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).
| 2018 | 2017 | 2016 | ||||||||||
| Insurance – underwriting | $ | 1,566 | $ | (2,219 | ) | $ | 1,370 | |||||
| Insurance – investment income | 4,554 | 3,887 | 3,636 | |||||||||
| Railroad | 5,219 | 3,959 | 3,569 | |||||||||
| Utilities and energy | 2,621 | 2,033 | 2,230 | |||||||||
| Manufacturing, service and retailing | 9,364 | 7,282 | 6,803 | |||||||||
| Investment and derivative gains/losses | (17,737 | ) | 1,377 | 6,497 | ||||||||
| Other | (1,566 | ) | (485 | ) | (31 | ) | ||||||
| Tax Cuts and Jobs Act of 2017 | — | 29,106 | — | |||||||||
| Net earnings attributable to Berkshire Hathaway shareholders | $ | 4,021 | $ | 44,940 | $ | 24,074 | ||||||
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. The business segment data (Note 26 to the accompanying Consolidated Financial Statements) should be read in conjunction with this discussion.
Beginning in 2018, our periodic net earnings include changes in unrealized gains and losses on our investments in equity securities. These gains and losses are likely to be very significant given the size of our current holdings and the inherent volatility in securities prices. Prior to 2018, the changes in unrealized gains and losses pertaining to such investments were recorded in other comprehensive income. The new accounting treatment has no effect on our consolidated shareholders’ equity.
After-tax earnings of our business operations in 2018 were favorably affected by lower U.S. income tax expense, primarily attributable to a reduction in the statutory U.S. corporate income tax rate from 35% to 21%. The effect of the lower U.S. statutory income tax rate in 2018 on the comparative after-tax earnings of our various business operations varied, reflecting the differences in the mix of earnings subject to income tax, income tax credits and the effects of state and local income taxes.
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 of 2017 (“TCJA”) on December 22, 2017. See Note 18 to the Consolidated Financial Statements. This benefit included approximately $29.6 billion related to a one-time non-cash reduction of net deferred income tax liabilities from the reduction in the statutory U.S. corporate income tax rate from 35% to 21%, and a net benefit of approximately $900 million primarily attributable to our earnings from Kraft Heinz, partly offset by a one-time income tax expense of approximately $1.4 billion 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 for 2017 in the discussion of our various operating businesses and other activities exclude the one-time effects of the TCJA.
After-tax earnings from insurance underwriting were approximately $1.6 billion in 2018 compared to after-tax losses of approximately $2.2 billion in 2017. Results in 2018 included reductions of estimated ultimate liabilities for prior years’ property/casualty loss events, gains from foreign currency exchange rate changes on certain non-U.S. Dollar denominated liabilities of U.S subsidiaries of $207 million and a lower effective income tax rate, partly offset by losses from significant catastrophe events of approximately $1.6 billion ($1.3 billion after-tax). After-tax losses from insurance underwriting in 2017 included estimated pre-tax losses of approximately $3.0 billion ($1.95 billion after-tax) from significant catastrophe events. Underwriting results in 2017 also included after-tax foreign currency exchange rate losses of $295 million.
Our railroad business generated a 31.8% increase in after-tax earnings in 2018 compared to 2017, reflecting an increase in unit volume, higher average revenue per car/unit and a lower effective income tax rate, partly offset by increased fuel and other operating costs. 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 utilities and energy businesses produced higher after-tax earnings in 2018 compared to 2017, primarily due to a lower overall effective income tax rate and the effects of losses incurred in 2017 in connection with the prepayment of certain long-term debt, partially offset by lower pre-tax earnings in certain of the regulated utilities. After-tax earnings of our utility and energy businesses in 2017 declined $197 million compared to 2016, reflecting the debt prepayment losses in 2017.
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Management’s Discussion and Analysis (Continued)
Results of Operations (Continued)
After-tax earnings in 2018 of our manufacturing, service and retailing businesses increased 29% over 2017, due to lower effective income tax rates and a 13% increase in pre-tax earnings. After-tax earnings in 2017 of our manufacturing, service and retailing businesses were $7.3 billion, an increase of 7.0% compared to 2016, reflecting comparatively higher earnings from several of our larger operations and the impact of businesses acquired in 2016 and 2017.
After-tax losses from investments and derivative contracts were $17.7 billion in 2018, which included after-tax losses of approximately $18 billion from changes in market values of our investments in equity securities held at December 31, 2018. Prior to 2018, after-tax investment gains or losses on equity securities arose from the sale of securities during the period based on the cost of the disposed security or through the recording of other-than-temporary impairment losses. In 2017, we recorded after-tax unrealized gains on our investments in equity securities of approximately $19 billion in other comprehensive income.
After-tax investment and derivative gains were approximately $1.4 billion in 2017 and $6.5 billion in 2016. Investment gains in 2016 included approximately $2.7 billion from the redemptions of our Wrigley and Kraft Heinz preferred stock investments, and sales of Dow Chemical common stock we received in the conversion of the Dow Chemical preferred stock investment. Investment gains in 2016 also included a non-cash after-tax 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.
We believe that investment and derivative gains/losses, whether realized from dispositions or unrealized from changes in market prices of equity securities, are generally meaningless in understanding our reported results or evaluating the economic performance of our businesses. These gains and losses have caused and will continue to cause significant volatility in our periodic earnings.
Other earnings included after-tax foreign currency exchange rate gains of $289 million in 2018, losses of $655 million in 2017 and gains of $159 million in 2016 related to parent company Euro-denominated debt. In addition, other earnings in 2018 included losses from equity method investments due to Kraft Heinz, partly offset by earnings from other equity method investments. Other earnings in 2018 also reflected increased interest income from short-term investments.
Insurance—Underwriting
Our management views our insurance businesses as possessing two distinct activities – 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 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 catastrophe losses in excess of $100 million (pre-tax) from a current year event as significant. We incurred estimated pre-tax losses of approximately $1.6 billion in 2018 and $3.0 billion in 2017 from significant catastrophe events.
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, were approximately $110 billion as of December 31, 2018. 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.
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.
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Underwriting results of our insurance businesses are summarized below (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||
| Underwriting gain (loss): | ||||||||||||
| GEICO | $ | 2,449 | $ | (310 | ) | $ | 462 | |||||
| Berkshire Hathaway Reinsurance Group | (1,109) | (3,648 | ) | 1,012 | ||||||||
| Berkshire Hathaway Primary Group | 670 | 719 | 657 | |||||||||
| Pre-tax underwriting gain (loss) | 2,010 | (3,239 | ) | 2,131 | ||||||||
| Income taxes and noncontrolling interests | 444 | (1,020 | ) | 761 | ||||||||
| Net underwriting gain (loss) | $ | 1,566 | $ | (2,219 | ) | $ | 1,370 | |||||
| Effective income tax rate | 21.4% | 32.0% | 34.8% | |||||||||
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).
| 2018 | 2017 | 2016 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 34,123 | $ | 30,547 | $ | 26,309 | ||||||||||||||||||
| Premiums earned | $ | 33,363 | 100.0 | $ | 29,441 | 100.0 | $ | 25,483 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 26,278 | 78.8 | 25,497 | 86.6 | 21,044 | 82.6 | ||||||||||||||||||
| Underwriting expenses | 4,636 | 13.9 | 4,254 | 14.5 | 3,977 | 15.6 | ||||||||||||||||||
| Total losses and expenses | 30,914 | 92.7 | 29,751 | 101.1 | 25,021 | 98.2 | ||||||||||||||||||
| Pre-tax underwriting gain (loss) | $ | 2,449 | $ | (310 | ) | $ | 462 | |||||||||||||||||
Premiums written were $34.1 billion in 2018, an increase of 11.7% compared to 2017. The increase reflected voluntary auto policies-in-force growth of 3.3% and increased premiums per auto policy of approximately 6.4%. The increase in premiums per policy was attributable to rate increases, coverage changes and changes in state and risk mix. The rate increases were in response to accelerating claim costs in recent years. Although policies-in-force increased 540,000 during 2018, the rate of increase slowed, as voluntary auto new business sales decreased 4.7% compared to 2017.
Pre-tax underwriting gains in 2018 were $2,449 million compared to losses of $310 million in 2017. Underwriting results in 2018 reflected the effects of lower losses from significant catastrophe events and from prior years’ loss events, as well as increased average premiums per policy.
Losses and loss adjustment expenses were $26.3 billion in 2018, an increase of $781 million (3.1%) compared to 2017. GEICO’s ratio of losses and loss adjustment expenses to premiums earned (the “loss ratio”) for 2018 was 78.8%, a decline of 7.8 percentage points compared to 2017. Losses from significant catastrophe events were $105 million in 2018 (Hurricanes Florence and Michael and the wildfires in California) and approximately $450 million in 2017 (Hurricanes Harvey and Irma).
