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
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).
| 2017 | 2016 | 2015 | ||||||||||
| Insurance – underwriting | $ | (2,219 | ) | $ | 1,370 | $ | 1,162 | |||||
| Insurance – investment income | 3,917 | 3,636 | 3,725 | |||||||||
| Railroad | 3,959 | 3,569 | 4,248 | |||||||||
| Utilities and energy | 2,083 | 2,287 | 2,132 | |||||||||
| Manufacturing, service and retailing | 6,208 | 5,631 | 4,683 | |||||||||
| Finance and financial products | 1,335 | 1,427 | 1,378 | |||||||||
| Investment and derivative gains/losses | 1,377 | 6,497 | 6,725 | |||||||||
| Other | (826 | ) | (343 | ) | 30 | |||||||
| Tax Cuts and Jobs Act of 2017 | 29,106 | — | — | |||||||||
| Net earnings attributable to Berkshire Hathaway shareholders | $ | 44,940 | $ | 24,074 | $ | 24,083 | ||||||
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 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. The business segment data (Note 23 to the accompanying Consolidated Financial Statements) should be read in conjunction with this discussion.
Our net earnings in 2017 included approximately $29.1 billion attributable to a one-time net benefit from the enactment of the Tax Cuts and Jobs Act (“TCJA”) on December 22, 2017. See Note 16 to the Consolidated Financial Statements. This benefit included approximately $29.6 billion related to a one-time non-cash reduction of our net deferred income tax liabilities that arose from the reduction in the statutory U.S. corporate income tax rate from 35% to 21%, as well as a net benefit of approximately $900 million primarily from our earnings from Kraft Heinz, partly offset by a one-time income tax expense of approximately $1.4 billion payable over eight years on the deemed repatriation of certain accumulated undistributed earnings of foreign subsidiaries. Due to their significance, we presented these one-time effects as a distinct item in the preceding table. Accordingly, the after-tax figures presented in the discussion of our various operating businesses and other activities in this section exclude the one-time effects of the TCJA.
Our insurance businesses generated after-tax losses from underwriting of $2.2 billion in 2017 compared to after-tax gains of $1.4 billion in 2016 and $1.2 billion in 2015. Underwriting results for 2017 included estimated pre-tax losses of approximately $3.0 billion ($1.95 billion after-tax), primarily attributable to three major hurricanes in the U.S. and Puerto Rico and wildfires in California. Underwriting results in each year also included after-tax foreign currency exchange rate gains and losses from the revaluation of certain non-U.S. Dollar denominated reinsurance liabilities. In 2017, such after-tax losses were $295 million compared to after-tax gains of $458 million in 2016 and $164 million in 2015.
After-tax earnings of our railroad business in 2017 were $4.0 billion, an increase of 10.9% compared to 2016, reflecting increased unit volume. Our railroad business generated lower net earnings in 2016 compared to 2015, primarily due to a 5.0% decline in unit volume. After-tax earnings of our utility and energy business in 2017 declined $204 million compared to 2016. Earnings in 2017 were negatively affected by losses from the prepayment of certain long-term debt. After-tax earnings of our utilities and energy businesses increased in 2016 compared to 2015, attributable to increased pre-tax earnings and a lower effective income tax rate.
After-tax earnings of our manufacturing, service and retailing businesses in 2017 were $6.2 billion, an increase of 10.2% compared to 2016. Earnings in 2017 reflected comparatively higher earnings from several of our larger operations and the impact of businesses acquired in 2016 and 2017. After-tax earnings in 2016 of our manufacturing, service and retailing businesses increased compared to 2015, primarily due to earnings from Precision Castparts, which was acquired on January 29, 2016, partly offset by comparatively lower overall earnings from the other businesses within this group.
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Management’s Discussion and Analysis (Continued)
Results of Operations (Continued)
After-tax investment and derivative gains were approximately $1.4 billion in 2017, $6.5 billion in 2016 and $6.7 billion in 2015. The gains in 2016 included approximately $2.7 billion from the redemptions of our Wrigley and Kraft Heinz preferred stock investments, sales of Dow Chemical common stock that we received upon conversion of our Dow Chemical preferred stock investment and a non-cash gain of approximately $1.9 billion related to the exchange of Procter & Gamble (“P&G”) common stock for 100% of the common stock of Duracell. Gains in 2015 included non-cash holding gains of approximately $4.4 billion in connection with our investment in Kraft Heinz common stock.
After-tax unrealized gains in 2017 related to our investments in equity securities included in other comprehensive income were approximately $19 billion. Beginning in 2018, unrealized gains and losses on equity securities will be included in net earnings due to a new accounting standard. We believe that investment and derivative gains/losses, whether realized from sales or unrealized from changes in market prices, are often meaningless in terms of understanding our reported results or evaluating our periodic economic performance. Investment and derivative gains and losses have caused and will continue to cause significant volatility in our earnings.
Other earnings in 2017 and 2016 included after-tax foreign currency exchange rate gains and losses related to parent company Euro-denominated debt. After-tax foreign exchange losses on our Euro-denominated debt were $655 million in 2017 compared to after-tax gains of $159 million in 2016. In addition, other earnings includes earnings from our investment in Kraft Heinz.
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, 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, while investing decisions are the responsibility of Berkshire’s Chairman and CEO, Warren E. Buffett and Berkshire’s corporate investment managers. Accordingly, we evaluate performance of underwriting operations without any allocation of investment income or investment gains/losses. We consider investment income as a component of our aggregate insurance operating results. However, we consider investment gains and losses, whether realized or unrealized as non-operating, based on our long-held philosophy of acquiring securities and holding those securities for long periods. Accordingly, we believe that such gains and losses are not predictable or necessarily meaningful in understanding the operating results of our insurance operations.
The timing and amount of catastrophe losses can produce significant volatility in our periodic underwriting results, particularly with respect to our reinsurance businesses. Generally, we consider pre-tax catastrophe losses in excess of $100 million from a current year event as significant, and we had six such events in 2017. There were no significant events in either 2016 or 2015. Changes in estimates for unpaid losses and loss adjustment expenses, including amounts established for occurrences in prior years can also significantly affect our periodic underwriting results. Unpaid loss estimates, including estimates under retroactive reinsurance contracts as of December 31, 2017 were approximately $104 billion. These estimates will be revised upward or downward in future periods, which could produce significant decreases or increases 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 due to 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).
| 2017 | 2016 | 2015 | ||||||||||
| Underwriting gain (loss): | ||||||||||||
| GEICO | $ | (310 | ) | $ | 462 | $ | 460 | |||||
| Berkshire Hathaway Reinsurance Group | (3,648 | ) | 1,012 | 553 | ||||||||
| Berkshire Hathaway Primary Group | 719 | 657 | 824 | |||||||||
| Pre-tax underwriting gain (loss) | (3,239 | ) | 2,131 | 1,837 | ||||||||
| Income taxes and noncontrolling interests | (1,020 | ) | 761 | 675 | ||||||||
| Net underwriting gain (loss) | $ | (2,219 | ) | $ | 1,370 | $ | 1,162 | |||||
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
GEICO
GEICO writes private passenger automobile insurance, offering coverages to insureds in all 50 states and the District of Columbia. GEICO markets its policies mainly by direct response methods where most customers apply for coverage directly to the company via the Internet or over the telephone. A summary of GEICO’s underwriting results follows (dollars in millions).
| 2017 | 2016 | 2015 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 30,547 | $ | 26,309 | $ | 23,378 | ||||||||||||||||||
| Premiums earned | $ | 29,441 | 100.0 | $ | 25,483 | 100.0 | $ | 22,718 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 25,497 | 86.6 | 21,044 | 82.6 | 18,647 | 82.1 | ||||||||||||||||||
| Underwriting expenses | 4,254 | 14.5 | 3,977 | 15.6 | 3,611 | 15.9 | ||||||||||||||||||
| Total losses and expenses | 29,751 | 101.1 | 25,021 | 98.2 | 22,258 | 98.0 | ||||||||||||||||||
| Pre-tax underwriting gain (loss) | $ | (310 | ) | $ | 462 | $ | 460 | |||||||||||||||||
Premiums written in 2017 were $30.5 billion, an increase of 16.1% compared to 2016. Premiums earned in 2017 were $29.4 billion, exceeding 2016 by approximately $4.0 billion (15.5%). During 2017, our voluntary auto policies-in-force grew approximately 8.6% and premiums per auto policy increased 6.9%. The increase in average premiums per policy was attributable to rate increases, coverage changes and changes in state and risk mix. Voluntary auto new business sales in 2017 increased 10.5% compared to 2016. Voluntary auto policies-in-force increased approximately 1,276,000 during 2017.
We incurred pre-tax underwriting losses in 2017, which included approximately $450 million from hurricanes Harvey and Irma. Our underwriting results in 2017 were also affected by increased average claims severities. Losses and loss adjustment expenses in 2017 were $25.5 billion, an increase of approximately $4.5 billion (21.2%) compared to 2016. Our loss ratio (the ratio of losses and loss adjustment expenses to earned premiums) in 2017 increased 4.0 percentage points compared to 2016. Average claims severities were higher in 2017 for property damage and collision coverages (four to six percent range) and bodily injury coverage (five to seven percent range). Claims frequencies in 2017 were relatively unchanged compared to 2016 for bodily injury coverage, decreased about one percent for property damage and collision coverages and decreased about two to three percent for personal injury protection coverage. Losses and loss adjustment expenses in 2017 also included pre-tax losses of $517 million from the re-estimation of liabilities for prior years’ claims compared to pre-tax gains of $61 million in 2016 and $150 million in 2015.
Underwriting expenses increased $277 million (7.0%) compared to 2016. Our expense ratios (underwriting expenses to premiums earned) in 2017 declined 1.1 percentage points compared to 2016. The largest components of underwriting expenses are employee-related (salaries and benefits) and advertising, which increased at lower rates than premiums earned.
Premiums written in 2016 increased 12.5% to $26.3 billion and premiums earned increased approximately $2.8 billion (12.2%) to $25.5 billion, compared to 2015. These increases reflected voluntary auto policies-in-force growth of 7% and increased average premiums per auto policy. Voluntary auto new business sales in 2016 increased 10.9% compared to the prior year. Voluntary auto new business growth 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 and our loss ratio in 2016 increased 0.5 percentage points compared to 2015. In 2016, we experienced increases in storm losses (primarily from hail and flooding) and claims severity, partly offset by the effects of premium rate increases. Claims frequencies in 2016 were relatively unchanged from 2015 for property damage, collision, bodily injury and personal injury protection coverages. Average claims severities were higher in 2016 for bodily injury, physical damage and collision coverages (four to six percent range). Underwriting expenses in 2016 were $4.0 billion, an increase of $366 million (10.1%) over 2015. The increase in underwriting expenses in 2016 reflected the increase in policies-in-force.
