Northern Natural Gas operates approximately 15,900 miles of natural gas pipelines, consisting of approximately 6,900 miles of mainline transmission pipelines and approximately 9,000 miles of lateral pipelines. The Northern Natural Gas system includes delivery points in the northern end of the system (Michigan, Illinois, Iowa, Minnesota, Nebraska, Wisconsin and South Dakota) and the natural gas supply and service area is at the southern end of the system (Kansas, Oklahoma, Texas and New Mexico). The Northern Natural Gas supply area is interconnected with many interstate and intrastate pipelines in the national grid system. Storage services are provided through the operation of one underground storage field in Iowa, two underground storage facilities in Kansas and one liquefied natural gas storage peaking unit each in Garner, Iowa and Wrenshall, Minnesota.
A summary follows of underwriting results from Berkshire’s insurance businesses for the past three years. Amounts are in millions.
On June 30, 2005, Berkshire acquired Medical Protective Corporation (“MedPro”), a provider of professional liability insurance to physicians, dentists and other healthcare providers. On May 19, 2006, Berkshire acquired 85% of Applied Underwriters, a provider of integrated workers’ compensation solutions. Underwriting results for these businesses are included in the Berkshire Hathaway Primary Group results beginning on their respective acquisition dates.
Premiums earned in 2006 and 2005 increased 9.4% and 13.3%, respectively, over the corresponding prior year amounts. The growth in premiums earned in 2006 for voluntary auto was 9.3% and reflects a 10.7% increase in policies-in-force during the past year. During 2006, policies-in-force increased 11.3% in the preferred risk markets and 8.6% in the standard and nonstandard markets. Voluntary auto new business sales in 2006 increased 8.8% compared to 2005. Voluntary auto policies-in-force at December 31, 2006 were 721,000 higher than at December 31, 2005. Premium rates have been reduced and underwriting guidelines have been adjusted in certain markets to better match price with the underlying risk resulting in relatively lower premiums per policy.
General Re conducts a reinsurance business offering property and casualty and life and health coverages to clients worldwide. In North America, property and casualty reinsurance is written on a direct basis through General Reinsurance Corporation. Internationally, property and casualty reinsurance is written on a direct basis through 95% owned Cologne Re (based in Germany) and other wholly-owned affiliates as well as through brokers with respect to Faraday in London. Life and health reinsurance is written for clients worldwide through Cologne Re. General Re’s pre-tax underwriting results are summarized for the past three years in the following table. Amounts are in millions.
Includes losses of $685 million related to Hurricanes Katrina, Rita and Wilma.
The 2005 underwriting loss included approximately $480 million in losses from three major hurricanes in 2005 (Katrina, Rita and Wilma). Otherwise, underwriting results for the 2005 accident year generally benefited from re-pricing efforts and improved coverage terms and conditions put into place over the preceding few years. Underwriting results in 2005 also included losses attributable to prior accident years’ consisting of net reserve increases on workers’ compensation of $228 million, asbestos and environmental mass tort exposures of $102 million and $136 million in discount accretion on workers’ compensation reserves and deferred charge amortization on retroactive reinsurance coverages. Offsetting these prior years’ losses were $419 million in gains from net reserve decreases in other casualty lines and property lines.
Catastrophe and individual risk contracts may provide exceptionally large limits of indemnification, often several hundred million dollars and occasionally in excess of $1 billion, and 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). Catastrophe and individual risk premiums written were approximately $2.4 billion in 2006, $1.8 billion in 2005 and $1.5 billion in 2004. The increase in volume in 2006 was principally attributable to improved rates in the U.S. and limited industry capacity for catastrophe reinsurance which led to more opportunities to write new business. The level of business written in future periods may vary significantly based upon market conditions and management’s assessment of the adequacy of premium rates.
Pre-tax underwriting results in 2006 reflect no significant losses from catastrophe events and incurred losses of approximately $200 million attributable to prior years’ events, primarily Hurricane Wilma which occurred in the fourth quarter of 2005. Underwriting results from catastrophe and individual risk business in 2005 included estimated losses of approximately $2.4 billion from Hurricanes Katrina, Rita and Wilma. In 2004, underwriting results from catastrophe and individual risk business included estimated catastrophe losses of $790 million from four hurricanes that struck the U.S. and Caribbean during the third quarter. The timing and magnitude of losses produce extraordinary volatility in periodic underwriting results of BHRG’s catastrophe and individual risk business. BHRG generally does not cede catastrophe and individual risks to mitigate the volatility. Management accepts such potential volatility provided that the long-term prospect of achieving underwriting profits is reasonable.
In November 2006, BHRG and Equitas, a London based entity established to reinsure and manage the 1992 and prior years’ non-life liabilities of the Names or Underwriters at Lloyd’s of London, entered into an agreement for BHRG to provide potentially up to $7 billion of new excess reinsurance to Equitas. BHRG will also employ the current staff of Equitas and manage the run-off of Equitas’ liabilities. The agreement is subject to the approval by certain regulatory authorities in the United States and the United Kingdom as well as various other conditions which must be obtained by March 31, 2007. Consideration payable to BHRG under the arrangement would initially consist of all of Equitas’ assets less 100 million Pounds Sterling.
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; Central States Indemnity Company (“CSI”), a provider of credit and disability insurance to individuals nationwide through financial institutions; and MedPro and Applied Underwriters, which as previously noted were acquired in June 2005 and May 2006, respectively.
