(2) In November 1997, Travelers Group Inc. completed its acquisition of Salomon Inc. A pre-tax realized gain of $677.9 million ($427.3 million after-tax) is included in 1997's results.
A summary follows of results to Berkshire from the insurance segment for the past three years.
The Berkshire Hathaway Insurance Group engages in both direct insurance and reinsurance of property and casualty risks. In direct insurance activities, Insurance Group members assume defined portions of the risks of loss from persons or organizations that are directly subject to the risks. In reinsurance activities, Insurance Group members assume defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves in their own insuring activities.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
A summary follows of the combined underwriting results of Berkshire's direct insurance businesses, stated on the basis of generally accepted accounting principles ("GAAP").
As shown in the table above, premiums earned by GEICO grew significantly during 1997 and 1996. Premiums earned by GEICO in 1997 exceeded amounts earned in 1996 by 12.6% and amounts earned in 1996 surpassed 1995 by 10.9%. The increases in premium volume were attributed to growth in voluntary auto insurance business partially offset by declines in involuntary residual auto market and homeowner's businesses. In-force policy growth for GEICO's core preferred-risk auto business was 12.8% in 1997 and 7.3% in 1996. Policy growth in standard and non-standard auto markets was 36.6% in 1997 and 33.5% in 1996 reflecting continued marketing efforts to offer rate quotes to potential customers who do not meet GEICO's preferred-risk underwriting guidelines. Voluntary new auto policy growth was 47.8% in 1997 as compared to 1996 and followed growth of 33.8% in 1996 as compared to 1995.
Underwriting expenses in 1997 for GEICO's businesses increased $84.3 million (17.3%) over 1996 and in 1996 increased $46.0 million (10.4%) over 1995. The increases reflect additional advertising and other costs incurred to generate the aforementioned in-force policy growth, as well as increased levels of administrative expenses, particularly profit-sharing costs.
GEICO's underwriting performance during 1997 was exceptional and better than its pricing targets. Generally, the results produced by the industry with respect to private passenger auto insurance during this period have been good as well. GEICO has taken certain rate reductions in 1997 and will take further rate reductions in 1998 to adjust its rates to its pricing targets. Premium rates are also subject to downward pressure through competition and through the ordinary rate regulation processes of state insurance departments. In addition, while the level of claim costs (including catastrophe losses) in 1997 and 1996 have been relatively low, there is no assurance that these favorable conditions will continue. Accordingly, management expects that GEICO's underwriting profit margins will return to more normal levels as losses increase faster than premiums. Notwithstanding, Berkshire's management believes that GEICO's underwriting results will remain better than industry averages.
Collectively, the non-GEICO direct insurance businesses produced earned premiums of $312.7 million in 1997, $268.7 million in 1996 and $239.9 million in 1995. The increases in premiums earned in recent years were achieved by the homestate, credit card credit, and specialty risk operations offset by declines in the traditional commercial motor vehicle business. Net underwriting gains attributed to non-GEICO direct insurance activities were $52.9 million in 1997, $58.5 million in 1996 and $40.6 million in 1995.
Underwriting results for the past three years, stated on a GAAP basis with respect to the reinsurance assumed business, are summarized in the following table.
Premiums earned from other property and casualty excess-of-loss and quota-share reinsurance contracts totaled $513.2 million in 1997, $484.5 million in 1996 and $450.7 million in 1995. These contracts often provide considerable amounts of indemnification in exchange for large premiums. Certain of these contracts, which produced annual premiums of approximately $200 million in 1997 and 1996, expired at the end of 1997 and are not expected to renew in 1998. Consequently, premiums earned in 1998 from other reinsurance activities may decline. Other property and casualty reinsurance contracts produced net underwriting losses of approximately $73.2 million in 1997, $101.0 million in 1996 and $97.7 million in 1995. Premiums from these types of reinsurance contracts are often based, in part, on time discounting of estimated loss payments because such payments are expected to occur over lengthy time periods. Estimated claim liabilities are established for financial reporting purposes without recognition of such discounting, thus producing underwriting losses. This business is accepted because of the large amounts of policyholder float that it generates.
