Results of Operations
Net earnings for each of the past three years are disaggregated in the table that follows. Amounts are after deducting minority interests and taxes.
(dollars in millions)
----------------------------
1997 1996 1995
-------- -------- --------
Insurance segment, except realized gain. . .$ 952.6 $ 689.6 $ 496.4
Non-Insurance business segments. . . . . . . 225.8 157.0 133.3
Other businesses . . . . . . . . . . . . . . 72.2 69.5 58.1
Interest expense . . . . . . . . . . . . . . (66.2) (55.7) (34.9)
Other. . . . . . . . . . . . . . . . . . . . 13.7 23.0 17.0
-------- -------- --------
Earnings before realized gain. . . . . . 1,198.1 883.4 669.9
Realized gain. . . . . . . . . . . . . . . . 703.5 1,605.2 125.0
-------- -------- --------
Net earnings . . . . . . . . . . . . . .$1,901.6 $2,488.6 $ 794.9
======== ======== ========
The business segment data (Note 15 to Consolidated Financial Statements) should be read in conjunction with this discussion.
Insurance Segment
A summary follows of results to Berkshire from the insurance segment for the past three years.
(dollars in millions)
----------------------------
1997 1996 1995
-------- -------- --------
Premiums earned from:
Direct insurance . . . . . . . . . . . . . . . . . . . $3,794.5 $3,360.3 $ 239.9
Reinsurance assumed. . . . . . . . . . . . . . . . . . 966.6 757.5 717.6
-------- -------- --------
$4,761.1 $4,117.8 $ 957.5
======== ======== ========
Underwriting gain (loss) attributable to:
Direct insurance . . . . . . . . . . . . . . . . . . . $ 333.6 $ 238.5 $ 40.6
Reinsurance assumed. . . . . . . . . . . . . . . . . . 127.8 (7.8) (21.0)
-------- -------- --------
461.4 230.7 19.6
Net investment income . . . . . . . . . . . . . . . . . . 872.9 712.1 575.8
Goodwill amortization . . . . . . . . . . . . . . . . . . (42.9)* (42.6)* --
-------- -------- --------
Pre-tax earnings . . . . . . . . . . . . . . . . . . . 1,291.4 900.2 595.4
Income taxes. . . . . . . . . . . . . . . . . . . . . . . 330.4 203.3 92.0
Minority interest . . . . . . . . . . . . . . . . . . . . 8.4 7.3 7.0
-------- -------- --------
Net earnings from insurance, except realized gain. . . $ 952.6 $ 689.6 $ 496.4
======== ======== ========
* Virtually all of the goodwill amortization relates to the amortization of goodwill that arose in connection with the GEICO
merger.
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.
A significant marketing strategy followed by all Insurance Group members is the maintenance of extraordinary capital strength. Statutory surplus as regards policyholders of the Insurance Group increased to approximately $37.2 billion at December 31, 1997. This superior capital strength creates opportunities, especially with respect to reinsurance activities, to negotiate and enter into contracts of insurance specially designed to meet unique needs of sophisticated insurance and reinsurance buyers.
Direct Insurance Underwriting
A summary follows of the combined underwriting results of Berkshire's direct insurance businesses, stated on the basis of generally accepted accounting principles ("GAAP").
(dollars are in millions)
-----------------------------------------------------
1997 1996 1995
--------------- --------------- ---------------
Amount % Amount % Amount %
-------- ----- -------- ----- -------- -----
Premiums written. . . . . . . . .$3,896.9 $3,389.7 $ 247.2
======== ======== ========
Premiums earned . . . . . . . . .$3,794.5 100.0 $3,360.3 100.0 $ 239.9 100.0
-------- ----- -------- ----- -------- -----
Losses and loss expenses. . . . . 2,744.3 72.3 2,516.6 74.9 90.0 37.5
Underwriting expenses . . . . . . 716.6 18.9 605.2 18.0 109.3 45.6
-------- ----- -------- ----- -------- -----
Total losses and expenses . . . . 3,460.9 91.2 3,121.8 92.9 199.3 83.1
-------- ===== -------- ===== -------- =====
Underwriting gain -- pre-tax. . .$ 333.6 $ 238.5 $ 40.6
======== ======== ========
The net underwriting results from direct insurance in 1997 and 1996 include the results of GEICO Corporation ("GEICO"). Through its subsidiaries, GEICO provides primarily private passenger automobile coverages to insureds in 48 states and the District of Columbia. GEICO policies are marketed mainly by direct response methods in which customers apply for coverage directly to the company over the telephone or through the mail. This is a significant element in GEICO's strategy to be a low-cost provider of such coverages. In previous years, a relatively small percentage of GEICO's insurance business was derived from homeowner's and other non-automobile insurance coverages. In 1995, GEICO entered into an agreement with another major insurance provider that over time will allow it to effectively exit the homeowner's insurance business.
