(3) In March 1996, The Walt Disney Company completed its acquisition of Capital Cities/ABC, Inc. A pre-tax realized gain related to this transaction of $2.2 billion ($1.4 billion after-tax) is included in 1996's results.
Berkshire Hathaway engages in both direct insurance and reinsurance of property and casualty risks. In direct insurance activities, Berkshire subsidiaries assume defined portions of the risks of loss from persons or organizations that are directly subject to the risks. In reinsurance activities, Berkshire subsidiaries assume defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves to in their own insuring activities. Berkshire's principal underwriting businesses are: (1) GEICO, which became a wholly owned subsidiary of Berkshire on January 3, 1996, (2) Berkshire Hathaway Reinsurance Group and (3) Berkshire Hathaway Direct Insurance Group. On December 21, 1998, Berkshire completed its merger with General Re. General Re and its affiliates comprise one of the four largest reinsurance companies in the world. See Note 2 to the Consolidated Financial Statements.
GEICO through its subsidiaries, 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 or through the mail. This is a significant element in GEICO's strategy to be a low-cost provider of such coverages. In 1995, GEICO entered into an agreement with another major insurance provider that over time will allow it to effectively exit the homeowners insurance business which represented a relatively small percentage of GEICO's business.
Underwriting expenses in 1998 for GEICO's businesses increased $215 million (37.7%) over 1997 and in 1997 increased $84 million (17.2%) over 1996. The increases reflect additional advertising and personnel costs incurred to generate and service the aforementioned in-force policy growth, as well as increased levels of administrative expenses, particularly profit-sharing costs.
Underwriting results for the past three years are summarized in the following table.
The catastrophe reinsurance business produced net underwriting gains in 1998 of $155 million as compared to net underwriting gains of $283 million in 1997 and $167 million in 1996. During the 1996-1998 period, there were no truly large catastrophic events. Catastrophe losses incurred were $34 million in 1998, nearly zero in 1997 and $46 million in 1996.
Berkshire's management continues to believe that, eventually, a large catastrophe event will occur which will produce a significant loss. The Berkshire Hathaway Reinsurance Group's exposure to loss from a single event with respect to in-force policies at year end 1998 is estimated at approximately $600 million after-tax (excludes losses which would likely be incurred by General Re). Accordingly, periodic underwriting results remain subject to extreme volatility. Berkshire's management is willing to accept such volatility provided there is a reasonable prospect of long-term profitability.
Premiums earned from other property and casualty excess-of-loss and quota-share reinsurance contracts totaled $310 million in 1998, $513 million in 1997 and $485 million in 1996. These contracts often provide considerable amounts of indemnification in exchange for large premiums. Certain of these contracts, which produced annual premiums of approximately $200 million in 1997 and 1996, expired at the end of 1997 and were not renewed in 1998. Other property and casualty reinsurance contracts produced net underwriting losses of approximately $86 million in 1998, $73 million in 1997 and $101 million in 1996. Premiums from these types of reinsurance contracts are often based, in part, on time discounting of estimated loss payments because such payments are expected to occur over lengthy time periods. Estimated claim liabilities are established for financial reporting purposes without recognition of such discounting, thus producing underwriting losses. This business is accepted because of the large amounts of policyholder float that it generates.
General Re and its affiliates operate a global insurance/reinsurance business with operations in the U.S. and 124 other countries around the world. General Re's principal reinsurance operations are internally classified: (1) North American property/casualty, (2) international property/casualty, and (3) global life/health reinsurance.
Summarized information regarding General Re's historical pre-tax underwriting results for 1998 and 1997 is presented below.
General Re's historical pre-tax net investment income in each of the years ending December 31, 1998 and 1997 totaled approximately $1.3 billion. On an after-tax basis, General Re's historical net investment income was about $975 million in both 1998 and 1997.
Berkshire's insurance businesses continue to generate significant levels of investment income from maintaining large levels of invested assets. The acquisition of General Re at the end of 1998 increased invested assets by about $25 billion. Increases in invested assets in recent years also derive from reinvested earnings and additional capital contributions, as well as increases in the amounts of "float". Reinvested earnings and capital contributions over the three year period ending December 31, 1998 were approximately $6 billion. Float represents the sum of unpaid losses and loss expenses, unearned premiums, and other liabilities to policyholders less the aggregate of premiums and reinsurance balances receivable, deferred policy acquisition costs, deferred charges re reinsurance assumed and related prepaid income taxes. Total float was approximately $22.8 billion at year end 1998 which includes $14.9 billion assumed as a result of the General Re acquisition.