Losses and loss adjustment expenses regularly include gains or losses for the decreases or increases in the ultimate claim loss estimates during the period for prior years’ loss events. These gains or losses produce corresponding increases or decreases to pre-tax underwriting gains. GEICO’s losses and loss adjustment expenses included gains of $222 million in 2018 and losses of $517 million in 2017 with respect to prior years’ loss events. In addition, claims frequencies in 2018 for property damage, collision, and bodily and personal injury protection coverages declined (two to four percent range) compared to 2017. Average claims severities in 2018 increased for property damage and collision coverages (four to six percent range) and bodily injury coverage (five to seven percent range) versus 2017.
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
GEICO (Continued)
Underwriting expenses were approximately $4.6 billion in 2018, an increase of $382 million (9.0%) over 2017. GEICO’s expense ratio (underwriting expenses to premiums earned) in 2018 was 13.9%, a decrease of 0.6 percentage points compared to 2017. The underwriting expense increase was primarily attributable to increases in advertising expenses, insurance premium taxes and employee-related costs, which reflected wage and staffing increases.
Premiums written were $30.5 billion in 2017, an increase of 16.1% over 2016, and premiums earned were $29.4 billion, an increase of 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.
Pre-tax underwriting losses in 2017 were $310 million compared to pre-tax gains of $462 million in 2016. Losses and loss adjustment expenses in 2017 increased approximately $4.5 billion (21.2%) compared to 2016. Our loss ratio in 2017 increased 4.0 percentage points compared to 2016. The increase in losses incurred was attributable to increased average claims severities, losses from significant catastrophe events in 2017 ($450 million) and losses with respect to prior years’ loss events ($517 million). 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. Underwriting expenses increased $277 million (7.0%) in 2017 compared to 2016. Our expense ratio in 2017 declined 1.1 percentage points compared to 2016.
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 subsidiaries, led by National Indemnity Company (“NICO”), Berkshire Hathaway Life Insurance Company of Nebraska (“BHLN”) and General Reinsurance Corporation, General Reinsurance AG and General Re Life Corporation (collectively, “General Re”). We also periodically assume property and casualty risks under retroactive reinsurance contracts written through NICO. In addition, we write periodic payment annuity contracts predominantly through BHLN.
With the exception of our retroactive reinsurance and periodic payment annuity businesses, we strive to generate pre-tax underwriting profits. Time-value-of-money concepts are important elements in establishing prices for 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. We receive premiums at the inception of these contracts, which are then available for investment. A summary of BHRG’s premiums and pre-tax underwriting results follows (dollars in millions).
| Premiums written | Premiums earned | Pre-tax underwriting gain (loss) | ||||||||||||||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | ||||||||||||||||||||||||||||
| Property/casualty | $ | 9,413 | $ | 7,713 | $ | 6,993 | $ | 8,928 | $ | 7,552 | $ | 7,218 | $ | (207) | $ | (1,595 | ) | $ | 895 | |||||||||||||||||
| Retroactive reinsurance | 517 | 10,755 | 1,254 | 517 | 10,755 | 1,254 | (778) | (1,330 | ) | (60) | ||||||||||||||||||||||||||
| Life/health | 5,446 | 4,846 | 4,588 | 5,343 | 4,808 | 4,587 | 216 | (52 | ) | 305 | ||||||||||||||||||||||||||
| Periodic payment annuity | 1,156 | 898 | 1,082 | 1,156 | 898 | 1,082 | (340) | (671 | ) | (128) | ||||||||||||||||||||||||||
| $ | 16,532 | $ | 24,212 | $ | 13,917 | $ | 15,944 | $ | 24,013 | $ | 14,141 | $ | (1,109) | $ | (3,648 | ) | $ | 1,012 | ||||||||||||||||||
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Berkshire Hathaway Reinsurance Group (Continued)
Property/casualty
A summary of property/casualty reinsurance underwriting results follows (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 9,413 | $ | 7,713 | $ | 6,993 | ||||||||||||||||||
| Premiums earned | $ | 8,928 | 100.0 | $ | 7,552 | 100.0 | $ | 7,218 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 6,929 | 77.6 | 7,217 | 95.6 | 4,336 | 60.1 | ||||||||||||||||||
| Underwriting expenses | 2,206 | 24.7 | 1,930 | 25.5 | 1,987 | 27.5 | ||||||||||||||||||
| Total losses and expenses | 9,135 | 102.3 | 9,147 | 121.1 | 6,323 | 87.6 | ||||||||||||||||||
| Pre-tax underwriting gain (loss) | $ | (207 | ) | $ | (1,595) | $ | 895 | |||||||||||||||||
Property/casualty premiums earned in 2018 were $8.9 billion, an increase of 18.2% compared to 2017, while premiums earned in 2017 increased 4.6% compared to 2016. These increases were primarily attributable to higher direct and broker markets business, derived primarily from new business and increased participations for renewal business in both property and casualty lines. Premiums earned included approximately $1.8 billion in both 2018 and 2017 and $1.7 billion in 2016 from a 10-year, 20% quota-share contract entered into by NICO with Insurance Australia Group Limited, which expires in 2025.
Losses and loss adjustment expenses in 2018 decreased $288 million (4.0%) compared to 2017, and the loss ratio declined 18 percentage points to 77.6%. Losses incurred from significant catastrophe events in 2018 were approximately $1.3 billion, which derived from Hurricanes Florence and Michael, Typhoon Jebi and the wildfires in California, including $1.1 billion in the fourth quarter. Losses from significant catastrophe events in 2017 were approximately $2.4 billion, which derived from 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. In addition, losses and loss adjustment expenses reflected net gains of $469 million in 2018, $295 million in 2017 and $874 million in 2016 from reductions of estimated ultimate losses for prior years’ events. The net gain in 2018 was primarily due to lower than expected property losses. The net gain from prior years’ loss events in 2017 reflected losses from higher than expected property claims and increases in certain United Kingdom (“U.K.”) claim liabilities attributable to the U.K. Ministry of Justice’s decision to reduce the fixed discount rate required in lump sum settlement calculations of personal injury claims from 2.5% to negative 0.75%.
Retroactive reinsurance
Retroactive reinsurance premiums earned in 2018 were $517 million, which derived primarily from one contract. 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 our retroactive reinsurance contracts, we record the estimated ultimate claim liabilities, and we also record the excess of such claim liabilities over the premiums received as a deferred charge asset. Thus, as of the inception dates of these contracts, there is no net underwriting gain or loss. Deferred charge assets are subsequently amortized over the expected claim settlement period as losses and loss adjustment expenses.
Pre-tax underwriting losses from retroactive reinsurance contracts were $778 million in 2018, $1,330 million in 2017 and $60 million in 2016. Certain retroactive reinsurance liabilities of our U.S. subsidiaries are denominated in foreign currencies. Pre-tax underwriting results included gains of $169 million in 2018, losses of $264 million in 2017 and gains of $392 million in 2016 associated with the re-measurement of such liabilities due to currency exchange rate changes. Pre-tax underwriting losses before foreign currency gains/losses were $947 million in 2018, $1,066 million in 2017 and $452 million in 2016, which derived from deferred charge amortization and changes in the estimated timing and amount of future claim payments. Pre-tax underwriting losses related to the AIG Agreement were $611 million in 2018 and $527 million in 2017.
In 2018, we decreased estimated ultimate liabilities $341 million for prior years’ retroactive reinsurance contracts, which after adjustments to the related unamortized deferred charges from changes in the estimated timing and amount of the future claim payments, produced pre-tax underwriting gains of approximately $185 million. Changes in estimated ultimate liabilities for prior years’ contracts had a relatively insignificant effect on pre-tax underwriting results in 2017 and 2016.
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Management’s Discussion and Analysis (Continued)
Insurance—Underwriting (Continued)
Berkshire Hathaway Reinsurance Group (Continued)
Retroactive reinsurance (Continued)
Unpaid losses assumed under retroactive reinsurance contracts were approximately $41.8 billion at December 31, 2018 and $42.9 billion at December 31, 2017. Deferred charge assets related to such contracts were approximately $14.1 billion at December 31, 2018 and $15.3 billion at December 31, 2017. Deferred charge assets will be charged to pre-tax earnings over the expected remaining claims settlement periods through periodic amortization.
