(1) The amount of realized investment gains and losses for any given period has no predictive value, and variations in amount from period to period have no practical analytical value, particularly in view of the unrealized appreciation now existing in Berkshire’s consolidated investment portfolio. After-tax realized investment gains were $383 million in 2002, $842 million in 2001, $2,392 million in 2000, $886 million in 1999, and $1,553 million in 1998.
(3) Net earnings for the year ending December 31, 2001 includes pre-tax underwriting losses of $2.4 billion in connection with the September 11th terrorist attack. Such loss reduced net earnings by approximately $1.5 billion and earnings per share by $982.
A reconciliation of Berkshire’s Consolidated Statements of Earnings for each of the five years ending December 31, 2002 from amounts reported to amounts exclusive of goodwill amortization is shown below. Goodwill amortization for the years ending December 31, 2001 and 2000 includes $78 million and $65 million, respectively, related to Berkshire’s equity method investment in MidAmerican Energy Holdings Company.
A summary follows of underwriting results from Berkshire’s insurance businesses for the past three years.
A significant marketing strategy followed by all these businesses is the maintenance of extraordinary capital strength. Statutory surplus of Berkshire’s insurance businesses totaled approximately $28.4 billion at December 31, 2002. This superior capital strength creates opportunities, especially with respect to reinsurance activities, to negotiate and enter into contracts of insurance and reinsurance specially designed to meet unique needs of sophisticated insurance and reinsurance buyers. Additional information regarding Berkshire’s insurance and reinsurance operations follows.
Premiums earned in 2002 were $6,670 million, up 10.1% from $6,060 million in 2001. The growth in premiums earned for voluntary auto was 9.6%, reflecting a 9.0% increase in policies-in-force during the past year. In 2001, premiums earned were $6,060 million, an increase of 8.0% over 2000. The increase in premiums in 2001 was due to increased rates, as policies-in-force declined 0.8%.
Losses and loss adjustment expenses incurred increased 6.1% to $5,137 million in 2002. GEICO’s loss ratio was 77.0% in 2002 compared to 79.9% in 2001. The improvement reflects the impact of rate increases and better than expected loss experience. Claims frequency changes have been slight for most coverages. In 2002, claim frequencies benefited from mild winter weather during the first quarter while during 2001 claim frequencies were lower than normal due to the September 11th terrorist attack. In 2002, claim severity continued to increase but at a slower rate than in 2001. Catastrophe losses added 0.3 points to the loss ratio in 2002 compared to 0.8 points in 2001.
General Re conducts a reinsurance business, which provides reinsurance coverage in the United States and worldwide. General Re’s principal reinsurance operations are comprised of: (1) North American property/casualty, (2) international property/casualty, which consists of reinsurance business written principally through Germany-based Cologne Re and London market business written principally through the Faraday operations, and (3) global life/health. At December 31, 2002, General Re had an 89% economic ownership interest in Cologne Re.
General Re’s pre-tax underwriting results for the past three years are summarized below.
General Re took significant underwriting actions to better align premium rates with coverage terms during the past two years. Improved current accident year results for 2002 in the North American, London market and global life/health operations, in part, reflect these efforts. However, management continues to believe that additional premium rate increases and more favorable coverage terms are needed in certain lines and territories to achieve targeted long-term underwriting profitability. Information with respect to each of General Re’s underwriting units is presented below.
General Re’s North American property/casualty operations underwrite predominantly excess reinsurance across multiple lines of 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.