Income tax expense as a percentage of investment income before taxes was 24.2% in 1998, 19.5% in 1997 and 17.6% in 1996. Investment income in each of these years includes substantial amounts of interest on municipal obligations and dividends from equity investments that are effectively taxed at rates below the full statutory federal rate.
Revenues from the eight identifiable non-insurance business segments of $4,458 million in 1998 increased $1,054 million (31.0%) from the prior year. The aggregate operating profits from these business segments of $635 million in 1998 increased $123 million (24.0%). The acquisitions of International Dairy Queen ("Dairy Queen") at the beginning of 1998 and Executive Jet during August, 1998 account for a significant portion of the comparative increases. The following is a discussion of other significant matters impacting comparative results for each of the non- insurance business segments.
This segment includes FlightSafety and Executive Jet. FlightSafety, acquired at the end of 1996, provides high technology training to operators of aircraft and ships. FlightSafety's worldwide clients include corporations, the military and government agencies. On August 7, 1998, Berkshire acquired Executive Jet, the worlds' leading provider of fractional ownership programs for general aviation aircraft. Executive Jet operates the NetJets(R) fractional ownership program in the United States and Europe. Revenues of this segment increased $447 million (108.8%) over comparable prior year amounts. The acquisition of Executive Jet accounts for about 85% of the overall revenue increase. Operating profits of this segment increased $41 million (29.3%) over comparable prior year amounts. The acquisition of Executive Jet accounts for about half of the overall increase. FlightSafety's operating profits increased significantly over 1997 as a result of continued growth in all areas of its training business.
This segment consists of two separately managed retailers of fine jewelry. Borsheim's operates from a single location in Omaha, Nebraska. Helzberg's Diamonds operates a national chain of retail stores located primarily in malls throughout the United States. Revenues of $440 million increased $42 million (10.6%) and operating profits of $39 million increased $7 million (21.9%) over the comparable prior year amounts. While the revenue increase accounted for much of the increase in operating profits, both of these businesses were able to effectively control operating expenses resulting in improved results.
The Scott Fetzer companies are a group of about twenty diverse manufacturing and distribution businesses under common management. Principal businesses in this group of companies sell products under the Kirby (home cleaning systems), Campbell Hausfeld (air compressors, paint sprayers and pressure washers) and World Book (encyclopedias and other educational products) names. Revenues of $1,002 million increased $41 million (4.3%) over the comparable prior year amount.
The increase in revenues was primarily due to increases at Campbell Hausfeld somewhat offset by lower World Book revenues. Operating profits of $137 million increased $18 million (15.1%) from the prior year. Increased sales at Campbell Hausfeld along with improved results from World Book's international businesses account for a significant portion of the improved results.
See's revenues increased $19 million (7.1%) over comparable prior year amounts. Total pounds of candy sold increased about 3.3% with 3% to 4% increases being achieved both in See's quantity order business as well as its retail stores. Operating profits increased $3 million (5.1%) as compared to the prior year.
Revenues from the non-insurance business segments increased $516 million (17.9%) in 1997 as compared to 1996. Operating profits of $512 million during 1997 increased $152 million (42.2%) from the comparable 1996 amount. The most significant factor which gave rise to the increase in both revenues and operating profits was the acquisition of FlightSafety at the end of 1996. With the exception of the shoe group, all other reportable segments reported excellent results in 1997 as compared to 1996.
Berkshire's primary investment strategy contemplates that most equity investments will be held for very long periods of time. Thus, Berkshire management is not necessarily troubled by short term price volatility with respect to its investments provided that the underlying business, economic and management characteristics of the investees remain favorable. Berkshire maintains above average levels of shareholder capital to provide a margin of safety against short term equity price volatility.
