the period. Assets and liabilities are translated at the exchange rate as of the end of the reporting period. Gains or losses from translating the financial statements of foreign-based operations are included in shareholders’ equity as a component of accumulated other comprehensive income. Gains and losses arising from other transactions denominated in a foreign currency are included in the Consolidated Statements of Earnings.
In December 2003, the Financial Accounting Standards Board (“FASB”) issued a revision to Statement No. 132, “Employers’ Disclosures about Pension Plans and Other Post Retirement Benefits”, which requires additional quantitative and qualitative disclosures concerning plan assets and benefit obligations. Certain of the new disclosures are effective immediately for U.S. plans and are included in Note 17.
Berkshire has concluded that Value Capital meets the definition of a VIE under FIN 46, as revised. As the primary beneficiary of the VIE, Berkshire is required to consolidate Value Capital beginning in the first quarter of 2004. This change will have no effect on previously reported net earnings. Berkshire’s consolidated assets and liabilities will increase approximately $18.5 billion based upon the assets and liabilities of Value Capital as of December 31, 2003.
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 with 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.
During 2002, Berkshire completed five business acquisitions for cash consideration of approximately $2.3 billion in the aggregate. Information concerning these acquisitions follows.
On April 30, 2002, Berkshire acquired the basic apparel business of Fruit of the Loom, LTD. FOL is a leading vertically integrated basic apparel company manufacturing and marketing underwear, activewear, casualwear and childrenswear. FOL operates on a worldwide basis and sells its products principally in North America under the Fruit of the Loom and BVD brand names.
In addition, Berkshire completed four business acquisitions during 2001. Information concerning these acquisitions follows.
On February 27, 2001, Berkshire acquired all of the outstanding shares of Johns Manville for $13 per share, or $1.8 billion in the aggregate. Johns Manville is a leading manufacturer of insulation and building products. Johns Manville manufactures and markets products for building and equipment insulation, commercial and industrial roofing systems, high-efficiency filtration media, and fibers and non-woven mats used as reinforcements in building and industrial applications.
On July 31, 2001, Berkshire acquired a 90% interest in MiTek for approximately $400 million. Existing MiTek management acquired the remaining 10% interest. MiTek produces steel connector products, design engineering software and ancillary services for the building components market.
On September 20, 2001, Berkshire acquired all of the outstanding shares of XTRA for approximately $578 million. XTRA is a leading operating lessor of transportation equipment, including over-the-road trailers, marine containers and intermodal equipment.
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 and 2002, 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.
MidAmerican is a U.S. based global energy company whose principal businesses are regulated electric and natural gas utilities, regulated interstate natural gas transmission and electric power generation. Through its subsidiaries it owns and operates a combined electric and natural gas utility company in the United States, two natural gas pipeline companies in the United States, two electricity distribution companies in the United Kingdom and a diversified portfolio of domestic and international electric power projects. It also owns the second largest residential real estate brokerage firm in the United States.
MidAmerican’s Articles of Incorporation further provide that the convertible preferred shares: a) are not mandatorily redeemable by MidAmerican or at the option of the holder; b) participate in dividends and other distributions to common shareholders as if they were common shares and otherwise possess no dividend rights; c) are convertible into common shares on a 1 for 1 basis, as adjusted for splits, combinations, reclassifications and other capital changes by MidAmerican; and d) upon liquidation, except for a de minimus first priority distribution of $1 per share, share ratably with the shareholders of common stock. Further, the aforementioned dividend and distribution arrangements cannot be modified without the positive consent of the preferred shareholders. Accordingly, the convertible preferred stock is, in substance, a substantially identical subordinate interest to a share of common stock and economically equivalent to common stock. Therefore, Berkshire accounts for its investments in MidAmerican pursuant to the equity method.
Condensed consolidated statements of earnings of MidAmerican for each of the three years in the period ending December 31, 2003 are as follows. Amounts are in millions.
Investments in securities with fixed maturities as of December 31, 2003 and 2002 are shown below (in millions).