The North American property/casualty business had underwriting losses of $1,019 million in 2002, $2,843 million in 2001, and $656 million in 2000. The underwriting loss in 2002 included charges of $990 million (24.9% of premiums earned in 2002) from increases to prior years’ loss reserves. Underwriting losses for 2001 and 2000 included charges of $800 million and $92 million respectively for prior years’ loss reserve increases. Underwriting results in 2002 also included a net gain of $66 million with respect to the 2002 accident year. The favorable effects of re-pricing efforts and improved contract terms and conditions implemented over the past two years contributed to the net gain. In addition, underwriting results for 2002 were favorably impacted by the absence of major catastrophes and other large individual property losses ($20 million or greater), a condition that is unusual and should not be expected to occur regularly in the future. As a result, 2002 accident year results for property lines were better than normally expected. Underwriting results for 2001 included approximately $1.54 billion of net losses from the September 11th terrorist attack, as well as $87 million of losses from other catastrophes (principally Tropical Storm Allison) and other large individual property losses. Results for 2000 included $53 million of catastrophe and other large property losses and a loss of $239 million from a large excess reinsurance contract.
workers’ compensation, medical malpractice, auto liability and professional liability coverages. The 2002 prior year loss reserve adjustment was net of a $115 million reduction in reserves established in connection with the September 11th terrorist attack. The reduction in reserves related to the September 11th terrorist attack was due primarily to decreased loss estimates for certain claims. As of December 31, 2002, approximately $241 million of claims arising as a result of the September 11th terrorist attack have been paid.
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, IBNR and direct excess coverage litigation expenses. At December 31, 2002, environmental and asbestos loss reserves for North America were $1,161 million ($1,008
million net of reinsurance). As of December 31, 2001 such amounts totaled $1,248 million ($966 million net of reinsurance). Net paid losses on such claims were $59 million in 2002. The changing legal environment concerning asbestos claims together with the widespread use of asbestos related products in the U.S. over the past century has made quantification of potential exposures very difficult. Future changes to the legal environment may precipitate significant changes in reserves.
Overall premiums earned in 2002 exceeded 2001 amounts by $250 million (10.4%). Adjusting for the effects of foreign exchange rates, premiums earned in local currencies increased 8.5% in 2002. In local currencies, premiums earned in the direct markets declined 2.1% in 2002, 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. London market premiums in local currencies increased 41.9% primarily due to increased participation in Faraday Syndicate 435 from 60.6% in 2001 to 96.7% in 2002. Premiums earned in 2001 declined $649 million from 2000. The primary reason for the decline was the elimination of the one-quarter lag in reporting by this business in the fourth quarter of 2000. As a result, 2000’s fourth quarter included two quarters of activity for the international property/casualty operations. Otherwise, international property/casualty premiums earned in 2001 reflected growth in the London market operations from increased participation in Faraday Syndicate 435 (60.6% in 2001 versus 39.7% in 2000).
At December 31, 2002, the international property/casualty operations had gross loss reserves accrued of $7.1 billion, ($6.4 billion net of reinsurance). Loss reserves for these operations are established based on methodologies similar to those used in the North American property/casualty operations; however, cedant reports for continental Europe and certain other international markets are generally required less frequent or are due later than those provided by North American cedants.
The Berkshire Hathaway Reinsurance Group (“BHRG”) underwrites excess-of-loss and quota-share reinsurance coverages for insurers and reinsurers around the world. BHRG is believed to be one of the leaders in providing catastrophe excess-of-loss reinsurance. Since July 2001, BHRG has also written a number of policies or contracts primarily for large or otherwise unusual discrete commercial property risks on a direct and facultative reinsurance basis. This business is referred to as individual risk. BHRG’s pre-tax underwriting results are summarized in the table below.
During the second half of 2001, opportunities for BHRG to write catastrophe and individual risk business increased significantly, particularly post-September 11. Contracts written may provide exceptionally large limits of indemnification, often several hundred million dollars and occasionally in excess of $1 billion, and may cover catastrophe risks (such as hurricanes, earthquakes or other natural disasters) or other property risks (such as aviation and aerospace, commercial multi-peril or terrorism). Industry capacity devoted to these coverages will likely increase in the future which will reduce the opportunities for BHRG to underwrite risks at acceptable prices. Consequently, the volume of such business may decline, perhaps significantly.