Collectively, Berkshire’s primary insurance businesses produced earned premiums of $1,858 million in 2006, $1,498 million in 2005 and $1,211 million in 2004. The increase in premiums earned in 2006 was primarily attributable to the impact of the MedPro and Applied Underwriters acquisitions partially offset by a decline in volume of the NICO Primary Group. Premiums earned in the last half of 2005 by MedPro accounted for most of the increase in total premiums earned by the primary group in 2005 compared with 2004. Pre-tax underwriting gains as percentages of premiums earned were approximately 18% in 2006, 16% in 2005 and 13% in 2004. Underwriting gains in 2006 were achieved in all of the businesses. The underwriting gain in 2005 reflected a decrease in loss reserve estimates for pre-2005 loss events in the NICO Primary Group business, improved results of Homestate, USIC and CSI operations partially offset by losses incurred from increases in medical malpractice reserves.
Following is a summary of the net investment income of Berkshire’s insurance operations for the past three years. Amounts are in millions.
Invested assets derive from shareholder capital and reinvested earnings as well as net liabilities assumed under insurance contracts or “float.” The major components of float are unpaid losses, unearned premiums and other liabilities to policyholders less premiums and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated $50.9 billion at December 31, 2006, $49.3 billion at December 31, 2005 and $46.1 billion at December 31, 2004. The cost of float, as represented by the ratio of pre-tax underwriting gain or loss to average float, was negative for the last three years, as Berkshire’s insurance businesses generated pre-tax underwriting gains in each year.
Revenues and earnings from MidAmerican for each of the past three years are summarized below. Amounts are in millions.
MidAmerican’s revenues of $10,644 million in 2006 increased $3,364 million (46%) and earnings before corporate interest and taxes (“EBIT”) of $1,718 million in 2006 increased $550 million (47%) as compared to 2005. The increases in revenues and EBIT were largely attributable to the acquisition of PacifiCorp on March 21, 2006. Revenues of MidAmerican
Revenues from natural gas pipelines of $972 million in 2006 increased $63 million (7%) and EBIT of $376 million in 2006 increased $67 million (22%) as compared to 2005. The comparative improvement in revenues and EBIT was primarily due to favorable market conditions resulting in higher demand and rates as well as additional transportation and storage services. EBIT of the U.K. utilities business of $338 million in 2006 increased $30 million (10%) as compared to 2005. The increase was due to an increase in regulated revenues as well as a favorable impact from the strengthening of the Pound Sterling versus the U.S. dollar.
Revenues from the real estate brokerage business of $1,724 million in 2006 decreased $170 million (9%) and EBIT of $74 million in 2006 decreased $74 million (50%) as compared to 2005. The declines were due to a significant reduction in the number of closed transactions due to the significant slowdown in U.S. residential real estate activity.
A comparison of revenues and pre-tax earnings between 2006, 2005 and 2004 for the manufacturing, service and retailing businesses follows. Amounts are in millions.
McLane Company, Inc., (“McLane”) is a distributor of grocery and food products to retailers, convenience stores and restaurants. McLane’s business is marked by high sales volume and very low profit margins. McLane’s revenues in 2006 increased $1,619 million (7%) as compared to 2005, which increased $701 million (3%) as compared to 2004. The comparative revenue increases in both 2006 and 2005 were due to increased grocery business partially offset by comparative reductions in restaurant food service revenues primarily due to the loss of a large customer in mid-2005.
Pre-tax earnings in 2006 increased $12 million over 2005 which reflects the increase in sales volume. Pre-tax earnings in 2006 were negatively affected by a comparative 0.13% reduction in gross margin percentage which was primarily attributable to increased competition in the grocery business. The impact from the decline in gross margin in 2006 was largely offset by comparatively lower operating expenses that were primarily attributable to lower insurance costs. About 1/3 of McLane’s annual revenues are to Wal-Mart. A curtailment of purchasing by Wal-Mart could have a material adverse impact on revenues and pre-tax earnings of McLane.
Revenues of $5,723 million in 2005 increased $549 million (11%) and pre-tax earnings of $485 million in 2005 increased $19 million (4%) as compared to 2004. Despite increases in selling prices, operating margins in 2005 were adversely affected by repeated increases in petroleum-based raw material costs. Consequently, increases in production costs outpaced increases in selling prices. In addition, product sample costs pertaining to the introduction of new products increased approximately $29 million in 2005 as compared to 2004.
Berkshire’s other service businesses include NetJets, the world’s leading provider of fractional ownership programs for general aviation aircraft and FlightSafety, a provider of high technology training to operators of aircraft and ships. Among other businesses included in this group are Pampered Chef, a direct seller of high quality kitchen tools; International Dairy Queen, a licensor and service provider to about 6,000 stores that offer prepared dairy treats and food; the Buffalo News, a publisher of a daily and Sunday newspaper; and Business Wire, a leading distributor of corporate news, multimedia and regulatory filings.
Revenues from other service businesses of $4,728 million in 2005 increased $221 million (5%) and pre-tax earnings of $329 million in 2005 declined $83 million (20%) as compared to 2004. NetJets incurred a pre-tax loss of about $80 million in 2005 compared to pre-tax earnings of about $10 million in 2004. Several factors contributed to the loss in 2005. Throughout 2005, NetJets experienced unusually high shortages of available aircraft due to increases in owner demand outpacing increases in capacity. Consequently, NetJets subcontracted additional aircraft capacity through charter services. The costs associated with subcontracted flights were not fully recoverable from clients and caused an incremental cost of approximately $85 million in 2005. NetJets has added aircraft to the core fleet and has developed strategies to address capacity issues and restore profitability as the results in 2006 reflect. NetJets also recorded a special charge of $20 million in the fourth quarter of 2005 for prior periods’ compensation related to a new labor contract with its pilots and flight attendants.