(1) Common shares of American Express Company (“AXP”) owned by Berkshire and its subsidiaries possessed approximately 11.8% of the voting rights of all AXP shares outstanding at December 31, 2003. The shares are held subject to various agreements which, generally, prohibit Berkshire from (i) unilaterally seeking representation on the Board of Directors of AXP and (ii) possessing 17% or more of the aggregate voting securities of AXP. Berkshire has entered into an agreement with AXP which will remain effective so long as Berkshire owns 5% or more of AXP’s voting securities. The agreement obligates Berkshire, so long as Kenneth Chenault is chief executive officer of AXP, to vote its shares in accordance with the recommendations of AXP’s Board of Directors. Additionally, subject to certain exceptions, Berkshire has agreed not to sell AXP common shares to any person who owns 5% or more of AXP voting securities or seeks to control AXP, without the consent of AXP.
Certain Berkshire subsidiaries, in particular, General Re Securities (“GRS”), regularly utilize derivatives as risk management tools. In January 2002, GRS commenced a long-term run-off of its operations. Previously GRS operated as a dealer in various types of derivatives instruments, such as swaps, forwards, futures and options, which are used by clients to manage economic risks arising from interest rate, foreign exchange rate, or market price movements. The run-off is expected to occur over a number of years during which GRS will limit its new business to certain risk management transactions and will unwind its existing asset and liability positions in an orderly manner. General Re Corporation, the parent of GRS, has guaranteed the obligations of GRS.
In addition, beginning in 2002, another Berkshire subsidiary entered into derivatives contracts with the objective of hedging a portion of certain corporate-wide risks. Accordingly, such contracts do not qualify for hedge accounting. During 2003, such contracts were primarily foreign currency exchange forward contracts. Additional information regarding Berkshire’s derivative contracts follows.
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 daily. For instance, GRS calculates the effect on operating results of potential changes in market variables, which include volatility, correlation and liquidity. GRS monitors risks over a one week period and has established $15 million as its value at risk limit with a 99th percentile confidence interval for potential losses over a weekly horizon. GRS, which may enter into long duration contracts, records fair value adjustments to recognize counterparty credit exposure and future costs associated with administering each contract. The fair value adjustment for counterparty credit exposures and future administrative costs on existing contracts was $55 million at December 31, 2003.
Master netting agreements are utilized to manage counterparty credit risk, where gains and losses are netted across all contracts with that counterparty. In addition, counterparty credit limits are established, and credit exposures are monitored in accordance with these limits. In addition, Berkshire may receive cash or investment grade securities from counterparties as collateral and, where appropriate, may purchase credit insurance or enter into other transactions to mitigate exposure, if balances exceed specified levels or if credit ratings of counterparties are downgraded below specified levels. Berkshire may incorporate contractual provisions that allow the unwinding of transactions under adverse conditions. Likewise, Berkshire may be required to post cash or securities as collateral with counterparties under similar circumstances.
As of December 31, 2003, Value Capital had total assets of $19.2 billion, total liabilities of $18.5 billion and capital of $688 million. For the year ending December 31, 2003, revenues were $596 million, expenses were $564 million and net earnings were $32 million.
The balances of unpaid losses and loss adjustment expenses are based upon estimates of the ultimate claim costs associated with claim occurrences as of the balance sheet dates including estimates for incurred but not reported (“IBNR”) claims. Considerable judgment is required to evaluate claims and establish estimated claim liabilities, particularly with respect to certain casualty or liability claims, which are typically reported over long periods of time and subject to changing legal and litigation trends. This delay in claim reporting is exacerbated in reinsurance of liability or casualty claims as claim reporting by ceding companies is further delayed by contract terms.
Incurred losses “all prior accident years” 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. Berkshire recorded additional losses of $480 million in 2003, $1,540 million in 2002 and $1,152 million in 2001 with respect to losses occurring in prior years. Such amounts as percentages of the net balance as of the beginning of the year were 1.3%, 4.5% and 4.2% in 2003, 2002 and 2001, respectively.
Prior accident years’ losses incurred also include amortization of deferred charges related to retroactive reinsurance contracts incepting prior to January 1, 2003. Amortization charges included in prior accident years’ losses were $432 million in 2003, $430 million in 2002 and $328 million in 2001. Certain workers’ compensation reserves of General Re are discounted. Net discounted liabilities at December 31, 2003 and 2002 were $2,211 million and $2,015 million, respectively, and are net of discounts totaling $2,435 million and $2,405 million. Periodic accretions of these discounts are also a component of prior years’ losses incurred. The accretion of discounted liabilities is included in incurred losses for all prior accident years and was approximately $85 million in 2003, $81 million in 2002 and $69 million in 2001. The most significant component of losses from prior years’ occurrences in both 2002 and 2001 was reserve increases with respect to General Re’s North American and international property/casualty reinsurance businesses.