The catastrophe and individual risk business produced substantial underwriting gains in 2002 and 2000, due to the lack of catastrophic or otherwise large loss events. The net underwriting loss in 2001 included about $410 million from the September 11th terrorist attack. Losses related to the September 11th terrorist attack were reduced by about $85 million in 2002, as payments to settle claims under certain policies were below original estimates. Approximately $300 million of reserves related to the terrorist attack remained as of December 31, 2002. Although a very large underwriting gain was achieved in 2002 as a result of unusually low catastrophe occurrences, a single loss event could have easily eliminated those gains. Berkshire’s management expects a catastrophic event will one day occur that will produce an extraordinary level of losses under policies written by BHRG.
BHRG cedes virtually none of the risk associated with this business to other reinsurers due to the perceived uncertainty of collecting recoverable losses ceded to financially weaker companies. Underwriting results of this business will remain subject to extreme volatility. Nevertheless, Berkshire’s management remains willing to accept such volatility provided there is a reasonable prospect of long-term profitability.
Retroactive reinsurance contracts are expected to generate significant underwriting losses over time due to the amortization of these deferred charges. This business is accepted due to the exceptionally large amounts of float generated which totaled about $7.5 billion at December 31, 2002. Unamortized deferred charges under BHRG contracts were $3.2 billion at December 31, 2002 and $3.1 billion as of December 31, 2001. It is currently expected that losses incurred in 2003 will include about $400 million of deferred charge amortization from contracts in effect as of December 31, 2002.
Collectively, Berkshire’s other primary insurance businesses produced earned premiums of $712 million in 2002, $501 million in 2001 and $325 million in 2000. The increases in premiums earned during the past two years were largely attributed to increased volume at USIC and the NICO Primary Group. Net underwriting gains of Berkshire’s other primary insurance businesses totaled $32 million in 2002, $30 million in 2001 and $25 million in 2000. The improvement in year-to-year comparative underwriting results was due in large part to USIC and the NICO Primary Group offset by poor results in the workers’ compensation business of the Homestate Group.
Following is a summary of the net investment income of Berkshire’s insurance operations for the past three years.
Investment income from insurance operations in 2002 increased $226 million (8.0%) over 2001. Investment income in 2001 exceeded amounts earned in 2000 by $51 million (1.8%). Investment income in 2000 included five quarters with respect to General Re’s international reinsurance operations, as a result of the elimination
of the one quarter lag in reporting in the fourth quarter. Pre-tax investment income in 2000 included $103 million related to the extra quarter.
Float represents an estimate of the amount of funds ultimately payable to policyholders that is available for investment. The total float at December 31, 2002 was approximately $41.2 billion compared to $35.5 billion at December 31, 2001 and about $27.9 billion at December 31, 2000. Increases in float were achieved at all underwriting units in 2002. The cost of float, represented by the ratio of the pre-tax underwriting loss over the average float, was about 1.1% for 2002 as compared to 12.8% for 2001. In 2000, the cost of float was approximately 6.1%.
Berkshire’s finance and financial products businesses segment grew in 2001 with the September acquisition of XTRA Corporation. Berkshire also acquired Ben Bridge Jeweler in July 2000, which is included as part of Berkshire’s retail segment. Other businesses acquired during the last three years include CORT Business Services (February 2000), MidAmerican Energy Holdings Company (March 2000), Albecca (February 2002), CTB (October 2002) and The Pampered Chef (October 2002). The results of each of the aforementioned businesses are reflected in Berkshire’s earnings from their respective acquisition dates.
On a comparative full year basis, building products revenues in 2002 were roughly unchanged from 2001. In 2002, a volume decline of 12% in insulation and roofing systems (Johns Manville) was offset by 5% growth in paint and coatings volume (Benjamin Moore), higher sales of connector plates and related products (MiTek) and increased brick and block unit sales (Acme). Full year pre-tax earnings of $516 million were relatively unchanged from 2001. A decline in pre-tax earnings occurred at Johns Manville where comparative results were negatively affected by the weakness in U.S. commercial construction and roofing markets. The other units benefited from relatively good conditions in the residential markets.