Berkshire’s retailing operations consist of several home furnishings (Nebraska Furniture Mart, R.C. Willey, Star Furniture and Jordan’s) and jewelry (Borsheim’s, Helzbergs and Ben Bridge) retailers. Also included in this group is See’s Candies. Revenues from this group of businesses of $3,334 million in 2006 increased $223 million (7%) and pre-tax earnings of $289 million increased $32 million (12%) as compared to 2005. Revenues of the home furnishings businesses were $2,144 million in 2006 and $1,958 million in 2005 and jewelry revenues were $815 million in 2006 and $801 million in 2005. Home furnishings revenues in 2006 included sales from two new R.C. Willey stores of $77 million. In addition, same store home furnishings sales in 2006 increased approximately 6% compared to 2005. A significant portion of the increase in pre-tax earnings was due to See’s Candies which reported an increase of approximately $27 million.
The increase in revenues in 2005 as compared to 2004 from Clayton Homes was primarily attributable to increased sales of manufactured homes of $491 million and increased interest income of $583 million from higher installment loan balances. Installment loan balances at the end of 2005 increased approximately $8.5 billion since Berkshire’s acquisition of Clayton Homes in 2003, reflecting the impact of several loan portfolio acquisitions as well as loan originations. Pre-tax earnings from Clayton Homes of $416 million in 2005, increased $224 million (117%) as compared to 2004. The significant increase in pre-tax earnings was primarily due to higher interest income from the loan portfolios acquired during 2004 and 2005, partially offset by higher interest expenses.
Pre-tax earnings from other finance activities of $462 million, increased $229 million as compared to 2005. Other finance activities include the General Re derivatives business, which has completed a major portion of its run-off, and Berkshire’s earnings from its investment in Value Capital, a partnership that was substantially liquidated as of June 30, 2006. These two activities generated breakeven results in 2006 compared to pre-tax losses of $137 million in 2005. Other pre-tax earnings for 2006 also include a fee of $67 million in connection with an Equity Commitment Agreement that Berkshire entered into with USG Corporation (“USG”). Under the Equity Commitment Agreement, Berkshire agreed to purchase no less than 6.5 million and up to 44.9 million additional shares of USG common stock to facilitate an equity rights offering.
Derivative gains and losses from foreign currency forward contracts arise as the value of the U.S. dollar changes against certain foreign currencies. Small changes in certain foreign currency exchange rates produce material changes in the fair value of these contracts and consequently can produce volatility in reported earnings. The notional values of open foreign currency forward contracts were approximately $1 billion and $14 billion as of December 31, 2006 and 2005, respectively. During 2005, the value of most foreign currencies decreased relative to the U.S. dollar and these contracts produced losses. Conversely, the value of many foreign currencies rose relative to the U.S. dollar in 2004, and Berkshire’s contract positions produced significant gains.
Berkshire’s balance sheet continues to reflect significant liquidity and a strong capital base. Consolidated shareholders’ equity at December 31, 2006 was $108.4 billion. Consolidated cash and invested assets, excluding assets of finance and financial products businesses, was approximately $126.1 billion at December 31, 2006 (including cash and cash equivalents of $38.3 billion) and $115.6 billion at December 31, 2005 (including cash and cash equivalents of $40.5 billion). Berkshire’s invested assets are held predominantly in its insurance businesses. Berkshire believes that it currently maintains sufficient liquidity to cover its contractual obligations and provide for contingent liquidity.
Berkshire’s consolidated notes payable and other borrowings of insurance and other businesses, was $3.7 billion at December 31, 2006 and $3.6 billion at December 31, 2005. As of December 31, 2006, outstanding borrowings include parent company borrowings of $612 million that mature in 2007, including senior notes issued as part of the SQUARZ securities in 2002. The outstanding SQUARZ securities consist of $334 million principal amount of senior notes due in November 2007 and outstanding warrants that expire in May 2007 to purchase 3,716 Class A equivalent shares of Berkshire common stock. A warrant premium is payable to Berkshire at an annual rate of 3.75% and interest is payable to note holders at a rate of 3.00%. Each warrant provides the holder the right to purchase either 0.1116 shares of Class A or 3.348 shares of Class B stock for $10,000. Short-term borrowings consist primarily of commercial paper and bank loans of NetJets, which are used in the ordinary course of business. The full and timely payment of such borrowings is guaranteed by Berkshire.
Assets of the finance and financial products businesses were $24.6 billion as of December 31, 2006 and $24.5 billion as of December 31, 2005, consisting primarily of loans and finance receivables, fixed maturity securities and cash and cash equivalents. Liabilities were $19.4 billion as of December 31, 2006 and $20.3 billion as of December 31, 2005 and include notes and other borrowings of $12.0 billion at December 31, 2006 and $10.9 billion at December 31, 2005. Notes payable include $8.85 billion par amount of medium-term notes issued by Berkshire Hathaway Finance Corporation (“BHFC”). The notes mature at various dates beginning in 2007 ($700 million) through 2015. The proceeds from these notes were used to finance originated and acquired loans of Clayton Homes. Full and timely payment of principal and interest on the notes issued by BHFC is guaranteed by Berkshire. In addition, during the fourth quarter of 2006, Clayton Homes borrowed $1.3 billion under non-public pass-through arrangements having an expected weighted average life of approximately eight years. Such borrowings are secured by portfolios of manufactured housing loans and are not guaranteed by Berkshire. The proceeds from these borrowings will be used to repay certain debt of BHFC.