GEICO's underwriting results for 1997 and 1996 are summarized below. Amounts for 1995 are shown for comparative purposes, although such amounts are not included in Berkshire's Consolidated Financial Statements.
(dollars are in millions)
-----------------------------------------------------
1997 1996 1995
--------------- --------------- ---------------
Amount % Amount % Amount %
-------- ----- -------- ----- -------- -----
Premiums written. . . . . . . . .$3,588.4 $3,122.1 $2,855.8
======== ======== ========
Premiums earned . . . . . . . . .$3,481.8 100.0 $3,091.6 100.0 $2,787.0 100.0
-------- ----- -------- ----- -------- -----
Losses and loss expenses. . . . . 2,630.1 75.5 2,424.9 78.4 2,254.2 80.9
Underwriting expenses . . . . . . 571.0 16.4 486.7 15.8 440.7 15.8
-------- ----- -------- ----- -------- -----
Total losses and expenses . . . . 3,201.1 91.9 2,911.6 94.2 2,694.9 96.7
-------- ===== -------- ===== -------- =====
Underwriting gain -- pre-tax. . .$ 280.7 $ 180.0 $ 92.1
======== ======== ========
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.
Losses and loss expenses incurred during 1997 were 8.5% greater than amounts incurred during 1996. This followed a 7.6% increase in such costs during 1996 as compared to 1995. The loss and loss expense ratio, a measurement of the portion of earned premiums that were paid or reserved for losses and related claims handling expenses, was 75.5% in 1997, 78.4% in 1996, and 80.9% in 1995. The lower ratio in 1997 reflects milder weather conditions resulting in reduced frequency of auto physical damage claims and lower catastrophe losses. Catastrophe losses added 0.3% to the loss and loss expense ratio in 1997 compared to 1.7% in 1996 and 1.9% in 1995. Both 1997 and 1996 benefitted from reduced average severity of liability claims.
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.
Berkshire's other direct insurance businesses are comprised of a wide variety of smaller property/casualty activities.
These businesses include: National Indemnity Company's traditional commercial motor vehicle and specialty risk operations;
five companies collectively referred to as "homestate" operations that provide primarily standard commercial coverages to
insureds in an increasing number of states; Cypress Insurance Company, a provider of workers' compensation insurance in
California and other states; Central States Indemnity Company, a provider of credit card credit insurance to individuals
nationwide through financial institutions; and Kansas Bankers Surety Company, an insurer for primarily small and medium
size banks located in the midwest.
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 $40.6 million in 1995.
Reinsurance Assumed
Underwriting results for the past three years, stated on a GAAP basis with respect to the reinsurance assumed business, are summarized in the following table.
(dollars are in millions)
-----------------------------------------------------
1997 1996 1995
--------------- --------------- ---------------
Amount % Amount % Amount %
-------- ----- -------- ----- -------- -----
Premiums written. . . . . . . . .$ 955.4 $ 715.5 $ 777.0
======== ======== ========
Premiums earned . . . . . . . . .$ 966.6 100.0 $ 757.5 100.0 $ 717.6 100.0
-------- ----- -------- ----- -------- -----
Losses and loss expenses. . . . . 675.8 69.9 572.9 75.6 522.0 72.7
Underwriting expenses . . . . . . 163.0 16.9 192.4 25.4 216.6 30.2
-------- ----- -------- ----- -------- -----
Total losses and expenses . . . . 838.8 86.8 765.3 101.0 738.6 102.9
-------- ===== -------- ===== -------- =====
Underwriting gain(loss)--pre-tax.$ 127.8 $ (7.8) $ (21.0)
======== ======== ========
Reinsurance premiums earned from catastrophe excess-of-loss policies totaled $309.9 million in 1997, $268.0
million in 1996 and $260.0 million in 1995. Management believes that increased industry capital devoted to this type of
business and the lack of large catastrophic events in recent years is contributing to intensifying price competition in the
catastrophe reinsurance markets. As a result, there are currently fewer opportunities to write catastrophe reinsurance coverages
at acceptable prices. Management anticipates that the level of catastrophe reinsurance business accepted will decline in 1998.
