filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Results of Operations
Net earnings attributable to Berkshire Hathaway shareholders for each of the past three years are disaggregated in the table that follows. Amounts are after deducting income taxes and exclude earnings attributable to noncontrolling interests (in millions).
| 2016 | 2015 | 2014 | ||||||||||
| Insurance – underwriting | $ | 1,370 | $ | 1,162 | $ | 1,692 | ||||||
| Insurance – investment income | 3,636 | 3,725 | 3,542 | |||||||||
| Railroad | 3,569 | 4,248 | 3,869 | |||||||||
| Utilities and energy | 2,287 | 2,132 | 1,882 | |||||||||
| Manufacturing, service and retailing | 5,631 | 4,683 | 4,468 | |||||||||
| Finance and financial products | 1,427 | 1,378 | 1,243 | |||||||||
| Investment and derivative gains/losses | 6,497 | 6,725 | 3,321 | |||||||||
| Other | (343 | ) | 30 | (145 | ) | |||||||
| Net earnings attributable to Berkshire Hathaway shareholders | $ | 24,074 | $ | 24,083 | $ | 19,872 | ||||||
Through our subsidiaries, we engage in a number of diverse business activities. We manage our operating businesses on an unusually decentralized basis. There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by our corporate headquarters in the day-to-day business activities of the operating businesses. Our senior corporate management team participates in and is ultimately responsible for significant capital allocation decisions, investment activities and the selection of the Chief Executive to head each of the operating businesses. It also is responsible for establishing and monitoring Berkshire’s corporate governance practices, including, but not limited to, communicating the appropriate “tone at the top” messages to employees and associates, monitoring governance efforts, including those at the operating businesses, and participating in the resolution of governance-related issues as needed. The business segment data (Note 23 to the accompanying Consolidated Financial Statements) should be read in conjunction with this discussion.
Our insurance businesses generated after-tax earnings from underwriting of $1.4 billion in 2016, an increase of $208 million from 2015, primarily due to increased earnings from Berkshire Hathaway Reinsurance Group and General Re, partly offset by lower net underwriting gains from primary insurance. Our railroad business generated lower net earnings in 2016, primarily due to a 5.0% decline in unit volume. Earnings of our utilities and energy businesses increased in 2016, attributable to increased pre-tax earnings and a lower effective income tax rate. The increase in after-tax earnings in 2016 as compared to 2015 of our manufacturing, service and retailing businesses was primarily due to earnings from PCC, partly offset by comparatively lower overall earnings from the other businesses within this group.
Our insurance businesses generated after-tax earnings from underwriting of $1.2 billion in 2015, a decline of $530 million from 2014, which reflected rising claim costs at GEICO and lower earnings from our reinsurers, partially offset by increased earnings from our other primary insurance operations. Our railroad business generated a 9.8% increase in after-tax earnings in 2015 compared to 2014, reflecting improved service levels and lower fuel costs. After-tax earnings of our utilities and energy businesses in 2015 increased 13.3% over 2014, attributable to the acquisition of AltaLink in December 2014 and higher earnings from several of our other energy businesses. After-tax earnings of our manufacturing, service and retailing businesses in 2015 increased 4.8% over 2014. The positive impacts of business acquisitions and higher earnings from our building products businesses were partly offset by lower earnings from certain of our industrial products and service businesses.
After-tax investment and derivative gains were approximately $6.5 billion in 2016, $6.7 billion in 2015 and $3.3 billion in 2014. After-tax investment gains in 2016 included approximately $2.7 billion from the disposition or conversion of our Wrigley, Kraft Heinz and Dow preferred stock investments and non-cash gains of approximately $1.9 billion related to the exchange of P&G common stock for 100% of the common stock of Duracell. After-tax investment and derivative gains in 2015 included non-cash holding gains of approximately $4.4 billion in connection with our investment in Kraft Heinz common stock. In 2014, after-tax gains included approximately $2.0 billion related to the exchanges of Phillips 66 common stock and Graham Holdings Company common stock for a specified subsidiary of each of those companies. Derivative contracts contributed after-tax gains of $488 million in 2016, $633 million in 2015 and $329 million in 2014. We believe that investment and derivative gains/losses are often meaningless in terms of understanding our reported results or evaluating our economic performance. Investment and derivative gains and losses have caused and will likely continue to cause significant volatility in our periodic earnings.
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting
We engage in both primary insurance and reinsurance of property/casualty, life and health risks. In primary insurance activities, we assume defined portions of the risks of loss from persons or organizations that are directly subject to the risks. In reinsurance activities, we assume defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves to in their own insuring activities. Our insurance and reinsurance businesses are GEICO, General Re, Berkshire Hathaway Reinsurance Group (“BHRG”) and Berkshire Hathaway Primary Group.
Our management views insurance businesses as possessing two distinct operations – underwriting and investing. Underwriting decisions are the responsibility of the unit managers; investing decisions, with limited exceptions, are the responsibility of Berkshire’s Chairman and CEO, Warren E. Buffett. Accordingly, we evaluate performance of underwriting operations without any allocation of investment income or investment gains/losses.
The timing and amount of catastrophe losses can produce significant volatility in our periodic underwriting results, particularly with respect to BHRG and General Re. Our periodic underwriting results may be affected significantly by changes in estimates for unpaid losses and loss adjustment expenses, including amounts established for occurrences in prior years. Actual claim settlements and revised loss estimates will develop over time, which will likely differ from the liabilities recorded as of year-end 2016 of approximately $76.9 billion. Accordingly, the unpaid loss estimates recorded as of December 31, 2016 will develop upward or downward in future periods, producing a corresponding decrease or increase to pre-tax earnings.
Our periodic underwriting results may also include significant foreign currency transaction gains and losses arising from the changes in the valuation of non-U.S. Dollar denominated reinsurance liabilities of our U.S. based insurance subsidiaries as a result of foreign currency exchange rate fluctuations. Foreign currency exchange rates can be volatile and the resulting impact on our underwriting earnings can be relatively significant.
Underwriting results of our insurance businesses are summarized below (in millions).
| 2016 | 2015 | 2014 | ||||||||||
| Underwriting gain attributable to: | ||||||||||||
| GEICO | $ | 462 | $ | 460 | $ | 1,159 | ||||||
| General Re | 190 | 132 | 277 | |||||||||
| Berkshire Hathaway Reinsurance Group | 822 | 421 | 606 | |||||||||
| Berkshire Hathaway Primary Group | 657 | 824 | 626 | |||||||||
| Pre-tax underwriting gain | 2,131 | 1,837 | 2,668 | |||||||||
| Income taxes and noncontrolling interests | 761 | 675 | 976 | |||||||||
| Net underwriting gain | $ | 1,370 | $ | 1,162 | $ | 1,692 | ||||||
GEICO
GEICO writes private passenger automobile insurance, offering coverages to insureds in all 50 states and the District of Columbia. GEICO’s policies are marketed mainly by direct response methods in which most customers apply for coverage directly to the company via the Internet or over the telephone. GEICO’s underwriting results are summarized below (in millions).
| 2016 | 2015 | 2014 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 26,309 | $ | 23,378 | $ | 20,962 | ||||||||||||||||||
| Premiums earned | $ | 25,483 | 100.0 | $ | 22,718 | 100.0 | $ | 20,496 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 21,044 | 82.6 | 18,647 | 82.1 | 15,924 | 77.7 | ||||||||||||||||||
| Underwriting expenses | 3,977 | 15.6 | 3,611 | 15.9 | 3,413 | 16.6 | ||||||||||||||||||
| Total losses and expenses | 25,021 | 98.2 | 22,258 | 98.0 | 19,337 | 94.3 | ||||||||||||||||||
| Pre-tax underwriting gain | $ | 462 | $ | 460 | $ | 1,159 | ||||||||||||||||||
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Premiums written in 2016 increased 12.5% to $26.3 billion and premiums earned increased approximately $2.8 billion (12.2%) compared to 2015. These increases reflected voluntary auto policy-in-force growth of 7% and increased average premiums per auto policy resulting from rate increases, changes in coverage and state and risk mix. Voluntary auto new business sales in 2016 increased 10.9% compared to the prior year. The growth in voluntary auto new business accelerated over the last half of 2016 and, for the year, voluntary auto policies-in-force increased 974,000.
Losses and loss adjustment expenses incurred in 2016 increased $2.4 billion (12.9%) to $21.0 billion. In 2016, our loss ratio (the ratio of losses and loss adjustment expenses to earned premiums) increased 0.5 percentage points, reflecting increased storm losses and claims severity, partly offset by the aforementioned premium rate increases. Claims frequencies (claim counts per exposure unit) in 2016 for property damage, collision, bodily injury and personal injury protection (PIP) coverages were relatively unchanged from 2015. Average claims severities were higher in 2016 for bodily injury, physical damage and collision coverages (four to six percent range). In addition, storm-related losses (primarily from hail and flooding) in 2016 were approximately $423 million compared to $162 million in 2015.
Underwriting expenses in 2016 were $4.0 billion, an increase of $366 million (10.1%) over 2015. Our expense ratio (underwriting expenses to premiums earned) in 2016 decreased 0.3 percentage points compared to 2015. The largest components of underwriting expenses are employee-related expenses (salaries and benefits) and advertising costs. The increase in underwriting expenses reflected the increase in policies-in-force.
Premiums written and earned in 2015 increased 11.5% and 10.8% over 2014. The increases in premiums reflected growth in voluntary auto policies-in-force (5.4%) and rate increases. Voluntary auto new business sales in 2015 exceeded 2014 by about 1%. In 2015, our voluntary auto policies-in-force grew by 707,000 policies.
Losses and loss adjustment expenses incurred in 2015 increased $2.7 billion (17.1%) over 2014. Our loss ratio was 82.1% in 2015 compared to 77.7% in 2014. Claims frequencies in 2015 increased in all major coverages over 2014, including property damage and collision coverages (three to five percent range), bodily injury coverage (four to six percent range) and PIP (one to two percent range). Average claims severities were also higher in 2015 for property damage and collision coverages (four to five percent range), bodily injury coverage (six to seven percent range) and PIP coverage (two to four percent range). We attributed these increases to miles driven, repair costs (parts and labor) and medical costs, as well as to weather conditions.
Underwriting expenses in 2015 increased 5.8% to $3.6 billion. During 2015, advertising and employee-related costs grew at a slower rate than premiums. As a result, our expense ratio in 2015 declined 0.7 percentage points compared to 2014.
General Re
General Re conducts a reinsurance business offering property and casualty coverages to clients worldwide through General Reinsurance Corporation, Germany-based General Reinsurance AG, Faraday Holdings in London and other wholly-owned affiliates. We write property and casualty reinsurance primarily on a direct basis, but is also written through brokers and intermediaries. We write life and health reinsurance primarily on a direct basis through General Re Life Corporation and General Reinsurance AG. We strive to generate underwriting profits in essentially all of our product lines. Our management does not evaluate underwriting performance based upon market share and our underwriters are instructed to reject inadequately priced risks. General Re’s underwriting results are summarized in the following table (in millions).
| Premiums written | Premiums earned | Pre-tax underwriting gain (loss) | ||||||||||||||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | ||||||||||||||||||||||||||||
| Property/casualty | $ | 2,560 | $ | 2,725 | $ | 3,257 | $ | 2,569 | $ | 2,805 | $ | 3,103 | $ | 117 | $ | 150 | $ | 204 | ||||||||||||||||||
| Life/health | 3,069 | 3,165 | 3,161 | 3,068 | 3,170 | 3,161 | 73 | (18 | ) | 73 | ||||||||||||||||||||||||||
| $ | 5,629 | $ | 5,890 | $ | 6,418 | $ | 5,637 | $ | 5,975 | $ | 6,264 | $ | 190 | $ | 132 | $ | 277 | |||||||||||||||||||
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Property/casualty
In 2016, property/casualty premiums written declined $165 million (6%) and premiums earned declined $236 million (8%) compared to 2015, primarily due to lower volume in direct and broker market business, and to a lesser degree, unfavorable foreign currency exchange rate changes. Insurance industry capacity remains high and price competition in most property/casualty reinsurance markets persists. We continue to decline business when we believe prices are inadequate. However, we remain prepared to write substantially more business when appropriate prices can be attained.
Our property/casualty business produced pre-tax underwriting gains of $117 million in 2016 and $150 million in 2015. Results included pre-tax underwriting gains from property business of $211 million in 2016, a decline of $78 million compared to 2015. The decline was primarily due to lower gains from reductions of estimated losses on prior years’ property business. There were no significant catastrophe or large property losses in each of the past three years.
Our casualty/workers’ compensation business produced pre-tax underwriting losses of $94 million in 2016 and $139 million in 2015. Underwriting results in each year included net losses on current year business and charges for recurring discount accretion on workers’ compensation liabilities and deferred charge amortization on retroactive reinsurance contracts, partially offset by gains from reductions of estimated losses on prior years’ business. Discount accretion and deferred charge amortization produced pre-tax underwriting losses of $89 million in 2016 and $94 million in 2015. Casualty losses tend to be long-tailed and the favorable loss experience is not a guarantee that the current ultimate liability estimates will develop favorably in the future.
In 2015, property/casualty premiums written declined $532 million (16%), while premiums earned decreased $298 million (10%) compared to 2014. Adjusting for changes in foreign currency exchange rates, premiums written and earned in 2015 declined 9% and 2% compared to 2014. Our premium volume declined in both the direct and broker markets worldwide.
Our property/casualty business produced pre-tax underwriting gains of $150 million in 2015 and $204 million in 2014. In 2015, our property business generated pre-tax underwriting gains of $289 million compared to $445 million in 2014. The comparative decrease in underwriting gains reflected an increase in the current accident year loss ratio, primarily attributable to a relative increase in reported losses. Our casualty/workers’ compensation business produced pre-tax underwriting losses of $139 million in 2015 and $241 million in 2014. Underwriting results in each year included net losses on current year business, partly offset by gains from reductions of estimated losses on prior years’ business. The reductions of prior years’ losses were net of recurring charges for discount accretion on workers’ compensation liabilities and deferred charge amortization on retroactive reinsurance contracts of $94 million in 2015 and $97 million in 2014.