Principally relates to NetJets’ aircraft purchases and MidAmerican purchases of coal, electricity and natural gas.
As of any balance sheet date, claims that have occurred have not all been reported, and if reported may not have been settled. Loss and loss adjustment expense reserves include provisions for those claims that have been reported (referred to as “case reserves”) and for those claims that have not been reported, referred to as incurred but not yet reported (“IBNR”) reserves. The time period between the occurrence date and payment date of a loss is referred to as the “claim-tail.” Property claims usually have fairly short claim-tails and, absent litigation, are reported and settled within no more than a few years after occurrence. Casualty losses usually have very long claim-tails, occasionally extending for decades. Casualty claims are more susceptible to litigation and can be significantly affected by changing contract interpretations and the legal environment which contributes to the extended claim-tails.
Each of Berkshire’s insurance businesses utilize loss reserving techniques that are believed to best fit the business. Additional information regarding reserves established by each of the significant businesses (GEICO, General Re and BHRG) follows.
GEICO’s gross unpaid losses and loss adjustment expense reserves as of December 31, 2006 were $6,095 million and net of reinsurance recoverables were $5,814 million. As of December 31, 2006, gross reserves included $4,315 million of reported average, case and case development reserves and $1,780 million of IBNR reserves.
For unreported claims, IBNR reserve estimates are calculated by first projecting the ultimate number of claims expected (reported and unreported) for each significant coverage by using historical quarterly and monthly claim counts, to develop age-to-age projections of the ultimate counts by accident quarter. Reported claims are subtracted from the ultimate claim projections to produce an estimate of the number of unreported claims. The number of unreported claims is multiplied by an estimate of the average cost per unreported claim to produce the IBNR reserve amount. Actuarial techniques are difficult to apply reliably in certain situations, such as to new legal precedents, class action suits or recent catastrophes. Consequently, supplemental IBNR reserves for these types of events may be established through the collaborative effort of actuarial, claims and other management.
The nature and extent of loss information provided under many facultative, per occurrence excess contracts or retroactive contracts where company personnel work closely with the ceding company in settling individual claims may not differ significantly from the information received under a primary insurance contract. Loss information from aggregate excess of loss contracts, including catastrophe losses and quota-share treaties, is often less detailed. Occasionally such information is reported in summary format rather than on an individual claim basis. Loss data is provided through periodic reports and may include the amount of ceded losses paid where reimbursement is sought as well as case loss reserve estimates. Ceding companies infrequently provide IBNR estimates to reinsurers.
Each of Berkshire’s reinsurance businesses has established practices to identify and gather needed information from clients. These practices include, for example, comparison of expected premiums to reported premiums to help identify delinquent client periodic reports, and claim reviews to facilitate loss reporting and identify inaccurate or incomplete claim reporting. These practices are periodically evaluated and changed as conditions, risk factors, and unanticipated areas of exposures are identified.
In summary, the scope, number and potential variability of assumptions required in estimating ultimate losses from reinsurance contracts of General Re and BHRG are more uncertain than primary property and casualty insurers due to the factors previously discussed. Additional information concerning General Re and BHRG follows.
Upon notification of a reinsurance claim from a ceding company, claim examiners make independent evaluations of loss amounts. In some cases, examiners’ estimates differ from amounts reported by ceding companies. If the examiners’ estimates are significantly greater than the ceding company’s estimates, the claims are further investigated. If deemed appropriate, ACRs are established above the amount reported by the ceding company. As of December 31, 2006, ACRs of $3.4 billion before discounts were concentrated in workers’ compensation and to a lesser extent in professional liability reserves. Examiners also periodically conduct claim reviews at client companies and case reserves are often increased as a result. In 2006, claim examiners conducted about 450 claim reviews.
Loss triangles are used to determine the expected case loss emergence patterns for most coverages and, in conjunction with expected loss ratios by accident year, are further used to determine IBNR reserves. Additional calculations form the basis for estimating the expected loss emergence pattern. The determination of the expected loss emergence pattern is not strictly a mechanical process. In instances where the historical loss data is insufficient, estimation formulas are used along with reliance on other loss triangles and judgment. Factors affecting loss development triangles include but are not limited to the following: changing client claims practices, changes in claim examiners’ use of ACRs or the frequency of client company claim reviews, changes in policy terms and coverage (such as client loss retention levels and occurrence and aggregate policy limits), changes in loss trends and changes in legal trends that result in unanticipated losses, as well as other sources of statistical variability. These items influence the selection of the expected loss emergence patterns.
In 2006, reported losses for North American workers’ compensation risks (primarily pre-2002 occurrences) exceeded expectations. Claims data continued to show increased costs of long-term medical care and prescription drug costs and increased medical care utilization by claimants. These developments produced changes in expectations for future development of reported claims and resulted in increases in nominal ACRs. For prior years’ workers’ compensation losses, reported claims exceeded expected claims in 2006 by $19 million. These developments further precipitated a $132 million net increase in nominal IBNR reserve estimates for unreported occurrences. After deducting $33 million for the change in net reserve discounts during the year, workers’ compensation losses from prior years’ reduced pre-tax earnings in 2006 by $118 million. To illustrate the sensitivity of changes in expected loss emergence patterns and expected loss ratios for General Re’s significant excess of loss workers’ compensation reserve cells, an increase of ten points in the tail of the expected emergence pattern and an increase of ten percent in the expected loss ratios would produce a net increase in nominal IBNR reserves of approximately $548 million and $278 million on a discounted basis as of December 31, 2006. The increase in discounted reserves would produce a corresponding decrease in pre-tax earnings. Management believes it is reasonably possible for the tail of the expected loss emergence patterns and expected loss ratios to increase at these rates.