Pre-tax earnings of the finance and financial products group in 2002 increased $497 million (95.8%) to $1,016 million. Pre-tax earnings of BH Finance in 2002 increased $425 million from 2001, due primarily to lower interest expense as a result of declining short-term rates as well as an increase of $152 million in realized investment gains. Under the current market conditions, BH Finance is expected to continue to produce significant earnings in 2003.
This segment includes FlightSafety, a leading provider of high technology training to operators of aircraft and ships and NetJets, the world’s leading provider of fractional ownership programs for general aviation aircraft. FlightSafety’s worldwide clients include corporations, the military and government agencies. Revenues in 2002 from flight services increased $274 million (10.7%) over 2001 due to increases in flight operations and aircraft sales at NetJets. Total revenues from FlightSafety in 2002 were relatively unchanged as compared to 2001 as a decline in training and product revenues was offset by a one-time gain of $60 million from the disposition of its interest in a joint venture training operation with Boeing. Excluding the aforementioned gain, pre-tax earnings from flight services in 2002 decreased $21 million from 2001 due to a slowdown in business aviation activity. NetJet’s pre-tax earnings in 2002 were relatively unchanged from 2001 as each year’s results reflect losses related to expansion into Europe somewhat offset by small profits from its domestic operations.
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 2002 increased $105 million (5.3%) as compared to 2001. The increase in revenues in 2002 was primarily attributed to comparatively higher sales at R.C. Willey’s recently opened Nevada location and to several new Helzberg stores. Comparative pre-tax earnings of the retail group in 2002 declined $9 million (5.1%) from 2001. Higher earnings associated with the new R.C. Willey store were more than offset by start-up costs incurred in connection with a new store being built in metropolitan Kansas City by NFM and comparatively lower pre-tax earnings at Star and Helzberg.
Shaw is a leading manufacturer and distributor of carpet and rugs for residential and commercial use. Shaw also provides installation services and offers hardwood floor and other floor coverings. Shaw’s revenues in 2002 of $4.3 billion increased by $322 million (8.0%) from 2001. The increase in revenues reflects a 5% increase in the volume of residential carpets sold and increased sales of hard floor surfaces. In 2002, Shaw’s pre-tax earnings totaled $424 million, an increase of $132 million (45.2%) over 2001. Shaw’s operating results in 2002 benefited from higher operating efficiencies and the increased levels of unit sales.
Revenues from the non-insurance businesses increased $7,725 million (86.8%) in 2001 as compared to 2000. Pre-tax earnings of $2,106 million during 2001 increased $706 million (50.4%) from the comparable 2000 amount. Business acquisitions, principally Shaw and the building products group, which were all completed during 2000 and 2001, account for much of the comparative revenue and earnings increases.
Purchase-accounting adjustments reflect the after-tax effect on net earnings with respect to the amortization of fair value adjustments to certain assets and liabilities recorded at various business acquisition dates. Prior to 2002, this amount also included the systematic amortization of goodwill.
The Consolidated Statements of Earnings include after-tax realized investment gains of $383 million in 2002, $842 million in 2001 and $2,392 million in 2000. In 2002 and 2001, realized investment gains were net of after-tax losses of $373 million and $161 million related to charges for 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 related to essentially all of Berkshire’s investments produced no effect on total shareholders’ equity because these investments were already carried at fair value with the difference between fair value and cost included directly in shareholders’ equity as a component of accumulated other comprehensive income.
Berkshire is contingently liable for the borrowings of Berkadia LLC through a primary guaranty of 90% of its debt and a secondary guaranty of the remaining 10% of Berkadia’s borrowings through Fleet Bank. At December 31, 2002, Berkadia’s unpaid loan balance was $2.175 billion. Through February 2003, the loan balance was subsequently reduced through prepayments to $1.725 billion.