Life/health
Life/health premiums earned in 2016 decreased 3% compared to 2015. Adjusting for changes in foreign currency exchange rates, premiums earned in 2016 were relatively unchanged from 2015, as growth in the United Kingdom and Asia markets was offset by a decline in Canada. Our life/health business produced pre-tax underwriting gains of $73 million in 2016 compared to losses of $18 million in 2015. In 2016, underwriting results reflected increased underwriting gains from our international life business, lower claim severity in North America, and lower losses from changes in actuarial assumptions related to long-term care business.
Life/health premiums written and earned in 2015 were relatively unchanged from 2014. However, adjusting for changes in foreign currency exchange rates, premiums earned in 2015 increased $266 million (8%) as compared to 2014. In 2015, life business increased across a number of non-U.S. markets, particularly in Canada and Asia. Our life/health business produced aggregate pre-tax underwriting losses in 2015 of $18 million compared to gains of $73 million in 2014. Our North American long-term care business generated increased underwriting losses of $77 million in 2015 compared to 2014 due primarily to increased reserves from estimated premium deficiencies. We also experienced higher frequency and severity of losses in North American individual life business in 2015, partially offset by increased underwriting gains from international life business.
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Berkshire Hathaway Reinsurance Group
BHRG underwrites excess-of-loss reinsurance and quota-share coverages on property and casualty risks for insurers and reinsurers worldwide, including property catastrophe insurance and reinsurance. BHRG also writes retroactive reinsurance on property/casualty exposures as well as life reinsurance and periodic payment annuity business. A summary of BHRG’s underwriting results follows (in millions).
| Premiums written | Premiums earned | Pre-tax underwriting gain (loss) | ||||||||||||||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | ||||||||||||||||||||||||||||
| Property/casualty | $ | 4,433 | $ | 4,702 | $ | 4,097 | $ | 4,649 | $ | 4,416 | $ | 4,064 | $ | 767 | $ | 944 | $ | 1,411 | ||||||||||||||||||
| Retroactive reinsurance | 1,254 | 5 | 3,371 | 1,254 | 5 | 3,371 | (49 | ) | (469 | ) | (632 | ) | ||||||||||||||||||||||||
| Life and annuity | 2,601 | 2,786 | 2,681 | 2,601 | 2,786 | 2,681 | 104 | (54 | ) | (173 | ) | |||||||||||||||||||||||||
| $ | 8,288 | $ | 7,493 | $ | 10,149 | $ | 8,504 | $ | 7,207 | $ | 10,116 | $ | 822 | $ | 421 | $ | 606 | |||||||||||||||||||
Property/casualty
Premiums earned in 2016 increased $233 million (5.3%) reflecting an increase from the 10-year, 20% quota-share contract with Insurance Australia Group Ltd. (“IAG”), which became effective on July 1, 2015, partly offset by declines from property catastrophe and other quota-share business. The IAG quota-share contract represented 37% of our property/casualty earned premiums in 2016. Our premium volume is generally constrained for most property/casualty reinsurance coverages as rates, in our view, are generally inadequate. Consistent with General Re, we have the capacity and desire to write more business when appropriate pricing can be attained.
Our property/casualty business generated pre-tax underwriting gains of $767 million in 2016 and $944 million in 2015. The decline in pre-tax underwriting gains in 2016 was primarily due to a comparative decline in gains from reductions of estimated prior years’ loss reserves. We experienced no significant catastrophe loss events during the last three years.
Premiums written and earned in 2015 increased $605 million (15%) and $352 million (9%), respectively, compared to 2014. These increases were primarily attributable to the IAG quota-share contract, partially offset by lower property catastrophe, property quota-share and London facilities volume. The property/casualty business generated pre-tax underwriting gains in 2015 of $944 million compared to $1.4 billion in 2014. Underwriting results in 2015 included comparatively lower gains from property catastrophe reinsurance and comparatively lower gains from reductions of estimated prior years’ loss reserves.
Retroactive reinsurance
We periodically write retroactive reinsurance contracts, which provide indemnification of losses and loss adjustment expenses with respect to past loss events. Retroactive reinsurance premiums earned in 2016 primarily derived from three new contracts, including $670 million from a contract with Hartford Fire Insurance Company covering the adverse development of certain asbestos and pollution claims losses, subject to an aggregate limit of $1.5 billion. Premiums earned in 2014 included $3 billion from a contract with Liberty Mutual Insurance Company (“LMIC”), which covers claim liabilities from specified asbestos and environmental exposures under policies incepting before 2005, and workers’ compensation occurrences arising before 2014.
Pre-tax underwriting results from certain retroactive reinsurance contracts include gains/losses associated with the re-measurement of foreign currency denominated liabilities due to changes in exchange rates. Such gains were $392 million in 2016, $150 million in 2015 and $273 million in 2014 and primarily related to strengthening of the U.S. Dollar versus the Great Britain Pound (“GBP”) and the Euro. Before such gains, retroactive reinsurance contracts produced pre-tax losses of $441 million in 2016, $619 million in 2015 and $905 million in 2014, attributable to deferred charge amortization and changes in the timing and amount of ultimate losses.
The underwriting results of retroactive reinsurance include the periodic amortization of deferred charge assets established in connection with these contracts. At the inception of a contract, we recognize deferred charge assets for the excess, if any, of the estimated ultimate losses payable over the premiums earned. We subsequently amortize the deferred charges over the estimated claims payment period based on estimates of the timing and amount of future loss payments. Amortization charges and deferred charge adjustments resulting from changes to the estimated timing and amount of future loss payments are included in earnings.
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Berkshire Hathaway Reinsurance Group (Continued)
Retroactive reinsurance (Continued)
Changes in estimated ultimate liabilities for contracts written in prior years were relatively insignificant in 2016, whereas during each of the prior two years, we increased estimated ultimate liabilities approximately $550 million in 2015 and $825 million in 2014 for contracts written in prior years. We also reevaluated the timing of future payments of remaining liabilities, which produced changes to unamortized deferred charges. These increases in estimated ultimate liabilities, net of related deferred charge adjustments, produced incremental pre-tax underwriting losses of approximately $90 million in 2015 and $450 million in 2014.
As discussed in Note 25 to the accompanying Consolidated Financial Statements, we entered into a retroactive reinsurance agreement with affiliates of American International Group, Inc. (collectively, “AIG”) in January 2017. Our premiums with respect to this contract are about $10 billion and our net aggregate limit is $20 billion.
Gross unpaid losses assumed under retroactive reinsurance contracts were approximately $24.7 billion at December 31, 2016 and $23.7 billion at December 31, 2015. Unamortized deferred charges related to such reinsurance contracts were approximately $8.0 billion at December 31, 2016 and $7.6 billion at December 31, 2015. We currently estimate pre-tax losses in 2017 from deferred charge amortization of approximately $950 million, including approximately $375 million related to the new AIG agreement.
Life and annuity
A summary BHRG’s life and annuity underwriting results follows (in millions).
| Premiums earned | Pre-tax underwriting gain (loss) | |||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | |||||||||||||||||||
| Periodic payment annuity | $ | 1,082 | $ | 1,286 | $ | 1,105 | $ | (128 | ) | $ | (202 | ) | $ | (197 | ) | |||||||||
| Life reinsurance | 1,502 | 1,481 | 1,555 | 1 | (45 | ) | (23 | ) | ||||||||||||||||
| Variable annuity | 17 | 19 | 21 | 231 | 193 | 47 | ||||||||||||||||||
| $ | 2,601 | $ | 2,786 | $ | 2,681 | $ | 104 | $ | (54 | ) | $ | (173 | ) | |||||||||||
Premiums earned in 2016 from periodic payment annuity contracts decreased $204 million (15.9%) compared to 2015. The decrease reflected the effect of a large reinsurance contract in 2015 that generated premiums of $425 million, which more than offset a comparative increase in direct business. There were no periodic payment annuity reinsurance contracts in 2016.
Generally, we receive premiums under periodic payment annuity contracts in full at inception and we make annuity payments over time, often extending for decades. At inception, we discount annuity liabilities for time value and recognize no gains or losses in earnings. Pre-tax underwriting losses are recognized over the annuity payment period from the recurring accretion of discounted annuity liabilities.
Periodic payment annuity contracts generated pre-tax underwriting losses of $128 million in 2016, $202 million in 2015 and $197 million in 2014. Liabilities under certain contracts of a U.S. subsidiary are denominated in foreign currencies, most significantly the GBP. Changes in the exchange rates produce changes in the values of related liabilities, which are reflected in underwriting results. Exchange rate changes resulted in pre-tax gains of $313 million in 2016, $103 million in 2015 and $102 million in 2014.
Before foreign currency exchange rate changes, pre-tax underwriting losses from annuity contracts were $441 million in 2016, $305 million in 2015 and $299 million in 2014. The increase in underwriting losses in 2016 reflected increased liabilities from new business and the impact of lower interest rates, which increased expected future loss payments under reinsurance contracts. Discounted annuity liabilities were approximately $9.8 billion at December 31, 2016 and $8.7 billion at December 31, 2015. The weighted average interest rate of these contracts was approximately 4.1% as of December 31, 2016.
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Berkshire Hathaway Reinsurance Group (Continued)
Life and annuity (Continued)
Life reinsurance premiums increased 1.4% in 2016 compared to 2015, which declined 4.8% compared to 2014. The life reinsurance business produced near break-even results in 2016 and a pre-tax loss of $45 million in 2015. Underwriting losses in 2015 included losses of $53 million incurred in connection with certain terminated business.
Our variable annuity business primarily consists of reinsurance contracts that provide guarantees on closed blocks of variable annuity business written by other insurers. Our pre-tax underwriting gains in each period of the past three years reflected changes in liabilities for guaranteed benefits, which were affected by changes in securities markets and interest rates, as well as from the periodic amortization of expected profit margins included in our liability estimates.
Berkshire Hathaway Primary Group
The Berkshire Hathaway Primary Group (“BH Primary”) consists of a wide variety of independently managed insurance underwriting businesses that primarily provide a variety of commercial insurance solutions, including healthcare malpractice, workers’ compensation, automobile, general liability, property and various specialty coverages for small, medium and large clients. The largest of these insurers include the MedPro Group, National Indemnity Company (“NICO Primary”), Berkshire Hathaway Homestate Companies (“BHHC”), Berkshire Hathaway Specialty Insurance (“BH Specialty”) and Berkshire Hathaway GUARD Insurance Companies (“GUARD”). Other BH Primary insurers include U.S. Liability Insurance Company, Applied Underwriters and Central States Indemnity Company.
| 2016 | 2015 | 2014 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 6,684 | $ | 5,906 | $ | 4,904 | ||||||||||||||||||
| Premiums earned | $ | 6,257 | 100.0 | $ | 5,394 | 100.0 | $ | 4,377 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 3,864 | 61.8 | 3,070 | 56.9 | 2,608 | 59.6 | ||||||||||||||||||
| Underwriting expenses | 1,736 | 27.7 | 1,500 | 27.8 | 1,143 | 26.1 | ||||||||||||||||||
| Total losses and expenses | 5,600 | 89.5 | 4,570 | 84.7 | 3,751 | 85.7 | ||||||||||||||||||
| Pre-tax underwriting gain | $ | 657 | $ | 824 | $ | 626 | ||||||||||||||||||
BH Primary premiums written and earned in 2016 increased 13.2% and 16.0%, respectively, compared to 2015. The increases were primarily attributable to volume increases from BH Specialty, MedPro Group, BHHC and GUARD. Premiums written and earned in 2015 increased 20.4% and 23.2%, respectively, over the prior year. The increases were primarily attributable to volume increases from BH Specialty, NICO Primary, BHHC and GUARD. BH Primary’s combined loss ratios were 61.8% in 2016, 56.9% in 2015 and 59.6% in 2014. The comparative increase in the loss ratio in 2016 reflected comparative declines in favorable loss development of prior years’ loss events and higher loss ratios on current year business. While our claims development has been favorable in recent years, our primary insurers write considerable amounts of healthcare malpractice, general liability and workers’ compensation business, which can have extended claim-tails. It should not be assumed that the current claim experience or underwriting results will continue into the future.
Insurance—Investment Income
A summary of net investment income generated from investments held by our insurance operations follows (in millions).
| 2016 | 2015 | 2014 | ||||||||||
| Interest income | $ | 930 | $ | 888 | $ | 1,009 | ||||||
| Dividend income | 3,552 | 3,662 | 3,348 | |||||||||
| Investment income before taxes and noncontrolling interests | 4,482 | 4,550 | 4,357 | |||||||||
| Income taxes and noncontrolling interests | 846 | 825 | 815 | |||||||||
| Net investment income | $ | 3,636 | $ | 3,725 | $ | 3,542 | ||||||
Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Investment Income (Continued)
Pre-tax investment income declined $68 million (1.5%) in 2016 compared to 2015, reflecting lower dividend income attributable to portfolio changes, partly offset by an increase in interest income. We continue to hold significant cash, cash equivalents and U.S. Treasury Bills earning very low yields, although such yields in 2016 were higher than in 2015. We believe that maintaining ample liquidity is paramount and we insist on safety over yield with respect to such balances. In December 2016, Dow exercised its option to convert our $3 billion Dow preferred stock investment into common stock. Prior to its conversion, we received dividends of $255 million per annum.
Interest earned declined $121 million (12%) in 2015 versus 2014. The reduction reflected the maturities and dispositions of fixed maturity securities with higher interest rates. Dividend income increased $314 million (9%) in 2015 versus 2014. Dividend income in 2015 included income from our investment in Restaurant Brands International, Inc. 9% Preferred Stock ($3 billion stated value), which was acquired in December 2014.
Invested assets of our insurance businesses derive from shareholder capital, including reinvested earnings, and from net liabilities under insurance contracts or “float.” The major components of float are unpaid losses, life, annuity and health benefit liabilities, unearned premiums and other liabilities to policyholders less premium and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated $91 billion at December 31, 2016, $88 billion at December 31, 2015 and $84 billion at December 31, 2014. The cost of float was negative over the last three years as our insurance business generated pre-tax underwriting gains in each year.