The catastrophe reinsurance business produced net underwriting gains in 1997 of $283.0 million as compared to
net underwriting gains of $167.0 million in 1996 and $152.1 million in 1995. During the 1995-1997 period, there were no
truly large insured catastrophic events. Catastrophe losses incurred during 1997 were minimal. In 1996 and 1995, catastrophe
losses incurred were $45.7 million and $39.4 million respectively. Underwriting results for 1997 also reflected lower
underwriting expenses than in previous years.
Berkshire's management continues to believe that, eventually, a large catastrophe event will occur that will
produce a significant loss to the Insurance Group, although the timing of the loss cannot be predicted. The Insurance Group's
exposure to loss from a single event with respect to in-force policies at year end 1997 is estimated at approximately $600
million after-tax. Accordingly, periodic underwriting results remain subject to extreme volatility. Berkshire's management
is willing to accept such volatility provided there is a reasonable prospect of long-term profitability.
Premiums earned from other property and casualty excess-of-loss and quota-share reinsurance contracts totaled
$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.
Premiums earned from retroactive reinsurance and structured settlement contracts were $143.5 million in 1997. Relatively minor amounts of premiums were earned from such contracts in 1996 and 1995. These contracts provide excess of loss coverage with respect to past loss events or periodic payments to claimants in connection with settled claims. Underwriting losses occur from such policies as a result of the recurring recognition of time value of money concepts--the amortization of deferred charges re reinsurance assumed and the accretion of discounted structured settlement liabilities. The amortization and accretion charges are reported as losses incurred, and because there is no offsetting premium income, as underwriting losses. Underwriting losses from retroactive reinsurance and structured settlement contacts were $82.0 million in 1997, $73.8 million in 1996 and $75.4 million in 1995.
Insurance Segment Investment Income
Following is a summary of Insurance Group net investment income for the past three years.
(dollars in millions)
--------------------------
1997 1996 1995
------- ------- -------
Investment income before taxes . . . . . . . . . . . . .$ 872.9 $ 712.1 $ 575.8
Applicable income taxes. . . . . . . . . . . . . . . . . 169.0 122.6 84.8
Applicable minority interest . . . . . . . . . . . . . . 6.4 5.7 5.0
------- ------- -------
Investment income after taxes and minority interest. . .$ 697.5 $ 583.8 $ 486.0
======= ======= =======
Investment income of the Insurance Group in 1997 exceeded amounts earned in 1996 by $160.8 million (22.6%). Investment income earned in 1997 reflects increased dividend income and taxable interest income, partially offset by lower tax-exempt interest income. Dividends earned from the Insurance Group's investment in US Airways Group, Inc. ("US Airways") Cumulative Convertible Preferred Stock, including amounts previously in arrears, were $78.4 million in 1997 and $46.5 million in 1996. No dividends were earned in 1995 from this investment. During the first quarter of 1998, Berkshire expects to convert the US Airways preferred shares, which have been called for redemption, into common shares of that company. Dividends earned by the Insurance Group in 1998 may decline from amounts earned in 1997.
Net investment income in 1997 and 1996 includes the investment results of GEICO, which became a wholly-owned subsidiary in January 1996. Investment income generated by GEICO was $262.1 million in 1997 and $227.2 million in 1996. Investment income before taxes of the Insurance Group in 1995 includes $112.6 million representing the equity in net earnings of GEICO less a charge for amortization of related goodwill.
Insurance Group members continue to generate significant levels of investment income from maintaining large
levels of invested assets. Increases in invested assets in recent years derive from reinvested earnings of the Group and
additional capital contributions, as well as increases in the amounts of "float". Reinvested earnings of the Insurance Group
and capital contributions over the three year period ending December 31, 1997 were approximately $5.5 billion. Float
represents the sum of unpaid losses and loss expenses, unearned premiums, and other liabilities to policyholders less the
aggregate of premiums and reinsurance balances receivable, deferred policy acquisition costs, deferred charges re reinsurance
assumed and related prepaid income taxes. Total float was approximately $7.3 billion at year end 1997.
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.