Income tax expense as a percentage of investment income before taxes was 19.4% in 1997, 17.2% in 1996 and 14.7% in 1995. Investment income in each of these years includes substantial amounts of interest on municipal obligations and dividends and earnings from equity investments that are effectively taxed at rates below the full statutory federal rate.
A comparison of revenues and operating profits between 1997, 1996 and 1995 for each of the six identifiable non-insurance business segments follows.
Revenues from the six identifiable non-insurance business segments of $2,297.8 million increased $485.5 million (26.8%) from the prior year. The overall operating profit from these business segments of $39l.9 million increased $132.3 million (51.0%). The acquisition of FlightSafety International ("FlightSafety") at the end of 1996 accounts for a substantial portion of these increases. The following is a discussion of significant matters impacting comparative results for each of the non-insurance business segments.
On December 23, 1996, FlightSafety became a wholly-owned subsidiary of Berkshire. FlightSafety provides high technology training to operators of aircraft and ships. Total training systems are used which include sophisticated simulators and training devices, computer based training and professional instructors. FlightSafety's worldwide clients include corporations, airlines, the military and government agencies. Revenues and operating profits for 1996 as shown in the preceding table only reflect the results for the last eight days of 1996. For the full year of 1996, FlightSafety revenues were $363.7 million and pro forma operating profits were $90.2 million (after adjusting for goodwill amortization which would have been reflected in FlightSafety's results had the acquisition occurred at the beginning of 1996). FlightSafety's operating results during 1997 were excellent reflecting increased revenues and operating margins. Management expects continued positive results from this business.
Revenues of the candy segment increased $20.3 million (8.2%) over comparable prior year amounts. Total pounds of candy sold increased about 5.5%. Substantially all of the volume increase arose from See's quantity order, mail order and licensee programs. Pounds sold during 1997 from quantity order and mail order programs increased about 10% over 1996's volume. Operating profits increased $6.7 million (13.2%) over comparable prior year amounts.
Revenues of the home cleaning systems segment (which consists of products sold principally under the Kirby name) were relatively unchanged and operating profits increased $4.0 million (6.4%) over comparable prior year amounts. Unit sales volume in foreign markets, which comprise about 30% of total volume, increased about 4%. However, domestic unit sales volume decreased 9%. The decline in domestic volume was due to ineffective recruiting and training of independent dealers. Management has addressed the problem and during early 1998, sales volume is exceeding 1997 levels. Offsetting the impact of the volume decline was the fact that during 1997, an improved model was introduced which was sold at higher prices than the prior model.
Revenues from this segment increased in 1997 by $80.5 million (13.7%) over the prior year. A major portion of this increase (about 75%) relates to the acquisition on July 1, 1997 of Star Furniture Company ("Star"). Star is headquartered in Houston, Texas and is a major retailer of home furnishings in that market. Additionally, Star has locations in other cities in Texas. Operating profits of $53.7 million were $12.7 million (31.0%) greater in 1997 than in the prior year. Star's inclusion in this segment's results for the last half of 1997 accounts for almost 50% of the comparative increase. The remainder of the increase arose primarily from increased sales and improved margins at Nebraska Furniture Mart and R.C. Willey.
This segment includes H. H. Brown Shoe Company, Inc., Lowell Shoe, Inc. and Dexter Shoe Companies. These businesses manufacture and distribute work, dress, casual and athletic footwear. In addition, over 100 retail shoe stores are included in this segment. Revenues for this segment decreased by $18.9 million (3.4%) in 1997 as compared to 1996. Operating profits of $40.1 million decreased $12.6 million (23.9%). The unfavorable results are primarily due to disappointing results at Dexter where sales volume declined about 12% in 1997 as compared to 1996. Management at Dexter is repositioning its brand to be more competitive in a highly discount oriented retail environment. It has implemented a brand marketing strategy that includes global advertising to better promote its products and brand. Management anticipates that a substantial portion of the lost volume will be recovered in 1998.