A summary of cash and investments held in our insurance businesses as of December 31, 2016 and 2015 follows (in millions).
| December 31, | ||||||||
| 2016 | 2015 | |||||||
| Cash, cash equivalents and U.S. Treasury Bills | $ | 48,888 | $ | 43,762 | ||||
| Equity securities | 119,780 | 109,922 | ||||||
| Fixed maturity securities | 22,778 | 23,621 | ||||||
| Other investments | 14,364 | 15,683 | ||||||
| $ | 205,810 | $ | 192,988 | |||||
Fixed maturity investments as of December 31, 2016 were as follows (in millions).
| Amortized cost | Unrealized gains/losses | Carrying value | ||||||||||
| U.S. Treasury, U.S. government corporations and agencies | $ | 4,243 | $ | 8 | $ | 4,251 | ||||||
| States, municipalities and political subdivisions | 1,129 | 57 | 1,186 | |||||||||
| Foreign governments | 8,813 | 140 | 8,953 | |||||||||
| Corporate bonds, investment grade | 5,457 | 459 | 5,916 | |||||||||
| Corporate bonds, non-investment grade | 1,220 | 248 | 1,468 | |||||||||
| Mortgage-backed securities | 886 | 118 | 1,004 | |||||||||
| $ | 21,748 | $ | 1,030 | $ | 22,778 | |||||||
U.S. government obligations are rated AA+ or Aaa by the major rating agencies and approximately 87% of all state, municipal and political subdivisions, foreign government obligations and mortgage-backed securities were rated AA or higher. Non-investment grade securities represent securities rated below BBB- or Baa3. Foreign government securities include obligations issued or unconditionally guaranteed by national or provincial government entities.
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Management’s Discussion and Analysis (Continued)
Railroad (“Burlington Northern Santa Fe”)
Burlington Northern Santa Fe, LLC (“BNSF”) operates one of the largest railroad systems in North America. BNSF operates approximately 32,500 route miles of track in 28 states and also operates in three Canadian provinces. BNSF’s major business groups are classified by type of product shipped and include consumer products, coal, industrial products and agricultural products. A summary of BNSF’s earnings follows (in millions).
| 2016 | 2015 | 2014 | ||||||||||
| Revenues | $ | 19,829 | $ | 21,967 | $ | 23,239 | ||||||
| Operating expenses: | ||||||||||||
| Compensation and benefits | 4,769 | 5,043 | 5,023 | |||||||||
| Fuel | 1,934 | 2,656 | 4,478 | |||||||||
| Purchased services | 2,418 | 2,546 | 2,592 | |||||||||
| Depreciation and amortization | 2,128 | 2,001 | 2,123 | |||||||||
| Equipment rents, materials and other | 1,895 | 2,018 | 2,021 | |||||||||
| Total operating expenses | 13,144 | 14,264 | 16,237 | |||||||||
| Interest expense | 992 | 928 | 833 | |||||||||
| 14,136 | 15,192 | 17,070 | ||||||||||
| Pre-tax earnings | 5,693 | 6,775 | 6,169 | |||||||||
| Income taxes | 2,124 | 2,527 | 2,300 | |||||||||
| Net earnings | $ | 3,569 | $ | 4,248 | $ | 3,869 | ||||||
Consolidated revenues were approximately $19.8 billion in 2016, a decrease of $2.1 billion (9.7%) compared to 2015. Pre-tax earnings were $5.7 billion in 2016, a decrease of $1.1 billion (16.0%) compared to 2015. Our total volume was approximately 9.8 million cars/units in 2016 compared to approximately 10.3 million in 2015. In 2016, we experienced declining demand, especially in our coal and crude oil categories. Coal had the largest decline, driven by structural changes in that business as well as competition from low natural gas prices. While natural gas prices and the amount of electricity burn will affect the demand for coal in 2017, our long-term demand outlook for U.S. and global coal consumption is lower.
Freight revenues reflected comparative declines in 2016 in average revenue per car/unit (5.2%) and volumes (5.0%). The decrease in average revenue per car/unit was primarily attributable to lower fuel surcharge revenue driven by lower fuel prices and to business mix changes. The fuel price impact on fuel surcharges generally lags its impact on fuel costs.
Freight revenues from consumer products were $6.5 billion in 2016, a decline of 0.9% from 2015. The revenue decline reflected lower average revenue per car/unit, partially offset by volume increases of 1%. Consumer products volumes increased primarily due to higher domestic intermodal volumes and the addition of a new automotive customer. Lower international intermodal volumes attributable to soft economic activity and excess retail inventories partially offset these increases.
Freight revenues from industrial products were $4.8 billion in 2016, a decline of 14.2% compared with 2015. The decrease reflects lower volumes, primarily for petroleum products, reflecting pipeline displacement of U.S. crude rail traffic and lower U.S. oil production. In addition, there was lower demand for steel and taconite, partially offset by increased plastics products volume. We expect low oil production and pipeline displacement will continue to negatively impact the demand for crude oil shipments in 2017.
Freight revenues from agricultural products remained relatively flat at $4.2 billion. Agricultural product volume increased by 6.3% in 2016, primarily due to higher corn, soybean and wheat exports, offsetting a decrease in average revenue per car/unit.
Freight revenues from coal decreased 26.9% to $3.4 billion in 2016 compared to 2015, reflecting a 21.1% decline in volumes and lower average rate per car/unit. Demand for coal has declined due to reduced energy consumption, coal unit retirements, high coal stockpiles and low natural gas prices.
Table of Contents
Management’s Discussion and Analysis (Continued)
Railroad (“Burlington Northern Santa Fe”) (Continued)
Operating expenses were $13.1 billion in 2016, a decrease of $1.1 billion (7.9%) compared to 2015, and our ratio of operating expenses to revenues increased 1.4 percentage points to 66.3%. Compensation and benefits expenses decreased $274 million (5.4%) compared to 2015. The decline was primarily due to lower employment levels resulting from lower freight volumes and productivity improvements, partially offset by inflation. Fuel expenses declined $722 million (27.2%) compared to 2015, due to lower average fuel prices and lower volumes. Purchased services declined $128 million (5.0%) due to lower volumes and cost reductions. Depreciation and amortization expense increased $127 million (6.3%) compared to 2015 due to increased assets in service reflecting our ongoing capital additions and improvement programs. Equipment rents, materials and other expense declined $123 million (6.1%) compared to 2015, primarily due to lower freight volumes and productivity improvements.
Interest expense was $992 million in 2016, an increase of $64 million (6.9%) compared to 2015. Interest expense in 2015 was $928 million, an increase of $95 million (11%) compared to 2014. BNSF funds its capital expenditures with cash flow from operations and new debt issuances. The comparative increases in each period resulted from higher average outstanding debt.
Consolidated revenues were approximately $22.0 billion in 2015, a decrease of $1.3 billion (5%) compared to 2014. Pre-tax earnings were $6.8 billion in 2015, an increase of $606 million (10%) over 2014. Results in 2015 benefitted from significantly improved operating performance compared to substandard service during 2014. The operational improvements in 2015 reflected the capacity added in 2014 and 2015 through capital investments for line expansion, system improvement projects, other operational initiatives and more favorable winter weather conditions. Our total volume was approximately 10.3 million cars/units in 2015. During the second half of 2015 and particularly in the fourth quarter, we experienced declining demand, especially in coal and certain industrial products categories.
The decrease in consolidated revenues in 2015 reflected a 6% decline in average revenue per car/unit and a 0.1% decrease in volume. The decrease in average revenue per car/unit was attributable to a 55% decline in fuel surcharges ($1.6 billion) versus 2014, primarily due to lower fuel prices. The impact of lower fuel surcharge revenues affected revenues of all product lines.
Freight revenues from industrial products decreased 11% in 2015 compared to 2014 to $5.6 billion. The decrease reflected lower volumes for petroleum products, frac sand and steel products and lower average revenue per car/unit. Freight revenues from agricultural products increased 2% in 2015 to approximately $4.2 billion as compared to revenues in 2014. The increase in 2015 was attributable to higher domestic grain shipments and milo exports.
Freight revenues from coal decreased 7% to $4.6 billion in 2015 compared to 2014. The revenue decline was primarily due to lower average rates per car. Coal volume increased 1% primarily due to higher demand in the early part of the year as customers restocked coal inventories.
Freight revenues from consumer products were $6.6 billion in 2015, a decline of 6% from 2014. The revenue decline reflected lower average rates per car/unit, partially offset by volume increases of 1%. In the first quarter of 2015, we experienced a decline in international intermodal volume attributable to diversions of freight from U.S. West Coast ports to other import gateways as a result of the port productivity slow-down from port labor disruptions. Over the remainder of 2015, we experienced increased volume, as port productivity improvements allowed the backlog to clear, as well as from higher demand.
Operating expenses were $14.3 billion in 2015, a decrease of $2 billion (12%) compared to 2014. The ratio of operating expenses to revenues declined 4.9 percentage points to 64.9% as compared to 2014. Compensation and benefits expenses were relatively flat versus 2014. In response to weakening customer demand in the latter half of 2015, employment levels were reduced. Fuel expenses declined $1.8 billion (41%) compared to 2014, reflecting significantly lower average fuel prices, improved efficiency and lower gross ton miles volume. Depreciation and amortization expense decreased $122 million (6%) compared to 2014 as a result of lower capitalized software amortization expenses, partially offset by increased depreciation expense attributable to increased levels of railroad assets in service.
Utilities and Energy (“Berkshire Hathaway Energy Company”)
We hold a 90% ownership interest in Berkshire Hathaway Energy Company (“BHE”), which operates a global energy business. BHE’s domestic regulated utility interests are comprised of PacifiCorp, MidAmerican Energy Company (“MEC”) and NV Energy. In Great Britain, BHE subsidiaries operate two regulated electricity distribution businesses referred to as Northern Powergrid. BHE also owns two domestic regulated interstate natural gas pipeline companies. Other energy businesses include AltaLink, L.P. (“AltaLink”), a regulated electricity transmission-only business in Alberta, Canada and a diversified portfolio of independent power projects. In addition, BHE also operates the second-largest residential real estate brokerage firm and one of the largest residential real estate brokerage franchise networks in the United States.
Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
The rates our regulated businesses charge customers for energy and services are based, in large part, on the costs of business operations, including a return on capital, and are subject to regulatory approval. To the extent these operations are not allowed to include such costs in the approved rates, operating results will be adversely affected. Revenues and earnings of BHE are summarized below (in millions).
| Revenues | Earnings | |||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | |||||||||||||||||||
| PacifiCorp | $ | 5,245 | $ | 5,279 | $ | 5,315 | $ | 1,105 | $ | 1,026 | $ | 1,010 | ||||||||||||
| MidAmerican Energy Company | 2,668 | 2,554 | 2,900 | 392 | 292 | 270 | ||||||||||||||||||
| NV Energy | 2,925 | 3,382 | 3,279 | 559 | 586 | 549 | ||||||||||||||||||
| Northern Powergrid | 997 | 1,141 | 1,284 | 367 | 460 | 527 | ||||||||||||||||||
| Natural gas pipelines | 986 | 1,018 | 1,093 | 413 | 401 | 379 | ||||||||||||||||||
| Other energy businesses | 2,223 | 2,321 | 1,582 | 377 | 394 | 264 | ||||||||||||||||||
| Real estate brokerage | 2,815 | 2,536 | 2,161 | 225 | 191 | 139 | ||||||||||||||||||
| $ | 17,859 | $ | 18,231 | $ | 17,614 | |||||||||||||||||||
| Earnings before corporate interest and income taxes (“EBIT”) | 3,438 | 3,350 | 3,138 | |||||||||||||||||||||
| Corporate interest | 465 | 499 | 427 | |||||||||||||||||||||
| Income taxes and noncontrolling interests | 686 | 719 | 829 | |||||||||||||||||||||
| Net earnings attributable to Berkshire Hathaway shareholders | $ | 2,287 | $ | 2,132 | $ | 1,882 | ||||||||||||||||||
PacifiCorp
PacifiCorp operates a regulated electric utility in portions of several Western states, including Utah, Oregon and Wyoming. PacifiCorp’s revenues were $5.25 billion in 2016, slightly lower than 2015. Revenues reflected increased retail revenues and lower wholesale and other operating revenues. The increase in retail revenues was primarily due to higher retail rates as volumes were relatively unchanged. The declines in wholesale revenues were attributable to lower volumes and average prices. EBIT in 2016 increased $79 million (7.7%) from 2015, primarily due to increased gross margins (operating revenues less cost of sales), reflecting lower fuel prices and changes in fuel mix.
Revenues declined $36 million (1%) in 2015 compared to 2014. Wholesale and other revenues declined $129 million, principally due to lower wholesale prices and volumes and lower renewable energy credit revenue, while retail revenues increased compared to 2014, reflecting higher average rates partially offset by slightly lower volumes. EBIT increased $16 million (2%) in 2015 compared to 2014. Gross margins increased $109 million versus 2014, as energy costs declined more than revenues. The increase in gross margins substantially offset an increase in depreciation and amortization expense ($35 million) due to increased plant-in-service, lower allowances for equity funds used during construction ($18 million) and the impact of the recognition in 2014 of expected insurance recoveries on fire losses.
MidAmerican Energy Company
MEC operates a regulated electric and natural gas utility primarily in Iowa and Illinois. Revenues increased $114 million (4.5%) in 2016 compared to 2015. Revenues in 2016 included increased electric revenues ($148 million), which were somewhat offset by lower natural gas revenues ($24 million). The increase in electric revenues resulted primarily from a 3.8% increase in customer volumes and higher rates. Wholesale and other revenues increased primarily due to increased average wholesale prices and higher transmission revenue. The decline in natural gas revenues was primarily due to lower average per-unit costs of gas sold ($42 million), which is offset in cost of sales, partly offset by higher wholesale volumes. EBIT increased $100 million (34.2%) in 2016 from 2015. The increase in EBIT was primarily due to increased gross margins from electric revenues and lower operations and maintenance expenses, partially offset by higher depreciation and amortization from additional assets placed in service, and higher interest expense.