Life/health
A summary of our life/health reinsurance underwriting results follows (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 5,446 | $ | 4,846 | $ | 4,588 | ||||||||||||||||||
| Premiums earned | $ | 5,343 | 100.0 | $ | 4,808 | 100.0 | $ | 4,587 | 100.0 | |||||||||||||||
| Life and health insurance benefits | 4,226 | 79.1 | 4,276 | 88.9 | 3,644 | 79.4 | ||||||||||||||||||
| Underwriting expenses | 901 | 16.9 | 584 | 12.2 | 638 | 13.9 | ||||||||||||||||||
| Total benefits and expenses | 5,127 | 96.0 | 4,860 | 101.1 | 4,282 | 93.3 | ||||||||||||||||||
| Pre-tax underwriting gain (loss) | $ | 216 | $ | (52 | ) | $ | 305 | |||||||||||||||||
Life/health premiums earned were $5.3 billion, an increase of $535 million (11.1%) over 2017, which increased $221 million (4.8%) compared to 2016. The increases in each year were primarily attributable to growth in the North America, Asia and Australia life insurance markets. In each of the last three years, premiums earned of approximately $1.0 billion derived from a BHLN reinsurance contract with a major reinsurer covering predominantly life risks in North America.
Our life/health business produced pre-tax underwriting gains of $216 million in 2018, losses of $52 million in 2017 and gains of $305 million in 2016. The underwriting gains in 2018 reflected lower losses from the run-off of U.S. long-term care business, partially offset by lower gains from the run-off of variable annuity guarantee contracts. In the fourth quarter of 2017, we recorded pre-tax losses of $450 million from discount rate reductions and changes in other actuarial assumptions associated with long-term care liabilities. Pre-tax gains from variable annuity guarantee reinsurance were $34 million in 2018, $256 million in 2017 and $231 million in 2016. Underwriting results from this business reflect changes in estimated liabilities for guaranteed benefits, which result from changes in securities markets and interest rates and from the periodic amortization of expected profit margins.
Periodic payment annuity
Periodic payment annuity premiums earned in 2018 were $1,156 million, an increase of $258 million (28.7%) compared to 2017, which declined $184 million (17.0%) from 2016, reflecting a corresponding increase and decrease in new business volumes. Periodic payment business is price sensitive, and the volume we write can change rapidly due to changes in prices, which are affected by prevailing interest rates, the perceived risks and durations associated with the expected annuity payments, and the level of competition.
Periodic payment annuity contracts produced pre-tax losses of $340 million in 2018, $671 million in 2017 and $128 million in 2016. Certain contracts written by our U.S. subsidiaries are denominated in foreign currencies and pre-tax underwriting results included gains of $93 million in 2018, losses of $190 million in 2017 and gains of $313 million in 2016 from the re-measurement of such liabilities due to changes in exchange rates. Before foreign currency gains and losses, pre-tax underwriting losses were $433 million in 2018, $481 million in 2017 and $441 million in 2016. These losses primarily derived from the recurring discount accretion of annuity liabilities, as well as the impact of mortality and interest rate changes. Discounted annuity liabilities approximated $12.5 billion at December 31, 2018 and $11.2 billion at December 31, 2017, reflecting a weighted average discount rate of approximately 4.1%.
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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”) provides 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 are 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, Central States Indemnity Company and MLMIC Insurance Company, acquired October 1, 2018. A summary of BH Primary underwriting results follows (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | |||||||||||||||||||
| Premiums written | $ | 8,561 | $ | 7,483 | $ | 6,684 | ||||||||||||||||||
| Premiums earned | $ | 8,111 | 100.0 | $ | 7,143 | 100.0 | $ | 6,257 | 100.0 | |||||||||||||||
| Losses and loss adjustment expenses | 5,261 | 64.9 | 4,511 | 63.1 | 3,864 | 61.8 | ||||||||||||||||||
| Underwriting expenses | 2,180 | 26.9 | 1,913 | 26.8 | 1,736 | 27.7 | ||||||||||||||||||
| Total losses and expenses | 7,441 | 91.8 | 6,424 | 89.9 | 5,600 | 89.5 | ||||||||||||||||||
| Pre-tax underwriting gain | $ | 670 | $ | 719 | $ | 657 | ||||||||||||||||||
Premiums written and earned in 2018 increased 14.4% and 13.6%, respectively, compared to 2017. The increases in premiums written and earned were primarily attributable to written premium growth at BH Specialty (32.5%), GUARD (19.4%), NICO Primary (14.0%) and BHHC (7.6%). Premiums written and earned in 2017 increased 12.0% and 14.2%, respectively, compared to 2016 reflecting written premium increases from all of the significant BH Primary insurers, led by GUARD (26%), BH Specialty (23%) and BHHC (9%).
BH Primary’s loss ratios were 64.9% in 2018, 63.1% in 2017, and 61.8% in 2016. Losses and loss adjustment expenses included losses from significant catastrophe events of $190 million in 2018 from Hurricanes Florence and Michael and the wildfires in California and $225 million in 2017 from Hurricanes Harvey, Irma and Maria. Losses and loss adjustment expenses also included net gains from the reductions of estimated ultimate liabilities for prior years’ loss events of $715 million in 2018, $766 million in 2017 and $503 million in 2016. The liability reductions in each year primarily related to healthcare malpractice and workers’ compensation business. BH Primary writes significant levels of commercial and professional liability and workers’ compensation insurance and the related claim costs may be subject to higher severity and longer claim-tails, which could give rise to significant increases in claims liabilities in the future attributable to higher than expected claim settlements, adverse litigation outcomes or judicial rulings and other factors not currently anticipated.
Insurance—Investment Income
A summary of net investment income attributable to our insurance operations follows (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||
| Interest and other investment income | $ | 1,851 | $ | 1,263 | $ | 930 | ||||||
| Dividend income | 3,652 | 3,592 | 3,552 | |||||||||
| Investment income before income taxes and noncontrolling interests | 5,503 | 4,855 | 4,482 | |||||||||
| Income taxes and noncontrolling interests | 949 | 968 | 846 | |||||||||
| Net investment income | $ | 4,554 | $ | 3,887 | $ | 3,636 | ||||||
| Effective income tax rate | 17.2% | 19.9% | 18.8% | |||||||||
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Management’s Discussion and Analysis (Continued)
Insurance—Investment Income (Continued)
Pre-tax interest and other investment income increased $588 million (46.6%) compared to 2017. The increase reflected the effect of higher short-term interest rates in 2018 and higher other investment income, partly offset by lower interest from lower average investments in fixed maturity securities. Our invested assets continue to include significant levels of short-term investments. We believe that maintaining ample liquidity is paramount and we insist on safety over yield with respect to such investments. Dividend income increased $60 million (1.7%) in 2018 as compared to 2017, reflecting the impact of increased investments in marketable equity securities and higher dividend rates, partially offset by Restaurant Brands International’s redemption of our $3 billion investment in 9% preferred stock in December 2017.
Pre-tax investment income increased $373 million (8.3%) in 2017 compared to 2016, attributable to higher interest rates on short-term investments and increased other investment income. 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.
Invested assets of our insurance businesses derive from shareholder capital, including reinvested earnings, and from net liabilities under insurance and reinsurance 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 insurance benefit liabilities, unearned premiums and other liabilities due to policyholders, less insurance premiums and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated $123 billion at December 31, 2018, $114 billion at December 31, 2017, and $91 billion at December 31, 2016.
The increase in float in 2018 reflected the effects of the acquisition of MLMIC and overall growth of our insurance operations. The significant increase in float in 2017 reflected increases in loss adjustment expenses, including liabilities (net of deferred charges) assumed under retroactive reinsurance contracts written in 2017 and estimated liabilities related to catastrophe events, and overall growth of our insurance operations. Our combined insurance operations generated pre-tax underwriting earnings of approximately $2.0 billion in 2018, and consequently, the average cost of float for the period was negative. Pre-tax underwriting losses were approximately $3.2 billion in 2017 and our average cost of float was approximately 3.0%.
A summary of cash and investments held in our insurance businesses as of December 31, 2018 and 2017 follows (in millions).
| December 31, | ||||||||
| 2018 | 2017 | |||||||
| Cash, cash equivalents and U.S. Treasury Bills | $ | 64,548 | $ | 73,285 | ||||
| Equity securities | 166,385 | 163,134 | ||||||
| Fixed maturity securities | 19,690 | 21,092 | ||||||
| $ | 250,623 | $ | 257,511 | |||||
Fixed maturity investments as of December 31, 2018 were as follows (in millions).
| Amortized cost | Unrealized gains/losses | Carrying value | ||||||||||
| U.S. Treasury, U.S. government corporations and agencies | $ | 4,213 | $ | — | $ | 4,213 | ||||||
| States, municipalities and political subdivisions | 177 | 7 | 184 | |||||||||
| Foreign governments | 7,478 | 22 | 7,500 | |||||||||
| Corporate bonds, investment grade | 6,241 | 361 | 6,602 | |||||||||
| Corporate bonds, non-investment grade | 664 | 26 | 690 | |||||||||
| Mortgage-backed securities | 443 | 58 | 501 | |||||||||
| $ | 19,216 | $ | 474 | $ | 19,690 | |||||||
U.S. government obligations are rated AA+ or Aaa by the major rating agencies. Approximately 87% of all state, municipal and political subdivisions, foreign government obligations and mortgage-backed securities were rated AA or higher. Non-investment grade securities represent securities rated below BBB- or Baa3. Foreign government securities include obligations issued or unconditionally guaranteed by national or provincial government entities.