While the effects of these transactions are material to the Consolidated Statements of Earnings, the completion of these acquisitions had a minimal impact on Berkshire's shareholders' equity. This is due to the fact that Berkshire's investments in Salomon Inc and Capital Cities had been carried in prior periods' consolidated financial statements at market value with unrealized gains, net of tax, reported as a separate component of shareholders' equity.
Strategically, Berkshire management strives to invest in businesses that possess excellent economics, with able and honest management and at sensible prices. Berkshire's management prefers, if possible to make an investment in each investee in a size that is meaningful in relation to Berkshire's investment portfolio. Accordingly, Berkshire's equity investments are concentrated in relatively few investees. As of December 31, 1997, over 60% of the total fair value of investments in equity securities is concentrated in three investees. See Note 4 to Consolidated Financial Statements.
Berkshire's investment strategy contemplates that most investments will be held for very long periods of time. Berkshire generally does not acquire investments for trading purposes. Thus, Berkshire management is not necessarily concerned with short term price volatility with respect to its investments provided that the underlying business, economic and management characteristics of the investees remain favorable. Berkshire maintains above average levels of shareholder capital to provide a margin of safety against short term equity price volatility.
The table below summarized Berkshire's equity price risks as of December 31, 1997 and shows the effects of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 1997. A comparison of quarter end stock prices on the individual stocks within the Company's equity portfolios over the three years ending December 31, 1997 indicated that the change from one quarter end to the next was 20% or less approximately 90% of the time. 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 concentration existing in Berkshire's investment portfolio.
Berkshire's management prefers to invest in equity securities or to acquire entire businesses based upon the principles discussed in the preceding section on equity price risk. When unable to do so, management may alternatively invest in bonds or other interest rate sensitive instruments. Berkshire's strategy is to make investments that are attractively priced in relation to the perceived credit risk. Management recognizes and accepts that losses may occur. Generally investments in interest rate sensitive instruments are not made for trading purposes. The Company does not actively utilize stand-alone derivatives to manage interest rate risks.
Berkshire's fixed maturity investments and borrowings under investment agreements and other debt are subject to interest rate risk. 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 credit worthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions.
The table below summarizes the estimated effects of hypothetical increases and decreases in interest rates. It is assumed that the changes occur immediately and uniformly to each category of instrument containing interest rate risks. The hypothetical changes in market interest rates reflect what could be deemed best or worst case scenarios. The hypothetical fair values are based upon the same prepayment assumptions utilized in computing fair values at December 31, 1997. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and therefore actual results might differ from those reflected in the table which follows.
As of December 31, 1997, Berkshire was party to derivative contracts with respect to crude oil and had commitments to purchase silver at future dates. Such contracts provide that Berkshire acquire the commodity at a fixed price at fixed future dates. At expiration, the derivative crude oil contracts are settled by a net amount equal to the difference between the then current price of crude oil and the fixed contract price. The silver contracts are settled by the delivery of silver to Berkshire in exchange for cash payments. These contracts were not entered into to offset any specific underlying commodity price risks associated with Berkshire's business activities.
We have audited the accompanying consolidated balance sheets of Berkshire Hathaway Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of earnings, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. 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 for 1997 and 1996 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 $51 per share for 1997 and $69 per share for 1996.
BERKSHIRE HATHAWAY INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997
(2) SFAS No. 131 -- "Disclosures about Segments of an Enterprise and Related Information", which establishes new standards for reporting information about operating segments in interim and annual financial statements.
Liability for unpaid losses and loss adjustment expenses represents the aggregate of such obligations of members of the Insurance Group with respect to: (i) prospective property/casualty insurance and reinsurance contracts, (ii) retroactive property/casualty reinsurance contracts that provide for indemnification of insurance risk, other than structured settlements, and (iii) reinsurance contracts providing for periodic payments with respect to settled claims ("structured settlements"). Except for structured settlement liabilities which are stated at discounted present values, the liability for unpaid losses and loss adjustment expenses is at the aggregate of estimated ultimate payment amounts.