Non-Insurance Business Segments
A summary follows of results to Berkshire from these identified business segments for the past three years.
(dollars are in millions)
-----------------------------------------------------
1997 1996 1995
--------------- --------------- ---------------
Amount % Amount % Amount %
-------- ----- -------- ----- -------- -----
Revenues. . . . . . . . . . . . .$2,297.8 100.0 $1,812.3 100.0 $1,617.2 100.0
Cost and expenses . . . . . . . . 1,905.9 83.0 1,552.7 85.7 1,391.4 86.0
-------- ----- -------- ----- -------- -----
Operating profit. . . . . . . . . 391.9 17.0 259.6 14.3 225.8 14.0
Income taxes. . . . . . . . . . . 163.2 7.1 100.2 5.5 90.5 5.6
Minority interest . . . . . . . . 2.9 0.1 2.4 0.1 2.0 0.1
-------- ----- -------- ----- -------- -----
Contribution to net earnings. . .$ 225.8 9.8 $ 157.0 8.7 $ 133.3 8.3
======== ===== ======== ===== ======== =====
A comparison of revenues and operating profits between 1997, 1996 and 1995 for each of the six identifiable non-insurance business segments follows.
(dollars in millions)
----------------------------------------------------- Operating Profit
Revenues Operating Profits as a % of Revenues
---------------------------- ---------------------- ------------------
Segment 1997 1996 1995 1997 1996 1995 1997 1996 1995
---------------------- -------- -------- -------- ------ ------ ------ ---- ---- ----
Aviation training. . . . .$ 410.9 $ 8.4 $ -- $118.6 $ 2.7 $ -- 28.9 32.1 --
Candy. . . . . . . . . . . 269.2 248.9 233.6 57.6 50.9 49.3 21.4 20.4 21.1
Home cleaning systems. . . 253.5 253.7 235.6 66.5 62.5 52.6 26.2 24.6 22.3
Home furnishings . . . . . 667.1 586.6 428.1 53.7 41.0 28.1 8.0 7.0 6.6
Newspaper. . . . . . . . . 155.5 154.2 154.8 55.4 49.8 46.3 35.6 32.3 29.9
Shoes. . . . . . . . . . . 541.6 560.5 565.1 40.1 52.7 49.5 7.4 9.4 8.8
-------- -------- -------- ------ ------ ------ ---- ---- ----
$2,297.8 $1,812.3 $1,617.2 $391.9 $259.6 $225.8
======== ======== ======== ====== ====== ======
1997 compared to 1996
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.
Aviation Training
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 had
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.
Candy
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.
Home Cleaning Systems
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.
Home Furnishings
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.
Newspaper
Operating profits during 1997 of $55.4 million increased $5.6 million (11.2%) over the comparable 1996 amount. Much of the increase in comparative operating profits arose because the average cost of newsprint in 1997 was about 13.6% less than 1996's average. However, it should be noted that by year end 1997 the cost of newsprint was above the average cost in 1997 and management believes the cost will remain at such levels for at least the foreseeable future.
Shoes
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.
1996 compared to 1995
Revenues from the non-insurance business segments increased $195.1 million (12.1%) in 1996 as compared to
1995. The most significant revenue increase arose in the "home furnishings" segment where revenues increased $158.5 million
(37.0%) over the comparable prior year figures. The inclusion of R.C. Willey's results for a full year in 1996 versus six
months in 1995 accounts for the comparative increase. Operating profits of $259.6 million during 1996 increased $33.8 million
(15.0%) from the comparable 1995 amount. As reflected in the preceding table, each segment reported increased operating
profits in 1996 as compared to 1995.
Business Other Than Identified Segments
(dollars in millions)
------------------------------
1997 1996 1995
-------- -------- --------
Revenues. . . . . . . . . . . . . .$1,349.4 $1,306.2 $1,179.6
======== ======== ========
Operating profits . . . . . . . . .$ 123.4 $ 116.1 $ 101.2
Income taxes . . . . . . . . . . . 48.3 44.6 40.8
Minority interest. . . . . . . . . 2.9 2.0 2.3
-------- -------- --------
Contribution to net earnings. . . .$ 72.2 $ 69.5 $ 58.1
======== ======== ========
The above represent aggregate data for businesses that numbered 28 in 1997. Revenues from businesses not identified with specific business segments increased by $43.2 million (3.3%) in 1997 as compared to the prior year. Operating profits from this group of businesses increased by $7.3 million (6.3%) in 1997 versus the prior year.