MEC’s revenues declined $346 million (12%) in 2015 from 2014. Regulated natural gas revenues declined $335 million, which was primarily attributable to lower average per-unit cost of gas sold, which is substantially offset in lower cost of sales. Regulated electric revenues increased slightly, due primarily to higher retail rates in Iowa and higher volumes, partially offset by lower average wholesale prices. The increases in regulated electric rates in Iowa are attributable to higher retail rates and changes in rate structure approved in August 2014, which results in a greater differential between higher rates from June to September and lower rates in the remaining months.
Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
MidAmerican Energy Company (Continued)
EBIT increased $22 million (8%) in 2015 compared to 2014, reflecting an increase in gross margins ($107 million), partially offset by increases in depreciation expense from new wind generation and other plant-in-service ($56 million), interest expense ($17 million) and lower allowances for equity funds used during construction ($19 million). The increase in gross margins derived primarily from the regulated electric business, which benefitted from the aforementioned changes in Iowa rates and rate structure and lower fuel and purchased power costs. In addition, EBIT included a gain of $13 million in 2015 from the sale of a generating facility lease.
NV Energy
NV Energy operates regulated electric and natural gas utilities in Nevada. Revenues were approximately $2.9 billion in 2016, a decrease of $457 million (13.5%) versus 2015. The decline was primarily attributable to lower electric retail rates resulting from lower energy costs. Electric retail volumes in 2016 were flat compared to 2015. EBIT fell $27 million (4.6%) compared to 2015. The decline in revenues was substantially offset by a decline in energy costs. Operating expenses increased $39 million (4%) and interest expense decreased $17 million (6.6%). The increase in operating expenses reflected higher depreciation and amortization and reductions in certain accrued liabilities in 2015.
Revenues and EBIT were $3.4 billion and $586 million in 2015, representing increases of $103 million (3%) and $37 million (7%) over 2014. The increase in revenues was due primarily to higher retail electric revenues reflecting increased customers and higher volumes. The increase in EBIT was attributable to an increase in gross margins ($82 million) and lower interest expense ($22 million), partially offset by increased depreciation and amortization ($31 million) and higher other operating expenses, including increased energy efficiency costs.
Northern Powergrid
Revenues declined $144 million (12.6%) to $997 million in 2016, primarily due to the impact of a stronger U.S. Dollar ($127 million) and lower distribution revenues. EBIT declined $93 million (20.2%) to $367 million. The decline was due to lower distribution revenues and the stronger U.S. Dollar, as well as increases in depreciation expense from increased assets in service and higher asset impairment charges.
Revenues declined $143 million (11%) in 2015 versus 2014, reflecting the adverse impact of the stronger U.S. Dollar ($90 million) and comparatively lower distribution revenues. The decline in distribution revenues reflected lower rates due mainly to the new price control period effective April 1, 2015. EBIT declined $67 million (13%) compared to 2014, reflecting the adverse effects of the stronger U.S. Dollar and lower distribution revenues partially offset by lower interest expense ($13 million).
Natural Gas Pipelines
Revenues declined $32 million (3.1%) in 2016 as compared to 2015, primarily due to the impact of lower gas sales from balancing activities and lower transportation revenues from lower volumes and rates, in part due to comparatively milder temperatures in the first quarter of 2016. EBIT increased $12 million (3.0%) versus 2015, reflecting lower interest expense, resulting from lower average debt balances and lower operating expenses, partly offset by the lower transportation revenues.
Revenues declined $75 million (7%) in 2015 versus 2014, which was primarily due to lower gas sales as a result of reduced system and operational balancing activities, partially offset by higher transportation revenues. EBIT increased $22 million (6%) as compared to 2014, as decreased costs of gas sold and lower operating expenses more than offset the decline in revenues.
Other energy businesses
Revenues declined $98 million (4.2%) in 2016 compared to 2015. The decline in comparative revenues was principally attributable to lower revenues from AltaLink and from our unregulated retail services business. AltaLink’s year-to-date revenue decline reflected the impact of a regulatory decision in the second quarter of 2016 that resulted in one-time net reductions in revenue, which more than offset increased revenues from additional assets placed in service. The regulatory decision changed the timing of when construction-in-progress expenditures included in the rate base are billable to customers and earned in revenues, but had no impact on net earnings, as one-time reductions in expenses offset the one-time revenue reduction. EBIT declined $17 million (4.3%) compared to 2015, primarily due to lower earnings from our renewable energy businesses, primarily due to higher depreciation expense from additional assets placed in service.
Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
Other energy businesses (Continued)
Revenues of other energy businesses increased $739 million (46.7%) in 2015 over revenues in 2014, while EBIT increased $130 million (49%) versus 2014. Revenues and EBIT in 2015 reflect the acquisition of AltaLink on December 1, 2014. AltaLink’s revenues and EBIT in 2015 were $621 million and $170 million, respectively. The remaining increase in revenues was primarily due to an increase in solar capacity placed in service. Excluding the acquisition of AltaLink, the impact of higher revenues in 2015 was more than offset by higher operating, depreciation and interest expenses.
Real estate brokerage
Revenues increased 11.0% to $2.8 billion in 2016 compared to 2015. The increase was primarily attributable to increased closed brokerage transactions (primarily resulting from business acquisitions) and a 2% increase in average home sales prices, as well as higher mortgage revenues. EBIT increased $34 million (17.8%) in 2016 compared to 2015, primarily due to the increases in mortgage revenues.
Real estate brokerage revenues and EBIT increased 17% and 37%, respectively, in 2015 compared to 2014. The revenue increase reflected comparative increases in closed transactions and average home prices and the impact of business acquisitions. The increase in EBIT was primarily due to the increased revenues, net of commission expense, as well as a lower operating expense to revenue ratio as compared to 2014.
Corporate interest and income taxes
Corporate interest includes interest on unsecured debt issued by BHE and borrowings from certain Berkshire insurance subsidiaries in connection with BHE’s acquisitions of NV Energy and AltaLink. The decline in corporate interest in 2016 was primarily due to lower average borrowings from Berkshire insurance subsidiaries. In 2015, corporate interest expense increased over the prior year due to new borrowings in connection with the AltaLink acquisition.
BHE’s consolidated effective income tax rates were approximately 14% in 2016, 16% in 2015, and 23% in 2014. BHE’s effective income tax rates regularly reflect significant production tax credits from wind-powered electricity generation placed in service. In addition, pre-tax earnings of Northern Powergrid and AltaLink are taxed at lower statutory rates in the United Kingdom and Canada compared to the U.S. statutory tax rate. BHE’s effective rates in 2016 and 2015 also included reductions in deferred income tax liabilities resulting from enacted statutory income tax rate decreases in the United Kingdom and deferred state income tax benefits.
Manufacturing, Service and Retailing
A summary of revenues and earnings of our manufacturing, retailing and service businesses follows (in millions).
| Revenues | **Earnings *** | |||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | |||||||||||||||||||
| Manufacturing | $ | 46,506 | $ | 36,136 | $ | 36,773 | $ | 6,211 | $ | 4,893 | $ | 4,811 | ||||||||||||
| Service and retailing | 73,553 | 71,689 | 60,916 | 2,251 | 2,222 | 1,981 | ||||||||||||||||||
| $ | 120,059 | $ | 107,825 | $ | 97,689 | |||||||||||||||||||
| Pre-tax earnings | 8,462 | 7,115 | 6,792 | |||||||||||||||||||||
| Income taxes and noncontrolling interests | 2,831 | 2,432 | 2,324 | |||||||||||||||||||||
| $ | 5,631 | $ | 4,683 | $ | 4,468 | |||||||||||||||||||
| * | Excludes certain acquisition accounting expenses, which were primarily from the amortization of identified intangible assets recorded in connection with our business acquisitions. The after-tax acquisition accounting expenses excluded from earnings above were $771 million in 2016, $476 million in 2015 and $496 million in 2014. These expenses are included in “other” in the summary of earnings on page 32 and in the “other” earnings section on page 51. |
|---|
Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Manufacturing
Our manufacturing group includes a variety of businesses that produce industrial, building and consumer products. Industrial products businesses include specialty chemicals (The Lubrizol Corporation (“Lubrizol”)), metal cutting tools/systems (IMC International Metalworking Companies (“IMC”)), equipment and systems for the livestock and agricultural industries (CTB International), and a variety of industrial products for diverse markets (Marmon and Scott Fetzer). Beginning on January 29, 2016, our industrial products group also includes Precision Castparts Corp. (“PCC”), a leading manufacturer of complex metal products for aerospace, power and general industrial markets.
Our building products businesses include flooring (Shaw), insulation, roofing and engineered products (Johns Manville), bricks and masonry products (Acme Building Brands), paint and coatings (Benjamin Moore), and residential and commercial construction and engineering products and systems (MiTek). Our consumer products businesses include leisure vehicles (Forest River), several apparel and footwear operations (including Fruit of the Loom, Garan, H.H. Brown Shoe Group and Brooks Sports), and beginning February 29, 2016, the Duracell Company (“Duracell”), a leading manufacturer of high performance alkaline batteries. This group also includes custom picture framing products (Larson Juhl) and jewelry products (Richline). A summary of revenues and pre-tax earnings of our manufacturing operations follows (in millions).
| Revenues | Pre-tax earnings | |||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | |||||||||||||||||||
| Industrial products | $ | 24,702 | $ | 16,760 | $ | 17,622 | $ | 4,209 | $ | 2,994 | $ | 3,159 | ||||||||||||
| Building products | 10,772 | 10,316 | 10,124 | 1,178 | 1,167 | 896 | ||||||||||||||||||
| Consumer products | 11,032 | 9,060 | 9,027 | 824 | 732 | 756 | ||||||||||||||||||
| $ | 46,506 | $ | 36,136 | $ | 36,773 | $ | 6,211 | $ | 4,893 | $ | 4,811 | |||||||||||||
Aggregate revenues in 2016 were approximately $46.5 billion, an increase of approximately $10.4 billion (28.7%) over 2015. Pre-tax earnings were approximately $6.2 billion in 2016, an increase of $1.3 billion (26.9%) compared to 2015. Excluding PCC and Duracell, manufacturing revenues were flat and pre-tax earnings declined compared to 2015.
Industrial products
Industrial products revenues increased approximately $7.9 billion (47.4%) in 2016 versus 2015, primarily due to the inclusion of PCC, partially offset by revenue declines of $859 million (5.1%) across our other businesses. Sales volumes of our other businesses declined compared to 2015, reflecting sluggish demand for many product categories, particularly for products sold to businesses in the oil and gas and heavy equipment industries. In addition, lower average costs of oil-based raw materials and metals and increased competitive pressures continued to lower average selling prices.
Pre-tax earnings increased $1.2 billion (40.6%) in 2016 compared to 2015, reflecting the inclusion of PCC, partially offset by comparative earnings declines from our other businesses. Lubrizol’s earnings in 2016 included pre-tax losses of $365 million in 2016 related to the disposition in the fourth quarter of an underperforming business. Earnings from several of Marmon’s manufacturing businesses and Lubrizol’s continuing operations declined, while earnings from IMC increased slightly. Generally, our industrial products manufacturers experienced a combination of weaker customer demand, sales price and mix changes, and increased restructuring costs, which were partly offset by benefits from cost containment initiatives and lower average material prices.
Revenues declined $862 million (5%) in 2015 versus 2014. The foreign currency translation impact of a stronger U.S. Dollar produced approximately $782 million of the comparative revenue decline. In addition, commodity cost deflation in petroleum and metals used in certain of our products resulted in lower average selling prices, in particular for specialty chemicals, metal cutting tools, copper wire and plumbing products. Certain of our businesses experienced slowing customer demand over the last half of 2015 as the decline in oil prices and competitive pressures resulted in significantly lower sales volumes to customers in or related to the oil and gas industry. These negative factors were partly offset by revenues from bolt-on acquisitions of Lubrizol.
Pre-tax earnings declined $165 million (5%) in 2015 compared to 2014. The comparative declines in earnings reflected the adverse impact of the stronger U.S. Dollar, partially offset by earnings from bolt-on acquisitions, lower average commodity-based material costs, and actions taken in response to the slowing sales volumes previously referenced. Such actions address cost structures and exiting lower margin business.
Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Building products
Building products revenues increased $456 million (4.4%) in 2016 compared to 2015, reflecting volume-driven revenue increases by MiTek, Johns Manville, Acme and Shaw, as well as revenues from bolt-on acquisitions by Shaw and MiTek. The revenue increase reflected increased unit sales across several product categories, partly offset by lower average sales prices and changes in product mix. Pre-tax earnings increased $11 million (0.9%) in 2016 compared to 2015. The favorable effects of increased sales volume and lower manufacturing costs in 2016 (attributable to deflation in certain commodity unit costs) were offset by increased charges for asset impairments, pension settlements and environmental claims.
Revenues increased $192 million (2%) in 2015 compared to 2014. The revenue increase reflected sales volume increases at Shaw, Johns Manville and MiTek, as well as the impact of bolt-on business acquisitions, partially offset by the unfavorable foreign currency translation from a stronger U.S. Dollar ($165 million). Pre-tax earnings increased $271 million (30%) compared to 2014. The overall increase in earnings was primarily attributable to the aforementioned increases in revenues and lower average raw material and energy costs, partially offset by the negative impact of foreign currency translation and increased restructuring charges. Shaw, Johns Manville and Benjamin Moore generated most of the comparative increase in earnings.
Consumer products
Consumer products revenues were approximately $11.0 billion in 2016, an increase of approximately $2.0 billion (21.8%) compared to 2015. The increase reflected the inclusion of Duracell and a 12% increase in Forest River’s revenues, which was primarily attributable to increased unit sales. Apparel revenues in 2016 declined $81 million (1.9%) compared to 2015, reflecting lower footwear sales and the impact of a divestiture by Fruit of the Loom in 2015.