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Table of Contents
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, with approximately 32,500 route miles of track in 28 states. BNSF also operates in three Canadian provinces. BNSF classifies its major business groups by type of product shipped and include consumer products, coal, industrial products and agricultural products. A summary of BNSF’s earnings follows (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||
| Revenues | $ | 23,855 | $ | 21,387 | $ | 19,829 | ||||||
| Operating expenses: | ||||||||||||
| Compensation and benefits | 5,394 | 5,023 | 4,809 | |||||||||
| Fuel | 3,346 | 2,518 | 1,934 | |||||||||
| Purchased services | 2,870 | 2,514 | 2,418 | |||||||||
| Depreciation and amortization | 2,317 | 2,352 | 2,128 | |||||||||
| Equipment rents, materials and other | 2,024 | 1,636 | 1,855 | |||||||||
| Total operating expenses | 15,951 | 14,043 | 13,144 | |||||||||
| Interest expense | 1,041 | 1,016 | 992 | |||||||||
| 16,992 | 15,059 | 14,136 | ||||||||||
| Pre-tax earnings | 6,863 | 6,328 | 5,693 | |||||||||
| Income taxes | 1,644 | 2,369 | 2,124 | |||||||||
| Net earnings | $ | 5,219 | $ | 3,959 | $ | 3,569 | ||||||
| Effective income tax rate | 24.0% | 37.4% | 37.3% | |||||||||
2018 versus 2017
BNSF’s revenues were $23.9 billion in 2018, representing an increase of $2.5 billion (11.5%) versus 2017. BNSF’s revenues in 2018 reflected a 6.2% comparative increase in average revenue per car/unit and a 4.1% increase in volume. Combined volume was 10.7 million cars/units compared to 10.3 million in 2017. The increase in average revenue per car/unit was attributable to increased rates per car/unit, higher fuel surcharge revenue driven by higher fuel prices, and business mix changes. Pre-tax earnings were approximately $6.9 billion in 2018, an increase of 8.5% compared to 2017.
Revenues from consumer products were $7.9 billion in 2018, an increase of 11.1% compared to 2017, reflecting higher average revenue per car/unit and volume increases of 2.9%. The volume increases were due to higher domestic intermodal volumes, primarily attributable to general economic growth and tight truck capacity leading to conversion from highway to rail, as well as growth in imports and containerized agricultural product exports, partially offset by a sizable contract loss.
Revenues from industrial products were $6.0 billion in 2018, an increase of 16.2% from 2017. The increase was attributable to volume increases of 9.8% as well as higher average revenue per car/unit. Volumes in 2018 were higher primarily due to strength in the industrial and energy sectors, which drove higher demand for petroleum products, building products, construction products, and plastics.
Revenues from agricultural products increased 8.8% in 2018 to $4.7 billion compared to 2017. The increase was due to higher volumes of 9.0%, partially offset by slightly lower average revenue per car/unit. Volumes increased due to strong export and domestic corn shipments, as well as higher fertilizer and other grain products volumes, partially offset by a reduction in soybean and wheat exports.
Revenues from coal in 2018 increased 4.3% to $4.0 billion compared to 2017, attributable to higher average revenue per car/unit, partially offset by lower volumes of 0.8%. The volume decreases in 2018 were due mainly to utility plant retirements combined with competition from natural gas and renewables, mostly offset by market share gains and improved export volumes.
Total operating expenses were $16.0 billion in 2018, an increase of $1.9 billion (13.6%) compared to 2017. Our ratio of operating expenses to revenues increased 1.2 percentage points to 66.9% in 2018 versus 2017. Compensation and benefits expenses increased $371 million (7.4%) compared to 2017. The increase was primarily due to wage inflation and increased headcount and associated training costs. Fuel expenses increased $828 million (32.9%) compared to 2017 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)
Purchased services expense increased $356 million (14.2%) compared to 2017. The increase was due to higher purchased transportation costs of our logistics services business, as well as increased intermodal ramping, drayage, and other volume-related costs. Equipment rents, materials and other expense increased $388 million (23.7%) compared to 2017. The increase resulted from higher locomotive material, personal injury expenses, derailment-related costs, and property taxes, as well as a benefit of the enactment of the TCJA on an equity method investee in 2017.
BNSF’s effective income tax rate was 24.0% for 2018 as compared to 37.4% for 2017 which excludes the effects of the TCJA. The reduction in the U.S. statutory income tax rate under the TCJA, effective January 1, 2018, drove most of the effective income tax rate decrease.
2017 versus 2016
BNSF’s 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, BNSF’s revenues reflected a 2.4% comparative increase in average revenue per car/unit and a 5.3% increase in volume. Combined volume was 10.3 million cars/units in 2017 compared to 9.8 million in 2016. 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, 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 the 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.
Total 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 $214 million (4.4%) 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. 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 $219 million (11.8%) compared to 2016. These declines resulted from the impact of the enactment of the TCJA on an equity method investee, as well as lower personal injury and casualty costs.
Utilities and Energy (“Berkshire Hathaway Energy Company”)
We currently own 90.9% of the outstanding common stock of 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 a regulated electricity transmission-only business in Alberta, Canada (“AltaLink, L.P.”) and a diversified portfolio of mostly renewable 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 income taxes and a return on capital, and are subject to regulatory approval. To the extent these regulated operations are not allowed to include such costs in the approved rates, operating results will be adversely affected. Among its provisions, the TCJA reduced the U.S. federal statutory income tax rate of our domestic regulated utilities from 35% to 21%. In 2018, BHE’s regulated subsidiaries began passing the benefits of lower income tax expense attributable to the TCJA to customers through various regulatory mechanisms, including lower rates, higher depreciation and reductions to rate base, which produced lower revenue and pre-tax earnings in 2018. Revenues and earnings of BHE are summarized below (dollars in millions).
| Revenues | Earnings | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||||||
| PacifiCorp | $ | 5,078 | $ | 5,276 | $ | 5,245 | $ | 745 | $ | 1,131 | $ | 1,105 | ||||||||||||
| MidAmerican Energy Company | 3,117 | 2,906 | 2,668 | 407 | 372 | 392 | ||||||||||||||||||
| NV Energy | 3,065 | 3,048 | 2,925 | 417 | 567 | 559 | ||||||||||||||||||
| Northern Powergrid | 1,021 | 950 | 997 | 304 | 311 | 367 | ||||||||||||||||||
| Natural gas pipelines | 1,226 | 1,009 | 986 | 507 | 446 | 413 | ||||||||||||||||||
| Other energy businesses | 2,252 | 2,209 | 2,128 | 296 | 296 | 282 | ||||||||||||||||||
| Real estate brokerage | 4,228 | 3,456 | 2,815 | 204 | 220 | 225 | ||||||||||||||||||
| Corporate interest | — | — | — | (408 | ) | (844 | ) | (465 | ) | |||||||||||||||
| $ | 19,987 | $ | 18,854 | $ | 17,764 | |||||||||||||||||||
| Pre-tax earnings | 2,472 | 2,499 | 2,878 | |||||||||||||||||||||
| Income tax expense (benefit) | (452 | ) | 148 | 371 | ||||||||||||||||||||
| Net earnings | 2,924 | 2,351 | 2,507 | |||||||||||||||||||||
| Noncontrolling interests | 303 | 318 | 277 | |||||||||||||||||||||
| Net earnings attributable to Berkshire Hathaway shareholders | $ | 2,621 | $ | 2,033 | $ | 2,230 | ||||||||||||||||||
| Effective income tax rate | (18.3)% | 5.9% | 12.9% | |||||||||||||||||||||
PacifiCorp
PacifiCorp operates a regulated electric utility in portions of several Western states, including Utah, Oregon and Wyoming. Revenues in 2018 decreased 4% compared to 2017. Retail revenues in 2018 decreased $197 million compared to 2017. The decline reflected the effects of lower average rates ($180 million, including the impact of the TCJA of $152 million), and a reduction in volumes (0.2%), largely attributable to the impacts of weather.
Pre-tax earnings decreased $386 million (34%) in 2018 as compared to 2017. Utility margin (operating revenues less cost of fuel and energy) in 2018 was $3,269 million, a decrease of $198 million (6%) versus 2017. The decrease was primarily due to the declines in revenues, which included the effects of the TCJA. In addition, pre-tax earnings were negatively impacted $174 million (offset in income tax expense) due to a state regulatory order that accelerated depreciation expense on certain thermal generation facilities. PacifiCorp’s after-tax earnings in 2018 were $739 million, a decrease of $24 million (3%) from 2017.