In certain reserve cells within excess directors and officers and errors and omissions (“D&O and E&O”) coverages, IBNR reserves are based on estimated ultimate losses without consideration of expected emergence patterns. These cells often involve a spike in loss activity arising from recent industry developments making it difficult to select an expected loss emergence pattern. For example, the recent wave of corporate scandals has caused an increase in reported losses. For General Re’s large D&O and E&O reserve cells an increase of ten points in the tail of the expected emergence pattern (for those cells where emergence patterns are considered) and an increase of ten percent in the expected loss ratios would produce a net increase in nominal IBNR reserves and a corresponding reduction in pre-tax earnings of approximately $133 million. Management believes it is reasonably possible for the tail of the expected loss emergence patterns and expected loss ratios to increase at these rates.
Overall industry-wide loss experience data and informed judgment are used when internal loss data is of limited reliability, such as in setting the estimates for mass tort, asbestos and hazardous waste (collectively, “mass tort”) claims. Unpaid mass tort reserves at December 31, 2006 were approximately $1.9 billion gross and $1.2 billion net of reinsurance. Such reserves were approximately $1.8 billion gross and $1.3 billion net of reinsurance as of December 31, 2005. Claims paid attributable to such losses were about $97 million in 2006. In 2006, reserves for mass tort claims were increased in response to continued reports of losses and the increased uncertainty of how, when and how much these types of losses will develop over time. In 2006, IBNR reserve estimates for asbestos and environmental claims were increased by $58 million, which decreased pre-tax earnings by $58 million. In addition to the previously described methodologies, General Re considers “survival ratios” based on net claim payments in recent years versus net unpaid losses as a rough guide to reserve adequacy. The survival ratio was approximately 13 years as of December 31, 2006. The insurance industry’s comparable survival ratio for asbestos and pollution reserves was approximately nine years. Estimating mass tort losses is very difficult due to the changing legal environment. Although such reserves are believed to be adequate, significant reserve increases may be required in the future if new exposures or claimants are identified, new claims are reported or new theories of liability emerge.
In establishing retroactive reinsurance reserves, historical aggregate loss payment patterns are analyzed and projected into the future under various scenarios. The claim-tail is expected to be very long for many policies and may last several decades. Management assigns judgmental probability factors to these aggregate loss payment scenarios and an expectancy outcome is determined. Management monitors claim payment activity and reviews ceding company reports or other information concerning the underlying losses. Since the claim-tail is expected to be very long for such contracts, management reassesses expected ultimate losses as significant events related to the underlying losses are reported or revealed during the monitoring and review process. During 2006, retroactive reserves developed downward by approximately $235 million, due primarily to commutations of contracts where final loss payments were less than the recorded reserves.
The maximum losses payable by BHRG under retroactive policies are not expected to exceed approximately $10.8 billion as of December 31, 2006. Absent significant judicial or legislative changes affecting asbestos, environmental or latent injury exposures, management believes it unlikely that unpaid losses as of December 31, 2006 ($8.1 billion) will develop upward to the maximum loss payable or downward by more than 15%.
A significant number of recent reinsurance contracts are expected to have a low frequency of claim occurrence combined with a potential for high severity of claims. These include losses from catastrophes, terrorism, and aviation risks under catastrophe and individual risk contracts. Loss reserves related to catastrophe and individual risk contracts decreased from approximately $3.5 billion at year end 2005 to approximately $2.2 billion at year end 2006. The decrease in reserves reflected loss payments in 2006 of approximately $1.7 billion that were primarily attributable to the major hurricanes that occurred in 2005. Partially offsetting the effect of the loss payments were increases in loss reserves on pre-2006 events of approximately $200 million that produced a corresponding charge to pre-tax earnings in 2006. The reserve increases were primarily due to higher than expected reported losses on Hurricane Wilma which occurred in the fourth quarter of 2005. Reserving techniques for catastrophe and individual risk contracts generally rely more on a per-policy assessment of the ultimate cost associated with the individual loss event rather than with an analysis of the historical development patterns of past losses. Catastrophe loss reserves are provided when it is probable that an insured loss has occurred and the amount can be reasonably estimated. Absent litigation affecting the interpretation of coverage terms, the expected claim-tail is relatively short and thus the estimation error in the initial reserve estimates usually emerges within 24 months after the loss event.
Berkshire records as assets deferred charges 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. Deferred charges are amortized using the interest method over an estimate of the ultimate claim payment period and are reflected in earnings as a component of losses and loss expenses. The deferred charge balances are 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 were $2.0 billion at December 31, 2006. Significant changes in the amount and payment timing of estimated unpaid losses may have a significant effect on unamortized deferred charges and the amount of periodic amortization.
Information concerning recently issued accounting pronouncements which are not yet effective is included in Note 1(r) to the Consolidated Financial Statements. Berkshire does not expect that the adoption of any of the recently issued accounting pronouncements will have a material effect on its financial condition.
Berkshire’s Consolidated Balance Sheets include 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, equity prices, foreign currency exchange rates and commodity prices. The following sections address the significant market risks associated with Berkshire’s business activities.
Berkshire’s management prefers to invest in equity securities or to acquire entire businesses based upon the principles discussed in the following section on equity price risk. When unable to do so, management may alternatively invest in bonds, loans 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. Further, Berkshire strives to maintain the highest credit ratings so that the cost of debt is minimized. Berkshire utilizes derivative products, such as interest rate swaps, to manage interest rate risks on a limited basis.