Notes payable and other borrowings of Berkshire and its subsidiaries as of December 31, 2003 and 2002 are summarized below. Amounts are in millions.
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, 2003 and 2002 were 1.3% and 2.4% respectively. Berkshire affiliates have approximately $6.6 billion available unused lines of credit and commercial paper capacity to support their short-term borrowing programs and, otherwise, provide additional liquidity.
Investment agreements represent numerous individual contractual 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, 2003 and 2002 was 3.1% and 3.9%, respectively. Under certain conditions, principal amounts may be redeemed without premium prior to the contractual maturity date at the option of the counterparties.
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, to purchase either 0.1116 shares of Class A common stock or 3.3480 shares 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, 2003.
In September 2003, Berkshire Hathaway Finance Corporation (“BHFC”), a wholly-owned subsidiary of Berkshire, issued $1.5 billion par of senior notes consisting of $750 million par of 3.375% notes due 2008 and $750 million par of 4.625% notes due 2013. In December 2003, BHFC issued an additional $500 million par of 4.20% notes due 2010. The proceeds were used in the financing activities of Clayton Homes.
Payments of principal amounts expected during the next five years are as follows (in millions).
The liability for income taxes as of December 31, 2003 and 2002 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, 2003 and 2002 are shown below (in millions).
Payments of dividends by insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, insurance subsidiaries may pay up to approximately $3.7 billion as ordinary dividends during 2004.
Combined shareholders’ equity of U.S. based property/casualty insurance subsidiaries determined pursuant to statutory accounting rules (Statutory Surplus as Regards Policyholders) was approximately $40.7 billion at December 31, 2003 and $28.4 billion at December 31, 2002.
Changes in issued and outstanding Berkshire common stock during the three years ended December 31, 2003 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 1,536,630 shares outstanding as of December 31, 2003 and 1,534,657 shares as of December 31, 2002.
Certain Berkshire subsidiaries individually sponsor defined benefit pension plans covering their employees. Benefits under the plans are generally based on years of service and compensation, although benefits under certain plans are based on years of service and fixed benefit rates. Funding policies are generally to contribute amounts required to meet regulatory requirements plus additional amounts determined by management based on actuarial valuations.
The components of net periodic pension expense for each of the three years ending December 31, 2003 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, 2003 and 2002, total plan assets were invested as follows:
Pension plan assets are generally invested with the long-term objective of earning sufficient amounts to cover expected benefit obligations, while assuming a prudent level of risk. There are no target allocation investment percentages with respect to individual or categories of investments. Allocations may change rapidly as a result of changing market conditions and investment opportunities. The expected rates of return on plan assets reflect Berkshire’s subjective assessment of expected invested asset returns over a period of several years, given the current low interest rate environment and current equity security valuations, in general. Actual experience will differ from the assumed rates, in particular over quarterly or annual periods as a result of market volatility and changes in the mix of assets.
The funded status of the plans as of December 31, 2003 and 2002 is as follows (in millions).
The total net deficit status for plans (including unfunded plans) with accumulated benefit obligations in excess of plan assets was $378 million and $320 million as of December 31, 2003 and 2002, respectively. Expected contributions to plans during 2004 are estimated to be $72 million.
The benefit payments, which reflect expected future service as appropriate, are expected to be paid as follows (in millions).
Most Berkshire subsidiaries also sponsor defined contribution retirement plans, such as a 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 $242 million, $202 million and $77 million for the years ended December 31, 2003, 2002 and 2001, respectively.
A summary of supplemental cash flow information for each of the three years ending December 31, 2003 is presented in the following table (in millions).
Manufacturing and distribution of a variety of footwear and clothing products, including underwear, activewear, children’s clothes and uniforms
Manufacturing and distribution of carpet and floor coverings under a variety of brand names
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 and The Pampered Chef, a direct seller of kitchen tools.
Insurance premiums written by geographic region (based upon the domicile of the insured) are summarized below. Dollars are in millions.
Premiums written and earned by Berkshire’s property/casualty and life/health insurance businesses during each of the three years ending December 31, 2003 are summarized below. Dollars are in millions.