Notes payable and other borrowings of Berkshire’s finance and financial products businesses totaled $4.5 billion at December 31, 2002 and $9.0 billion at December 31, 2001. These balances include Berkadia’s outstanding term loan of $2.175 billion at December 31, 2002 and $4.9 billion at December 31, 2001. The remaining decrease in finance business borrowings relates to decreases in notes payable and commercial paper borrowings by GRS.
Berkshire believes that it currently maintains sufficient liquidity to cover its existing requirements and provide for contingent liquidity.
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 financial products. The following sections address the significant market risks associated with Berkshire’s business activities.
The fair values of Berkshire’s fixed maturity investments and notes payable and other borrowings will fluctuate in response to changes in market interest rates. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the creditworthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions.
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, 2002, 68.9% of the total fair value of equity investments was concentrated in four investees.
The table below summarizes Berkshire’s equity price risks as of December 31, 2002 and 2001 and shows the effects of a hypothetical 30% increase and a 30% decrease in market prices as of those dates. The selected hypothetical change does not reflect what could be considered the best or worst case scenarios. Indeed, results could be far worse due both to the nature of equity markets and the aforementioned concentrations existing in Berkshire’s equity investment portfolio. Dollars are in millions.
General Re Securities (“GRS”) operates as a dealer in various types of derivative instruments in conjunction with offering risk management products to its clients. As previously noted, in January 2002, it was announced that GRS would commence a long-term run off of its business. It is expected that the orderly run-off will take several years to complete. GRS monitors its market risk on a daily basis across all swap and option products by estimating 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 performed on an individual trading book basis, against limits set by individual book, to a 99% probability level. GRS sets market risk limits for each type of risk, and for an aggregate measure of risk across all trading books, 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. GRS’s weekly aggregate market risk limit was $15 million in 2002. In 2002, weekly losses exceeded the estimated value at risk twice. There were no days during 2002 when the value at risk exceeded the aggregate limit. In addition to these daily and weekly assessments of risk, GRS prepares periodic stress tests to assess its exposure to extreme movements in various market risk factors.
The table below shows the highest, lowest and average value at risk, as calculated using the above methodology, by broad category of market risk to which GRS is exposed over one week intervals. Dollars are in millions.
In applying certain accounting policies, Berkshire’s management is required to make estimates and judgments regarding transactions that have occurred and ultimately will be settled several years in the future. Amounts recognized in the financial statements from such estimates are necessarily based on assumptions about numerous factors involving varying, and possibly significant, degrees of judgment and uncertainty. Accordingly, the amounts currently recorded in the financial statements may prove, with the benefit of hindsight, to be inaccurate. The balance sheet items most significantly affected by these estimates are property and casualty insurance and reinsurance related liabilities, invested assets where no market quotations are available and goodwill.
Berkshire accrues 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. As of any balance sheet date, all claims have not yet been reported and some claims may not be reported for many years. As a result, the liability includes significant estimates for incurred-but-not-reported claims. Additionally, reported claims are in various stages of the settlement process. Each claim is settled individually based upon its merits and certain liability or workers’ compensation claims may take years to settle, especially if legal action is involved.
Berkshire’s Consolidated Balance Sheet includes estimated liabilities for unpaid losses and loss adjustment expenses from property and casualty insurance and reinsurance contracts of $43.9 billion and reinsurance recoverables of $2.6 billion at December 31, 2002. Due to the inherent uncertainties in the process of establishing these amounts, the actual ultimate claims amounts will differ from the currently recorded estimated amounts. A small percentage change in estimates of this magnitude will result in a material effect on reported earnings. For instance, a 5% increase in the December 31, 2002 net estimate would produce a $2.1 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 $3.4 billion at December 31, 2002. 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.
Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. The principal important risk factors that could cause the Company’s actual performance and future events and actions to differ materially from such forward-looking statements, include, but are not limited to, changes in market prices of Berkshire’s significant equity investees, the occurrence of one or more catastrophic events, such as an earthquake or hurricane that causes losses insured by Berkshire’s insurance subsidiaries, changes in insurance laws or regulations, changes in Federal income tax laws, and changes in general economic and market factors that affect the prices of securities or the industries in which Berkshire and its affiliates do business, especially those affecting the property and casualty insurance industry.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries as of December 31, 2002 and 2001, 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, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Average shares outstanding include average Class A common shares and average Class B common shares determined on an equivalent Class A common stock basis. Net earnings per common share shown above represents net earnings per equivalent Class A common share. Net earnings per Class B common share is equal to one-thirtieth (1/30) of such amount or $93 per share for 2002, $17 per share for 2001, and $73 per share for 2000.
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 invested assets and related impairments, and the determination of goodwill impairments require considerable judgement by management. Actual results may differ from the estimates and assumptions used in preparing the Consolidated Financial Statements.
Other investments include investments in commodities, limited partnerships, and equity warrants, which are carried at fair value in the accompanying Consolidated Balance Sheets. Realized and unrealized gains and losses associated with these investments are included in the Consolidated Statements of Earnings as a component of realized investment gains. Other investments also include commercial loans, which are carried at amortized cost.
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, 2002, approximately 44% of the total inventory cost was determined using the last-in-first-out (“LIFO”) method, 33% 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, 2002 and December 31, 2001.
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. Consideration received for retroactive reinsurance policies is recognized as premiums 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.
Certain costs of acquiring insurance premiums are deferred, subject to ultimate recoverability, and charged to income as the premiums are earned. Acquisition costs consist of commissions, premium taxes, advertising and other underwriting costs. The recoverability of premium acquisition costs, generally, reflects anticipation of investment income. The unamortized balances of deferred premium acquisition costs are included in other assets and were $1,303 million and $1,029 million at December 31, 2002 and 2001, respectively.
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 reinsurance businesses 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.
Changes to the timing and amount of estimated loss payments produce changes in the unamortized deferred charge balance. Such changes in estimates are accounted for under the retrospective method with the net effect included in amortization expense in the period of the change.
In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS 146 generally requires that costs associated with an exit or disposal activity be recognized as liabilities when incurred, rather than the date of commitment to an exit plan, and it establishes that fair value is the standard for initial measurement of such liabilities. SFAS 146 applies to exit or disposal activities that are initiated after December 31, 2002.
In November 2002, the FASB issued FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” Initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of annual periods ending after December 31, 2002.
The adoption of SFAS 143, SFAS 146 and FIN 45 is not expected to have a material effect on Berkshire’s consolidated financial position or results of operations.
Berkshire’s long-held acquisition strategy is to purchase businesses with consistent earning power, good returns on equity, able and honest management and at sensible prices. Businesses with these characteristics typically have market values that exceed net asset value, thus producing goodwill for accounting purposes.
Shaw is the world’s largest manufacturer of tufted broadloom carpet and rugs for residential and commercial applications throughout the U.S. Shaw markets its residential and commercial products under a variety of brand names.
Berkshire completed five acquisitions in 2000. Aggregate consideration paid for the five business acquisitions consummated in 2000 totaled $2,370 million, consisting of $2,146 million in cash and the remainder in Berkshire Class A and Class B common stock. Information concerning these acquisitions follows.
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 2002, Berkshire acquired an additional 6,700,000 shares of convertible preferred stock for $402 million. Such investments currently give Berkshire about a 9.7% voting interest and an 83.4% economic interest in the equity of MidAmerican (80.2% on a fully diluted basis). Berkshire and certain of its subsidiaries have also acquired approximately $1,728 million of 11% non-transferable trust preferred securities, of which $455 million were acquired in 2000 and $1,273 million were acquired in 2002. Mr. Walter Scott, Jr., a member of Berkshire’s Board of Directors, controls approximately 86% of the voting interest in MidAmerican.