Includes securities sold under agreements to repurchase and effects of interest rate swaps.
Berkshire’s preferred strategy is to hold equity investments for very long periods of time. Thus, Berkshire’s management is not troubled by short-term equity price volatility with respect to its investments provided that the underlying business, economic and management characteristics of the investees remain favorable. Berkshire strives to maintain above average levels of shareholder capital to provide a margin of safety against short-term equity price volatility.
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, hurricane or an act of terrorism 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.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, 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, 2006. 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.
The Pro Forma Balance Sheet gives effect to the conversion on February 9, 2006 of MidAmerican Energy Holdings Company (“MidAmerican”) non-voting cumulative convertible preferred stock into MidAmerican voting common stock as if such conversion had occurred on December 31, 2005. See Note 2 to the Consolidated Financial Statements for additional information.
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 $238 per share for 2006, $185 per share for 2005 and $158 per share for 2004.
Derivative instruments include interest rate, currency, equity and credit swaps and options, interest rate caps and floors and futures and forward contracts.
Goodwill represents the difference between purchase cost and the fair value of net assets acquired in business acquisitions. Goodwill is tested for impairment using a variety of methods at least annually and impairments, if any, are charged to earnings. Key assumptions used in the testing include, but are not limited to, the use of an appropriate discount rate and estimated future cash flows. In estimating cash flows, the Company incorporates current market information as well as historical factors.
Commission revenue from real estate brokerage transactions and related amounts due to agents which are included as components of operating revenues and expenses of utilities and energy businesses are recognized when a real estate transaction is closed.
Costs that vary and are related to the issuance of insurance policies are deferred, subject to ultimate recoverability, and charged to underwriting expenses as the related 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 $1,432 million and $1,287 million at December 31, 2006 and 2005, respectively.
Utilities and energy businesses recognize legal asset retirement obligations (“ARO”), mainly related to the decommissioning of nuclear generation assets and the final reclamation of leased coal mining property. The estimated fair value of a legal ARO is recognized as a liability when a reasonable estimate of the expected future cash flows can be made. This liability is added to the carrying amount of the associated asset, which is then depreciated over the remaining useful life of the asset. Subsequent to the initial recognition, the liability is periodically adjusted for revisions to assumptions used in determining the present value of the retirement obligation. The ARO as of December 31, 2006 was approximately $423 million and is reflected in other liabilities of utilities and energy businesses.
In July 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition of positions taken or expected to be taken in income tax returns. Only tax positions meeting a “more-likely-than-not” threshold of being sustained are recognized under FIN 48. FIN 48 also provides guidance on derecognition, classification of interest and penalties and accounting and disclosures for annual and interim financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. The cumulative effect of any changes arising from the initial application of FIN 48 is required to be reported as an adjustment to the opening balance of retained earnings in the period of adoption.
On September 10, 2004, MidAmerican’s management decided to cease operations of mineral extraction facilities installed near certain geothermal energy generation sites (“the Project”) at which proprietary processes were used to extract zinc from geothermal brine and fluids. MidAmerican’s management concluded that the Project could not become commercially viable. Consequently, a non-cash impairment charge of approximately $340 million, after tax, was recorded to write-down assets of the Project, rights to quantities of extractable minerals and allocated goodwill to estimated net realizable value.
On February 28, 2006, Berkshire acquired Business Wire, a leading global distributor of corporate news, multimedia and regulatory filings. On March 21, 2006, PacifiCorp, a regulated electric utility providing service to customers in six Western states, was acquired for approximately $5.1 billion in cash. On May 19, 2006, Berkshire acquired 85% of Applied Underwriters (“Applied”), an industry leader in integrated workers’ compensation solutions. Under certain conditions, existing minority shareholders of Applied may acquire up to an additional 4% interest in Applied from Berkshire.
Receivables of insurance and other businesses are comprised of the following (in millions).
Net gains (losses) are reflected in the Consolidated Statements of Earnings as follows.
Property, plant and equipment of utilities and energy businesses is comprised of the following (in millions):
Master netting agreements are utilized to manage counterparty credit risk, where gains and losses are netted across other contracts with that counterparty. In addition, Berkshire may receive cash or securities from counterparties as collateral. Likewise, Berkshire may be required to post cash or securities as collateral with counterparties under similar circumstances. At December 31, 2006, Berkshire held collateral with a fair value of $338 million, including cash of $314 million to secure open contract assets. At December 31, 2006, Berkshire had posted no collateral with counterparties as security on contract liabilities. Berkshire may be required to post collateral to cover derivative liabilities in the event of a downgrade of its credit rating below specified levels. Assuming non-performance by all counterparties on all contracts potentially subject to a credit loss, the maximum potential receivable loss, net of collateral held, at December 31, 2006 approximated $274 million.
Supplemental data with respect to unpaid losses and loss adjustment expenses of property/casualty insurance subsidiaries is as follows (in millions).
Incurred losses “all prior accident years” reflects the amount of estimation error charged or credited to earnings in each calendar year with respect to the liabilities established as of the beginning of that year. The beginning of the year net loss and loss adjustment expense liability was reduced by $1,071 million in 2006, $743 million in 2005 and $119 million in 2004. In both 2005 and 2006, the reductions in loss estimates for occurrences in prior years were primarily due to lower than expected frequencies and severities on reported and settled claims in the primary private passenger and commercial auto lines and lower than expected general liability losses. In 2006 and 2005, developed frequencies were generally more favorable than originally expected, particularly for liability coverages and claim severity increases were generally less than originally estimated. In addition, in 2006 prior years loss estimates were reduced for certain casualty reinsurance claims as a result of lower than expected losses reported during the year. Accident year loss estimates are regularly adjusted to consider emerging loss development patterns of prior years losses, whether favorable or unfavorable.