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 utility margin, lower operations and maintenance expenses, and increased depreciation and amortization attributable to additional plant in-service. PacifiCorp’s after-tax earnings in 2017 were $763 million, a decrease of $1 million from 2016.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
MidAmerican Energy Company
MEC operates a regulated electric and natural gas utility primarily in Iowa and Illinois. Revenues in 2018 increased $211 million (7%) compared to 2017. Electric operating revenues increased $175 million (8%) and natural gas revenues increased $35 million (5%) in 2018 versus 2017. The increase in electric revenues was primarily attributable to higher retail revenues of $102 million, reflecting higher recoveries through bill riders (substantially offset in cost of sales, operating expenses and income tax expense) and volumes, partially offset by lower average rates, predominantly from the impact of the TCJA, and higher wholesale and other revenues of $73 million from higher volumes and average prices. The increase in natural gas revenues was primarily due to increased volumes, partially offset by a lower average per-unit price and the effects of the TCJA.
Pre-tax earnings in 2018 increased $35 million (9%) compared to 2017. Electric utility margin in 2018 was $1,796 million, an increase of $122 million (7%) over 2017, which was primarily due to the net increase in retail revenues. However, the increase in electric utility margin was mostly offset by increased depreciation, maintenance and other operating expenses. The increase in depreciation expense included $65 million from additional wind generation and other plant placed in-service and $44 million from Iowa revenue sharing.
MEC’s after-tax earnings in 2018 and 2017 were $669 million and $584 million, respectively, increases of $85 million (15%) and $52 million (10%), respectively, as compared to the corresponding prior years. MEC’s after-tax earnings were significantly greater than pre-tax earnings, primarily due to production income tax credits received relating to wind-powered generating facilities.
Revenues increased $238 million (9%) in 2017 as compared to 2016. The increase was primarily attributable to higher electric operating revenues ($123 million) and increased natural gas operating revenues ($82 million). Retail electric revenues increased $84 million in 2017 compared to 2016, primarily attributable to higher recoveries through bill riders and from non-weather usage and growth and rate factors, partially offset by the unfavorable impact of milder temperatures in 2017. 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 utility margins of $76 million.
NV Energy
NV Energy operates regulated electric and natural gas utilities in Nevada. Revenues in 2018 increased 1% compared to 2017. Electric operating revenues increased $17 million in 2018, reflecting increased pass-through cost adjustments and higher volumes largely attributable to the impacts of weather and retail customer growth, partly offset by reductions from the impact of the TCJA and lower retail rates resulting from a 2017 regulatory rate review. Natural gas operating revenue increased $5 million in 2018, primarily due to a higher average per-unit price, partially offset by lower customer usage.
Pre-tax earnings in 2018 decreased $150 million (26%) compared to 2017. The decrease was primarily due to lower electric utility margin and increased depreciation, maintenance and other operating costs. Electric utility margin in 2018 was $1,696 million, representing a $52 million (3%) decrease versus 2017. The decrease was primarily due to the effects of the TCJA, partially offset by the higher sales volumes. NV Energy’s after-tax earnings in 2018 were $317 million, a decline of 13% from 2017.
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. NV Energy’s after-tax earnings in 2017 were $365 million, an increase of 2% from 2016.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
Northern Powergrid
Revenues increased $71 million (7%) in 2018 compared to 2017, primarily due to the favorable foreign currency translation effects of a weaker average U.S. Dollar in 2018 and increased smart meter and distribution revenues. Pre-tax earnings in 2018 decreased $7 million (2%) compared to 2017, primarily due to higher depreciation and other operating expenses, including higher pension settlement losses, partly offset by favorable foreign currency translation effects and the increases in revenues.
Revenues declined $47 million (5%) in 2017 compared to 2016. Foreign currency translation effects of a comparatively stronger average U.S. Dollar in 2017 resulted in a $48 million comparative decline in revenues. In addition, 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 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.
Natural gas pipelines
Revenues increased $217 million (22%) in 2018 as compared to 2017, primarily due to higher transportation revenues of $113 million from higher volumes and rates due to unique market opportunities and colder average temperatures and increased sales volumes ($99 million) related to system balancing activities (substantially offset in cost of sales). Pre-tax earnings increased $61 million (14%) in 2018 compared to 2017, primarily due to the increases in transportation revenues and lower depreciation expense, partly offset by comparative increases in operations and maintenance expenses.
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, 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.
Other energy businesses
Revenues in 2018 increased $43 million (2%) compared to 2017, reflecting a comparative increase from renewable energy. Pre-tax earnings in 2018 were unchanged from 2017 as the increased revenues from renewable energy were offset by increased depreciation expense and higher other operating expenses.
Revenues increased 4% in 2017 compared to 2016. AltaLink L.P.’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 increased 5% compared to 2016, as increased earnings from renewable energy and AltaLink L.P. were partly offset by lower earnings from the unregulated retail services business and other energy ventures.
Real estate brokerage
Revenues in 2018 increased 22% as compared to 2017, primarily due to recent business acquisitions. Pre-tax earnings decreased $16 million in 2018 compared to 2017, as higher operating costs and interest expense more than offset the revenue increase.
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.
Corporate interest and income taxes
Corporate interest includes interest on unsecured debt issued by the BHE holding company and borrowings from Berkshire insurance subsidiaries in connection with certain of BHE’s business acquisitions. The borrowings from Berkshire insurance subsidiaries were repaid in the third quarter of 2017. Corporate interest in 2017 also 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 6% and 7%, respectively, in 2018 and 2017 as compared to the corresponding prior years, primarily due to lower average borrowings.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued)
Corporate interest and income taxes (Continued)
BHE’s consolidated effective income tax rates were (18.3)% in 2018, 5.9% in 2017 and 12.9% in 2016. BHE’s effective income tax rates regularly reflect significant production tax credits from wind-powered electricity generation placed in service by our domestic regulated utilities and other energy businesses. The decrease in the effective income tax rate in 2018 compared to 2017 was attributable to the reduction in the U.S. Federal corporate income tax rate, the impacts of rate making, adjustments to the amounts recorded for the repatriation tax on foreign earnings, higher production tax credits and lower U.S. income taxes on foreign earnings. The effective income tax rate in 2017 decreased versus 2016 primarily due to an increase in production tax credits.
Manufacturing, Service and Retailing
A summary of revenues and earnings of our manufacturing, service and retailing businesses follows (dollars in millions).
| Revenues | **Earnings *** | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||||||
| Manufacturing | $ | 61,883 | $ | 57,645 | $ | 52,969 | $ | 9,366 | $ | 8,324 | $ | 7,735 | ||||||||||||
| Service and retailing | 78,926 | 76,994 | 74,467 | 2,942 | 2,603 | 2,489 | ||||||||||||||||||
| $ | 140,809 | $ | 134,639 | $ | 127,436 | |||||||||||||||||||
| Pre-tax earnings | 12,308 | 10,927 | 10,224 | |||||||||||||||||||||
| Income taxes and noncontrolling interests | 2,944 | 3,645 | 3,421 | |||||||||||||||||||||
| $ | 9,364 | $ | 7,282 | $ | 6,803 | |||||||||||||||||||
| Effective income tax rate | 23.4% | 32.8% | 33.0% | |||||||||||||||||||||
| * | 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 $932 million in 2018, $937 million in 2017 and $814 million in 2016. These expenses are included in “Other” in the summary of earnings on page K-32 and in the “Other” earnings section on page K-53. |
|---|
Manufacturing
Our manufacturing group includes a variety of industrial, building and consumer products businesses. Industrial products group includes specialty chemicals (The Lubrizol Corporation (“Lubrizol”)), complex metal products for aerospace, power and general industrial markets (Precision Castparts Corp. (“PCC”)), 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”)). Marmon includes UTLX Company (“UTLX”), which provides various products and services (including equipment leasing) for the rail and mobile crane industries.