The merger was consummated pursuant to an Agreement and Plan of Merger dated October 14, 1996 (the "FlightSafety Agreement"). Pursuant to the FlightSafety Agreement, aggregate consideration of approximately $1.5 billion was paid to FlightSafety shareholders consisting of $769.0 million in cash, 17,728 shares of Berkshire's Class A common stock and 112,655 shares of Berkshire's Class B common stock.
The results of operations for each of these entities are fully included in Berkshire's Consolidated Statements of Earnings beginning on the effective dates of each of the mergers (GEICO -- January 2, 1996 and FlightSafety -- December 23, 1996). In the accompanying Consolidated Statement of Earnings for 1995, Berkshire's previous investment in GEICO was accounted for under the equity method. Berkshire's proportionate share of GEICO's net earnings, reduced by amortization of goodwill, is included as a component of interest, dividends, and other investment income.
The following table sets forth certain unaudited condensed consolidated earnings data for the years ended December 31, 1996 and 1995, as if the GEICO and FlightSafety mergers had been consummated on the same terms at the beginning of 1995. Dollar amounts are in millions, except per share amounts.
On October 21, 1997, Berkshire and International Dairy Queen, Inc. ("Dairy Queen") executed a definitive Merger Agreement pursuant to which Berkshire would acquire Dairy Queen through the merger of Dairy Queen with and into a wholly-owned subsidiary of Berkshire. The Merger Agreement provided that, subject to certain limitations and conditions, the holders of Dairy Queen Class A and Class B common stock could receive either $27.00 cash or $26.00 of Berkshire Class A or Class B common stock for each Dairy Queen share. The total merger consideration was approximately $587.8 million consisting of $264.5 million in cash and the remainder in Class A and Class B common stock. The merger was completed on January 7, 1998.
Dairy Queen develops, licenses and services a system of approximately 5,800 Dairy Queen stores located throughout the United States, Canada and other foreign countries, which feature hamburgers, hot dogs, various dairy desserts and beverages. Dairy Queen also develops, licenses and services other stores and shops operating under the names of Orange Julius and Karmelkorn, which feature blended fruit drinks, popcorn and other snacks.
Data with respect to the consolidated investment in equity securities are shown below. Individual investments whose fair values exceed ten percent of consolidated shareholders' equity at December 31, 1997 and 1996 are listed separately. Amounts are in millions.
* Represents gross unrealized gains $7,995.9 less gross unrealized losses $45.8.
** Represents gross unrealized gains $4,861.3 less gross unrealized losses $22.4.
Common shares of American Express Company ("AXP") owned by Berkshire and its subsidiaries possessed approximately 10.5% of the voting rights of all AXP shares outstanding at December 31, 1997. The shares are held subject to various agreements with certain insurance and banking regulators which, among other things, prohibit Berkshire from (i) seeking representation on the Board of Directors of AXP (Berkshire may agree, if it so desires, at the request of management or the Board of Directors of AXP to have no more than one representative stand for election to the Board of Directors of AXP) and (ii) acquiring or retaining shares that would cause its ownership of AXP voting securities to equal or exceed 17% of the amount outstanding (should Berkshire have a representative on the Board of Directors, such amount is limited to 15%). In connection therewith, Berkshire has entered into an agreement with AXP which became effective when Berkshire's ownership interest in AXP voting securities reached 10% and will remain effective so long as Berkshire owns 5% or more of AXP's voting securities. The agreement obligates Berkshire, so long as Harvey Golub is chief executive officer of AXP, to vote its shares in accordance with the recommendations of AXP's Board of Directors. Additionally, subject to certain exceptions, Berkshire has agreed not to sell AXP common shares to any person who owns 5% or more of AXP voting securities or seeks to control AXP, without the consent of AXP.