Interest Expense and Other
The increase in interest expense in 1997 as compared to 1996 is primarily due to the issuance during late 1996
of $500 million principal amount of 1% Senior Exchangeable Notes, due December 2, 2001. For additional information
regarding these notes, see Note 9 to Consolidated Financial Statements.
Other earnings consist primarily of investment income of Berkshire and its non-insurance subsidiaries offset by
Berkshire's corporate costs (including charges related to Berkshire's shareholder designated contribution program). The
decrease in 1997 as compared to 1996 primarily relates to a decrease in interest income earned by Berkshire.
Realized Investment Gain
Realized investment gain has been a recurring element in Berkshire's net earnings for many years. The amount -- recorded when investments are sold, other-than-temporarily impaired or in certain situations, as required by GAAP, when investments are marked-to-market with the corresponding gain or loss included in earnings -- may fluctuate significantly from period to period, with a meaningful effect upon Berkshire's consolidated net earnings. However, the amount of realized investment gain or loss 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 net unrealized price appreciation now existing in Berkshire's consolidated investment portfolio.
The Consolidated Statement of Earnings for 1997 reflects a pre-tax realized investment gain of $1.1 billion ($703.5 million after-tax). A significant portion ($677.9 million pre-tax) of this gain resulted from Travelers Group Inc.'s acquisition of Salomon Inc. See Notes 5 and 9 to Consolidated Financial Statements for additional details regarding this transaction.
The Consolidated Statement of Earnings for 1996 reflects a pre-tax realized investment gain of $2.5 billion ($1.6 billion after-tax). Most of this gain resulted from The Walt Disney Company's ("Disney") acquisition of Capital Cities/ABC, Inc. ("Capital Cities"). Prior to the acquisition, subsidiaries of Berkshire owned common stock of Capital Cities that had been acquired in 1986 for an aggregate cost of $345.0 million. In exchange for the Capital Cities common stock, Berkshire subsidiaries received cash and Disney common stock having an aggregate value of $2.5 billion.
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.
Liquidity and Capital Resources
Berkshire's Consolidated Balance Sheet as of December 31, 1997, reflects continuing capital strength. In the past three years, Berkshire shareholders' equity has increased from approximately $11.7 billion at December 31, 1994, to approximately $31.5 billion at December 31, 1997. In that three-year period, realized and unrealized securities gains increased equity capital by approximately $15 billion, and reinvested earnings, other than realized securities gains, were about $2.8 billion.
Market Risk Disclosures
Berkshire's Consolidated Balance Sheet includes a substantial amount of assets and liabilities whose fair values are subject to market risks. Due to Berkshire's significant level of investments in equity securities and, to a lesser degree, in certain securities with fixed maturities (convertible preferred stocks), equity price fluctuations represent the largest market risk factor affecting Berkshire's consolidated financial position. The following sections address the significant market risks associated with Berkshire's financial activities as of year end 1997.
Equity Price Risk
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 carrying values of investments subject to equity price risks are based on quoted market prices or management's estimates of fair value as of the balance sheet date. Market prices are subject to fluctuation and, consequently, the amount realized in the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from perceived changes in the underlying economic characteristics of the investee, the relative price of alternative investments and general market conditions. Furthermore, amounts realized in the sale of a particular security may be affected by the relative quantity of the security being sold.
In addition to common stock investments, Berkshire's investments in preferred stocks and its obligations with respect to the 1% Senior Exchangeable Notes are subject to equity price risks. As of December 31, 1997, approximately 97% of the total fair value of preferred stocks is comprised of convertible preferred shares of Travelers and US Airways. As of that date, the market prices of the common stocks into which these preferred shares are convertible far exceeded the related conversion prices. The Exchange Notes are, under certain conditions, exchangeable into shares of Travelers common stock. As of December 31, 1997 the market price of Travelers common stock far exceeded the current exchange price of the Exchange Notes. Therefore, the fair values of preferred stock investments and the Exchange Notes are primarily subject to equity price risk.
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.