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Berkshire Hathaway Reinsurance Group
We offer excess-of-loss and quota-share reinsurance coverages on property and casualty risks and life and health reinsurance to insurers and reinsurers worldwide through several legal entities, led by National Indemnity Company (“NICO Group”), Berkshire Hathaway Life Insurance Company of Nebraska (“BHLN Group”), and General Reinsurance Corporation, General Reinsurance AG and General Re Life Corporation (collectively, “General Re Group”). We also periodically assume property and casualty risks under retroactive reinsurance contracts written through NICO. In addition, the BHLN Group writes periodic payment annuity contracts.
With the exception of our retroactive reinsurance and periodic payment annuity businesses, we strive to generate pre-tax underwriting profits in all product lines. Time-value-of-money concepts are important elements in establishing prices for our retroactive reinsurance and periodic payment annuity businesses due to the expected long durations of the liabilities. We expect to incur pre-tax underwriting losses from such businesses, primarily through deferred charge amortization and discount accretion charges. Premiums received at inception under these contracts are often large, which are then available for investment. A summary of the premiums and pre-tax underwriting results of our reinsurers follows (in millions).
| Premiums written | Premiums earned | Pre-tax underwriting gain (loss) | ||||||||||||||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | ||||||||||||||||||||||||||||
| Property/casualty | $ | 7,713 | $ | 6,993 | $ | 7,427 | $ | 7,552 | $ | 7,218 | $ | 7,221 | $ | (1,595) | $ | 895 | $ | 1,095 | ||||||||||||||||||
| Retroactive reinsurance | 10,755 | 1,254 | 5 | 10,755 | 1,254 | 5 | (1,330) | (60) | (470) | |||||||||||||||||||||||||||
| 18,468 | 8,247 | 7,432 | 18,307 | 8,472 | 7,226 | (2,925) | 835 | 625 | ||||||||||||||||||||||||||||
| Life/health | 4,846 | 4,588 | 4,665 | 4,808 | 4,587 | 4,670 | (52) | 305 | 130 | |||||||||||||||||||||||||||
| Periodic payment annuity | 898 | 1,082 | 1,286 | 898 | 1,082 | 1,286 | (671) | (128) | (202) | |||||||||||||||||||||||||||
| 5,744 | 5,670 | 5,951 | 5,706 | 5,669 | 5,956 | (723) | 177 | (72) | ||||||||||||||||||||||||||||
| $ | 24,212 | $ | 13,917 | $ | 13,383 | $ | 24,013 | $ | 14,141 | $ | 13,182 | $ | (3,648) | $ | 1,012 | $ | 553 | |||||||||||||||||||
Property/casualty
A summary of premiums and underwriting results of our property/casualty reinsurance businesses follows (in millions).
| Premiums written | Premiums earned | Pre-tax underwriting gain (loss) | ||||||||||||||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | ||||||||||||||||||||||||||||
| NICO Group | $ | 4,371 | $ | 4,433 | $ | 4,702 | $ | 4,451 | $ | 4,649 | $ | 4,416 | $(1,044) | $ | 767 | $ | 944 | |||||||||||||||||||
| General Re Group | 3,342 | 2,560 | 2,725 | 3,101 | 2,569 | 2,805 | (551) | 128 | 151 | |||||||||||||||||||||||||||
| $ | 7,713 | $ | 6,993 | $ | 7,427 | $ | 7,552 | $ | 7,218 | $ | 7,221 | $(1,595) | 895 | 1,095 | ||||||||||||||||||||||
NICO Group’s premiums earned were $4.4 billion, a decrease of $198 million (4%) in 2017 compared to 2016, while premiums written declined slightly. Roughly 40% of NICO Group’s premiums written and earned in 2017 and 2016 derived from a 10-year, 20% quota-share contract with Insurance Australia Group Ltd. (“IAG”) that incepted in July 2015. General Re Group’s premiums earned were $3.1 billion in 2017, an increase of $532 million (21%) compared to 2016. The increase reflected higher written premiums in both direct and broker markets, derived primarily from new business and increased participations for renewal business. Industry capacity dedicated to property and casualty markets remains high and price competition in most reinsurance markets persists. We continue to decline business when we believe prices are inadequate.
On a combined basis, our property/casualty reinsurance business sustained pre-tax underwriting losses of $1.6 billion in 2017. We incurred estimated losses of approximately $2.4 billion in 2017 from several significant catastrophe loss events occurring during the year including hurricanes Harvey, Irma and Maria, an earthquake in Mexico, a cyclone in Australia and wildfires in California. There were no significant catastrophe loss events in 2016 or 2015.
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Property/casualty (Continued)
On a combined basis, we also decreased estimated ultimate claims liabilities for prior years’ loss events by $295 million in 2017 compared to $955 million in 2016. The comparative decline reflected higher than expected reported property claims and the effects of increases in certain United Kingdom (“U.K.”) claim liabilities attributable to the U.K. Ministry of Justice’s decision in the first quarter of 2017 to reduce the fixed discount rate required in lump sum settlement calculations of U.K. personal injury claims, known as the Ogden rate, from 2.5% to negative 0.75%. The Ogden rate is subject to adjustment in the future at the discretion of the U.K. Government and significant changes in that rate may have a significant effect on our claim liability estimates.
NICO Group’s premiums earned in 2016 increased $233 million (5%) compared to 2015 reflecting the impact of the IAG quota-share contract, partly offset by declines from other business, while General Re Group’s premiums earned declined $236 million (8%) versus 2015. The decline in General Re Group’s premiums earned was primarily due to lower volume in direct and broker market business.
Our property/casualty reinsurers produced pre-tax underwriting gains of $895 million in 2016 and $1,095 million in 2015. On a combined basis, we decreased estimated ultimate claims liabilities for prior years’ loss events by $955 million in 2016 and $1.2 billion in 2015. These decreases were primarily attributable to lower than expected reported losses from ceding companies with respect to property coverages. Pre-tax underwriting results in 2016 and 2015 included discount accretion related to certain workers’ compensation claim liabilities of $80 million in 2016 and $82 million in 2015. There was no effect from discounting on 2017 results, as the practice of discounting these related liabilities was discontinued in 2017.
Retroactive reinsurance
Premiums earned in 2017 included $10.2 billion from an aggregate excess-of-loss retroactive reinsurance agreement with various subsidiaries of American International Group, Inc. (the “AIG Agreement”). At the inception of the AIG Agreement, we also recorded losses and loss adjustment expenses incurred of $10.2 billion, representing our initial estimate of the unpaid losses and loss adjustment expenses assumed of $16.4 billion, partly offset by an initial deferred charge asset of $6.2 billion. Thus, on the effective date, the AIG Agreement had no effect on our pre-tax underwriting results. In the fourth quarter of 2017, we increased our ultimate claim liability estimates related to the AIG Agreement by approximately $1.8 billion based on higher than expected loss payments being reported under the contractual retention, which affected our estimate of our liability. We also increased the related deferred charge asset by $1.7 billion based on our re-estimation of the amount and timing of our recorded liabilities.
Certain liabilities related to retroactive reinsurance contracts written by our U.S. subsidiaries are denominated in foreign currencies. Underwriting results included pre-tax losses of $264 million in 2017 and pre-tax gains of $392 million in 2016 and $150 million in 2015 associated with the re-measurement of such liabilities due to changes in foreign currency exchange rates, primarily related to the Great Britain Pound Sterling (“GBP”).
Pre-tax underwriting losses before foreign currency gains/losses were $1,066 million in 2017, $452 million in 2016 and $620 million in 2015 derived from deferred charge amortization and changes in the timing and amount of ultimate losses. Pre-tax losses in 2017 increased compared to 2016, due to amortization charges related to new contracts, including the AIG Agreement, partly offset by lower amortization on prior years’ contracts. Changes in estimated ultimate liabilities for prior years’ contracts were relatively insignificant in 2017 and 2016. During 2015, we increased estimated ultimate liabilities approximately $550 million for prior years’ contracts. The increase in estimated ultimate liabilities, net of related deferred charge adjustments, produced incremental pre-tax underwriting losses of approximately $90 million in 2015.
Gross unpaid losses assumed under retroactive reinsurance contracts were approximately $42.9 billion at December 31, 2017 and $25.0 billion at December 31, 2016. Unamortized deferred charge assets related to such reinsurance contracts were approximately $15.3 billion at December 31, 2017 and $8.0 billion at December 31, 2016. The increases in unpaid losses and deferred charges were predominantly attributable to the AIG Agreement. Our deferred charge asset balances will be amortized as charges to pre-tax earnings over the expected remaining claims settlement period.
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Life/health
Premiums earned and pre-tax underwriting results of our life/health reinsurance businesses are further summarized as follows (in millions).
| Premiums earned | Pre-tax underwriting gain (loss) | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | |||||||||||||||||||
| General Re Group | $ | 3,306 | $ | 3,068 | $ | 3,170 | $ | (369 | ) | $ | 73 | $ | (18 | ) | ||||||||||
| BHLN Group | 1,502 | 1,519 | 1,500 | 317 | 232 | 148 | ||||||||||||||||||
| $ | 4,808 | $ | 4,587 | $ | 4,670 | $ | (52 | ) | $ | 305 | $ | 130 | ||||||||||||
General Re Group’s premiums earned increased $238 million (8%) in 2017 compared to 2016, which reflected growth in the U.S., Asia, Europe and Australia markets. Premiums earned declined $102 million (3%) in 2016 compared to 2015, primarily attributable to foreign currency translation effects and lower volume in Canada, partly offset by increased volume in the United Kingdom and Asia markets. Approximately 65% of BHLN Group’s premiums earned in each of the past three years was derived primarily from a single yearly renewable term life agreement in the U.S. with a major reinsurer.
The General Re Group produced pre-tax underwriting losses of $369 million in 2017, gains of $73 million in 2016 and losses of $18 million in 2015. Pre-tax underwriting losses in 2017 included losses of approximately $450 million from the run-off of our U.S. long-term care business driven by discount rate reductions and changes in other actuarial assumptions in the fourth quarter, which increased our estimated benefit liabilities. 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 the long-term care business as compared to 2015.
BHLN Group’s pre-tax underwriting results included pre-tax gains of $256 million in 2017, $231 million in 2016 and $193 million in 2015 from the run-off of variable annuity business (reinsurance contracts that provide guarantees on closed blocks of variable annuity business). Periodic underwriting results from this business reflect changes in remaining liabilities for guaranteed benefits, resulting from changes in securities markets and interest rates and from the periodic amortization of expected profit margins. Periodic underwriting results from these variable annuity contracts can be volatile, reflecting the volatility of securities markets, interest rates and foreign currency exchange rates. Estimated liabilities for variable annuity guarantees were approximately $1.8 billion at December 31, 2017 and $2.1 billion at December 31, 2016. BHLN Group’s life reinsurance business produced pre-tax gains of $61 million in 2017 and $1 million in 2016 and losses of $45 million in 2015.