Realized gains (losses) from sales and redemptions of investments are summarized below (in millions):
In November 1997, the merger of Salomon Inc ("Salomon") with and into a subsidiary of Travelers Group Inc. ("Travelers") was completed. Berkshire subsidiaries received common and preferred stock of Travelers in exchange for common and preferred shares of Salomon then owned. The value of the Travelers shares received was approximately $1.8 billion. Realized investment gains for 1997 include $677.9 million with respect to the transaction. The gain is net of a charge of $298.4 million for the contingent value associated with Berkshire's Exchange Notes. See Note 9 for additional information regarding the Exchange Notes.
During 1997, the Company entered into several forward contracts to purchase silver during the first quarter of 1998. As of December 31, 1997, the Company had committed to purchase 111.2 million ounces of silver which had an estimated fair value of about $665 million. Subsequent to year end, the Company committed to purchase an additional 18.5 million ounces of silver. The Consolidated Statement of Earnings for 1997 includes a pre-tax gain of $97.4 million representing the excess of fair value over net cost of the commitments.
The preceding summarized financial data includes the commercial and consumer finance activities conducted by the Scott Fetzer Financial Group and its subsidiaries. Assets and liabilities of these businesses are summarized below (in millions).
Net income from Scott Fetzer Financial Group businesses for each of the past three years is summarized below (in millions).
** Unpaid losses and loss adjustment expenses include liabilities established with respect to retroactive reinsurance contracts that provide for indemnification of insurance risk. These liabilities aggregated $1,398.1, $1,263.6, and $1,283.5 at December 31, 1997, 1996 and 1995 respectively. Related deferred charges were established with respect to these contracts and are reported as other assets. Also included in unpaid losses and loss adjustment expenses are discounted structured settlement reinsurance liabilities, which totaled $212.3, $217.2, and $221.7 at December 31, 1997, 1996 and 1995 respectively.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996, are shown below (in millions):
Charges for income taxes are reconciled to hypothetical amounts computed at the federal statutory rate in the table shown below (in millions):
Combined shareholders' equity of insurance subsidiaries determined pursuant to statutory accounting rules (Statutory Surplus as Regards Policyholders) was approximately $37.2 billion at December 31, 1997. This amount exceeded by approximately $7.8 billion the corresponding amount determined on the basis of GAAP. The major differences between statutory basis accounting and GAAP are that deferred income tax assets and liabilities, deferred charges re reinsurance assumed, and unrealized gains and losses on investments in securities with fixed maturities are recognized under GAAP but not for statutory reporting purposes. In addition, goodwill of acquired businesses is subject to a shorter amortization period under statutory accounting rules than is permitted under GAAP.
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires certain fair value disclosures. Fair value disclosures are required for most investment securities as well as other contractual assets and liabilities. Certain financial instruments, including insurance contracts, are excluded from SFAS 107 disclosure requirements due to perceived difficulties in measuring fair value. Accordingly, an estimation of fair value was not made with respect to unpaid losses and loss adjustment expenses .
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. The estimated fair values of the Company's other financial instruments as of December 31, 1997 and 1996, are as follows (in millions):
* Includes $427.3 million ($346.47/share), net of taxes, related to gain arising from Travelers Group Inc.'s acquisition of Salomon Inc. See Note 5.
Berkshire identified seven business segments for purposes of 1997 reporting pursuant to SFAS No. 14. These include the property and casualty insurance business (The Insurance Segment) conducted on both a direct and reinsurance basis through a number of subsidiaries. Included in this segment is GEICO Corporation, the seventh largest auto insurer in the United States and National Indemnity Company, one of the world's leading providers of catastrophe excess of loss reinsurance. Berkshire's six separately conducted non-insurance business segments are as follows:
The business segments identified above were responsible in 1997 for 86% of Berkshire's consolidated revenues. Other businesses activities that contributed for 1997, in the aggregate, 13% of Berkshire's consolidated revenues, were as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (15) BUSINESS SEGMENT DATA (Continued)