* Includes redeemable convertible preferred shares of investees in which the market prices of the common stock of the investees significantly exceeded the related conversion prices. ** Less than 1%
This section discusses interest rate risks associated with Berkshire's financial assets and liabilities, other than those of its finance and financial products businesses, which are discussed later. Berkshire's management prefers to invest in equity securities or to acquire entire businesses based upon the principles discussed in the preceding section on equity price risk. When unable to do so, management may alternatively invest in bonds or other interest rate sensitive instruments. Berkshire's strategy is to acquire securities that are attractively priced in relation to the perceived credit risk. Management recognizes and accepts that losses may occur. The Company has historically utilized a modest level of corporate borrowings and debt. Further, Berkshire strives to maintain the highest credit ratings so that the cost of debt is minimized. The Company does not actively utilize stand-alone derivatives to manage interest rate risks.
(1) Excludes redeemable convertible preferred stocks (See Equity Price Risk) (2) Excludes 1% Senior Exchangeable Notes (See Equity Price Risk)
The finance and financial products operations are subject to market risk principally through General Re Financial Products ("GRFP"). GRFP monitors its market risk on a daily basis across all swap and option products by calculating the effect on operating results of potential changes in market variables over a one week period, based on historical market volatility, correlation data and informed judgment. This evaluation is done on an individual trading book basis, against limits set by individual book, to a 95% probability level. GRFP sets market risk limits for each type of risk, and for an aggregate measure of risk, based on a 99% probability that movements in market rates will not affect the results from operations in excess of the risk limit over a one week period. GRFP's weekly aggregate market risk limit is $15 million. Risk is measured primarily by Monte Carlo simulations to obtain the required degree of confidence. In addition to these daily and weekly assessments of risk, GRFP prepares periodic stress tests to assess its exposure to extreme movements in various market risk factors.
Berkshire's Consolidated Balance Sheet as of December 31, 1998, reflects continuing capital strength. In the past three years, Berkshire shareholders' equity has increased from approximately $16.7 billion at December 31, 1995, to approximately $57.4 billion at December 31, 1998. In that three-year period, realized and unrealized securities gains increased equity capital by approximately $13.2 billion, and reinvested earnings, other than realized securities gains, were about $3.4 billion.
Many computer systems in use today may be unable to correctly process data or may not operate at all after December 31, 1999 because those systems recognize the year within a date only by the last two digits. Some computer programs may interpret the year "00" as 1900, instead of as 2000, causing errors in calculations or the value "00" may be considered invalid by the computer program, causing the system to fail. Year 2000 issues affect: (1) Information Technology (IT) utilized in the Company's widely diversified business information systems, including mainframe and client server hardware and software applications, (2) non-IT systems utilized by the Company, such as communications, facilities management, and manufacturing and service equipment containing embedded computer chips, and (3) IT and non-IT systems of significant customers, suppliers, business partners and equity investees.
Berkshire and its subsidiaries could be adversely affected if Year 2000 issues are not resolved by Berkshire or its significant customers, suppliers, business partners or equity investees before the Year 2000. Possible adverse consequences include but are not limited to: (1) the inability to obtain products or services used in business operations, (2) the inability to transact business with key customers, (3) the inability to execute transactions through the financial markets, (4) the inability to manufacture or deliver goods or services sold to customers, (5) the decline in economic value of one or more of Berkshire's significant equity investees and (6) the occurrence of Year 2000 related losses under property and casualty insurance and reinsurance contracts entered into by subsidiaries. Berkshire's management believes that at least some minor disruptions due to Year 2000 issues will occur. On a worst case basis, if Berkshire,
one or more of its significant business partners, equity investees or key governmental bodies are unable to implement timely and effective solutions to the Year 2000 issues, Berkshire could suffer material adverse effects. The financial impact of such effects cannot currently be estimated.
Berkshire and its subsidiaries expect to ultimately incur about $60 million in identification, remediation and testing of Year 2000 issues. Approximately $40 million of this amount was incurred as of December 31, 1998. Year 2000 related costs are expensed as incurred. The Company does not believe that any significant IT projects have been delayed due to Year 2000 efforts.
Berkshire and its subsidiaries have begun consideration of contingency plans to deal with certain Year 2000 issues in the event that remediation efforts are unsuccessful. Such plans will be more fully developed in 1999 to address specific areas of need.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of earnings, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. 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.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Berkshire Hathaway Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
* 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 $75 per share for 1998, $51 per share for 1997 and $69 per share for 1996.