Periodic payment annuity
Periodic payment annuity premiums earned declined $184 million (17%) in 2017 compared to 2016, due to lower volumes. Premiums earned decreased $204 million (16%) in 2016 compared to 2015. Premiums earned in 2015 included $425 million from a single reinsurance contract.
Certain periodic payment annuity liabilities are denominated in foreign currencies, primarily the GBP. Underwriting results included pre-tax losses of $190 million in 2017 and pre-tax gains of $313 million in 2016 and $103 million in 2015 associated with the re-measurement of such liabilities due to changes in exchange rates.
Before foreign currency gains and losses, pre-tax underwriting losses from periodic payment annuity contracts were $481 million in 2017, $441 million in 2016 and $305 million in 2015. These losses were primarily attributable to the recurring discount accretion on new business and existing liabilities and the impact of lower interest rates in 2017 and 2016, which increased expected future loss payments under certain reinsurance contracts in those years. Discounted annuity liabilities were approximately $11.2 billion at December 31, 2017 and $9.8 billion at December 31, 2016. The weighted average annual discount rate for these liabilities was approximately 4.1% as of December 31, 2017.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
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 Berkshire Hathaway Specialty Insurance (“BH Specialty”), Berkshire Hathaway Homestate Companies (“BHHC”), MedPro Group, Berkshire Hathaway GUARD Insurance Companies (“GUARD”), and National Indemnity Company (“NICO Primary”). Other BH Primary insurers include U.S. Liability Insurance Company, Applied Underwriters and Central States Indemnity Company. A summary of BH Primary underwriting results follows (dollars in millions).
| 2017 | 2016 | 2015 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 7,483 | $ | 6,684 | $ | 5,906 | ||||||||||||||||||
| Premiums earned | $ | 7,143 | 100.0 | $ | 6,257 | 100.0 | $ | 5,394 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 4,511 | 63.1 | 3,864 | 61.8 | 3,070 | 56.9 | ||||||||||||||||||
| Underwriting expenses | 1,913 | 26.8 | 1,736 | 27.7 | 1,500 | 27.8 | ||||||||||||||||||
| Total losses and expenses | 6,424 | 89.9 | 5,600 | 89.5 | 4,570 | 84.7 | ||||||||||||||||||
| Pre-tax underwriting gain | $ | 719 | $ | 657 | $ | 824 | ||||||||||||||||||
Premiums written in 2017 increased 12.0% compared to 2016. All of the significant BH Primary insurers generated increased premiums written, led by GUARD (26%), BH Specialty (23%) and BHHC (9%). Premiums earned were $7.1 billion in 2017, an increase of $886 million (14.2%) compared to 2016. BH Primary’s 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.
BH Primary produced pre-tax underwriting gains of $719 million in 2017, $657 million in 2016 and $824 million in 2015. BH Primary’s overall loss ratios were 63.1% in 2017, 61.8% in 2016 and 56.9% in 2015. Losses and loss adjustment expenses in 2017 included approximately $225 million (3% of premiums earned) related to the significant catastrophe events, primarily hurricanes Harvey and Irma. Losses and loss adjustment expenses also included net reductions of estimated ultimate liabilities for prior years’ loss events of $766 million in 2017, $503 million in 2016 and $643 million in 2015, which produced corresponding increases in pre-tax underwriting gains. The reductions of prior years’ estimates in each year primarily related to healthcare malpractice and workers’ compensation business. BH Primary writes significant levels of liability and workers’ compensation business and the related claim costs may be subject to higher severity and longer claims-tails, which could contribute to significant increases in claims liabilities in the future attributable to higher than expected claim settlements, adverse litigation or judicial rulings and other factors we have not anticipated.
Insurance—Investment Income
A summary of net investment income generated from investments held by our insurance operations follows (in millions).
| 2017 | 2016 | 2015 | ||||||||||
| Interest income | $ | 1,310 | $ | 930 | $ | 888 | ||||||
| Dividend income | 3,592 | 3,552 | 3,662 | |||||||||
| Investment income before taxes and noncontrolling interests | 4,902 | 4,482 | 4,550 | |||||||||
| Income taxes and noncontrolling interests | 985 | 846 | 825 | |||||||||
| Net investment income | $ | 3,917 | $ | 3,636 | $ | 3,725 | ||||||
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Table of Contents
Management’s Discussion and Analysis (Continued)
Insurance—Investment Income (Continued)
Pre-tax investment income increased $420 million (9%) in 2017 compared to 2016, attributable to an increase in interest income which reflected higher interest rates on short-term investments and increased other investment income. Pre-tax investment income in 2016 declined $68 million (1.5%) compared to 2015, reflecting lower dividend income attributable to portfolio changes, partly offset by an increase in interest income. We continue to hold significant amounts of cash and cash equivalents and U.S. Treasury Bills earning low yields. We believe that maintaining ample liquidity is paramount and we insist on safety over yield with respect to such balances.
Dividend income in 2017 was relatively unchanged compared to 2016 reflecting increased dividend rates and increased overall investment levels, offset by the impact of the conversion of our $3 billion investment in Dow Chemical Company (“Dow”) 8.5% preferred stock into Dow common stock at the end of 2016. Prior to its conversion, we received dividends of $255 million per annum. In December 2017, RBI redeemed our $3 billion investment in 9% RBI Preferred stock investment, which will negatively affect investment income in 2018 when compared to 2017.
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 and loss adjustment expenses, including liabilities under retroactive reinsurance contracts, life, annuity and health benefit liabilities, unearned premiums and other liabilities due to policyholders, less premium and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated $114 billion at December 31, 2017 and $91 billion at December 31, 2016. The increase in float in 2017 reflected increases in unpaid losses and loss adjustment expenses, including liabilities assumed under retroactive reinsurance contracts written in 2017 and estimated liabilities related to catastrophe events, and overall growth of our insurance operations, partly offset by an increase in deferred charges on retroactive reinsurance contracts. Our pre-tax underwriting losses were approximately $3.2 billion in 2017 and our average cost of float was approximately 3.0%. During the prior fourteen years, the cost of float was negative 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, 2017 and 2016 follows (in millions).
| December 31, | ||||||||
| 2017 | 2016 | |||||||
| Cash, cash equivalents and U.S. Treasury Bills | $ | 73,285 | $ | 48,888 | ||||
| Equity securities | 163,134 | 134,144 | ||||||
| Fixed maturity securities | 21,092 | 22,778 | ||||||
| $ | 257,511 | $ | 205,810 | |||||
Fixed maturity investments as of December 31, 2017 were as follows (in millions).
| Amortized cost | Unrealized gains/losses | Carrying value | ||||||||||
| U.S. Treasury, U.S. government corporations and agencies | $ | 3,968 | $ | (22 | ) | $ | 3,946 | |||||
| States, municipalities and political subdivisions | 840 | 7 | 847 | |||||||||
| Foreign governments | 8,570 | 250 | 8,820 | |||||||||
| Corporate bonds, investment grade | 5,395 | 392 | 5,787 | |||||||||
| Corporate bonds, non-investment grade | 698 | 190 | 888 | |||||||||
| Mortgage-backed securities | 714 | 90 | 804 | |||||||||
| $ | 20,185 | $ | 907 | $ | 21,092 | |||||||
U.S. government obligations are rated AA+ or Aaa by the major rating agencies. Approximately 88% 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).
| 2017 | 2016 | 2015 | ||||||||||
| Revenues | $ | 21,387 | $ | 19,829 | $ | 21,967 | ||||||
| Operating expenses: | ||||||||||||
| Compensation and benefits | 4,969 | 4,769 | 5,043 | |||||||||
| Fuel | 2,518 | 1,934 | 2,656 | |||||||||
| Purchased services | 2,514 | 2,418 | 2,546 | |||||||||
| Depreciation and amortization | 2,352 | 2,128 | 2,001 | |||||||||
| Equipment rents, materials and other | 1,690 | 1,895 | 2,018 | |||||||||
| Total operating expenses | 14,043 | 13,144 | 14,264 | |||||||||
| Interest expense | 1,016 | 992 | 928 | |||||||||
| 15,059 | 14,136 | 15,192 | ||||||||||
| Pre-tax earnings | 6,328 | 5,693 | 6,775 | |||||||||
| Income taxes | 2,369 | 2,124 | 2,527 | |||||||||
| Net earnings | $ | 3,959 | $ | 3,569 | $ | 4,248 | ||||||
Consolidated revenues were $21.4 billion in 2017, representing an increase of $1.6 billion (7.9%) versus 2016. Pre-tax earnings increased 11.2% in 2017 compared to 2016. During 2017, consolidated revenues reflected a 2.4% comparative increase in average revenue per car/unit and a 5.3% increase in volume. Our volume was 10.3 million cars/units in 2017 compared to 9.8 million in 2016. Our overall volume growth moderated in the second half of the year compared to the growth experienced in the first half of the year. While we believe the general economy will continue to be strong in 2018, we expect a slower pace of volume growth. The increase in average revenue per car/unit was primarily attributable to higher fuel surcharge revenue, increased rates per car/unit and business mix changes.
Revenues from consumer products were $7.1 billion in 2017, representing an increase of 8.8% compared to 2016, reflecting volume increases of 6.3% as well as higher average revenue per car/unit. The volume increases were primarily attributable to improving economic conditions, normalizing of retail inventories, new services and higher market share, which benefited domestic intermodal, international intermodal and automotive volumes.
Revenues from industrial products were $5.1 billion in 2017, an increase of 7.7% from 2016, attributable to a volume increase of 5.0% as well as higher average revenue per car/unit. Volumes in 2017 were higher for sand and other commodities that support drilling. In addition, broad strengthening in the industrial sector drove greater demand for steel and taconite. These volume increases were partially offset by lower petroleum products volume due to pipeline displacement of U.S. crude rail traffic.
Revenues from agricultural products increased 1.8% to $4.3 billion in 2017 compared to 2016, primarily due to higher average revenue per car/unit. Volumes were relatively flat, primarily due to higher shipments of domestic grain, as well as ethanol and other grain products, offset by lower grain exports.
Revenues from coal increased 13.7% to $3.8 billion in 2017 compared to 2016. This increase reflected higher average revenue per car/unit as well as 6.3% higher volumes. The volume increases in 2017 were due to continued effects of higher natural gas prices, which led to increased utility coal usage. This was partially offset by the effects of unit retirements at coal generating facilities, increased renewable generation and coal inventory adjustments at customer facilities.