The building products group includes homebuilding and manufactured housing finance (Clayton Homes), 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). The consumer products group includes leisure vehicles (Forest River), several apparel and footwear operations (including Fruit of the Loom, Garan, H.H. Brown Shoe Group and Brooks Sports) and the Duracell Company (“Duracell”), a 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 (dollars in millions).
| Revenues | Pre-tax earnings | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||||||
| Industrial products | $ | 30,679 | $ | 28,566 | $ | 26,935 | $ | 5,822 | $ | 5,065 | $ | 4,989 | ||||||||||||
| Building products | 18,677 | 16,946 | 15,002 | 2,336 | 2,147 | 1,922 | ||||||||||||||||||
| Consumer products | 12,527 | 12,133 | 11,032 | 1,208 | 1,112 | 824 | ||||||||||||||||||
| $ | 61,883 | $ | 57,645 | $ | 52,969 | $ | 9,366 | $ | 8,324 | $ | 7,735 | |||||||||||||
K-45
Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Industrial products
2018 versus 2017
Revenues from industrial products businesses were approximately $30.7 billion in 2018, an increase of approximately $2.1 billion (7.4%) compared to 2017. PCC’s revenues in 2018 were $10.2 billion, an increase of 7.2% compared to 2017. The increase reflected increased demand in aerospace markets in connection with new aircraft programs, partly offset by lower demand for industrial gas turbine products. PCC is in the process of repurposing certain manufacturing assets previously used to support industrial gas turbine business to accommodate aerospace products. In addition, PCC experienced lower sales of certain pipe products in 2018, primarily attributable to the U.S tariffs.
Lubrizol’s revenues in 2018 were $6.8 billion, an increase of 5.9% compared to 2017 due to higher average sales prices, favorable changes in product mix and foreign currency translation effects, and a 2% increase in aggregate unit volumes. Lubrizol experienced significant increases in average material unit costs during 2018 and 2017, necessitating increases in sales prices. Lubrizol’s consolidated volume included increases in the Advanced Materials (5%) and the Additives (1%) product lines.
Marmon’s revenues in 2018 were $8.2 billion, an increase of 5.5% as compared to 2017. The revenue increase was primarily attributable to volume increases in the Transportation Products sector, higher average metals prices in the Plumbing & Refrigeration, Electrical Products, and Metal Services sectors, and business acquisitions in the Transportation Products, Crane Services, and Engineered Wire & Cable sectors. These increases were partially offset by revenue decreases in the Beverage Technologies and Rail Products and Services sectors. Rail Products and Services sector revenues decreased due to lower railcar lease revenues, partly offset by increased railcar equipment sales and repair services. Throughout 2018, the railcar leasing business experienced the negative effects of lower lease renewal rates for railcars versus the rates on expiring leases.
IMC’s revenues increased 16.1% in 2018 compared to 2017, due to a combination of factors, including higher unit sales, the effects of business acquisitions during 2017 and 2018, and foreign currency translation effects from a weaker average U.S. Dollar in the first half of 2018. CTB’s revenues increased 4.0% in 2018 versus 2017, due to favorable foreign currency translation effects and modest sales growth in protein production and processing systems.
Pre-tax earnings of the industrial products group were approximately $5.8 billion in 2018, an increase of $757 million (14.9%) compared to 2017. Pre-tax earnings as a percentage of revenues were 19.0% in 2018 and 17.7% in 2017. The comparative earnings increase was partially attributable to certain one-time charges at PCC and Lubrizol in 2017.
PCC’s pre-tax earnings increased 16.0% in 2018 compared to 2017. PCC’s earnings in 2017 included certain one-time inventory and impairment charges of $272 million. Results in 2018 were negatively affected by costs associated with the temporary unplanned shut-down of certain metals facilities, metal press outages and lower earnings from the industrial gas turbine business. The facilities that were shut-down gradually resumed production and were approximately 80% operational at the end of 2018. These facilities are expected to resume normal production in early 2019. In addition, the aforementioned new aircraft programs involve relatively complex manufacturing processes and manufacturing costs to-date have been relatively high, negatively affecting earnings. However, we expect costs will decline as processes improve and efficiencies develop.
Lubrizol’s pre-tax earnings in 2018 increased 43.5% compared to earnings in 2017, which included pre-tax losses of approximately $190 million related to Lubrizol’s disposition of an underperforming bolt-on business and related intangible asset impairments and restructuring charges. Before such charges, Lubrizol’s earnings increased 17%, reflecting the previously mentioned increases in sales volumes and selling prices, as well as lower other restructuring charges, lower net interest expense, and the favorable effects of foreign currency translation and ongoing expense control efforts, partly offset by higher raw material costs.
Marmon’s pre-tax earnings in 2018 decreased 5.6% compared to 2017. The decrease was primarily due to lower pre-tax earnings from the Rail Products and Services sector ($126 million) and the Foodservice Technologies and Retail Solutions sectors ($33 million), partially offset by increased earnings from the Transportation Products sector and a non-recurring gain of $42 million in 2018 from the sale of certain assets of the Beverage Technologies sector. The Rail Products and Services earnings decline was attributable to lower railcar leasing revenues and higher lease fleet repair costs.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Industrial products (Continued)
IMC’s pre-tax earnings increased significantly in 2018 compared to 2017, reflecting a combination of higher sales, increased manufacturing efficiencies, the effects of business acquisitions and ongoing expense control efforts, partly offset by higher raw material costs. CTB’s pre-tax earnings in 2018 were lower, primarily due to lower gross sales margins attributable to raw material cost increases and higher other operating expenses.
2017 versus 2016
Industrial products revenues were approximately $28.6 billion in 2017, an increase of approximately $1.6 billion (6.1%) versus 2016, reflecting increased revenues at several of our businesses. PCC’s revenues increased $754 million (8.6%) 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.
In 2017, PCC generated 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. Revenue increases associated with PCC’s transition into products for new aerospace programs were partly offset by revenue decreases from the winding down of prior programs. Lubrizol’s revenues increased $165 million (2.6%) compared to 2016, primarily due to higher unit volumes, partly offset by effects of the disposition of an underperforming business.
Marmon’s revenues increased $305 million (4.1%) in 2017 versus 2016, primarily due to business acquisitions and higher average metal prices, partly offset by lower overall volumes, changes in mix and lower leasing revenues from the Rail Products and Services sector. Railcar leasing revenues declined due to fewer railcars on lease at lower rates. During 2017, railcars available for lease exceeded demand, which contributed to the lower lease rates.
IMC’s revenues increased 13.3%, primarily due to increased customer demand and from business acquisitions. The global demand for cutting tools was generally higher in 2017. CTB’s revenues increased 5.3% 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.
Industrial products pre-tax earnings were approximately $5.1 billion in 2017, an increase of $76 million (1.5%) compared to 2016. Overall, pre-tax earnings as a percentage of revenues were 17.7% in 2017 and 18.5% in 2016.
PCC’s pre-tax earnings declined 12.5% in 2017 compared to the post-acquisition period in 2016, primarily due to certain one-time inventory and impairment charges. Lubrizol’s pre-tax earnings increased 17.3% in 2017 compared to 2016, due 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.
Marmon’s earnings in 2017 declined 3.5% compared to 2016, primarily due to lower earnings of the Rail Products and Services sector, partially offset by the effects of business acquisitions and ongoing cost control efforts.
Building products
2018 versus 2017
Revenues of the building products group in 2018 were approximately $18.7 billion, an increase of 10.2% compared to 2017. Pre-tax earnings of the building products group were approximately $2.3 billion in 2018, an increase of 8.8% versus 2017. Overall, pre-tax earnings as a percentage of revenues were 12.5% in 2018 and 12.7% in 2017. The pre-tax earnings increase was primarily due to higher earnings from Clayton Homes and Shaw, partly offset by lower earnings from Johns Manville.
Clayton Homes’ revenues were $6,046 million in 2018, an increase of $1,036 million (20.7%) over 2017. The increase was driven by an increase in revenues from home sales of $971 million (28.2%), primarily due to a 105% increase in unit sales of site built homes attributable to businesses acquired over the last two years. Unit sales of manufactured homes in 2018 also increased 4.9% compared to 2017. Average unit prices of site built homes are considerably higher than traditional manufactured homes. In addition, interest income from lending activities increased 4% in 2018 compared to 2017 primarily due to increased average outstanding loan balances.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Building products (Continued)
Clayton Homes pre-tax earnings were $911 million in 2018, an increase of $145 million (19.0%) compared to 2017. The increase in earnings in 2018 was primarily attributable to a significant increase in earnings from home building (manufactured housing and site built homes) activities, which reflected the impact of increased home sales and margins, as well as increased earnings from lending activities. A significant part of Clayton Homes’ earnings derives from manufactured housing lending activities. Pre-tax earnings from lending activities in 2018 declined 2% compared to 2017, reflecting increased interest expense, attributable to higher average debt balances and interest rates and higher operating costs, which more than offset the increase in interest income. As of December 31, 2018 and 2017, aggregate loan balances outstanding were approximately $14.7 billion and $13.7 billion, respectively.
Revenues of our other building products businesses increased 5.8% in 2018 to approximately $12.6 billion compared to 2017. In 2018, Shaw’s sales increased 7.9% and Johns Manville’s sales increased 7.2% as compared to 2017. The increases reflected higher average selling prices, product mix changes and overall unit volume increases.