(dollars in millions)
-----------------------------------------------------------------------
Estimated Hypothetical
Fair Value after Percentage
Fair Value at Hypothetical Hypothetical Increase (Decrease) in
December 31, 1997 Price Change Change in Prices Shareholders' Equity
----------------- ------------ ---------------- --------------------
Equity securities. . . . . . . . . $36,247.7 20% increase $43,497.2 15.0
20% decrease 28,998.2 (15.0)
Convertible preferred stocks . . . 1,279.7 20% increase 1,535.4 *
20% decrease 1,023.7 *
1% Senior Exchangeable Notes . . . 780.0 20% increase 936.0 *
20% decrease 624.0 *
* Less than 1%
Interest Rate Risk
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.
The Company has historically utilized a modest level of corporate borrowings and debt. Further, Berkshire strives to maintain the highest credit ratings so that the cost of debt is minimized. Berkshire customarily utilizes debt or debt-like instruments in its finance businesses.
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.
(dollars in millions)
----------------------------------------------------------------------------
Estimated
Hypothetical Fair Value after Hypothetical
Change in Hypothetical Percentage
Fair Value at Interest Rate Change in Increase (Decrease) in
December 31, 1997 (bp=basis points) Interest Rate Shareholders' Equity
----------------- ----------------- ---------------- --------------------
Assets:
US Treasury securities and
obligations of US government
corporations and agencies. . . $6,490.6 100 bp decrease $7,693.2 2.5
100 bp increase 5,454.0 (2.1)
200 bp increase 4,766.8 (3.6)
300 bp increase 4,198.7 (4.7)
Other fixed maturity investments(1) 2,527.4 100 bp decrease 2,589.8 *
100 bp increase 2,402.6 *
200 bp increase 2,307.4 *
300 bp increase 2,217.5 *
Assets of finance businesses(2) 1,311.2 100 bp decrease 1,420.9 *
100 bp increase 1,188.9 *
200 bp increase 1,094.5 *
300 bp increase 1,012.9 *
Liabilities:
Borrowings under investment
agreements and other debt(3) 1,482.0 100 bp decrease 1,534.7 *
100 bp increase 1,407.9 *
200 bp increase 1,354.3 *
300 bp increase 1,302.7 *
Liabilities of finance businesses 1,149.4 100 bp decrease 1,344.8 *
100 bp increase 989.3 *
200 bp increase 859.8 *
300 bp increase 753.6 *
* Less than 1%
(1) Excludes preferred stocks (See Equity Price Risk)
(2) Excludes cash and cash equivalents
(3) Excludes 1% Senior Exchangeable Notes (See Equity Price Risk)
Commodity Price Risk
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.
Berkshire is subject to commodity price risk to the extent that crude oil and/or silver market prices deviate from the fixed contract settlement prices. As of December 31, 1997, the aggregate contract or notional amounts of these commitments were less than 3% of Berkshire's consolidated shareholders' equity. Therefore, any significant change in price in either of these commodities would not have a material impact on Berkshire's financial condition.
Year 2000 Issue
Many computer systems used today may be unable to interpret data correctly after December 31, 1999 because they allow only two digits to indicate the year in a date. Berkshire and its subsidiaries have been engaged in assessing this Year 2000 issue as it relates to their businesses, including their electronic interactions with banks, vendors, customers, and others. This project, along with developing and implementing solutions to the Year 2000 issue, is continuing. Management currently anticipates that the project will be substantially completed well in advance of year end 1999, and will not have a material impact on Berkshire's consolidated financial results or position. Berkshire's consolidated financial results could also be adversely affected if one or more of the companies in which it has material investments were materially adversely affected by the Year 2000 issue.
Forward-Looking Statements
Investors are cautioned that certain statements contained in this document, including but not limited to those under the caption "Market Risk Disclosures", as well as some statements by the Company in periodic press releases and some oral statements of Company officials during presentations about the company, are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"). Forward-looking statements include statements which are predictive in nature, which depend upon or refer to future events or conditions, which include words such as "expects", "anticipates", "intends", "plans", "believes", "estimates", or similar expressions, or which, like those under "Market Risk Disclosure" involve hypothetical events. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible future Company actions, which may be provided by management are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about the Company, economic and market factors and the industries in which the Company does business, among other things. These statements are not guaranties of future performance and the Company has no specific intention to update these statements.
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 investees (see discussion under "Market Risk Disclosure"), the occurrence of one or more catastrophic events, such as an earthquake or hurricane, that causes losses insured by members of Berkshire's Insurance Group, changes in insurance laws or regulations, changes in Federal income tax laws, as well as 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.