Operating expenses were $14.0 billion in 2017, an increase of $899 million (6.8%) compared to 2016. Our ratio of operating expenses to revenues decreased 0.6 percentage points to 65.7% in 2017 versus 2016. Compensation and benefits expenses increased $200 million (4.2%) compared to 2016. The increase was primarily due to higher health and welfare costs and volume-related increases, partially offset by lower headcount. Fuel expenses increased $584 million (30.2%) compared to 2016 primarily due to higher average fuel prices and increased volumes.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Railroad (“Burlington Northern Santa Fe”) (Continued)
Depreciation and amortization expense increased $224 million (10.5%) compared to 2016 due to a larger base of depreciable assets in service. Equipment rents, materials and other expense declined $205 million (10.8%) compared to 2016. These declines resulted from the impact of the enactment of the TCJA on an equity method subsidiary, as well as lower personal injury and casualty related costs.
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. The decrease in revenue reflected comparative declines 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 business mix changes.
Revenues from consumer products were $6.5 billion in 2016, a decline of 0.9% from 2015, reflecting 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, partially offset by lower international intermodal volumes.
Revenues from industrial products were $4.8 billion in 2016, a decline of 14.2% compared with 2015. The decrease was attributable to lower volumes, primarily for petroleum products, reflecting pipeline displacement of U.S. crude rail traffic and lower U.S. oil production. In addition, we experienced lower demand for steel and taconite, partially offset by increased plastics products volume.
Revenues from agricultural products remained relatively unchanged in 2016 at $4.2 billion compared to 2015. Agricultural product volume increased by 6.3%, primarily due to higher corn, soybean and wheat exports, which offset a decrease in average revenue per car/unit.
Revenues from coal decreased 26.9% to $3.4 billion in 2016 compared to 2015, reflecting a 21.1% decline in volumes and a lower average rate per car/unit. Demand for coal declined due to reduced energy consumption, coal unit retirements, high coal stockpiles and low natural gas prices.
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.
Utilities and Energy (“Berkshire Hathaway Energy Company”)
We hold a 90.2% 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.
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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 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | |||||||||||||||||||
| PacifiCorp | $ | 5,276 | $ | 5,245 | $ | 5,279 | $ | 1,131 | $ | 1,105 | $ | 1,026 | ||||||||||||
| MidAmerican Energy Company | 2,906 | 2,668 | 2,554 | 372 | 392 | 292 | ||||||||||||||||||
| NV Energy | 3,048 | 2,925 | 3,382 | 567 | 559 | 586 | ||||||||||||||||||
| Northern Powergrid | 950 | 997 | 1,141 | 311 | 367 | 460 | ||||||||||||||||||
| Natural gas pipelines | 1,009 | 986 | 1,018 | 446 | 413 | 401 | ||||||||||||||||||
| Other energy businesses | 2,294 | 2,223 | 2,321 | 381 | 377 | 394 | ||||||||||||||||||
| Real estate brokerage | 3,456 | 2,815 | 2,536 | 220 | 225 | 191 | ||||||||||||||||||
| Corporate interest | — | — | — | (844 | ) | (465 | ) | (499 | ) | |||||||||||||||
| $ | 18,939 | $ | 17,859 | $ | 18,231 | |||||||||||||||||||
| Pre-tax earnings | 2,584 | 2,973 | 2,851 | |||||||||||||||||||||
| Income taxes and noncontrolling interests | 501 | 686 | 719 | |||||||||||||||||||||
| Net earnings attributable to Berkshire Hathaway shareholders | $ | 2,083 | $ | 2,287 | $ | 2,132 | ||||||||||||||||||
PacifiCorp
PacifiCorp operates a regulated electric utility in portions of several Western states, including Utah, Oregon and Wyoming. Revenues increased 1% in 2017 compared to 2016. Wholesale and other revenues increased, reflecting higher volumes and average rates, and retail revenues decreased slightly, attributable to lower average rates, partly offset by higher volumes. Pre-tax earnings increased $26 million (2%) in 2017 as compared to 2016. The increase in earnings reflected higher gross margins (operating revenues less cost of sales), lower operations and maintenance expenses, and increased depreciation and amortization attributable to additional plant in-service.
Revenues were $5.25 billion in 2016, a slight decline from 2015, reflecting 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. Pre-tax earnings in 2016 increased $79 million (7.7%) from 2015, primarily due to increased gross margins, reflecting lower fuel prices and changes in fuel mix.
MidAmerican Energy Company
MEC operates a regulated electric and natural gas utility primarily in Iowa and Illinois. Revenues increased $238 million (9%) in 2017 as compared to 2016, primarily attributable to higher electric operating revenues ($123 million) and increased natural gas operating revenues ($82 million). Our retail electric revenues increased $84 million in 2017 compared to 2016, primarily attributable to higher recoveries through bill riders (which are substantially offset by increases in costs of sales and other expenses) and from non-weather usage and growth and rate factors, partially offset by the unfavorable impact of milder temperatures in 2017. Our wholesale electric and other revenues increased $39 million in 2017 versus 2016, attributable to comparative increases in volumes, average rates and transmission fees. The natural gas operating revenues increase was primarily due to higher average per-unit costs of gas sold, which was offset by an increase in cost of sales. Pre-tax earnings declined $20 million (5%) in 2017 compared to 2016, reflecting increased depreciation, maintenance and other operating expenses and interest expense and debt extinguishment costs, partially offset by comparative increases in electric gross sales margins of $76 million.
Revenues increased $114 million (4.5%) in 2016 compared to 2015, primarily due to increased electric revenues ($148 million), partially 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 natural gas revenue decline was primarily due to lower average per-unit costs of gas sold ($42 million), partly offset by higher wholesale volumes. Pre-tax earnings increased $100 million (34.2%) in 2016 compared to 2015. The increase in pre-tax earnings 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.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
NV Energy
NV Energy operates regulated electric and natural gas utilities in Nevada. Revenues increased $123 million (4%) in 2017 compared to 2016. The increase was due primarily to an increase in retail electric operating revenues, which included a combination of increased rates from pass-through cost adjustments and higher volumes, partly offset by lower revenues from energy efficiency programs (offset by lower operating expenses). NV Energy also experienced retail electric revenue declines from the transition of certain commercial and industrial customers electing to purchase power from alternative sources and thus becoming distribution service only customers. Natural gas operating revenue declined $11 million in 2017, primarily due to lower rates, partially offset by higher customer usage. Pre-tax earnings increased $8 million (1%) in 2017 compared to 2016, primarily due to lower interest expenses.
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 were relatively unchanged. Pre-tax earnings declined $27 million (4.6%) in 2016 compared to 2015. The decline was primarily due to an increase in operating expenses of $39 million, partly offset by a decrease in interest expense of $17 million. The increase in operating expenses reflected higher depreciation and amortization and reductions of certain accrued liabilities in 2015.
Northern Powergrid
Revenues declined $47 million (5%) in 2017 compared to 2016. Unfavorable foreign currency translation effects of a comparatively stronger U.S. Dollar in 2017 resulted in a $48 million comparative decline in revenues, substantially all of which occurred in the first half of the year. Otherwise, we experienced comparative declines in distribution revenues, which were substantially offset by higher smart metering revenue. Pre-tax earnings declined $56 million (15%) in 2017 compared to the same period in 2016. The decline was primarily due to foreign currency translation effects, as well as from increased pension expenses and lower distribution revenues, partially offset by lower asset impairment charges and lower distribution costs.
Revenues declined $144 million (12.6%) in 2016 compared to 2015, primarily due to the impact of a stronger U.S. Dollar ($127 million) and lower distribution revenues. Pre-tax earnings 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.
Natural Gas Pipelines
Revenues increased $23 million (2%) in 2017 compared to 2016. Northern Natural Gas produced higher transportation revenues and higher gas sales, primarily from system balancing activities (largely offset in cost of sales), which were partly offset by lower transportation revenues at Kern River. Pre-tax earnings increased $33 million (8%) in 2017 compared to 2016. The increase was primarily due to the increase in transportation revenues and a reduction in expenses and regulatory liabilities related to the impact of an alternative rate structure approved by Kern River’s regulators in the first quarter of 2017, partially offset by higher operating expenses.
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. Pre-tax earnings 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.
Other energy businesses
Revenues increased 3% in 2017 compared to 2016. AltaLink’s operating revenues increased $197 million (39%) in 2017 compared to 2016, primarily due to effects of a decision in 2016 by its regulator, which changed the timing of when construction-in-progress expenditures included in the rate base are billable to customers and earned in revenues. The decision resulted in a one-time net reduction in revenue in 2016, with offsetting reductions in expenses. In 2017, we also experienced a comparative revenue increase of 13% from renewable energy and a comparative decline of 12% from the unregulated retail services business. Pre-tax earnings in 2017 were relatively unchanged from 2016, as increased earnings from renewable energy and AltaLink were offset by lower earnings from the unregulated retail services business and other energy ventures.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
Other energy businesses (Continued)
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 revenue decline reflected the impact of the aforementioned regulatory decision by AltaLink’s regulator. Pre-tax earnings 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.
Real estate brokerage
Revenues increased 23% in 2017 compared to 2016, primarily due to business acquisitions and an increase in average home sales prices. Pre-tax earnings decreased 2% in 2017 as compared to 2016. Earnings in 2017 included increased earnings from franchise businesses, partially offset by lower earnings from brokerage businesses, primarily due to higher operating expenses.
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. Pre-tax earnings increased $34 million (17.8%) in 2016 compared to 2015, primarily due to the increases in mortgage revenues.
Corporate interest and income taxes
Corporate interest includes interest on unsecured debt issued by BHE and borrowings from Berkshire insurance subsidiaries in connection with BHE’s acquisitions of NV Energy and AltaLink. Corporate interest in 2017 included pre-tax charges of $410 million from a tender offer completed in December 2017 to redeem certain long-term debt of BHE. Otherwise, corporate interest declined 7% in 2017 and 2016 compared to the corresponding prior years, primarily due to lower average borrowings.
BHE’s consolidated effective income tax rates were approximately 7% in 2017, 14% in 2016 and 16% in 2015. BHE’s effective income tax rates regularly reflect significant production tax credits from wind-powered electricity generation placed in service. In addition, income tax rates applicable to Northern Powergrid and AltaLink were lower than the U.S. statutory income tax rate. The effective tax rate in 2017 decreased primarily due to an increase in recognized production tax credits.