Shareholders’ equity was reduced during 2002 by a net charge to other comprehensive income of $177 million, consisting of a minimum pension liability charge of $313 million net of a credit of $136 million related primarily to a foreign currency translation adjustment.
Condensed consolidated statements of earnings of MidAmerican for the years ending December 31, 2002 and 2001 and for the period March 14, 2000 through December 31, 2000 are as follows. Amounts are in millions.
Shown below are the amortized cost and estimated fair values of securities with fixed maturities at December 31, 2002, by contractual maturity dates. Actual maturities will differ from contractual maturities because issuers of certain of the securities retain early call or prepayment rights. Amounts are in millions.
(2) Net of unrealized losses of $406 million and $143 million as of December 31, 2002 and 2001, respectively.
Realized gains (losses) from sales and redemptions of investments are summarized below (in millions). Realized losses include impairment charges of $574 million and $247 million in 2002 and 2001, respectively.
The increase in goodwill from December 31, 2001 to December 31, 2002 reflects Berkshire’s acquisitions that were completed during 2002. Substantially all of the $788 million increase is attributable to the several business acquisitions described in Note 2.
During the fourth quarter of 2000, Berkshire concluded that an impairment of goodwill existed with respect to the Dexter Shoe business. Goodwill amortization shown in the accompanying Consolidated Statement of Earnings for 2000 includes a goodwill impairment charge of $219 million related to this business.
At December 31, 2002, GRS had accepted collateral that is permitted by contract or industry practice to sell or repledge with a fair value of $1,884 million. Of the securities held as collateral, approximately $83 million were repledged as of December 31, 2002. At December 31, 2002, securities owned by GRS with a fair value of approximately $421 million (which includes $83 million of repledged securities as described above) were pledged against derivative transactions with a fair value of $753 million. Further, securities with a fair value of approximately $75 million were pledged against futures positions at two futures clearing brokers. Contractual terms with counterparties often require additional collateral to be posted immediately in the event of a decline in the financial rating of the counterparty or its guarantor.
Assuming non-performance by all counterparties on all contracts potentially subject to a loss, the maximum potential loss, based on the cost of replacement, net of collateral held, at market rates prevailing at December 31, 2002 approximated $4,933 million. The following table presents GRS’s derivatives portfolio by counterparty credit quality and maturity at December 31, 2002. The amounts shown under gross exposure in the table are before consideration of netting arrangements and collateral held by GRS. Net fair value shown in the table represents unrealized gains on financial instrument contracts in gain positions, net of any unrealized loss owed to these counterparties on offsetting positions. Net exposure shown in the table that follows is net fair value less collateral held by GRS. Amounts are in millions.
Liquidity risk can arise from funding of GRS’s portfolio of open transactions. Movements in underlying market variables affect both future cash flows related to the transactions and collateral required to cover the value of open positions. Strategies have been developed to ensure GRS has sufficient resources to cover its potential liquidity needs through its access to General Re Corporation’s (the parent company of GRS) internal sources of liquidity, commercial paper program, lines of credit and medium-term program.
As discussed in Note 1(p), Berkshire has preliminarily concluded that Value Capital is a variable interest entity. Accordingly, pursuant to the provisions of FIN 46, Berkshire will be required to consolidate the accounts of Value Capital in the third quarter of 2003. This change will have no effect on reported net earnings but based upon December 31, 2002 balances will increase Berkshire’s reported assets by about $20 billion with a corresponding increase to liabilities and minority interest.
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 lines of business, such as reinsurance assumed because of the inherent delays in receiving loss information from ceding companies. Also, certain types of claims, such as asbestos, environmental or latent injury liabilities are both long-tailed and subject to changing legal and settlement cost trends. Additional information regarding incurred losses will be revealed over time and the estimates will be revised resulting in gains or losses in the periods made.