Raw material and production costs of our building products businesses were generally higher in 2018. In particular, costs for steel, titanium dioxide and petrochemicals were substantially higher in 2018 than in 2017, as were product delivery costs, due in part to the shortage of truck drivers in the U.S. These cost increases precipitated sales price increases, although such increases have lagged the increases in raw materials costs. As a result, the increase in pre-tax earnings in 2018 of our other building products businesses ($43 million or 3.1%) lagged the 5.8% increase in revenues.
2017 versus 2016
Building products revenues were approximately $16.9 billion in 2017, an increase of approximately $1.9 billion (13.0%) compared to 2016. The increase was primarily attributable to bolt-on business acquisitions by Clayton, 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.
Clayton Homes’ revenues were approximately $5.0 billion in 2017, an increase of $780 million (18%) compared to 2016. The increase was primarily due to sales from newly-acquired site built home businesses, an increase in overall unit sales (9%) and higher average prices. Interest income from lending activities and other and financial services revenues increased 2% in 2017 compared to 2016.
Building products pre-tax earnings were $2.1 billion in 2017, an increase of $225 million (11.7%) compared to 2016. Pre-tax earnings as a percentage of revenues were 12.7% in 2017 and 12.8% in 2016. Clayton Homes’ 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. Clayton Homes’ earnings in 2017 also included a gain from a legal settlement, offset by increased employee healthcare, technology, marketing and other expenses. The comparative earnings increase reflected the effects of asset impairment, pension settlement and environmental claim charges of $107 million 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.
Consumer products
2018 versus 2017
Consumer products revenues were approximately $12.5 billion in 2018, an increase of $394 million (3.2%) compared to 2017, which was primarily due to revenue increases of Forest River and of our apparel and footwear businesses. Forest River’s revenues increased 2.6% in 2018, reflecting relatively unchanged unit sales versus 2017. However, over the second half of the year, comparative sales declined 5%, reflecting a 7% decline in units sold. Management attributes the slowing of sales, in part, to the effects of U.S. tariffs on steel products. Apparel and footwear revenues increased 4.6% to approximately $4.3 billion, primarily due to increased sales volume at Brooks Sports and Garan.
Pre-tax earnings were $1,208 million in 2018, an increase of $96 million (8.6%) compared to 2017. Pre-tax earnings as a percentage of revenues were 9.6% in 2018 and 9.2% in 2017. The increase in earnings reflected increases from Duracell and the apparel and footwear businesses, partly offset by lower earnings from Forest River and Larson Juhl.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Consumer products (Continued)
Forest River’s pre-tax earnings in 2018 declined 9.0% compared to 2017. Operating results were adversely affected over the second half of 2018, and in the fourth quarter in particular, by higher material costs, which, together with the effects of lower sales volumes, contributed to a 28% reduction in fourth quarter pre-tax earnings.
Pre-tax earnings of the apparel and footwear businesses increased 6.4% in 2018 compared to 2017, primarily attributable to the overall increase in revenues and sales mix changes. Duracell’s pre-tax earnings increased in 2018 compared to 2017, reflecting the favorable effects of ongoing operational improvement efforts and a comparative decline in restructuring charges. Since its acquisition in 2016, Duracell has undertaken significant transition and restructuring initiatives intended to restore and maintain adequate profit levels over the long-term.
2017 versus 2016
Consumer products revenues were approximately $12.1 billion in 2017, an increase of $1.1 billion (10%) compared to 2016, driven by 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.
Consumer products 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. The improvement in Duracell’s 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.
Service and retailing
A summary of revenues and pre-tax earnings of our service and retailing businesses follows (dollars in millions).
| Revenues | Pre-tax earnings | |||||||||||||||||||||||
| 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | |||||||||||||||||||
| Service | $ | 13,333 | $ | 12,155 | $ | 11,300 | $ | 1,836 | $ | 1,519 | $ | 1,399 | ||||||||||||
| Retailing | 15,606 | 15,064 | 15,092 | 860 | 785 | 659 | ||||||||||||||||||
| McLane Company | 49,987 | 49,775 | 48,075 | 246 | 299 | 431 | ||||||||||||||||||
| $ | 78,926 | $ | 76,994 | $ | 74,467 | $ | 2,942 | $ | 2,603 | $ | 2,489 | |||||||||||||
Service
Our service business group offers 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 transportation equipment leasing (XTRA) and furniture leasing (CORT), electronic news distribution, multimedia and regulatory filings (Business Wire), publication of newspapers and other publications (Buffalo News and the BH Media Group) and operation of a television station in Miami, Florida (WPLG). We also offer third party logistics services that primarily serve the petroleum and chemical industries (Charter Brokerage).
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Service (Continued)
2018 versus 2017
Revenues of the service group were approximately $13.3 billion in 2018, an increase of approximately $1.2 billion (9.7%) compared to 2017. TTI’s revenues in 2018 increased approximately 33.7% compared to 2017, reflecting industry-wide increases in demand for electronic components in many geographic markets around the world, and the effects of recent business acquisitions and favorable foreign currency translation effects. While TTI’s revenue increase in 2018 was significant, revenue growth began to moderate in the fourth quarter, in part attributable to the impact of U.S. trade tariffs. WPLG generated a revenue increase of 20.8% in 2018 over 2017, primarily due to increased political advertising revenue. Revenues of Charter Brokerage increased 53.3%, reflecting increased fees and product mix changes. Revenues of our leasing businesses increased 8.4% in 2018 compared to 2017 due to increased over-the road trailer units on lease (XTRA) and increased furniture rental income (CORT).
Pre-tax earnings of the service group in 2018 were approximately $1.8 billion, an increase of $317 million (20.9%) compared to 2017. The comparative earnings increase was primarily due to TTI, which accounted for almost 84% of the increase. The earnings increase of TTI was primarily due to the effects of the sales volume increases. In addition, XTRA, Charter Brokerage and NetJets each generated increased earnings in 2018 compared to 2017. The increases in earnings of these businesses were partly offset by lower earnings at FlightSafety, primarily due to reduced margins from sales of flight simulators and impairment charges of $41 million related to certain fixed assets.
2017 versus 2016
Service business revenues were approximately $12.2 billion in 2017, an increase of $855 million (7.6%) compared to 2016. The increase was primarily attributable to TTI and NetJets. TTI’s revenues increased 16.4% 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 services.
Pre-tax earnings were approximately $1.5 billion in 2017, an increase of $120 million (8.6%) compared to 2016. The comparative increase in earnings was primarily attributable to increased earnings of NetJets and TTI, partly offset by comparatively lower earnings from FlightSafety, and from our leasing, media and logistics businesses.
Retailing
Our retailers include Berkshire Hathaway Automotive (“BHA”). 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.
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.
2018 versus 2017
Revenues of the retailing group were approximately $15.6 billion in 2018, an increase of $542 million (3.6%) compared to 2017. BHA’s revenues, which represented approximately 63% of the aggregate retailing revenues in each of the past three years, increased 4.0% in 2018 as compared to 2017. The increase derived primarily from increased pre-owned vehicle sales and service contract revenues. Revenues from new vehicle sales were relatively unchanged. Louis revenues increased 7.8% in 2018 versus 2017, primarily due to the translation effects of a weaker average U.S. Dollar. Home furnishings revenues increased 4.7% in 2018 over 2017, reflecting increased sales in certain geographic markets and the effect of a new store.
Pre-tax earnings of the retailing group were $860 million in 2018, an increase of $75 million (9.6%) over 2017. The earnings increase included higher earnings from BHA and Louis, partly offset by lower earnings from the home furnishings retailers. The earnings increase of BHA was primarily from finance and service contract activities, partly offset by higher floorplan interest expense. The earnings increase at Louis reflected the revenues increase and an increase in operating margin rate. Earnings of the home furnishings businesses declined 2.4% in 2018 compared to 2017, partly due to increased inventory liquidation, delivery and occupancy costs at Star Furniture.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Manufacturing, Service and Retailing (Continued)
Retailing (Continued)
2017 versus 2016
Retailing revenues were $15.1 billion in 2017, slightly lower than in 2016. BHA’s aggregate revenues declined 1.3% in 2017 compared to 2016, due primarily due to a 3.7% decline in new and used cars sold, partly offset by higher service and finance revenues. Revenues of our other retailers increased 1.7% in 2017 compared to 2016.
Pre-tax earnings increased $126 million (19.1%) in 2017 as compared to 2016. The increase reflected comparatively higher earnings from BHA, primarily due to increased earnings from service contract and finance 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.
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 and very low profit margins. These businesses have several significant customers, including Walmart, 7-Eleven, Yum! Brands and others. Grocery sales comprised approximately 67% of McLane’s consolidated sales in 2018 with food service comprising most of the remainder. A curtailment of purchasing by any of its significant customers could have an adverse impact on periodic revenues and earnings.