Manufacturing, Service and Retailing
A summary of revenues and earnings of our manufacturing, retailing and service businesses follows (in millions).
| Revenues | **Earnings *** | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | |||||||||||||||||||
| Manufacturing | $ | 50,445 | $ | 46,506 | $ | 36,136 | $ | 6,861 | $ | 6,211 | $ | 4,893 | ||||||||||||
| Service and retailing | 76,088 | 73,553 | 71,689 | 2,382 | 2,251 | 2,222 | ||||||||||||||||||
| $ | 126,533 | $ | 120,059 | $ | 107,825 | |||||||||||||||||||
| Pre-tax earnings | 9,243 | 8,462 | 7,115 | |||||||||||||||||||||
| Income taxes and noncontrolling interests | 3,035 | 2,831 | 2,432 | |||||||||||||||||||||
| $ | 6,208 | $ | 5,631 | $ | 4,683 | |||||||||||||||||||
| * | Excludes certain acquisition accounting expenses, which primarily related to the amortization of identified intangible assets recorded in connection with our business acquisitions. The after-tax acquisition accounting expenses excluded from earnings above were $896 million in 2017, $771 million in 2016 and $476 million in 2015. These expenses are included in “Other” in the summary of earnings on page K-32 and in the “Other” earnings section on page K-51. |
|---|
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 (“CTB”)), and a variety of industrial products for diverse markets (Marmon, Scott Fetzer and LiquidPower Specialty Products (“LSPI”)). 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.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Manufacturing (Continued)
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 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | |||||||||||||||||||
| Industrial products | $ | 26,376 | $ | 24,702 | $ | 16,760 | $ | 4,367 | $ | 4,209 | $ | 2,994 | ||||||||||||
| Building products | 11,936 | 10,772 | 10,316 | 1,382 | 1,178 | 1,167 | ||||||||||||||||||
| Consumer products | 12,133 | 11,032 | 9,060 | 1,112 | 824 | 732 | ||||||||||||||||||
| $ | 50,445 | $ | 46,506 | $ | 36,136 | $ | 6,861 | $ | 6,211 | $ | 4,893 | |||||||||||||
Revenues of our manufacturers were approximately $50.4 billion in 2017, an increase of approximately $3.9 billion (8.5%) over 2016, which increased approximately $10.4 billion (28.7%) over 2015. Pre-tax earnings were approximately $6.9 billion in 2017, an increase of $650 million (10.5%) over 2016 and earnings in 2016 increased $1.3 billion (26.9%) compared to 2015.
Industrial products
Industrial products revenues were approximately $26.4 billion in 2017, an increase of approximately $1.7 billion (6.8%) versus 2016, reflecting increased revenues at several of our businesses. PCC’s revenues increased $754 million (9%) in 2017 compared to the eleven month post-acquisition period in 2016. On a comparable full year-to-date basis, PCC’s revenues increased approximately 2.3% compared to 2016, reflecting increases in aerospace and oil and gas markets, partially offset by declines in other power markets. In 2017, PCC produced revenue increases from structural castings, airfoils and forged products and from business acquisitions, partly offset by lower revenues from airframe products and industrial gas turbine products used in power markets. PCC continues to transition into product lines for new programs within the aerospace markets, which we expect will produce future revenue increases, but may have negative effects on revenues in the near term as prior programs wind down.
IMC’s revenues increased 13%, primarily due to increased customer demand and unit sales and from business acquisitions. The global demand for cutting tools was generally higher in 2017. Marmon’s revenues increased $349 million (7%) in 2017 versus 2016, primarily due to business acquisitions and higher average metal prices, partly offset by lower overall volumes and changes in mix. Marmon’s highway transportation, retail food and restaurant equipment businesses experienced volume-based revenue growth in 2017, which was more than offset by declines at the engineered wire/cable and retail store products businesses. Lubrizol’s revenues increased $165 million (3%) compared to 2016, primarily due to higher unit volumes, partly offset by effects of the disposition of an underperforming business in 2016. CTB’s revenues increased 5% in 2017 compared to 2016. The increase reflected the impact of a bolt-on business acquisition, partly offset by weak demand in the U.S. egg and poultry production markets and selling price pressures for grain storage systems.
Pre-tax earnings of our industrial products businesses in 2017 increased $158 million (3.8%) compared to 2016. Overall, pre-tax earnings as a percentage of revenues were 16.6% in 2017 and 17.0% in 2016.
PCC’s pre-tax earnings decreased 12.5% in 2017 compared to the post-acquisition period in 2016, primarily due to certain one-time inventory and impairment charges that were recorded in the fourth quarter of 2017. Pre-tax earnings from IMC and Marmon increased in 2017 compared to 2016, due to a combination of increased sales, increased manufacturing efficiencies, the effects of business acquisitions and ongoing expense control efforts. Lubrizol’s pre-tax earnings increased 17% in 2017 compared to 2016 due to comparatively lower earnings charges related to the disposition in 2016 of an underperforming bolt-on business and ongoing cost containment efforts, partly offset by lower gross sales margins, which were primarily attributable to higher average raw material prices. In 2017, average raw material prices at Lubrizol, including base oil feedstock and petrochemicals, increased about 9% versus 2016.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Industrial products (Continued)
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 related to the aforementioned disposition 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 earnings in 2016 reflected the negative effects of a combination of weaker customer demand, sales price and mix changes, and increased restructuring costs, partially offset by the favorable effects of cost containment initiatives and lower average material prices.
Building products
Building products revenues were approximately $11.9 billion in 2017, an increase of approximately $1.2 billion (10.8%) compared to 2016. Approximately half of the increase was attributable to bolt-on business acquisitions by Shaw and MiTek. The remainder of the increase reflected sales volume increases at MiTek, Benjamin Moore and Johns Manville, partly offset by changes in prices and product mix.
Pre-tax earnings were $1.4 billion in 2017, an increase of $204 million (17.3%) compared to 2016. The comparative earnings increase reflected the fact that approximately $107 million of asset impairment, pension settlement and environmental claim charges were recorded in 2016 by Shaw and Benjamin Moore. The comparative earnings increase also was a result of bolt-on acquisitions, partly offset by comparative declines in average gross sales margin rates due to higher raw material and other production costs.
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 substantially offset by increased charges for asset impairments, pension settlements and environmental claims.
Consumer products
Consumer products revenues were approximately $12.1 billion in 2017, an increase of $1.1 billion (10%) compared to 2016, driven by comparative revenue increases from Duracell and Forest River. Duracell’s revenues increased 25.3% in 2017 compared to the ten-month post-acquisition period in 2016. Forest River’s revenues increased 13.7% in 2017 compared to 2016, reflecting a 13.5% comparative increase in units sold. Apparel and footwear revenues were approximately $4.2 billion in 2017, an increase of 1.6% compared to 2016.
Pre-tax earnings increased $288 million (35%) in 2017 compared to 2016. The increase in earnings was primarily due to increased earnings from Duracell and Forest River. Pre-tax earnings from Duracell were $82 million in 2017, compared to a pre-tax loss of $89 million in 2016, which included significant transition costs arising from the acquisition. The improvement in operating results in 2017 reflects an overall reduction in transition costs and the positive effects of ongoing restructuring and business development efforts. Forest River’s earnings increased 23% in 2017, primarily attributable to the increase in sales and lower manufacturing overhead rates. Earnings from apparel and footwear businesses increased 5% in 2017 compared to 2016, primarily due to increased earnings from the footwear businesses.
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, primarily attributable to increased unit sales. Apparel revenues declined $81 million (1.9%) in 2016 compared to 2015, reflecting lower footwear sales and the impact of a divestiture by Fruit of the Loom.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Consumer products (Continued)
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. In 2016, Duracell incurred a pre-tax loss of approximately $89 million primarily due to significant 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.
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 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | |||||||||||||||||||
| Service | $ | 11,249 | $ | 10,386 | $ | 10,201 | $ | 1,298 | $ | 1,161 | $ | 1,156 | ||||||||||||
| Retailing | 15,064 | 15,092 | 13,265 | 785 | 659 | 564 | ||||||||||||||||||
| McLane Company | 49,775 | 48,075 | 48,223 | 299 | 431 | 502 | ||||||||||||||||||
| $ | 76,088 | $ | 73,553 | $ | 71,689 | $ | 2,382 | $ | 2,251 | $ | 2,222 | |||||||||||||
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). Other service businesses include the electronic distribution of corporate news, multimedia and regulatory filings (Business Wire), publication of newspapers (Buffalo News and the BH Media Group) and operation of a television station in Miami, Florida (WPLG). Also included in this group is a third party logistics business that primarily serves the petroleum and chemical industries (Charter Brokerage).
Service business revenues were $11.2 billion in 2017, an increase of $863 million (8%) compared to 2016, primarily attributable to comparative increases at TTI and NetJets. TTI’s sales increased 16% in 2017 compared to 2016, primarily due to higher customer demand. NetJets’ revenues increased due to an increase in revenue flight hours and increased aircraft management service revenues.
Pre-tax earnings were $1.3 billion in 2017, an increase of $137 million (12%) compared to 2016. The comparative increase in earnings was primarily attributable to increased earnings of NetJets and TTI, partly offset by lower earnings from FlightSafety, as well as our media and logistics businesses.
Revenues increased 1.8% to $10.4 billion in 2016, 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 sales 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.
Retailing
Our retailers include Berkshire Hathaway Automotive (“BHA”), which we acquired in the first quarter of 2015. BHA includes over 80 auto dealerships that sell new and pre-owned automobiles, and offer repair services and related products. BHA also operates two insurance businesses, two auto auctions and an automotive fluid maintenance products distributor. Our retailing businesses also include four home furnishings retailing businesses (Nebraska Furniture Mart, R.C. Willey, Star Furniture and Jordan’s), which sell furniture, appliances, flooring and electronics.
K-47
Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Retailing (Continued)
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 were $15.1 billion in 2017, slightly lower than 2016. BHA’s aggregate revenues, which represented 63% of our total retailing revenues, declined 1.3% in 2017 compared to 2016, due primarily to a 3.7% decline in new and used cars sold, partly offset by higher service and finance and insurance revenues. Revenues of our other retailers increased 1.7% in 2017 compared to 2016.
Pre-tax earnings increased $126 million (19%) in 2017 as compared to 2016. The increase reflected comparatively higher earnings from BHA, primarily due to increased earnings from finance and insurance activities and lower selling and administrative expenses, partly offset by lower auto sales volumes and margins. Pre-tax earnings of our home furnishings retailers increased 6.5% in 2017 compared to 2016. Pampered Chef also produced comparatively higher earnings in 2017, primarily attributable to revenue increases and expense management efforts.
Retailing revenues increased $1.8 billion (13.8%) in 2016 to $15.1 billion as compared to 2015. The acquisitions of BHA and Louis 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.
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 Walmart, 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.