Prior accident years incurred losses also include amortization of deferred charges related to retroactive reinsurance contracts incepting prior to the beginning of the year. Amortization charges included in prior accident years losses were $358 million in 2006, $294 million in 2005 and $451 million in 2004. Certain workers’ compensation reserves are discounted. Net discounted liabilities at December 31, 2006 and 2005 were $2,705 million and $2,434 million, respectively, reflecting net discounts of $2,793 million and $2,798 million, respectively. Periodic accretions of these discounts are also a component of prior years losses incurred. The accretion of discounted liabilities was approximately $101 million in 2006, $92 million in 2005 and $87 million in 2004.
Parent company debt includes several individual investment agreement borrowings under which Berkshire is required to periodically pay interest over the contract terms. The weighted average interest rate on amounts outstanding as of December 31, 2006 was 3.2%. Under certain conditions, principal amounts may be redeemed without premium prior to the contractual maturity date at the option of the counterparties. Parent company debt also includes $334 million principal amount of senior notes associated with SQUARZ securities issued in 2002. When issued, each SQUARZ security consisted of a 3% senior note due in November 2007 together with a warrant which expires in May 2007. The warrant permits each holder the right to purchase either 0.1116 shares of Class A common stock (effectively at $89,606 per share) or 3.3480 shares of Class B common stock (effectively at $2,987 per share) for $10,000. A warrant premium is payable to Berkshire at an annual rate of 3.75%.
Principal payments expected during the next five years are as follows (in millions).
Deferred income taxes have not been established with respect to undistributed earnings of certain foreign subsidiaries. Earnings expected to remain reinvested indefinitely was approximately $1,762 million as of December 31, 2006. Upon distribution as dividends or otherwise, such amounts would be subject to taxation in the United States as well as foreign countries. However, U.S. income tax liabilities could be offset, in whole or in part, by tax credits allowable from taxes paid to foreign jurisdictions. Determination of the potential net tax due is impracticable due to the complexities of hypothetical calculations involving uncertain timing and amounts of taxable income and the effects of multiple taxing jurisdictions.
Berkshire and its subsidiaries’ income tax returns are continuously under audit by Federal and various local and international taxing authorities. Berkshire’s consolidated Federal income tax return liabilities have been settled with the Internal Revenue Service through 1998. Berkshire has received approximately $50 million in income tax refunds and interest with respect to certain issues in its Federal income tax returns dating back to 1988 that were litigated and for which a favorable ruling from the U.S. District Court was received in the fourth quarter of 2005. Berkshire does not currently believe that the impact of potential future audit adjustments will have a material effect on its Consolidated Financial Statements.
Combined shareholders’ equity of U.S. based property/casualty insurance subsidiaries determined pursuant to statutory accounting rules (Statutory Surplus as Regards Policyholders) was approximately $59 billion at December 31, 2006 and $52 billion at December 31, 2005.
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, accounts receivable and payable, other accruals, securities sold under agreements to repurchase and other liabilities are deemed to be reasonable estimates of their fair values.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). SFAS No. 158 requires an employer to recognize in its statement of financial position the over-funded or under-funded status of a defined benefit postretirement plan. SFAS No. 158 also requires entities to recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period, but are not recognized as components of net periodic benefit cost of the period pursuant to SFAS No. 87, “Employers’ Accounting for Pensions” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” Berkshire adopted the recognition and related disclosure provisions of SFAS No. 158 as of December 31, 2006. The incremental impact to the accompanying Consolidated Balance Sheet of such adoption is as follows (in millions).
Consists of $30 million related to Insurance and Other and $105 million related to Utilities and Energy businesses.
The components of net periodic pension expense for each of the three years ending December 31, 2006 are as follows (in millions).
In 2004, a Berkshire subsidiary amended its defined benefit plan to freeze benefits. Such an event is considered a curtailment and the curtailment gain included in the table above represents the elimination of projected plan benefits and the recognition of unamortized prior service costs and actuarial losses as of the amendment date.
The total net deficit status for plans (including unfunded plans) with accumulated benefit obligations in excess of plan assets was $836 million and $589 million as of December 31, 2006 and 2005, respectively. Expected contributions to defined benefit pension plans during 2007 are estimated to be $248 million.
Berkshire’s reportable business segments are organized in a manner that reflects how management views those business activities. Certain businesses have been grouped together for segment reporting based upon similar products or product lines, marketing, selling and distribution characteristics, even though those business units are operated under separate local management. There are over 40 separate business units.
Regulated electric and gas utility, including power generation and distribution activities in the U.S. and internationally; domestic real estate brokerage
Acme Building Brands, Benjamin Moore, H.H. Brown Shoe Group, CTB, Fechheimer Brothers, Forest River, Fruit of the Loom, Garan, ISCAR, Johns Manville, Justin Brands, Larson-Juhl, MiTek, Russell and Scott Fetzer
Ben Bridge Jeweler, Borsheim’s, Helzberg Diamond Shops, Jordan’s Furniture, Nebraska Furniture Mart, See’s, Star Furniture and R.C. Willey
Investment and derivative gains/losses exclude derivative losses of GRS of $86 million and $25 million in 2005 and 2004, respectively. The GRS derivative losses have been included in the results of the finance and financial products segment.