Prior accident years’ losses incurred also include amortization of deferred charges related to retroactive reinsurance contracts incepting prior to January 1, 2002. Amortization charges included in prior accident years’ losses were $430 million in 2002, $328 million in 2001, and $145 million in 2000. The increases in such charges are the result of several new contracts written over the past three years. Net discounted liabilities at December 31, 2002 and 2001 were $2,169 million and $1,834 million, respectively, and are net of discounts totaling $2,974 million and $2,653 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 $95 million in 2002 and $80 million in both 2001 and 2000.
Borrowings under investment agreements are made pursuant to contracts calling for interest payable, normally semiannually, at fixed rates ranging from 2.5% to 8.6% per annum. Contractual maturities of borrowings under investment agreements generally range from 3 months to 30 years. Under certain conditions, these borrowings may be redeemable without premium prior to the contractual maturity dates.
In connection with the restructuring and concurrent with Berkadia’s loan to FNV Capital, Berkadia received 61,020,581 shares of FNV common stock representing 50% of the total FNV outstanding shares. Berkadia initially recorded the FNV common stock at fair value and subsequently accounted for the stock pursuant to the equity method. Berkshire and Leucadia each possess a 50% economic interest in Berkadia’s ownership of FNV common stock. Due to large operating losses of FNV between August 21, 2001 and September 30, 2001, Berkadia’s investment in FNV common stock was written down to zero through the application of the equity method. Consequently, the equity method was suspended as of September 30, 2001, because neither Berkshire nor Berkadia has guaranteed any obligations of FNV.
Statutory surplus differs from the corresponding amount determined on the basis of GAAP. The major differences between statutory basis accounting and GAAP are that deferred charges reinsurance assumed, deferred policy acquisition costs, unrealized gains and losses on investments in securities with fixed maturities and related deferred income taxes are recognized under GAAP but not for statutory reporting purposes. In addition, statutory accounting for goodwill of acquired businesses requires amortization of goodwill over 10 years as compared to 40 years under GAAP for periods ending December 31, 2001 and prior. As described in Note 7, as of January 1, 2002, goodwill is no longer amortized under GAAP and is only subject to tests for impairment.
The estimated fair values of Berkshire’s financial instruments as of December 31, 2002 and 2001, are as follows (in millions).
In determining fair value of financial instruments, Berkshire used quoted market prices when available. For instruments where quoted market prices were not available, independent pricing services or appraisals by Berkshire’s management were used. Those services and appraisals reflected the estimated present values utilizing current risk adjusted market rates of similar instruments. The carrying values of cash and cash equivalents, receivables and accounts payable, accruals and other liabilities are deemed to be reasonable estimates of their fair values.
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 $193 million, $70 million and $80 million for the years ended December 31, 2002, 2001 and 2000, respectively.
GEICO is a defendant in a number of class action lawsuits related to the use of replacement repair parts not produced by the original auto manufacturer, the calculation of “total loss” value and whether to pay diminished value as part of the settlement of certain claims. Management intends to vigorously defend GEICO’s position on these claim settlement procedures. However, these lawsuits are in various stages of development and the ultimate outcome cannot be reasonably determined.
Berkshire and its subsidiaries are parties in a variety of legal actions arising out of the normal course of business. In particular, such legal actions affect Berkshire’s insurance and reinsurance businesses. Such litigation generally seeks to establish liability directly through insurance contracts or indirectly through reinsurance contracts issued by Berkshire subsidiaries. Plaintiffs occasionally seek punitive or exemplary damages. Berkshire does not believe that such normal and routine litigation will have a material effect on its financial condition or results of operations.
Fruit of the Loom, Garan, Fechheimer Brothers, H.H. Brown Shoe, Lowell Shoe, Justin Brands and Dexter Shoe (“Apparel”)
Amounts of interest expense represent interest on borrowings under investment agreements and other debt exclusive of that of finance and financial products businesses and interest allocated to certain other businesses.