McLane’s revenues were approximately $49.8 billion in 2017, an increase of 3.5% compared to 2016. The increase in revenues was primarily due to a 4.7% increase in grocery business sales. Pre-tax earnings in 2017 were $299 million, a decrease of $132 million (31%) compared to 2016. The earnings decline reflected a 57% decline in earnings from our grocery operations, partly offset by a $39 million increase in gains from asset sales. Throughout 2017, significant pricing pressures and an increasingly competitive business environment negatively affected our operating results, particularly with respect to the grocery business. These conditions contributed to declining gross margin rates, which together with increases in fuel, depreciation and certain other operating expenses produced a 29 basis point decline in our consolidated operating margin rate (ratio of pre-tax earnings to revenues) in 2017 compared to 2016. Our grocery and foodservice businesses will likely continue to be subject to intense competition in 2018.
Revenues were $48.1 billion in 2016, a decline of $148 million (0.3%) compared to 2015. In 2016, we experienced a 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 rate. The decline was primarily due to increased employee related costs. Additionally, earnings in 2015 included a gain of $19 million from the disposition of a subsidiary.
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Table of Contents
Management’s Discussion and Analysis (Continued)
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 | |||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | 2015 | |||||||||||||||||||
| Manufactured housing and finance | $ | 5,010 | $ | 4,230 | $ | 3,576 | $ | 765 | $ | 744 | $ | 706 | ||||||||||||
| Transportation equipment leasing | 2,609 | 2,650 | 2,540 | 869 | 959 | 909 | ||||||||||||||||||
| Other | 757 | 795 | 848 | 424 | 427 | 471 | ||||||||||||||||||
| $ | 8,376 | $ | 7,675 | $ | 6,964 | |||||||||||||||||||
| Pre-tax earnings | 2,058 | 2,130 | 2,086 | |||||||||||||||||||||
| Income taxes and noncontrolling interests | 723 | 703 | 708 | |||||||||||||||||||||
| $ | 1,335 | $ | 1,427 | $ | 1,378 | |||||||||||||||||||
Manufactured housing and finance
Clayton Homes’ revenues were $5.0 billion in 2017, an increase of $780 million (18%) compared to 2016. The revenues increase was primarily due to higher home sales, attributable to an increase in overall unit sales (9%) and higher average prices. The increase in average prices was primarily due to sales mix changes, which reflected increases in site built home sales, a relatively new business for Clayton. Site built homes include higher land content and unit prices tend to be higher, although gross sales margin rates are typically lower than manufactured homes. Interest and financial services revenues increased 2% in 2017 compared to 2016.
Pre-tax earnings increased $21 million (2.8%) in 2017 compared to 2016. Pre-tax earnings in 2017 from manufacturing, retailing and site built activities increased, while earnings from finance activities declined slightly from 2016. Earnings in 2017 also included a gain from a legal settlement, offset by increased employee healthcare, technology, marketing and other expenses. A significant portion of Clayton Homes’ earnings are generated from lending activities, which in recent years benefitted from relatively low delinquency rates and loan losses and from low average interest rates on borrowings. As of December 31, 2017, Clayton Homes’ installment loan portfolio was approximately $13.7 billion.
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 and increased insurance losses.
Transportation equipment leasing
Transportation equipment leasing revenues declined $41 million (2%) in 2017 compared to 2016. The revenue decline was due to lower railcar and trailer units on lease and lower railcar lease rates. We currently believe industry railcar capacity available for lease exceeds demand, which is contributing to lower lease rates. We also experienced increased other service revenues, primarily attributable to business acquisitions and favorable foreign currency translation effects.
Pre-tax earnings declined $90 million (9%) in 2017 compared to 2016. Earnings as a percentage of revenues decreased from 36.2% in 2016 to 33.3% in 2017. These decreases reflected the aforementioned lease revenue declines and higher railcar repair, storage costs and depreciation expense. Significant components of our operating costs, such as depreciation expense, do not vary proportionately to revenue changes and therefore changes in revenues can produce a disproportionate effect on earnings. In response to weakened demand in the railcar and oil and gas industries, we undertook overhead cost reduction initiatives.
Transportation equipment leasing revenues increased $110 million (4.3%) in 2016 compared to 2015, primarily from the acquisition of General Electric Company’s tank car fleet and its railcar repair services business in 2015 and increased rates and tank car additions. These revenue increases were partly offset by lower utilization rates, unfavorable foreign currency translation effects, lower crane lease demand in North America and reduced volume related to oil and gas markets.
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Table of Contents
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 borrowings from a Berkshire financing subsidiary.
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 loans and equity security investments. Pre-tax earnings were $424 million in 2017, relatively unchanged from 2016, and reflected lower earnings from CORT, partly offset by slightly higher interest and finance income. Other earnings also includes income from interest rate spreads charged on borrowings by a Berkshire financing subsidiary that are used to finance installment loans made by Clayton Homes and assets held for lease by UTLX. Other earnings in 2016 were $427 million, a decrease of $44 million compared to 2015. The decline reflected lower earnings from investment securities, partly offset by increased earnings from CORT and Berkadia.
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).
| 2017 | 2016 | 2015 | ||||||||||||||||||||||||||||||||||
| Investment gains/losses | $ | 1,410 | $ | 7,553 | $ | 9,373 | ||||||||||||||||||||||||||||||
| Derivative gains/losses | 718 | 751 | 974 | |||||||||||||||||||||||||||||||||
| Gains/losses before income taxes and noncontrolling interests | 2,128 | 8,304 | 10,347 | |||||||||||||||||||||||||||||||||
| Income taxes and noncontrolling interests | 751 | 1,807 | 3,622 | |||||||||||||||||||||||||||||||||
| Net gains/losses | $ | 1,377 | $ | 6,497 | $ | 6,725 | ||||||||||||||||||||||||||||||
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 provide information to explain the nature of such gains and losses when reflected in our earnings.
As discussed in Note 1(u) to the Consolidated Financial Statements, we adopted a new accounting standard on January 1, 2018 that changes the reporting of unrealized gains and losses on our investments in equity securities. Beginning as of that date, unrealized gains and losses on investments in equity securities will be included in our Consolidated Statements of Earnings along with realized gains and losses from dispositions. This new standard does not permit the restatement of prior years’ statements of earnings. Upon adoption of this accounting standard, we reclassified net after-tax unrealized gains of $61.5 billion related to our investments in equity securities from accumulated other comprehensive income to retained earnings.
While the adoption of this standard did not affect our consolidated shareholders’ equity, it will almost certainly produce a very significant increase in the volatility of our periodic net earnings in the future given the magnitude of our existing equity securities portfolio and the inherent volatility of equity securities prices. To illustrate the impact of this standard, our other comprehensive income for the year ending December 31, 2017 included after-tax net unrealized gains from equity securities of approximately $19 billion. Had the new accounting standard been in effect as of the beginning of 2017, this amount would have been included in our Consolidated Statements of Earnings. However, our consolidated comprehensive income for the period would have been unchanged.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Investment and Derivative Gains/Losses (Continued)
Investment gains/losses (Continued)
Pre-tax investment gains were approximately $1.4 billion in 2017, $7.6 billion in 2016 and $9.4 billion in 2015. Investment gains in 2016 included $4.2 billion from the redemptions of our Wrigley and Kraft Heinz preferred stock investments and from the sales of Dow Chemical common stock that was received upon the conversion of our Dow Chemical preferred stock investment. We also realized pre-tax gains of $1.1 billion in connection with the tax-free exchange of our shares of P&G common stock for 100% of the common stock of Duracell. Income tax expense allocated to investment gains in 2016 included a benefit from the reduction of certain deferred income tax liabilities in connection with the exchange of P&G common stock for Duracell. Our after-tax gain from this transaction was approximately $1.9 billion. Pre-tax investment gains in 2015 included non-cash holding gains related to our investment in Kraft Heinz of $6.8 billion. 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.
Derivative gains/losses
Derivative gains/losses primarily represented the changes in fair value of our 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 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 $718 million in 2017, $662 million in 2016 and $1.0 billion in 2015. The gains in each year reflected the effects of shorter remaining contract durations and overall higher index values.
As of December 31, 2017, the aggregate intrinsic value of our equity put option contracts was approximately $800 million and our recorded liability was approximately $2.2 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 June 2018), and will be based on the intrinsic value as defined under the contracts.
In July 2016, our last 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 and pre-tax losses of $34 million in 2015.
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).
| 2017 | 2016 | 2015 | ||||||||||||||
| Kraft Heinz earnings | $ 972 | $ 706 | $ 841 | |||||||||||||
| Acquisition accounting expenses | (936) | (846) | (515) | |||||||||||||
| Corporate interest expense, before foreign currency effects | (266) | (256) | (146) | |||||||||||||
| Corporate interest expense – Euro note foreign exchange gains (losses) | (655) | 159 | (45) | |||||||||||||
| Other | 59 | (106) | (105) | |||||||||||||
| Net earnings (losses) attributable to Berkshire Hathaway shareholders | $ (826) | $ (343) | $ 30 | |||||||||||||
Our after-tax Kraft Heinz earnings includes Berkshire’s share of Kraft Heinz’s earnings attributable to common shareholders determined pursuant to the equity method. Our after-tax Kraft Heinz earnings in 2017 excludes approximately $1.1 billion from the net effects of the TCJA on Kraft Heinz’s net earnings. Kraft Heinz earnings included pre-tax dividend income from our preferred stock investment of $180 million in 2016 and $852 million in 2015. Kraft Heinz redeemed the preferred stock in June 2016.
After-tax other earnings (losses) also include charges arising from the application of the acquisition method in connection with Berkshire’s past business acquisitions. Such charges were primarily from the amortization of intangible assets recorded in connection with those business acquisitions.
In each of the last three years, Berkshire issued Euro-denominated debt and at December 31, 2017, the aggregate par amount outstanding was €6.85 billion. Changes in foreign currency exchange rates can produce sizable non-cash gains and losses from the periodic revaluation of these liabilities into U.S. Dollars. The increase in interest expense in 2016 over 2015 before those gains and losses was primarily attributable to increased average outstanding debt.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Financial Condition
Our consolidated balance sheet continues to reflect significant liquidity and a strong capital base. Our consolidated shareholders’ equity at December 31, 2017 was $348.3 billion, an increase of $65.3 billion since December 31, 2016 (based upon shareholders’ equity as originally reported in our 2016 Form 10-K). Net earnings attributable to Berkshire shareholders in 2017 were $44.9 billion. Net unrealized appreciation of investments and foreign currency translation gains included in other comprehensive income in 2017 were approximately $18.9 billion and $2.2 billion, respectively.