Consolidated sales and service revenues in 2006, 2005 and 2004 were $51.8 billion, $46.1 billion and $43.2 billion, respectively. Over 90% of such amounts in each year were in the United States with the remainder primarily in Canada and Europe. In 2006, consolidated sales and service revenues included $9.6 billion of sales to Wal-Mart Stores, Inc. which were primarily related to McLane’s wholesale distribution business.
In one case, a transaction initially effected with American International Group (“AIG”) in late 2000 (the “AIG Transaction”), AIG has corrected its prior accounting for the transaction on the grounds, as stated in AIG’s 2004 10-K, that the transaction was done to accomplish a desired accounting result and did not entail sufficient qualifying risk transfer to support reinsurance accounting. General Reinsurance has been named in related civil actions brought against AIG, as described below. As part of their ongoing investigations, governmental authorities have also inquired about the accounting by certain of Berkshire’s insurance subsidiaries for certain assumed and ceded finite reinsurance transactions.
In April 2005, the Australian Prudential Regulation Authority (“APRA”) announced an investigation involving financial or finite reinsurance transactions by General Reinsurance Australia Limited (“GRA”), a subsidiary of General Reinsurance. An inspector was appointed by APRA under section 52 of the Insurance Act 1973 to conduct an investigation of GRA’s financial or finite reinsurance business. GRA and General Reinsurance have cooperated fully with this investigation. The inspector has submitted its final investigative report to APRA.
Berkshire cannot at this time predict the outcome of these matters and is unable to estimate a range of possible loss and cannot predict whether or not the outcomes will have a material adverse effect on Berkshire’s business or results of operations for at least the quarterly period when these matters are completed or otherwise resolved.
General Reinsurance and several current and former employees, along with numerous other defendants, have been sued in thirteen federal lawsuits involving Reciprocal of America (“ROA”) and related entities. Nine are putative class actions initiated by doctors, hospitals and lawyers that purchased insurance through ROA or certain of its Tennessee-based risk retention groups. ROA was a Virginia-based reciprocal insurer and reinsurer of physician, hospital and lawyer professional liability risks. These complaints seek compensatory, treble, and punitive damages in an amount plaintiffs contend is just and reasonable. General Reinsurance is also subject to actions brought by the Virginia Commissioner of Insurance, as Deputy Receiver of ROA, the Tennessee Commissioner of Insurance, as Receiver for purposes of liquidating three Tennessee risk retention groups, a state lawsuit filed by a Missouri-based hospital group that was removed to federal court and another state lawsuit filed by an Alabama doctor that was also removed to federal court. The first of these actions was filed in March 2003 and additional actions were filed in April 2003 through June 2006. In the action filed by the Virginia Commissioner of Insurance, the Commissioner asserts in several of its claims that the alleged damages are believed to exceed $200 million in the aggregate as against all defendants. All of these cases are collectively assigned to the U.S. District Court for the Western District of Tennessee for pretrial proceedings. General Reinsurance filed motions to dismiss all of the claims against it in these cases and, in June 2006, the court granted General Reinsurance’s motion to dismiss the complaints of the Virginia and Tennessee receivers. The court granted the Tennessee receiver leave to amend her complaint, and the Tennessee receiver filed her amended complaint on August 7, 2006. General Reinsurance has filed a motion to dismiss the amended complaint in its entirety and awaits a ruling by the court. The Virginia receiver has moved for reconsideration of the dismissal and for leave to amend his complaint. General Reinsurance has filed its opposition to that motion and awaits a ruling by the court. In September 2006, the court also dismissed the complaint filed by the Missouri-based hospital group. The Missouri-based hospital group has filed a motion for reconsideration of the dismissal and for leave to file an amended complaint. General Reinsurance has filed its opposition to that motion and awaits a ruling by the court. The court has also not yet ruled on General Reinsurance’s motions to dismiss the complaints of the other plaintiffs. The parties have commenced discovery.
In December 2006, General Reinsurance entered into settlement agreements with respect to two lawsuits filed in Alabama state courts that related to ROA and related entities, and these lawsuits have been dismissed.
In December 2003, the Liquidators of both FAI Insurance Limited (“FAI”) and HIH Insurance Limited (“HIH”) advised GRA and Cologne Re that they intended to assert claims arising from insurance transactions GRA entered into with FAI in May and June 1998. In August 2004, the Liquidators filed claims in the Supreme Court of New South Wales in order to avoid the expiration of a statute of limitations for certain plaintiffs. The focus of the Liquidators’ allegations against GRA and Cologne Re are the 1998 transactions GRA entered into with FAI (which was acquired by HIH in 1999). The Liquidators contend, among other things, that GRA and Cologne Re engaged in deceptive conduct that assisted FAI in improperly accounting for such transactions as reinsurance, and that such deception led to HIH’s acquisition of FAI and caused various losses to FAI and HIH. The Liquidator of HIH served its Complaint on GRA and Cologne Re in June 2006. The FAI Liquidator has until March 30, 2007 to serve his complaint on GRA and Cologne Re.
Several of Berkshire’s subsidiaries have made long-term commitments to purchase goods and services used in their businesses. The most significant of these relate to NetJets’ commitments to purchase up to 483 aircraft through 2015 and MidAmerican’s commitments to purchase coal, electricity and natural gas. Commitments under all such subsidiary arrangements are approximately $6.4 billion in 2007, $3.4 billion in 2008, $3.0 billion in 2009, $2.8 billion in 2010, $2.1 billion in 2011 and $7.3 billion after 2011.