Consumer products pre-tax earnings increased $92 million (12.6%) in 2016 compared to 2015. The earnings increase reflected increased earnings from Forest River and apparel and footwear businesses, partly offset by pre-tax losses of Duracell. From its acquisition date, Duracell incurred approximately $109 million in transition, business integration and restructuring costs. Forest River generated a pre-tax earnings increase of 28%, primarily due to increased sales volumes and higher gross margins. Earnings of our apparel businesses increased 22% in 2016, primarily attributable to lower restructuring costs and a loss in 2015 from the disposition of a Fruit of the Loom operation, partly offset by lower earnings from our footwear businesses.
Revenues of our consumer products manufacturers were approximately $9.1 billion in 2015, relatively unchanged from 2014. Forest River’s revenues increased 6% compared to 2014, due to a 4% increase in unit sales and increased average prices. Apparel revenues in 2015 declined 4% compared to 2014. The decline in apparel revenues was attributable to lower volume and the negative impact of foreign currency translation resulting from a stronger U.S. Dollar. Pre-tax earnings declined $24 million (3%) in 2015 compared to 2014. The decline was primarily due to a pre-tax loss in 2015 from the disposition of an unprofitable Fruit of the Loom operation and lower earnings from our footwear businesses, partially offset by higher earnings from Forest River.
Service and retailing
Our service and retailing businesses are comprised of a large group of independently managed businesses engaged in a variety of activities. A summary of revenues and pre-tax earnings of these operations follows (in millions).
| Revenues | Pre-tax earnings | |||||||||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | |||||||||||||||||||||||||
| Service | $ | 10,386 | $ | 10,201 | $ | 9,854 | $ | 1,161 | $ | 1,156 | $ | 1,202 | ||||||||||||||||||
| Retailing | 15,092 | 13,265 | 4,422 | 659 | 564 | 344 | ||||||||||||||||||||||||
| McLane Company | 48,075 | 48,223 | 46,640 | 431 | 502 | 435 | ||||||||||||||||||||||||
| $ | 73,553 | $ | 71,689 | $ | 60,916 | $ | 2,251 | $ | 2,222 | $ | 1,981 | |||||||||||||||||||
Service
Our service businesses offer fractional ownership programs for general aviation aircraft (NetJets) and high technology training to operators of aircraft (FlightSafety). We also distribute electronic components (TTI) and franchise and service a network of quick service restaurants (Dairy Queen). Services also include the electronic distribution of corporate news, multimedia and regulatory filings (Business Wire), publication of newspapers and other publications (Buffalo News and the BH Media Group) and operation of a television station in Miami, Florida (WPLG). We also offer third party logistics services that primarily serve the petroleum and chemical industries (Charter Brokerage).
Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Service (Continued)
Service revenues increased 1.8% to approximately $10.4 billion in 2016 compared to 2015, primarily due to revenue increases from TTI and Charter Brokerage partly offset by a revenue decrease from NetJets. TTI’s revenues increased 7.2%, primarily due to sales volume increases in Asia, Europe and through the Internet, while the increase from Charter Brokerage primarily derived from a commodity trading business launched in 2015. NetJets’ revenues decreased 2.0% reflecting lower aircraft sales.
Pre-tax earnings were $1.2 billion in 2016, relatively unchanged versus 2015, reflecting increased earnings from NetJets and lower earnings from our newspaper operations. NetJets’ earnings increased 19%, primarily due to lower subcontracting expense and a decline in losses from aircraft impairments and dispositions, partly offset by increases in depreciation and restructuring charges and reduced aircraft sale margins. TTI’s earnings were relatively unchanged, as changes in geographic sales mix and price competition produced lower gross margin rates, substantially offsetting the aforementioned revenue increase.
Revenues increased $347 million (3.5%) in 2015 as compared to 2014. The increase included a 5% increase in NetJets’ revenues and the impact of the acquisitions of Charter Brokerage and WPLG during 2014, partly offset by reduced revenues from our newspaper operations. The increase in NetJets’ revenues was attributable to a 50% increase in aircraft sales, partially offset by lower flight operations revenue.
Pre-tax earnings declined $46 million in 2015 compared to 2014. Earnings benefitted from the WPLG and Charter Brokerage acquisitions, which were more than offset by lower earnings from NetJets. Earnings declined at NetJets as the impact of increased aircraft sales margins was more than offset by increased personnel, aircraft subcontracting and maintenance expenses. A portion of the increase in personnel costs pertained to lump-sum payments made in connection with a collective bargaining agreement reached with our pilots in the fourth quarter of 2015.
Retailing
Our retailing businesses include four distinct home furnishings retailing businesses (Nebraska Furniture Mart, R.C. Willey, Star Furniture and Jordan’s), which sell furniture, appliances, flooring and electronics. Our retailers also include Berkshire Hathaway Automotive (“BHA”), which we acquired in the first quarter of 2015. BHA currently includes 83 auto dealerships. BHA sells new and pre-owned automobiles, offering repair and other related services and products, and also includes two related insurance businesses, two auto auctions and a distributor of automotive fluid maintenance products.
Our other retailing businesses include three jewelry retailing businesses (Borsheims, Helzberg and Ben Bridge), See’s Candies (confectionary products), Pampered Chef (high quality kitchen tools), Oriental Trading Company (party supplies, school supplies and toys and novelties) and Detlev Louis Motorrad (“Louis”), a Germany-based retailer of motorcycle accessories acquired in the second quarter of 2015.
Retailing revenues increased $1.8 billion (13.8%) in 2016 to $15.1 billion as compared to 2015. The increase in revenues reflected the impact of the BHA and Louis acquisitions during 2015, which accounted for approximately $1.6 billion of the comparative increase. Home furnishings revenues increased $227 million (7.8%), primarily due to new stores opened in 2015 by Nebraska Furniture Mart and Jordan’s, as well as modest organic growth. Pre-tax earnings increased $95 million (16.8%) in 2016 compared to 2015. The increase reflected the impact of the BHA and Louis acquisitions and increased earnings from most of our other retailers, which benefitted from a combination of revenue increases and cost savings initiatives.
Revenues increased approximately $8.8 billion in 2015 as compared to 2014. The increase reflected the impact of the BHA and Louis acquisitions, which together contributed revenues of approximately $8.3 billion. Revenues of our home furnishings retailers increased $572 million (24%) over 2014, driven by Nebraska Furniture Mart, which opened a new store in March 2015 and from increases at R.C. Willey and Jordan’s. Pre-tax earnings increased $220 million (64%) compared to 2014. The increase was primarily due to the impact of the BHA and Louis acquisitions.
McLane Company
McLane operates a wholesale distribution business that provides grocery and non-food consumer products to retailers and convenience stores (“grocery”) and to restaurants (“foodservice”). McLane also operates businesses that are wholesale distributors of distilled spirits, wine and beer (“beverage”). The grocery and foodservice businesses generate high sales volumes and very low profit margins and have several significant customers, including Wal-Mart, 7-Eleven and Yum! Brands. A curtailment of purchasing by any of its significant customers could have an adverse impact on McLane’s periodic revenues and earnings.
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Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
McLane Company (Continued)
Revenues were $48.1 billion in 2016, a decline of $148 million (0.3%) relative to 2015. In 2016, we experienced a comparative decline in grocery revenues, partly offset by an increase in foodservice revenues. Earnings were $431 million in 2016, a decrease of $71 million (14%) compared to 2015. The reduced earnings was primarily due to a reduction in McLane’s operating margin (ratio of earnings to revenues). The decline was primarily due to increased employee related costs. Competition in our grocery and foodservice businesses has been and will likely continue to be intense and our ability to control operating costs is a key factor in maintaining profitability. Additionally, earnings in 2015 included a gain of $19 million from the disposition of a subsidiary.
Revenues increased $1.6 billion (3%) in 2015 compared to 2014, reflecting revenue increases in the foodservice unit (6%), beverage unit (8%) and grocery unit (2%). Pre-tax earnings increased $67 million (15%) in 2015 versus 2014. Pre-tax earnings in 2015 included the aforementioned gain from the sale of a subsidiary and otherwise benefitted from lower fuel and trucking costs.
Finance and Financial Products
Our finance and financial products businesses include manufactured housing and finance (Clayton Homes), transportation equipment manufacturing and leasing businesses (UTLX and XTRA, and together, “transportation equipment leasing”), as well as other leasing and financing activities. A summary of revenues and earnings from our finance and financial products businesses follows (in millions).
| Revenues | Earnings | |||||||||||||||||||||||||||||
| 2016 | 2015 | 2014 | 2016 | 2015 | 2014 | |||||||||||||||||||||||||
| Manufactured housing and finance | $ | 4,230 | $ | 3,576 | $ | 3,310 | $ | 744 | $ | 706 | $ | 558 | ||||||||||||||||||
| Transportation equipment leasing | 2,650 | 2,540 | 2,427 | 959 | 909 | 827 | ||||||||||||||||||||||||
| Other | 795 | 848 | 789 | 427 | 471 | 454 | ||||||||||||||||||||||||
| $ | 7,675 | $ | 6,964 | $ | 6,526 | |||||||||||||||||||||||||
| Pre-tax earnings | 2,130 | 2,086 | 1,839 | |||||||||||||||||||||||||||
| Income taxes and noncontrolling interests | 703 | 708 | 596 | |||||||||||||||||||||||||||
| $ | 1,427 | $ | 1,378 | $ | 1,243 | |||||||||||||||||||||||||
Manufactured housing and finance
Clayton Homes’ revenues increased $654 million (18%) in 2016 compared to 2015, attributable to a 30% increase in revenues from home sales, primarily due to a 25% increase in units sold and product mix changes. Interest and other financial service income increased 1.8% from 2015. Pre-tax earnings increased $38 million (5.4%) compared to 2015. Earnings benefitted from increased home sales and improved manufacturing and retailing operating margins, partly offset by lower earnings from lending and financial services, which were negatively impacted by increased insurance losses. A significant portion of Clayton’s earnings are generated from lending activities, which in recent years benefitted from relatively low delinquency rates and loan losses and from declining borrowing costs attributable to lower average interest rates. As of December 31, 2016, Clayton Homes’ installment loan portfolio was approximately $13.3 billion and approximately 94% of the loan balances were current in terms of payment status.
Revenues and pre-tax earnings increased $266 million (8%) and $148 million (27%) in 2015, respectively, as compared to 2014. The revenue increase was primarily due to a 9% increase in home unit sales. The increase in earnings was primarily due to lower interest expense, improved manufacturing results, relatively low delinquency rates and lower loss rates on loan foreclosures. The decline in interest expense was primarily due to lower interest rates and to a lesser extent lower average balances.
Transportation equipment leasing
Transportation equipment leasing revenues increased $110 million (4.3%) in 2016 compared to 2015. The increase derived primarily from the acquisition of General Electric Company’s (“GE”) tank car fleet and its railcar repair services business in 2015 and increased rates and tank car additions. These increases were partly offset by lower utilization rates, unfavorable foreign currency effects, lower crane lease demand in North America and reduced volume related to oil and gas markets.
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Management’s Discussion and Analysis (Continued)
Finance and Financial Products (Continued)
Transportation equipment leasing (Continued)
Pre-tax earnings increased $50 million (5.5%) in 2016 compared to 2015. The increase was primarily attributable to revenue growth and lower depreciation rates on certain tank car assets, partially offset by higher repair costs and interest expense on new borrowings from a Berkshire financing subsidiary. Significant portions of transportation leasing expenses, such as depreciation, do not vary proportionately to revenue changes and therefore changes in revenues can disproportionately impact earnings.
Revenues increased 5% in 2015 compared to 2014. The increase reflected increased railcar lease rates, a larger fleet of railcars, higher volumes in our Australian crane business, increased over-the-road trailers on lease and gains on dispositions of trailers. These increases were partially offset by the unfavorable effects of foreign currency exchange attributable to a stronger U.S. Dollar and lower volumes in our North American crane leasing business due to declines in oil drilling activity. As previously mentioned, we acquired GE’s tank car fleet on September 30, 2015, which included approximately 25,000 tank cars. We also acquired several railcar repair and maintenance facilities at the end of 2015.
Pre-tax earnings increased $82 million (10%) in 2015 compared to 2014. The increase was primarily attributable to the positive impact of the revenue growth discussed above, which more than offset the unfavorable impact of foreign currency translation and higher railcar repair and warranty costs and depreciation attributable to a larger fleet size.
Other
Other finance activities include CORT furniture leasing, our share of the earnings of a commercial mortgage servicing business (“Berkadia”) in which we own a 50% interest, and interest and dividends from a portfolio of investments. Other earnings decreased $44 million in 2016 compared to 2015, reflecting lower earnings from investment securities, partly offset by increased earnings from CORT and Berkadia. Other earnings also includes income from interest rate spreads charged on borrowings by a Berkshire financing subsidiary that are used to finance Clayton Homes’ installment loans and beginning in 2016, UTLX’s fleet of rail/tank cars held for lease. Offsetting expenses ($74 million in 2016, $62 million in 2015 and $68 million in 2014) were included in Clayton Homes’ and UTLX’s results.
Investment and Derivative Gains/Losses
A summary of investment and derivative gains and losses and other-than-temporary impairment losses on investments follows (in millions).
| 2016 | 2015 | 2014 | ||||||||||
| Investment gains/losses | $ | 7,635 | $ | 9,399 | $ | 4,272 | ||||||
| Other-than-temporary impairments | (82 | ) | (26 | ) | (697 | ) | ||||||
| Derivative gains/losses | 751 | 974 | 506 | |||||||||
| Gains/losses before income taxes and noncontrolling interests | 8,304 | 10,347 | 4,081 | |||||||||
| Income taxes and noncontrolling interests | 1,807 | 3,622 | 760 | |||||||||
| Net gains/losses | $ | 6,497 | $ | 6,725 | $ | 3,321 | ||||||
Investment gains/losses
Investment gains/losses arise primarily from the sale, redemption or exchange of investments. The timing of gains or losses can have a material effect on periodic earnings. Investment gains and losses included in earnings usually have minimal impact on the periodic changes in our consolidated shareholders’ equity since most of our investments are recorded at fair value with the unrealized gains and losses included in shareholders’ equity as a component of accumulated other comprehensive income.