At December 31, 2017, our insurance and other businesses held cash, cash equivalents and U.S. Treasury Bills of approximately $104.0 billion and investments (excluding our investment in Kraft Heinz) of $185.4 billion. In 2017, Berkshire issued €1.1 billion of senior notes and repaid $1.1 billion of maturing senior notes. Berkshire’s outstanding debt at December 31, 2017 was approximately $18.8 billion, an increase of $1.1 billion from December 31, 2016, of which $990 million was attributable to foreign currency exchange rate changes applicable to the €6.85 billion par amount of Euro-denominated senior notes. Berkshire term debt of $800 million matured in February 2018 and $750 million will mature in August 2018.
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. During 2017, BHE’s and BNSF’s capital expenditures were $4.6 billion and $3.3 billion, respectively. We forecast capital expenditures of these two operations will approximate $9.7 billion in 2018.
BNSF’s outstanding debt approximated $22.5 billion as of December 31, 2017, an increase of $455 million since December 31, 2016. In March 2017, BNSF issued $1.25 billion of senior unsecured debentures with $500 million due in 2027 and $750 million due in 2047. BNSF debentures of $650 million par amount will mature in March 2018. Outstanding borrowings of BHE and its subsidiaries were approximately $39.7 billion at December 31, 2017, an increase of $2.6 billion since December 31, 2016. During 2017, BHE and its subsidiaries issued approximately $1.9 billion of debt with maturity dates ranging from 2022 to 2057. In January 2018, BHE issued senior unsecured debt of $2.2 billion with maturities ranging from 2021 to 2048. The proceeds from these borrowings were used to repay certain short-term borrowings and for other general corporate purposes. Within the next twelve months, approximately $3.4 billion of BHE and subsidiary term debt will mature. 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, BHE or any of their subsidiaries.
Finance and financial products assets were approximately $41.9 billion as of December 31, 2017, a decrease of $175 million from December 31, 2016. Finance assets consist primarily of loans and finance receivables, various types of property held for lease, cash, cash equivalents and U.S. Treasury Bills. Finance and financial products liabilities declined $3.0 billion to approximately $16.7 billion as of December 31, 2017. The decrease was primarily due to a reduction in borrowings of approximately $2.3 billion, reflecting repayments of $3.6 billion, partly offset by $1.3 billion of senior unsecured notes issued in January by a wholly-owned financing subsidiary, Berkshire Hathaway Finance Corporation (“BHFC”). The new BHFC notes mature in 2019 and 2020. BHFC’s outstanding borrowings were $12.9 billion at December 31, 2017. In January 2018, $600 million par amount of BHFC senior notes matured and an additional $4.0 billion will mature over the remainder of 2018. BHFC’s senior note borrowings are used to fund loans originated and acquired by Clayton Homes and a portion of assets held for lease by our UTLX railcar leasing business. Berkshire guarantees the full and timely payment of principal and interest with respect to BHFC’s senior notes.
Berkshire’s Board of Directors has authorized Berkshire management to repurchase, at its discretion, Berkshire Class A and Class B common stock at prices no higher than a 20% premium over book value per share. We will not repurchase our stock if it reduces the total amount of Berkshire’s consolidated cash, cash equivalents and U.S. Treasury Bills holdings below $20 billion. There is no obligation to repurchase any stock and the program is expected to continue indefinitely. Financial strength and redundant liquidity will always be of paramount importance at Berkshire. There were no share repurchases in 2017.
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 included in our Consolidated Balance Sheets, such as notes payable, 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 our financial statements. These obligations will be recognized in future periods as the goods are delivered or services are provided.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Contractual Obligations (Continued)
The timing and/or amount of the payments under certain contracts are contingent upon the outcome of future events. Most significantly, the timing and amount of future payments of unpaid losses and loss adjustment expenses arising under property and casualty insurance and reinsurance contracts, including retroactive reinsurance contracts, are contingent upon the outcome of claim settlement activities or events. Obligations arising under life, annuity and health insurance benefits are also contingent on future premiums, allowances, mortality, morbidity, expenses and policy lapse rates. The amounts included in the following table are based on the liability estimates reflected in our Consolidated Balance Sheet as of December 31, 2017. Although certain insurance losses and loss adjustment expenses and life, annuity and health benefits are recoverable under reinsurance contracts, those receivables are not reflected in the table.
A summary of our contractual obligations as of December 31, 2017 follows (in millions). Actual payments will likely vary, perhaps significantly, from estimates reflected in the table.
| Estimated payments due by period | ||||||||||||||||||||
| Total | 2018 | 2019-2020 | 2021-2022 | After 2022 | ||||||||||||||||
| Notes payable and other borrowings, including interest | $ | 151,777 | $ | 21,736 | $ | 19,099 | $ | 15,707 | $ | 95,235 | ||||||||||
| Operating leases | 8,486 | 1,330 | 2,259 | 1,581 | 3,316 | |||||||||||||||
| Purchase obligations (1) | 39,957 | 12,959 | 6,940 | 5,018 | 15,040 | |||||||||||||||
| Unpaid losses and loss adjustment expenses (2) | 104,059 | 20,614 | 21,377 | 14,740 | 47,328 | |||||||||||||||
| Life, annuity and health insurance benefits (3) | 33,095 | 1,196 | (29) | 293 | 31,635 | |||||||||||||||
| Other | 16,899 | 3,328 | 813 | 2,344 | 10,414 | |||||||||||||||
| Total | $ | 354,273 | $ | 61,163 | $ | 50,459 | $ | 39,683 | $ | 202,968 | ||||||||||
| (1) | Primarily related to fuel, capacity, transmission and maintenance contracts and capital expenditure commitments of BHE and BNSF and aircraft purchase commitments of NetJets. |
|---|
| (2) | Includes unpaid losses and loss adjustment expenses under retroactive reinsurance contracts. |
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| (3) | Amounts represent estimated undiscounted benefits, net of estimated future premiums, as applicable. |
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Critical Accounting Policies
Certain accounting policies require us to make estimates and judgments in determining 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 (also referred to as “gross unpaid losses” or “claim liabilities”) based upon estimates of the ultimate amounts payable for losses occurring on or before the balance sheet date. 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 claim liabilities and all techniques require significant judgments and assumptions.
As of the balance sheet date, recorded claim 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 contribute to extending claim-tails.
Our consolidated claim liabilities as of December 31, 2017 were $104 billion, of which 87% related to GEICO and the Berkshire Hathaway Reinsurance Group (General Re Group and NICO Group). Additional information regarding significant uncertainties inherent in the processes and techniques of these businesses follows.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
GEICO
GEICO predominantly writes private passenger auto insurance. As of December 31, 2017, GEICO’s gross unpaid losses were $18.1 billion. Claim liabilities, net of reinsurance recoverable were $17.2 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.
Claim 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, 2017, case development liabilities averaged approximately 30% of the case reserves. We select case development factors through analysis of the overall adequacy of historical case liabilities.
For incurred-but-not-reported (“IBNR”) claims, 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.
We test the adequacy of the aggregate claim liabilities 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.
Our claim liability estimates recorded at the end of 2016 increased $517 million during 2017, which produced a corresponding decrease to pre-tax earnings. We modified the assumptions used to estimate liabilities at December 31, 2017 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.
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, 2017. We estimate that a one percentage point increase or decrease in BI severities would produce a $275 million increase or decrease in recorded liabilities, with a corresponding decrease or increase in pre-tax earnings. Many of the 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.
Berkshire Hathaway Reinsurance Group (“BHRG”)
BHRG’s liabilities for unpaid losses and loss adjustment expenses derive primarily from reinsurance contracts issued through the NICO Group and the General Re Group. In connection with reinsurance contracts, the nature, extent, timing and perceived reliability of premium and loss 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 quarterly 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 parties 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, the magnitude of the claim relative to the attachment point of the reinsurance coverage, and for other reasons.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
Berkshire Hathaway Reinsurance Group (“BHRG”) (Continued)
As reinsurers, the premium and loss data we receive is at least one level removed from the underlying claimant, 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 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.
A summary of BHRG’s property and casualty unpaid losses and loss adjustment expenses, other than retroactive reinsurance losses and loss adjustment expenses, as of December 31, 2017 follows (in millions).
| General Re Group | NICO Group | Total | ||||||||||||||||||||||||||||||||||
| Property | Casualty | Total | Property | Casualty | Total | Property | Casualty | Total | ||||||||||||||||||||||||||||
| Reported case liabilities | $ | 1,488 | $ | 6,608 | $ | 8,096 | $ | 3,477 | $ | 2,833 | $ | 6,310 | $ | 4,965 | $ | 9,441 | $ | 14,406 | ||||||||||||||||||
| IBNR liabilities | 1,622 | 6,630 | 8,252 | 2,574 | 4,487 | 7,061 | 4,196 | 11,117 | 15,313 | |||||||||||||||||||||||||||
| Gross unpaid losses and loss adjustment expenses | 3,110 | 13,238 | 16,348 | 6,051 | 7,320 | 13,371 | 9,161 | 20,558 | 29,719 | |||||||||||||||||||||||||||
| Reinsurance recoverable | 256 | 610 | 866 | 33 | 418 | 451 | 289 | 1,028 | 1,317 | |||||||||||||||||||||||||||
| Net unpaid losses and loss adjustment expenses | $ | 2,854 | $ | 12,628 | $ | 15,482 | $ | 6,018 | $ | 6,902 | $ | 12,920 | $ | 8,872 | $ | 19,530 | $ | 28,402 | ||||||||||||||||||
Gross unpaid losses and loss adjustment expenses in the table above consist primarily of traditional property and casualty coverages written primarily under excess-of-loss and quota-share treaties. Under certain contracts, coverage can apply to multiple lines of business written and the ceding company may not report loss data by such lines consistently, if at all. In those instances, we allocated losses to property and casualty coverages based on internal estimates.
With respect to the General Re Group, 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. 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 and loss reporting patterns, which drive IBNR liability estimates, and the comparison of reported activity to the expected loss reporting patterns.
General Re Group’s process for estimating unpaid losses and loss adjustment expenses starts with case loss estimates reported by ceding companies. We independently evaluate certain reported case losses and if appropriate, we use our own case liability estimate. As of December 31, 2017, our case loss estimates exceeded ceding company estimates by approximately $2.2 billion, which were concentrated in legacy workers’ compensation claims occurring over 10 years ago. We also periodically conduct detailed reviews of individual client claims, which may cause us to adjust our case estimates.
In estimating General Re Group’s 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 groups or portfolios of policies based primarily on product type (e.g., treaty, facultative and program), line of business (e.g., auto liability, property and workers’ compensation) and/or geographic jurisdiction, and in some cases contractual features or market segment. For each portfolio, we aggregate premiums and losses by accident year or coverage period and analyze the paid and incurred loss data over time. We estimate the expected development of reported claims, which, together with the expected loss ratios, are used to calculate IBNR liability estimates. Factors affecting our loss development analysis include, but are not limited to, changes in the following: client claims reporting and settlement 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 case loss emergence patterns.