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 direct and reinsurance basis. Further information regarding these businesses and Berkshire's other reportable business segments is contained in Note 15. The accompanying consolidated financial statements include the accounts of Berkshire consolidated with accounts of all its subsidiaries. Intercompany accounts and transactions have been eliminated. As more fully described in Note 2, on December 21, 1998, Berkshire consummated a merger with General Re Corporation ("General Re"). The balance sheet of General Re is consolidated with the balance sheets of Berkshire and its other subsidiaries as of December 31, 1998. However, General Re's results of operations are only included in the Consolidated Statement of Earnings for the ten day period ended December 31, 1998.
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. Actual results may differ from the estimates and assumptions used in preparing the consolidated financial statements.
Berkshire's management determines the appropriate classifications of investments at the time of acquisition and re-evaluates the classifications at each balance sheet date. Investments may be classified as held for trading, held to maturity, or, when neither of those classifications is appropriate, as available-for-sale. Berkshire's investments in fixed maturity and equity securities are classified as available-for-sale. Available-for-sale securities are stated at fair value with unrealized gains or losses, net of tax, reported as a separate component in shareholders' equity. Realized gains and losses, which arise when available-for-sale investments are sold (as determined on a specific identification basis) or other than temporarily impaired are included in the Consolidated Statements of Earnings.
Insurance premiums for prospective insurance and 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. Consideration received for retroactive reinsurance policies, including structured settlements, is recognized as premiums earned at the inception of the contracts. Premiums earned are stated net of amounts ceded to reinsurers. Earned premiums ceded were $93 million in 1998, $86 million in 1997 and $79 million in 1996.
Liabilities for unpaid losses and loss adjustment expenses represent estimated claim and claim settlement costs of property/casualty insurance and reinsurance contracts. The liabilities for losses and loss adjustment expenses are recorded at the estimated ultimate payment amounts, except amounts arising from certain reinsurance assumed businesses are discounted. Estimated ultimate payment amounts are based upon (i) individual case estimates, (ii) estimates of incurred-but-not reported losses, based upon past experience and (iii) reports of losses from ceding insurers.
The estimated liabilities of certain workers' compensation claims assumed under reinsurance contracts and liabilities assumed under structured settlement reinsurance contracts are carried in the Consolidated Balance Sheets at discounted amounts. Discounted amounts pertaining to reinsurance of certain workers' compensation risks are based upon an annual discount rate of 4.5%. The discounted amounts for structured settlement reinsurance contracts are based upon the prevailing market discount rates when the contracts were written. The periodic accretion of discounts is included in the Consolidated Statements of Earnings as a component of losses and loss adjustment expenses incurred.
(m) Accounting pronouncements to be adopted subsequent to December 31, 1998
(i) The FASB issued Statement of Financial Accounting Standard No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments imbedded in other contracts, and hedging activities. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. Berkshire expects to adopt SFAS No. 133 as of the beginning of 2000.
During 1998, Berkshire consummated three business acquisitions -- International Dairy Queen, Inc. ("Dairy Queen"), effective January 7, 1998; Executive Jet, Inc. ("Executive Jet"), effective August 7, 1998; and General Re Corporation ("General Re"), effective December 21, 1998. Additional information regarding these acquisitions is provided below.
On January 7, 1998, the merger of Dairy Queen with and into a wholly owned subsidiary of Berkshire was completed. Shareholders of Dairy Queen received merger consideration of approximately $590 million, consisting of $265 million in cash and the remainder in Class A and Class B Common Stock.
Dairy Queen develops, licenses and services a system of approximately 5,900 Dairy Queen stores located throughout the United States, Canada, and other foreign countries, which feature hamburgers, hot dogs, various dairy desserts and beverages. Dairy Queen also develops, licenses and services other stores and shops operating under the names of Orange Julius and Karmelkorn, which feature blended fruit drinks, popcorn and other snacks.
Each of the business acquisitions described above was accounted for under the purchase method. The excess of the purchase cost of the business over the fair value of net assets acquired was recorded as goodwill of acquired businesses. The aggregate goodwill associated with the three acquisitions discussed above was $15.5 billion, including $14.5 billion associated with the General Re merger.