We believe the amount of investment gains/losses included in earnings in any given period typically has little analytical or predictive value. Our decisions to sell securities are not motivated by the impact that the resulting gains or losses will have on our reported earnings. Although we do not consider investment gains and losses as necessarily meaningful or useful in evaluating our periodic results, we are providing information to explain the nature of such gains and losses when reflected in our earnings.
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Management’s Discussion and Analysis (Continued)
Investment and Derivative Gains/Losses (Continued)
Investment gains/losses (Continued)
Pre-tax investment gains were $7.6 billion in 2016 and included gains of $2.4 billion from the sale to Mars Inc. of our Wrigley preferred stock investment, $610 million from the Kraft Heinz Preferred Stock redemption, $1.2 billion from the Dow Preferred Stock conversion into common stock, and $1.1 billion from the exchange of shares of P&G common stock for 100% of the common stock of Duracell. Income tax expense allocated to investment gains included a benefit from the reduction of certain deferred income tax liabilities in connection with the exchange of P&G common stock for Duracell. Pre-tax investment gains included non-cash holding gains related to our investment in Kraft Heinz of $6.8 billion in 2015. In connection with its acquisition of Kraft Foods on July 2, 2015, Kraft Heinz issued new shares of its common stock in exchange for the outstanding shares of Kraft Foods common stock, thus reducing Berkshire’s ownership interest in Kraft Heinz by approximately 50%. Under the equity method of accounting, such transactions are treated by the investor as if it sold a portion of its interests.
Pre-tax investment gains were $4.3 billion in 2014, which included gains of approximately $2.1 billion realized in connection with the exchanges of common stock of Phillips 66 and Graham Holdings Company for 100% of the common stock of a specified subsidiary of each of those companies. Each exchange transaction in 2016 and 2014 was structured as a tax-free reorganization under the Internal Revenue Code. As a result, no income taxes are payable on the excess of the fair value of the businesses received over the tax-basis of the common stock exchanged.
Other-than-temporary impairments (“OTTI”)
OTTI charges in 2016 and 2015 were not significant and in 2014 were $697 million, predominantly relating to our investment in equity securities of Tesco PLC. Although we have periodically recorded OTTI charges in earnings in past years, we continue to hold some of those securities. If the market values of those investments increase following the date we recorded OTTI charges, the increases are included in shareholders’ equity as a component of accumulated other comprehensive income and not in earnings. When recorded, OTTI charges have no impact whatsoever on the asset values otherwise recorded in our Consolidated Balance Sheets or on our consolidated shareholders’ equity. In addition, the recognition of such losses in earnings rather than in accumulated other comprehensive income does not necessarily indicate that sales are planned and sales ultimately may not occur for a number of years. Furthermore, the recognition of OTTI charges does not necessarily indicate that the loss in value of the security is permanent or that the market price of the security will not subsequently increase to and ultimately exceed our original cost.
Derivative gains/losses
Derivative gains/losses primarily represented the changes in fair value of our credit default and equity index put option contract liabilities. The periodic changes in the fair values of these liabilities are recorded in earnings and can be significant, reflecting the volatility of underlying credit and equity markets and the changes in the inputs used to measure such liabilities.
Changes in the values of our equity index put option contract liabilities produced pre-tax gains of $662 million in 2016, which were primarily due to increases in the index values, favorable foreign currency exchange rate changes and shorter remaining contract durations, partly offset by lower interest rates. Our equity index put option contracts produced pre-tax gains of approximately $1.0 billion in 2015, which were primarily attributable to a stronger U.S. Dollar and shorter remaining durations. These contracts produced pre-tax gains of $108 million in 2014. Such gains reflected the favorable impact of foreign currency exchange rate changes and generally higher index values, partially offset by the effect of lower interest rate assumptions.
As of December 31, 2016, the aggregate intrinsic value of our equity put option contracts was approximately $1.0 billion and our recorded liability was approximately $2.9 billion. Our ultimate payment obligations, if any, under our equity index put option contracts will be determined as of the contract expiration dates (beginning in 2018), and will be based on the intrinsic value as defined under the contracts.
In July 2016, our remaining credit default contract was terminated by mutual agreement with the counterparty and we paid the counterparty $195 million. This contract produced pre-tax earnings of $89 million in 2016, pre-tax losses of $34 million in 2015 and pre-tax earnings of $397 million in 2014. We have no further exposure to losses under credit default contracts.
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Management’s Discussion and Analysis (Continued)
Other
A summary of after-tax other earnings (losses) which include corporate income (including income from our investments in Kraft Heinz), expenses and income taxes not allocated to operating businesses is summarized below (in millions).
| 2016 | 2015 | 2014 | ||||||||||
| Kraft Heinz earnings | $ | 706 | $ | 841 | $ | 653 | ||||||
| Acquisition accounting expenses | (846 | ) | (515 | ) | (531 | ) | ||||||
| Corporate interest expense | (97 | ) | (191 | ) | (153 | ) | ||||||
| Other | (106 | ) | (105 | ) | (114 | ) | ||||||
| Net earnings (losses) attributable to Berkshire Hathaway shareholders | $ | (343 | ) | $ | 30 | $ | (145 | ) | ||||
The reduced earnings in 2016 from our investments in Kraft Heinz were due to lower dividends from our Preferred Stock investment, which was redeemed in June 2016, somewhat offset by increased equity method earnings from our common stock investment. Other earnings also include charges from the application of the acquisition method in connection with Berkshire’s business acquisitions. Such charges were primarily from the amortization of intangible assets recorded in connection with those business acquisitions, which we view as corporate expenses. Corporate interest expense includes after-tax foreign exchange gains of $159 million in 2016 and losses of $45 million in 2015 with respect to Euro denominated debt issued by Berkshire in March 2015 (€3.0 billion par) and March 2016 (€2.75 billion par). Excluding foreign currency effects, after-tax corporate interest expense was $256 million in 2016 and $146 million in 2015. The increase in 2016 was attributable to increased average outstanding debt.
Financial Condition
Our balance sheet continues to reflect significant liquidity and a strong capital base. Our consolidated shareholders’ equity at December 31, 2016 was $283.0 billion, an increase of $27.5 billion since December 31, 2015. Net earnings attributable to Berkshire shareholders in 2016 were $24.1 billion. At December 31, 2016, our insurance and other businesses held cash, cash equivalents and U.S. Treasury Bills of $70.9 billion, and investments (excluding our investment in Kraft Heinz) of $158.3 billion.
In January 2016, we used cash of approximately $32.1 billion to fund the acquisition of PCC, which we funded through a combination of cash on hand and $10 billion borrowed under a 364-day revolving credit agreement. We repaid these borrowings following our issuance in March 2016, of €2.75 billion and $5.5 billion of senior unsecured notes. In August 2016, we issued $750 million of senior unsecured notes to replace $750 million of maturing notes. In January 2017, Berkshire issued new senior notes aggregating €1.1 billion and repaid $1.1 billion of maturing senior notes. There are no other parent company term debt maturities in 2017.
Our railroad, utilities and energy businesses (conducted by BNSF and BHE) maintain very large investments in capital assets (property, plant and equipment) and will regularly make significant capital expenditures in the normal course of business. In 2016, capital expenditures included $5.1 billion by BHE and $3.8 billion by BNSF. Aggregate capital expenditures of these businesses are forecasted to be $8.6 billion in 2017. We expect future capital expenditures will be funded by cash flows from operations and debt issuances.
BNSF’s outstanding debt was approximately $22.0 billion as of December 31, 2016, an increase of $307 million from December 31, 2015. Outstanding borrowings of BHE and its subsidiaries, excluding its borrowings from Berkshire insurance subsidiaries, were approximately $37.0 billion as of December 31, 2016, an increase of approximately $1.0 billion from December 31, 2015. BNSF and BHE debt maturities in 2017 will be $3.6 billion. Berkshire does not guarantee the repayment of debt issued by BNSF, BHE or any of their subsidiaries and is not committed to provide capital to support BNSF or BHE or any of their subsidiaries.
Finance and financial products assets were approximately $41.7 billion as of December 31, 2016, an increase of approximately $2.7 billion since December 31, 2015. Finance assets consist primarily of loans and finance receivables, various types of property held for lease, and cash, cash equivalents, U.S. Treasury Bills and other investments. In September 2016, a Berkshire finance subsidiary received approximately $4.6 billion from the sale of its Wrigley preferred stock investment.
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Management’s Discussion and Analysis (Continued)
Financial Condition (Continued)
Finance and financial products liabilities were approximately $19.7 billion as of December 31, 2016, an increase of approximately $2.5 billion compared to December 31, 2015. The increase was attributable to $3.5 billion of debt issued by Berkshire Hathaway Finance Corporation (“BHFC”) in March, partly offset by lower derivative contract liabilities. The debt proceeds were used to fund loans originated and acquired by Clayton Homes and to fund a portion of existing assets held for lease by our UTLX railcar leasing business. In January 2017, BHFC issued new senior notes aggregating $1.3 billion due in 2019 and 2020 and repaid $1.05 billion of maturing notes. Over the remainder of 2017, an additional $1.75 billion of BHFC senior notes will mature. While we currently intend to have BHFC issue additional notes in 2017 to replace the maturing debt, the amount to be issued will be based on prevailing market conditions.
Berkshire’s Board of Directors has authorized Berkshire to repurchase its Class A and Class B common shares at prices no higher than a 20% premium over the book value of the shares. Berkshire may repurchase shares at management’s discretion and there is no obligation to repurchase any shares. We expect the program to continue indefinitely. We will not repurchase shares if it reduces the total amount of Berkshire’s consolidated cash, cash equivalents and U.S. Treasury Bills holdings below $20 billion. Financial strength and redundant liquidity will always be of paramount importance at Berkshire. There were no share repurchases under the program in 2016.
Contractual Obligations
We are party to contracts associated with ongoing business and financing activities, which will result in cash payments to counterparties in future periods. Certain obligations are included in our Consolidated Balance Sheets, such as notes payable, which require future payments on contractually specified dates and in fixed and determinable amounts. Other obligations pertain to the acquisition of goods or services in the future, such as minimum rentals under operating leases and certain purchase obligations, and are not currently reflected in the financial statements, but will be recognized in future periods as the goods are delivered or services are provided.
The timing and/or amount of the payments under certain contracts are contingent upon the outcome of future events. Actual payments will likely vary, perhaps significantly, from estimates reflected in the table that follows. Most significantly, the timing and amount of future payments arising under property and casualty insurance and reinsurance contracts are contingent upon the outcome of claim settlement activities or events. In addition, obligations arising under life, annuity and health insurance benefits are contingent on future premiums, allowances, mortality, morbidity, expenses and policy lapse rates, as applicable. These amounts are included in the following table based on the liability estimates reflected in our Consolidated Balance Sheet as of December 31, 2016. Although certain insurance losses and loss adjustment expenses and life, annuity and health benefits are recoverable under reinsurance contracts, those receivables recorded in the Consolidated Balance Sheet are not reflected in the table.
A summary of contractual obligations as of December 31, 2016 follows (in millions).
| Estimated payments due by period | |||||||||||||||||||||||||
| Total | 2017 | 2018-2019 | 2020-2021 | After 2021 | |||||||||||||||||||||
| Notes payable and other borrowings, including interest | $ | 152,519 | $ | 14,038 | $ | 26,047 | $ | 14,396 | $ | 98,038 | |||||||||||||||
| Operating leases | 8,285 | 1,337 | 2,168 | 1,610 | 3,170 | ||||||||||||||||||||
| Purchase obligations (1) | 38,189 | 11,072 | 7,560 | 4,937 | 14,620 | ||||||||||||||||||||
| Losses and loss adjustment expenses (2) | 78,351 | 17,591 | 17,684 | 9,791 | 33,285 | ||||||||||||||||||||
| Life, annuity and health insurance benefits (3) | 30,705 | 1,299 | 323 | 490 | 28,593 | ||||||||||||||||||||
| Other | 13,173 | 2,221 | 909 | 1,639 | 8,404 | ||||||||||||||||||||
| Total | $ | 321,222 | $ | 47,558 | $ | 54,691 | $ | 32,863 | $ | 186,110 | |||||||||||||||
| (1) | Primarily obligations of BHE, BNSF and NetJets. |
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| (2) | Before reserve discounts of $1.4 billion. |
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| (3) | Amounts represent estimated undiscounted benefits, net of estimated future premiums, as applicable. |
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Management’s Discussion and Analysis (Continued)
Critical Accounting Policies
Certain accounting policies require us to make estimates and judgments that affect the amounts reflected in the Consolidated Financial Statements. Such estimates and judgments necessarily involve varying, and possibly significant, degrees of uncertainty. Accordingly, certain amounts currently recorded in the financial statements will likely be adjusted in the future based on new available information and changes in other facts and circumstances.
Property and casualty losses
We record liabilities for unpaid losses and loss adjustment expenses based upon estimates of the ultimate amounts payable for losses occurring on or before the balance sheet date. Except for certain workers’ compensation reinsurance claims, we record all liabilities for unpaid losses and loss adjustment expenses (referred to in this section as “gross unpaid losses”) in the Consolidated Balance Sheets without discounting for time value. The timing and amount of ultimate loss payments are contingent upon, among other things, the timing of claim reporting from insureds and ceding companies and the final determination of the loss amount through the loss adjustment process. We use a variety of techniques in establishing liabilities and all techniques require significant judgments and assumptions. We believe the processes and techniques utilized best suit the underlying claims and available data.
As of any balance sheet date, recorded liabilities include provisions for reported claims, as well as claims not yet reported and the development of reported claims. The period between the loss occurrence date and loss settlement date is the “claim-tail.” Property claims usually have relatively short claim-tails, absent litigation. Casualty claims usually have longer claim-tails, occasionally extending for decades. Casualty claims may be more susceptible to litigation and the impact of changing contract interpretations. The legal environment and judicial process further contributes to extending claim-tails. Our liabilities as of December 31, 2016 were $76.9 billion, of which 85% related to GEICO, General Re and BHRG. Additional information regarding significant uncertainties inherent in the processes and techniques of GEICO, General Re and BHRG follows.