For the NICO Group, we generally also establish reinsurance claim liabilities on a contract-by-contract basis determined from reported case loss estimates reported by ceding companies and IBNR liabilities that are primarily a function of an anticipated loss ratio for the contract and the reported case loss estimates. Liabilities are subsequently adjusted over time to reflect case losses reported versus expected case losses, which are used to form judgments on the adequacy of the expected loss ratio and the level of IBNR liabilities required for unreported claims. Anticipated loss ratios are also revised to include estimates of the impact of major catastrophe events as they become known.
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Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
Berkshire Hathaway Reinsurance Group (“BHRG”) (Continued)
Certain catastrophe, individual risk and aviation excess-of-loss contracts tend to generate low frequency/high severity losses. Our processes and techniques for estimating liabilities under such 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.
In the aggregate, we reduced net losses for prior years’ occurrences by $295 million in 2017, which produced a corresponding increase in pre-tax earnings. Reported claims for prior years’ property loss events were less than anticipated and we reduced our estimated ultimate liabilities by $152 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 2017, reported nominal losses for prior years’ workers’ compensation claims of the General Re Group were less than expected. After reevaluating expected remaining IBNR estimates, we reduced our liabilities by $160 million. 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 workers’ compensation IBNR liabilities of approximately $1 billion, producing a corresponding decrease in pre-tax earnings. We believe it is reasonably possible for these assumptions to increase at these rates.
We reduced General Re Group’s other casualty, excluding asbestos and environmental, estimated ultimate losses for prior years’ events by $114 million in 2017 reflecting lower than expected reported losses, resulting in a $114 million increase in pre-tax earnings. For our significant casualty and general liability portfolios, 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.
Overall industry-wide loss experience data and informed judgment are used when internal loss data is of limited reliability, such as for asbestos, environmental and latent injury liability estimates. Our combined net liabilities for such losses at December 31, 2017, were approximately $1.6 billion, which included an increase in estimated ultimate losses of approximately $145 million during 2017, which produced a corresponding reduction in pre-tax earnings. Loss estimations for these exposures 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. Our survival ratio was approximately 15 years as of December 31, 2017.
Retroactive reinsurance
Our retroactive reinsurance contracts cover loss events occurring before the contract inception dates. Claim liabilities relating to our retroactive reinsurance contracts are predominately related to casualty or liability exposures. We expect the claim-tails to be very long. Our gross unpaid losses, deferred charge assets, and net liabilities at December 31, 2017 were as follows (in millions).
| Gross unpaid losses | Deferred charges | Liabilities, net of deferred charges | ||||||||||
| December 31, 2017 | $42,937 | $15,278 | $27,659 |
Our contracts are generally subject to maximum limits of indemnifications. We currently expect that maximum remaining gross losses payable under our retroactive policies will not exceed $57 billion due to the applicable aggregate contract limits. 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 losses payable or downward by more than 15% of our $42.9 billion estimated liability at December 31, 2017.
We establish liability estimates by individual contract, considering exposure and development trends. In establishing our liability estimates, we often analyze historical aggregate loss payment patterns and project expected ultimate losses under various scenarios. We assign judgmental probability factors to these scenarios and an expected outcome is determined. We then monitor subsequent loss payment activity and review ceding company reports and other available information concerning the underlying losses. We re-estimate the expected ultimate losses when significant events or significant deviations from expected results are revealed.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
Retroactive reinsurance (Continued)
Certain of our retroactive reinsurance contracts include asbestos, environmental and other latent injury claims. Our estimated liabilities for such claims were approximately $14.0 billion at December 31, 2017. We do not consistently receive reliable detailed data regarding asbestos, environmental and latent injury claims from all ceding companies, particularly with respect to multi-line or aggregate excess-of-loss policies. When possible, 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 2017, as were changes in the estimated timing and amount of remaining unpaid losses. In 2017, we paid losses and loss adjustment expenses of approximately $1.0 billion with respect to these contracts.
In connection with our retroactive reinsurance contracts, we also record deferred charge assets, which at contract inception represents the excess, if any, of the estimated ultimate liability for unpaid losses over premiums. We amortize deferred charge assets, which produces charges to pre-tax earnings in future periods based on the expected timing and amount of loss payments. We also adjust deferred charge balances due to changes in the expected timing and ultimate amount of claim payments. Significant changes in such estimates may have a significant effect on unamortized deferred charge balances and the amount of periodic amortization. Based on the contracts in effect as of December 31, 2017, we currently estimate that amortization expense in 2018 will approximate $1.2 billion.
Derivative contract liabilities
We measure derivative contract liabilities at fair value. Our remaining significant derivative contract exposures relate to equity index put option contracts written between 2004 and 2008. Our recorded liabilities are based on models as there are essentially no observable prices for comparable contracts. Actual values in an exchange may differ significantly from the values produced by such models, as transaction values may also reflect the prevailing perceptions of individual buyers and sellers and other changes in market conditions.
We determine the fair values 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, 2017 were 1.1% and 3.2%, respectively. The interest rates were approximately 40 basis points (on a weighted average basis) over benchmark interest rates at the end of 2017 and represented our estimate of our nonperformance risk.
The Black-Scholes based model also incorporates volatility inputs that estimate potential price changes over time. Our contracts have an average remaining maturity of about three years. The weighted average volatility used as of December 31, 2017 was approximately 17.4%. We determine the weighted average volatilities based on the volatility input for each contract weighted by the contract’s notional value. The potential impact from changes in our volatility assumptions are as follows. (Dollars in millions).
| Fair value at December 31, 2017 | $2,172 | |
| Hypothetical change in volatility | Hypothetical fair value | |
| Increase 2 percentage points | $2,332 | |
| Increase 4 percentage points | 2,502 | |
| Decrease 2 percentage points | 2,022 | |
| Decrease 4 percentage points | 1,883 |
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Management’s Discussion and Analysis (Continued)
Other Critical Accounting Policies
Our Consolidated Balance Sheet at December 31, 2017 included goodwill of acquired businesses of $81.3 billion. We evaluate goodwill for impairment at least annually and we conducted our most recent annual review during the fourth quarter of 2017. 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
Equity securities represent a significant portion of our investment portfolio. Strategically, we strive to invest in businesses that possess excellent economics and able and honest management, and we prefer to invest a meaningful amount in each investee. Consequently, equity investments are concentrated in relatively few issuers. At December 31, 2017, approximately 65% of the total fair value of equity securities was concentrated in five issuers.
We often hold our equity investments for long periods and short-term price volatility has occurred in the past and will occur in the future. We strive to maintain significant levels of shareholder capital and ample liquidity to provide a margin of safety against short-term price volatility.
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 contracts.
The following table summarizes our equity securities and derivative contract liabilities with significant equity price risk as of December 31, 2017 and 2016 and the estimated effects of a hypothetical 30% increase and a 30% decrease in market prices as of those dates. The selected 30% hypothetical increase and decrease does not reflect the best or worst case scenario. Indeed, results from declines 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 (1) | |||||||||||||
| December 31, 2017 | ||||||||||||||||
| Investments in equity securities | $ | 170,540 | 30% increase | $ | 221,702 | 11.6 | % | |||||||||
| 30% decrease | 119,378 | (11.6 | ) | |||||||||||||
| Equity index put option contract liabilities | 2,172 | 30% increase | 1,036 | 0.3 | ||||||||||||
| 30% decrease | 4,804 | (0.6 | ) | |||||||||||||
| December 31, 2016 | ||||||||||||||||
| Investments in equity securities | $ | 131,629 | 30% increase | $ | 172,341 | 9.4 | % | |||||||||
| 30% decrease | 91,099 | (9.4 | ) | |||||||||||||
| Equity index put option contract liabilities | 2,890 | 30% increase | 1,602 | 0.3 | ||||||||||||
| 30% decrease | 5,572 | (0.6 | ) |
| (1) | The hypothetical percentage increase (decrease) is after income taxes at the statutory rate in effect as of the balance sheet date. |
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Management’s Discussion and Analysis (Continued)
Interest Rate Risk
We may also invest in bonds, loans or other interest rate sensitive instruments. Our strategy is to acquire or originate such instruments at prices considered appropriate relative to the perceived credit risk. We recognize and accept that credit 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, in order 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, loans and finance receivables, 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 these 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 following table summarizes the estimated effects of hypothetical changes in interest rates on our significant assets and liabilities that are subject to significant interest rate risk at December 31, 2017 and 2016. We assumed that the interest rate changes occur immediately and uniformly to each category of instrument containing interest rate risk, and that there were 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. Actual results may 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, 2017 | ||||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Investments in fixed maturity securities | $ | 21,353 | $ | 22,053 | $ | 20,742 | $ | 20,200 | $ | 19,717 | ||||||||||
| Loans and finance receivables | 14,136 | 14,655 | 13,652 | 13,199 | 12,774 | |||||||||||||||
| Liabilities: | ||||||||||||||||||||
| Notes payable and other borrowings: | ||||||||||||||||||||
| Insurance and other | 28,180 | 29,879 | 26,670 | 25,319 | 24,105 | |||||||||||||||
| Railroad, utilities and energy | 70,538 | 77,091 | 64,582 | 59,730 | 55,581 | |||||||||||||||
| Finance and financial products | 13,582 | 14,058 | 13,174 | 12,821 | 12,514 | |||||||||||||||
| Equity index put option contracts | 2,172 | 2,460 | 1,911 | 1,676 | 1,465 | |||||||||||||||
| December 31, 2016 | ||||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Investments in fixed maturity securities | $ | 23,432 | $ | 24,087 | $ | 22,860 | $ | 22,395 | $ | 21,952 | ||||||||||
| Investments in equity securities | 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 |
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Table of Contents
Management’s Discussion and Analysis (Continued)
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 included in net earnings related to net liabilities of Berkshire and certain of its U.S. subsidiaries that are denominated in foreign currencies, due to changes in exchange rates. A summary of these gains (losses), after-tax, for each of the years ending December 31, 2017 and 2016 follows (in millions).
| 2017 | 2016 | |||||||
| Euro-denominated debt included in net earnings | $ | (655) | $ | 159 | ||||
| Net liabilities under certain reinsurance contracts included in net earnings | (295) | 458 | ||||||
| Foreign currency translation included in other comprehensive income | 2,151 | (1,412) |
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 may utilize derivative contracts to manage a portion of commodity price risks at BHE.
Previous: Item 6. Selected Financial Data · Next: Item 7A. Quantitative and Qualitative Disclosures About Market Risk