In 1996, Berkshire consummated mergers with GEICO Corporation ("GEICO") and FlightSafety International, Inc. ("FlightSafety"). Additional information concerning each merger is provided below.
On January 2, 1996, GEICO became a wholly-owned subsidiary of Berkshire. GEICO, through its subsidiaries, is a multiple line property and casualty insurer, the principal business of which is underwriting private passenger automobile insurance. Pursuant to the GEICO merger agreement, each issued and outstanding common share of GEICO, except shares held by Berkshire subsidiaries and GEICO, was converted into the right to receive $70 per share, or an aggregate amount of $2.3 billion. As of the merger date, subsidiaries of Berkshire owned 34,250,000 common shares of GEICO, which were acquired prior to 1981 at an aggregate cost of $45.7 million. Up to the merger date, neither Berkshire nor its subsidiaries had acquired any shares of GEICO common stock since 1980. However, Berkshire's ownership percentage, due to intervening stock repurchases by GEICO, gradually increased from about 33% in 1980 to almost 51% immediately prior to the merger date.
On December 23, 1996, FlightSafety became a wholly-owned subsidiary of Berkshire. FlightSafety provides high technology training to operators of aircraft and ships throughout the world. Pursuant to the FlightSafety merger agreement aggregate consideration of approximately $1.5 billion was paid to FlightSafety shareholders consisting of $769 million in cash and the remainder in Class A and Class B Common Stock.
** In March 1996, The Walt Disney Company ("Disney") completed its acquisition of Capital Cities/ABC, Inc. ("Capital Cities"). Subsidiaries of Berkshire received aggregate consideration of $2.5 billion, which included cash of $1.2 billion and common shares of Disney with a value of $1.3 billion. Gross realized gains from sales of equity securities include a gain of $2.2 billion relating to Disney's acquisition of Capital Cities.
Berkshire's finance and financial products businesses consist primarily of the financial products businesses of General Re, the finance business of Scott Fetzer Financial Group and a life insurance subsidiary in the business of selling annuities. General Re's financial products businesses consist of General Re Financial Products ("GRFP") group and a collection of other businesses that provide investment, insurance, reinsurance and real estate management and brokerage services. Significant accounting policies and disclosures for these businesses are as follows:
GRFP is engaged as a dealer in various types of derivative instruments, including interest rate, currency and equity swaps and options, as well as structured finance products. These instruments are carried at their current estimates of fair value, which is a function of underlying interest rates, currency rates, security values, volatilities and the creditworthiness of counterparties. Future changes in these factors or a combination thereof may affect the fair value of these instruments with any resulting adjustment to be included currently in the Statement of Earnings.
The table below discloses the net fair value or carrying amount at the reporting date for each class of derivative financial contract held or issued by GRFP.
The Company continuously evaluates its liabilities and related reinsurance recoverable for environmental and latent injury claims and claim expenses, which arise from exposures in the U.S., as well as internationally. Environmental and latent injury exposures do not lend themselves to traditional methods of loss development determination and therefore
Changes in issued and outstanding common stock of the Company during the three years ended December 31, 1998, are shown in the table below.
* Prior to the General Re merger the number of authorized Class A and Class B Common Shares was 1,500,000 and 50,000,000 respectively.
In connection with the General Re merger, all Class A and Class B Common Stock of the Company outstanding immediately prior to the effective date of the merger were canceled and replaced with new Class A and Class B common shares and all Class A treasury shares were canceled and retired. See Note 2 for information regarding the General Re merger.
* The amount of realized gain for any given period has no predictive value and variations in amount from period to period have no practical analytical value particulary in view of the unrealized appreciation now existing in Berkshire's consolidated investment portfolio.
Berkshire identified the following eleven business segments for purposes of 1998 reporting pursuant to SFAS No. 131.
The accompanying consolidated financial statements include the accounts of OBH Inc. (formerly Berkshire Hathaway Inc.), which became a wholly-owned subsidiary of Berkshire Hathaway Inc. upon completion of the General Re merger. The condensed consolidated balance sheet of OBH Inc. as of December 31, 1998 is as follows (dollars in millions):