GEICO
GEICO predominantly writes private passenger auto insurance. As of December 31, 2016, GEICO’s gross unpaid losses and loss adjustment expenses were $15.5 billion and unpaid losses net of reinsurance recoverable were $14.4 billion.
GEICO’s claim reserving methodologies produce liability estimates based upon the individual claims. The key assumptions affecting our liability estimates include projections of ultimate claim counts (“frequency”) and average loss per claim (“severity”). We utilize a combination of several actuarial estimation methods, including Bornhuetter-Ferguson and chain-ladder methodologies.
Liability estimates for automobile liability coverages (such as bodily injury (“BI”), uninsured motorists, and personal injury protection) are more uncertain due to the longer claim-tails, so we establish additional case development estimates. As of December 31, 2016, case development liabilities averaged approximately 25% of the case reserves. We select case development factors through analysis of the overall adequacy of historical case liabilities.
For unreported claims, IBNR liabilities are based on projections of the ultimate number of claims expected (reported and unreported) for each significant coverage. We use historical claim count data to develop age-to-age projections of the ultimate counts by quarterly accident period, from which we deduct reported claims to produce the number of unreported claims. We estimate the average costs per unreported claim and apply such estimates to the unreported claim counts, producing an IBNR liability estimate. We may record additional IBNR estimates when actuarial techniques are difficult to apply.
For significant coverages, we test the adequacy of the aggregate liabilities for unpaid losses using one or more actuarial projections based on claim closure models, and paid and incurred loss triangles. Each type of projection analyzes loss occurrence data for claims occurring in a given period and projects the ultimate cost.
Unpaid loss and loss adjustment expense liability estimates recorded at the end of 2015 developed downward by $61 million when reevaluated through December 31, 2016, which produced a corresponding increase to pre-tax earnings in 2016. We modified the assumptions used to estimate liabilities at December 31, 2016 as appropriate to reflect the most recent frequency and severity results. Future development of recorded liabilities will depend on whether actual frequency and severity are more or less than anticipated.
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Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
GEICO (Continued)
With respect to liabilities for BI claims, our most significant claim category, we believe it is reasonably possible that average severities will change by at least one percentage point from the severities used in establishing the recorded liabilities at December 31, 2016. We estimate that a one percentage point increase or decrease in BI severities would produce a $240 million increase or decrease in recorded liabilities, with a corresponding decrease or increase in pre-tax earnings. Many of the same economic forces that would likely cause BI severity to differ from expectations would likely also cause severities for other injury coverages to differ in the same direction.
General Re and BHRG
Liabilities for unpaid property and casualty losses and loss adjustment expenses of General Re and BHRG derive primarily from reinsurance contracts. In connection with reinsurance contracts, the nature, extent, timing and perceived reliability of information received from ceding companies varies widely depending on the type of coverage and the contractual reporting terms. Contract terms, conditions and coverages also tend to lack standardization and may evolve more rapidly than primary insurance policies.
The nature and extent of loss information provided under many facultative (individual risk), per occurrence excess or retroactive reinsurance contracts may not differ significantly from the information received under a primary insurance contract if reinsurer personnel either work closely with the ceding company in settling individual claims or manage the claims themselves. However, loss information is often less detailed with respect to aggregate excess-of-loss and quota-share contracts. Additionally, loss information we receive through periodic reports is often in a summary format rather than on an individual claim basis. Loss data includes recoverable paid losses, as well as case loss estimates. Ceding companies infrequently provide IBNR estimates to reinsurers.
Loss reporting to reinsurers is typically slower in comparison to primary insurers. Periodic premium and claims reports are required from ceding companies. In the U.S., such reports are generally required at quarterly intervals ranging from 30 to 90 days after the end of the accounting period. Outside of the U.S., reinsurance reporting practices may vary further. In certain countries, clients report annually, often 90 to 180 days after the end of the annual period. In some instances, reinsurers assume and cede underlying risks thereby creating multiple contractual intermediaries between us and the primary insured potentially compounding the claim reporting delays. The relative impact of reporting delays on the reinsurer may vary depending on the type of coverage, contractual reporting terms and the magnitude of the claim relative to the attachment point of the reinsurance contract and for other reasons.
The premium and loss data we receive is through at least one intermediary (the primary insurer), so there is a risk that the loss data reported is incomplete, inaccurate or the claim is outside the coverage terms. When received, we review the information for completeness and compliance with the contract terms. Generally, our reinsurance contracts permit us to access the ceding company’s books and records with respect to the subject business, thus providing the ability to audit the reported information.
In the normal course of business, disputes occasionally arise concerning whether claims are covered by our reinsurance policies. We resolve most coverage disputes through negotiation with the client. If disputes cannot be resolved, our contracts generally provide arbitration, litigation or alternative dispute resolution processes. There are no coverage disputes at this time for which an adverse resolution would likely have a material impact on our consolidated results of operations or financial condition.
General Re
Information concerning General Re’s gross and net unpaid losses and loss adjustment expenses as of December 31, 2016 follows (in millions).
| Type | Line of business | |||||||||
| Reported case liabilities | $ | 6,536 | Liability and workers’ compensation (1) | $ | 11,408 | |||||
| IBNR liabilities | 6,884 | Property | 2,012 | |||||||
| Gross unpaid losses and loss adjustment expenses | 13,420 | Total | $ | 13,420 | ||||||
| Reinsurance recoverable and deferred charges | (693 | ) | ||||||||
| Net unpaid losses and loss adjustment expenses | $ | 12,727 | ||||||||
| (1) | Net of discounts of approximately $1.4 billion. |
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Table of Contents
Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
General Re (Continued)
For General Re, the critical processes involved in estimating unpaid losses and loss adjustment expenses include the establishment of case liability estimates, the determination of expected loss ratios, which drive IBNR liability estimates, and the comparison of reported loss trends to the expected loss reporting patterns. Recorded liabilities are subject to “tail risk” where reported losses are beyond the expected loss emergence period.
Our process for estimating unpaid losses and loss adjustment expenses begins with case loss estimates made by the ceding company. Upon notification of a reinsurance claim from a ceding company, we independently evaluate the case losses reported and if appropriate, we use our own case liability estimate. As of December 31, 2016, our case loss estimates exceeded ceding company estimates by approximately $2.2 billion, which were concentrated in the workers’ compensation line. We also periodically conduct detailed reviews of individual client claims, which may cause us to adjust our case estimates.
In estimating IBNR liabilities, we consider expected case loss emergence and development patterns, together with expected loss ratios by year. In this process, we classify all loss and premium data into segments (“cells”) based primarily on product type (e.g., treaty, facultative and program), line of business (e.g., auto liability, property and workers’ compensation) and geographic jurisdiction. For each cell, we aggregate premiums and losses by accident year, policy year or underwriting year and analyze the data over time. There are several hundred cells. We use loss triangles to determine the expected development of reported claims for most coverages, which, together with the expected loss ratios, are used to calculate IBNR liability estimates. We select expected loss ratios by cell and by year based upon indicated ultimate loss ratios and forecasted losses obtained from pricing statistics. Indicated ultimate loss ratios are determined from the selected loss emergence pattern, reported losses and earned premiums. Factors affecting our loss development triangles include, but are not limited to, changes in the following: client claims practices; the frequency of client company claim reviews; policy terms and coverage (such as loss retention levels and occurrence and aggregate policy limits); loss trends, and legal trends that result in unanticipated losses. Collectively, these factors influence our selections of expected loss emergence patterns.
Once the IBNR liabilities are determined, we estimate the expected case loss emergence for the upcoming calendar year, based on the prior year-end expected loss emergence patterns and expected loss ratios. We allocate the expected losses into interim estimates, which we compare to actual reported losses. This comparison provides a test of the adequacy of prior year-end IBNR liabilities and forms the basis for possibly changing IBNR liability assumptions during the course of the year.
During 2016, we reduced net losses for prior years’ occurrences by $280 million in the aggregate. This reduction produced a corresponding increase in pre-tax earnings.
Reported claims for prior years’ property loss events were less than expected and we reduced our estimated ultimate liabilities by $157 million. However, property losses incurred during any given period may be more volatile because of the effect of catastrophe and large individual property loss events.
In 2016, reported nominal losses for prior years’ workers’ compensation were less than expected, which after reevaluating expected remaining IBNR estimates, resulted in a reduction of nominal liabilities by $165 million. However, we discount workers’ compensation liabilities and after adjusting for changes in discounts, workers’ compensation losses for prior years’ occurrences had a minimal impact on pre-tax earnings. An increase of ten percent in the tail of the expected loss emergence pattern and an increase of ten percent in the expected loss ratios would produce a net increase in discounted workers’ compensation IBNR liabilities of approximately $889 million, producing a corresponding decrease in pre-tax earnings. We believe it is reasonably possible for these assumptions to increase at these rates.
Other casualty and general liability reported losses (excluding mass tort losses) were less than expected in 2016, resulting in a $205 million increase in pre-tax earnings. However, casualty losses tend to be long-tailed and it should not be assumed that favorable loss experience in a given period will continue in the future. For our significant casualty and general liability cells, we estimate that an increase of five percent in the claim-tails of the expected loss emergence patterns and a five percent increase in expected loss ratios would produce a net increase in our nominal IBNR liabilities and a corresponding reduction in pre-tax earnings of approximately $900 million. While we believe it is reasonably possible for these assumptions to increase at these rates, more likely outcomes are less than $900 million given the diversification in worldwide business.
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Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
General Re (Continued)
Overall industry-wide loss experience data and informed judgment are used when internal loss data is of limited reliability, such as for mass tort, asbestos and hazardous waste (collectively, “mass tort”) liability estimates. General Re’s net liability for such losses at December 31, 2016, was approximately $1.2 billion, which included an increase in estimated ultimate losses of $98 million during 2016, which produced a corresponding reduction in pre-tax earnings. Mass tort loss estimations are difficult to determine due to the changing legal environment, and 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 addition to the previously described methodologies, we consider “survival ratios”, which is the average net claim payments in recent years in relation to net unpaid losses, as a rough guide to reserve adequacy. General Re’s survival ratio was approximately 15 years as of December 31, 2016.
BHRG
A summary of BHRG’s unpaid losses and loss adjustment expenses as of December 31, 2016 follows (in millions).
| Property | Casualty | Total | ||||||||||
| Reported case liabilities | $ | 1,556 | $ | 2,399 | $ | 3,955 | ||||||
| IBNR liabilities | 2,904 | 4,831 | 7,735 | |||||||||
| Retroactive reinsurance liabilities | — | 24,675 | 24,675 | |||||||||
| Gross unpaid losses and loss adjustment expenses | $ | 4,460 | $ | 31,905 | 36,365 | |||||||
| Deferred charges and reinsurance recoverable | (8,509 | ) | ||||||||||
| Net unpaid losses and loss adjustment expenses | $ | 27,856 | ||||||||||
We use a variety of actuarial methodologies to establish unpaid losses and loss adjustment expenses. Certain methodologies, such as paid and incurred loss development techniques, incurred and paid loss Bornhuetter-Ferguson techniques and frequency and severity techniques, are utilized, as well as ground-up techniques when appropriate.
A large percentage of BHRG’s unpaid losses and loss adjustment expenses derive from retroactive reinsurance contracts, which relate to loss events occurring before the contract inception date. Gross liabilities with respect to such contracts were approximately $24.7 billion at December 31, 2016, and were predominately for casualty and liability coverages. We expect the claim-tail related to certain of these contracts to be very long.
We establish aggregate liability estimates by individual contract, considering exposure and development trends. In establishing retroactive reinsurance liabilities, we often analyze historical aggregate loss payment patterns and project expected losses under various scenarios. We assign judgmental probability factors to these scenarios and an expected outcome is determined. We then monitor loss payment activity and review ceding company reports and other information concerning the underlying losses, and we re-estimate expected ultimate losses when significant events are reported or revealed.
Certain of our contracts include significant exposures to asbestos, environmental and other latent injury claims. We estimate that our liabilities for such claims were approximately $13.7 billion at December 31, 2016. We do not receive consistently reliable information regarding asbestos, environmental and latent injury claims data from all ceding companies, particularly with respect to multi-line or aggregate excess-of-loss policies. Periodically, we conduct a detailed analysis of the underlying loss data to make an estimate of ultimate reinsured losses. When detailed loss information is unavailable, we develop estimates by applying recent industry trends and projections to aggregate client data. Judgments in these areas necessarily consider the stability of the legal and regulatory environment under which we expect these claims will be adjudicated. Legal reform and legislation could also have a significant impact on our ultimate liabilities.
Changes in ultimate estimated liabilities for prior years’ retroactive reinsurance contracts were relatively insignificant in 2016, as were changes in the estimated timing and amount of remaining unpaid losses. In 2016, we paid losses and loss adjustment expenses of approximately $1.1 billion with respect to these contracts.
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Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
BHRG (Continued)
We currently believe that maximum losses payable under our retroactive policies will not exceed $40 billion due to the aggregate contract limits that are applicable to most of these contracts. Absent significant judicial or legislative changes affecting asbestos, environmental or latent injury exposures, we also currently believe it unlikely that losses will develop upward to the maximum loss payable or downward by more than 15% of our year-end estimate.
We also record deferred charges with respect to our retroactive reinsurance contracts, which at contract inception represents the excess, if any, of the estimated ultimate liability for unpaid losses over premiums. Unamortized deferred charges were approximately $8.0 billion at December 31, 2016, which will be amortized and charged to pre-tax earnings in the future based on the expected timing and amount of loss payments. Significant changes in such estimates may have a significant effect on unamortized deferred charges and the amount of periodic amortization. Based on the contracts in effect as of December 31, 2016, and the new AIG contract we currently estimate that amortization expense in 2017 will approximate $950 million.
Gross unpaid losses and loss adjustment expense liabilities related to property and casualty contracts, other than retroactive reinsurance, were approximately $11.7 billion as of December 31, 2016 and consisted primarily of traditional property and casualty coverages written primarily under excess-of-loss and quota-share treaties. These coverages included catastrophe and aviation contracts that tend to generate low frequency/high severity losses, although such liabilities have diminished in recent years due to declines in business written. 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.
We generally establish liabilities for unpaid losses and loss adjustments expenses for these contracts based upon loss estimates reported by ceding companies and IBNR reserves that are primarily a function of reported losses from ceding companies and anticipated loss ratios established on a portfolio basis, supplemented by management’s estimates of the impact of major catastrophe events as they become known. In 2016, we decreased estimated ultimate losses for prior years’ occurrences by approximately $585 million, which primarily derived from lower than expected losses reported by ceding companies. The decrease produced a corresponding increase in pre-tax earnings.
Derivative contract liabilities
We measure derivative contract liabilities at fair value. Our most significant derivative contract exposures relate to equity index put option contracts written between 2004 and 2008. We believe that the fair values produced for long-duration options are inherently subjective. Actual values in an exchange may differ significantly from the values produced by any mathematical model, as transaction values may also reflect perceptions of individual buyers and sellers as well as other changes in market conditions.
We determine the fair value of equity index put option contracts using a Black-Scholes based option valuation model. Inputs to the model include the current index value, strike price, interest rate, dividend rate and contract expiration date. The weighted average interest and dividend rates used as of December 31, 2016 were 1.2% and 3.3%, respectively. The interest rates were approximately 57 basis points (on a weighted average basis) over benchmark interest rates at the end of 2016 and represented our estimate of our nonperformance risk. We believe that the most significant economic risks under these contracts relate to changes in the index value component and, to a lesser degree, the foreign currency component.
The Black-Scholes based model also incorporates volatility estimates that measure potential price changes over time. Our contracts have an average remaining maturity of about four years. The weighted average volatility used as of December 31, 2016 was approximately 20.2%. We determine the weighted average volatilities based on the volatility input for each contract weighted by the contract’s notional value. The volatility input for each contract reflects our expectation of future price volatility. The potential impact from changes in our volatility assumptions are as follows. (Dollars in millions).
| Fair value at December 31, 2016 | $2,890 | ||||
| Hypothetical change in volatility | Hypothetical fair value | ||||
| Increase 2 percentage points | $ | 3,098 | |||
| Increase 4 percentage points | 3,319 | ||||
| Decrease 2 percentage points | 2,695 | ||||
| Decrease 4 percentage points | 2,516 |
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Management’s Discussion and Analysis (Continued)
Other Critical Accounting Policies
Our Consolidated Balance Sheet at December 31, 2016 included goodwill of acquired businesses of $79.5 billion. We evaluate goodwill for impairment at least annually and we conducted our most recent annual review during the fourth quarter of 2016. Our review includes determining the estimated fair values of our reporting units. There are several methods of estimating a reporting unit’s fair value, including market quotations, underlying asset and liability fair value determinations and other valuation techniques, such as discounted projected future net earnings or net cash flows and multiples of earnings. We primarily use discounted projected future earnings or cash flow methods. The key assumptions and inputs used in such methods may include forecasting revenues and expenses, operating cash flows and capital expenditures, as well as an appropriate discount rate and other inputs. A significant amount of judgment is required in estimating the fair value of a reporting unit and in performing goodwill impairment tests. Due to the inherent uncertainty in forecasting cash flows and earnings, actual results may vary significantly from the forecasts. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then, as required by GAAP, we estimate the fair values of the identifiable assets and liabilities of the reporting unit. The excess of the estimated fair value of the reporting unit over the estimated fair value of its net assets establishes the implied value of goodwill. The excess of the recorded amount of goodwill over the implied goodwill value is charged to earnings as an impairment loss.
Market Risk Disclosures
Our Consolidated Balance Sheets include substantial amounts of assets and liabilities whose fair values are subject to market risks. Our significant market risks are primarily associated with equity prices, interest rates, foreign currency exchange rates and commodity prices. The fair values of our investment portfolios and equity index put option contracts remain subject to considerable volatility. The following sections address the significant market risks associated with our business activities.
Equity Price Risk
Historically, equity securities have represented a significant portion of our investment portfolio. Strategically, we strive to invest in businesses that possess excellent economics and able and honest management and at sensible prices, and we prefer to invest a meaningful amount in each investee. Consequently, equity investments are concentrated in relatively few issuers. At December 31, 2016, approximately 60% of the total fair value of equity securities and other investments was concentrated in five issuers.
We often hold our equity investments for long periods and short-term price volatility has and will occur. We are not necessarily disturbed by market price declines provided the underlying business, economic and management characteristics of the investees remain favorable. We strive to maintain significant levels of shareholder capital and ample liquidity to provide a margin of safety against short-term price volatility.
Market prices for equity securities 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.
We are also subject to equity price risk with respect to our equity index put option contracts. While our ultimate liability with respect to these contracts is determined from the movement of the underlying stock index between the contract inception date and expiration date, fair values of these contracts are also affected by changes in other factors such as interest rates, expected dividend rates and the remaining duration of the contract.
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Management’s Discussion and Analysis (Continued)
Equity Price Risk (Continued)
The following table summarizes our equity securities and other investments and derivative contract liabilities with significant equity price risk as of December 31, 2016 and 2015. We also show the effects of a hypothetical 30% increase and a 30% decrease in market prices as of those dates. The selected 30% hypothetical changes does not reflect the best or worst case scenarios. Indeed, results could be far worse due both to the nature of equity markets and the aforementioned concentrations existing in our equity investment portfolio. Dollar amounts are in millions.
| Fair Value | Hypothetical Price Change | Estimated Fair Value after Hypothetical Change in Prices | Hypothetical Percentage Increase (Decrease) in Shareholders’ Equity | |||||||||||||||||
| December 31, 2016 | ||||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Equity securities | $ | 122,032 | 30% increase | $ | 158,642 | 8.4 | ||||||||||||||
| 30% decrease | 85,422 | (8.4 | ) | |||||||||||||||||
| Other investments (1) | 9,597 | 30% increase | 13,699 | 0.9 | ||||||||||||||||
| 30% decrease | 5,677 | (0.9 | ) | |||||||||||||||||
| Liabilities: | ||||||||||||||||||||
| Equity index put option contracts | 2,890 | 30% increase | 1,602 | 0.3 | ||||||||||||||||
| 30% decrease | 5,572 | (0.6 | ) | |||||||||||||||||
| December 31, 2015 | ||||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Equity securities | $ | 112,137 | 30% increase | $ | 145,778 | 8.6 | ||||||||||||||
| 30% decrease | 78,496 | (8.6 | ) | |||||||||||||||||
| Other investments (1) | 13,839 | 30% increase | 17,985 | 1.1 | ||||||||||||||||
| 30% decrease | 9,385 | (1.1 | ) | |||||||||||||||||
| Liabilities: | ||||||||||||||||||||
| Equity index put option contracts | 3,552 | 30% increase | 2,044 | 0.4 | ||||||||||||||||
| 30% decrease | 6,561 | (0.8 | ) |
| (1) | Excludes other investments that do not possess significant equity price risk. |
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Interest Rate Risk
We regularly invest in bonds, loans or other interest rate sensitive instruments. Our strategy is to acquire securities that are attractively priced relative to the perceived credit risk. Our management recognizes and accepts that losses may occur. We also issue debt in the ordinary course of business to fund business operations, business acquisitions and for other general purposes. We strive to maintain high credit ratings so as to minimize the cost of our debt. We rarely utilize derivative products, such as interest rate swaps, to manage interest rate risks.
The fair values of our fixed maturity investments and notes payable and other borrowings will fluctuate in response to changes in market interest rates. In addition, changes in interest rate assumptions used in our equity index put option contract models cause changes in reported liabilities with respect to those contracts. Increases and decreases in interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the creditworthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions. The fair values of fixed interest rate instruments are usually more sensitive to interest rate changes than variable rate instruments.
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Management’s Discussion and Analysis (Continued)
Interest Rate Risk (Continued)
The following table summarizes the estimated effects of hypothetical changes in interest rates on our significant assets and liabilities that are subject to interest rate risk. We assumed that the interest rate changes occur immediately and uniformly to each category of instrument containing interest rate risk, and that there are no significant changes to other factors used to determine the value of the instrument. The hypothetical changes in interest rates do not reflect the best or worst case scenarios. Variations in interest rates could produce significant changes in the timing of repayments due to prepayment options available to the issuer. For these reasons, actual results might differ from those reflected in the table. Dollars are in millions.
| Estimated Fair Value after Hypothetical Change in Interest Rates | |||||||||||||||||||||||||
| (bp=basis points) | |||||||||||||||||||||||||
| Fair Value | 100 bp decrease | 100 bp increase | 200 bp increase | 300 bp increase | |||||||||||||||||||||
| December 31, 2016 | |||||||||||||||||||||||||
| Assets: | |||||||||||||||||||||||||
| Investments in fixed maturity securities | $ | 23,465 | $ | 24,120 | $ | 22,893 | $ | 22,428 | $ | 21,985 | |||||||||||||||
| Other investments (1) | 7,659 | 8,095 | 7,213 | 6,780 | 6,367 | ||||||||||||||||||||
| Loans and finance receivables | 13,717 | 14,230 | 13,237 | 12,790 | 12,370 | ||||||||||||||||||||
| Liabilities: | |||||||||||||||||||||||||
| Notes payable and other borrowings: | |||||||||||||||||||||||||
| Insurance and other | 27,712 | 29,475 | 26,154 | 24,770 | 23,533 | ||||||||||||||||||||
| Railroad, utilities and energy | 65,774 | 72,261 | 60,302 | 55,634 | 51,624 | ||||||||||||||||||||
| Finance and financial products | 15,825 | 16,408 | 15,318 | 14,872 | 14,476 | ||||||||||||||||||||
| Equity index put option contracts | 2,890 | 3,287 | 2,533 | 2,213 | 1,928 | ||||||||||||||||||||
| December 31, 2015 | |||||||||||||||||||||||||
| Assets: | |||||||||||||||||||||||||
| Investments in fixed maturity securities | $ | 26,027 | $ | 26,618 | $ | 25,351 | $ | 24,733 | $ | 24,164 | |||||||||||||||
| Other investments (1) | 11,394 | 11,571 | 10,664 | 10,228 | 9,814 | ||||||||||||||||||||
| Loans and finance receivables | 13,112 | 13,594 | 12,661 | 12,240 | 11,844 | ||||||||||||||||||||
| Liabilities: | |||||||||||||||||||||||||
| Notes payable and other borrowings: | |||||||||||||||||||||||||
| Insurance and other | 14,773 | 15,589 | 13,979 | 13,287 | 12,679 | ||||||||||||||||||||
| Railroad, utilities and energy | 62,471 | 68,625 | 57,279 | 52,833 | 49,006 | ||||||||||||||||||||
| Finance and financial products | 12,363 | 12,942 | 11,860 | 11,420 | 11,032 | ||||||||||||||||||||
| Equity index put option contracts | 3,552 | 4,110 | 3,059 | 2,624 | 2,242 |
| (1) | Excludes other investments that are not subject to a significant level of interest rate risk. |
|---|
Foreign Currency Risk
Certain of our subsidiaries operate in foreign jurisdictions and we transact business in foreign currencies. In addition, we hold investments in common stocks of major multinational companies, such as The Coca-Cola Company, who have significant foreign business and foreign currency risk of their own. We generally do not attempt to match assets and liabilities by currency and do not use derivative contracts to hedge or manage foreign currency price changes in any meaningful way. Our net assets subject to financial statement translation into U.S. Dollars are primarily in our insurance, utilities and energy and certain manufacturing and services subsidiaries. This translation related impact may be offset by gains or losses related to net liabilities of Berkshire and certain of its U.S. subsidiaries that are denominated in foreign currencies, including gains and losses from the remeasurement of such liabilities due to changes in exchange rates.
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Management’s Discussion and Analysis (Continued)
Commodity Price Risk
Our subsidiaries use commodities in various ways in manufacturing and providing services. As such, we are subject to price risks related to various commodities. In most instances, we attempt to manage these risks through the pricing of our products and services to customers. To the extent that we are unable to sustain price increases in response to commodity price increases, our operating results will likely be adversely affected. We utilize derivative contracts to manage commodity price risks at BHE.
BHE’s exposures to commodities include variations in the price of fuel required to generate electricity, wholesale electricity purchased and sold and natural gas supply for customers. Commodity prices are subject to wide price swings as supply and demand are impacted by, among many other unpredictable items, weather, market liquidity, generating facility availability, customer usage, storage and transmission and transportation constraints.
To mitigate a portion of the price volatility, BHE uses derivative instruments, including forwards, futures, options, swaps and other agreements, to effectively secure future supply or sell future production generally at fixed prices. The settled cost of these contracts is generally recoverable from customers in regulated rates. Financial results would be negatively impacted if the costs of wholesale electricity, fuel or natural gas are greater than what is permitted to be recovered in rates. The table that follows summarizes commodity price risk on energy derivative contracts of BHE as of December 31, 2016 and 2015 and shows the effects of a hypothetical 10% increase and a 10% decrease in forward market prices by the expected volumes for these contracts as of each date. The selected hypothetical change does not reflect the best or worst case scenarios. Dollars are in millions.
| Fair Value Net Assets (Liabilities) | Hypothetical Price Change | Estimated Fair Value after Hypothetical Change in Price | ||||||
| December 31, 2016 | $ | (87) | 10% increase | $(18) | ||||
| 10% decrease | (156) | |||||||
| December 31, 2015 | $ | (233) | 10% increase | $(152) | ||||
| 10% decrease | (313) |
FORWARD-LOOKING STATEMENTS
Investors are cautioned that certain statements contained in this document as well as some statements in periodic press releases and some oral statements of Berkshire officials during presentations about Berkshire or its subsidiaries 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. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects and possible future Berkshire 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 Berkshire and its subsidiaries, economic and market factors and the industries in which we do business, among other things. These statements are not guarantees of future performance and we have 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 important risk factors that could cause our 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 our investments in fixed maturity and equity securities, losses realized from derivative contracts, the occurrence of one or more catastrophic events, such as an earthquake, hurricane, act of terrorism or cyber attack that causes losses insured by our insurance subsidiaries and/or losses to our business operations, changes in laws or regulations affecting our insurance, railroad, utilities and energy and finance subsidiaries, 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 we do business.
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