McLane’s revenues were approximately $50.0 billion in 2018, slightly higher than 2017, reflecting a slight increase in grocery sales (1%) and a slight decrease in foodservice sales (1%). The decline in foodservice revenues was primarily due to a net loss of customers. Pre-tax earnings were $246 million in 2018, a decline of $53 million (17.7%), compared to 2017. McLane’s grocery and foodservice businesses continue to operate in a highly competitive business environment, which is negatively affecting its current operating results. While gross margin rates increased slightly over 2018, increases in fuel, depreciation and certain other operating expenses more than offset the increase, producing a decline in pre-tax earnings compared to 2017. We expect the current unfavorable operating conditions will continue in 2019.
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 (30.6%) 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 McLane’s operating results, particularly with respect to the grocery business.
Investment and Derivative Gains (Losses)
A summary of investment and derivative gains and losses follows (dollars in millions).
| 2018 | 2017 | 2016 | ||||||||||
| Investment gains (losses) | $ | (22,155 | ) | $ | 1,410 | $7,553 | ||||||
| Derivative gains (losses) | (300 | ) | 718 | 751 | ||||||||
| Gains (losses) before income taxes and noncontrolling interests | (22,455 | ) | 2,128 | 8,304 | ||||||||
| Income taxes and noncontrolling interests | (4,718 | ) | 751 | 1,807 | ||||||||
| Net gains (losses) | $ | (17,737 | ) | $ | 1,377 | $6,497 | ||||||
| Effective income tax rate | 20.8% | 34.9% | 21.8% | |||||||||
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Table of Contents
Management’s Discussion and Analysis (Continued)
Investment and Derivative Gains (Losses) (Continued)
Investment gains (losses)
As discussed in Note 1(w) to the accompanying Consolidated Financial Statements, on January 1, 2018, we adopted a new accounting pronouncement (“ASU 2016-01”), which requires the recognition of unrealized gains and losses arising from changes in market values of investments in equity securities in the Consolidated Statements of Earnings. Prior to 2018, investment gains/losses related to equity securities were generally recorded as the securities were sold, redeemed or exchanged based on the cost of the disposed securities. While ASU 2016-01 does not affect our consolidated shareholders’ equity or total comprehensive income, it has significantly increased the volatility of our periodic net earnings due to the magnitude of our equity securities portfolio and the inherent volatility of equity securities prices. Investment gains and losses from periodic changes in securities prices will continue to cause significant volatility in our consolidated earnings.
Pre-tax investment gains/losses reflected in earnings in 2018 included net unrealized losses of approximately $22.7 billion from investments in equity securities still held at December 31, 2018, reflecting the declines in securities prices in the fourth quarter. Prior to the adoption of ASU 2016-01, such unrealized gains and losses were included in other comprehensive income. Pre-tax net unrealized gains on equity securities recorded in other comprehensive income were approximately $29 billion in 2017 and $7 billion in 2016.
Pre-tax investment gains were approximately $1.4 billion in 2017 and $7.6 billion in 2016. 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.
We believe that investment gains/losses, whether realized from sales or unrealized from changes in market prices, are often meaningless in terms of understanding our reported consolidated earnings or evaluating our periodic economic performance. We continue to believe the amount of investment gains/losses included in earnings, including the changes in market prices for equity securities, in any given period has little analytical or predictive value.
Derivative gains (losses)
Derivative contract gains/losses include the changes in fair value of our equity index put option contract liabilities. These liabilities relate to contracts entered into before March 2008. Substantially all of these contracts will expire between April 2019 and February 2023. 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.
As of December 31, 2018, the intrinsic value of our equity index put option contracts was approximately $1,653 million and our recorded liabilities at fair value were approximately $2,452 million. Our ultimate payment obligations, if any, under our contracts will be determined as of the contract expiration dates based on the intrinsic value as defined under the contracts. Contracts with an aggregate notional value of approximately $12.2 billion will expire in 2019.
Derivative contracts produced pre-tax losses in 2018 of $300 million, which were primarily due to lower index values. Equity index put option contracts produced pre-tax gains of $718 million in 2017 and $662 million in 2016, which reflected the effects of shorter remaining contract durations and overall higher index values. 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.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Other
A summary of after-tax other earnings (losses) follows (in millions).
| 2018 | 2017 | 2016 | ||||||||||
| Equity method earnings (losses) | $ | (1,419) | $ | 1,111 | $ | 707 | ||||||
| Acquisition accounting expenses | (1,111) | (936) | (846) | |||||||||
| Corporate interest expense, before foreign currency effects | (311) | (266) | (256) | |||||||||
| Euro note foreign exchange gains (losses) | 289 | (655) | 159 | |||||||||
| Corporate interest and dividend income | 530 | 232 | 288 | |||||||||
| Other | 456 | 29 | (83) | |||||||||
| Net earnings (losses) attributable to Berkshire Hathaway shareholders | $ | (1,566) | $ | (485) | $ | (31) | ||||||
After-tax equity method earnings includes Berkshire’s share of earnings attributable to Kraft Heinz, Pilot Flying J, Berkadia and Electric Transmission of Texas. Our after-tax equity method losses in 2018 included approximately $2.7 billion from intangible asset impairment charges recorded by Kraft Heinz. Our after-tax equity method earnings in 2017 excluded approximately $1.1 billion from the net effects of the TCJA on Kraft Heinz’s net earnings. Corporate interest and dividend income in 2016 included pre-tax dividend income of $180 million from our Kraft Heinz preferred stock investment, which Kraft Heinz redeemed in June 2016.
After-tax other earnings (losses) also include charges arising from the application of the acquisition method in connection with certain of Berkshire’s past business acquisitions. Such charges were primarily from the amortization or impairment of intangible assets recorded in connection with those business acquisitions.
Berkshire issued Euro denominated debt in 2015, 2016 and 2017 and the aggregate par amount outstanding was €6.85 billion at December 31, 2018. Changes in foreign currency exchange rates produced sizable non-cash unrealized gains and losses in each of the past three years from the periodic revaluation of these liabilities into U.S. Dollars.
Financial Condition
Our consolidated balance sheet continues to reflect significant liquidity and a strong capital base. Consolidated shareholders’ equity at December 31, 2018 was approximately $349 billion, a decrease of $26.9 billion since September 30, 2018 and an increase of $407 million since December 31, 2017. Net earnings attributable to Berkshire shareholders in 2018 were $4.0 billion, which included after-tax losses on our investments of approximately $17.5 billion. After-tax losses on investments were approximately $27.6 billion in the fourth quarter of 2018, reflecting the declines in market prices of the equity securities we owned at December 31, 2018.
At December 31, 2018, our insurance and other businesses held cash, cash equivalents and U.S. Treasury Bills of approximately $109 billion, which included $85 billion in U.S. Treasury Bills. Investments in equity and fixed maturity securities (excluding our investment in Kraft Heinz) were approximately $193 billion.
Berkshire parent company debt outstanding at December 31, 2018 was approximately $16.9 billion, a decrease of $1.9 billion since December 31, 2017, reflecting term debt maturities of $1.55 billion and a $366 million decrease attributable to foreign currency exchange rate changes applicable to the €6.85 billion par amount of Euro denominated senior notes. Berkshire parent company debt of $750 million matures in 2019.
Borrowings of Berkshire’s insurance and other subsidiaries declined $3.5 billion in 2018 to approximately $18.1 billion at December 31, 2018, primarily attributable to a net decrease in borrowings of Berkshire Hathaway Finance Corporation (“BHFC”), a wholly-owned financing subsidiary. During 2018, BHFC repaid $4.6 billion of maturing senior notes and issued $2.35 billion of 4.2% senior notes due in 2048. 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. In January 2019, BHFC repaid $950 million of maturing senior notes and issued $1.25 billion of 4.25% senior notes due in 2049. An additional $3.0 billion of BHFC senior notes will mature in 2019. Berkshire guarantees the full and timely payment of principal and interest with respect to BHFC’s senior notes.
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. We forecast capital expenditures of these two operations will approximate $10.5 billion for the year ending December 31, 2019.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Financial Condition (Continued)
BNSF’s outstanding debt approximated $23.2 billion as of December 31, 2018, an increase of $727 million since December 31, 2017. In 2018, BNSF issued $1.5 billion of senior unsecured debentures due in 2048 with a weighted average interest rate of 4.1%. BNSF debentures of $750 million will mature in 2019.
Outstanding borrowings of BHE and its subsidiaries were approximately $39.3 billion at December 31, 2018, a decrease of $390 million since December 31, 2017. In 2018, BHE issued $3.2 billion of senior unsecured debt with maturities ranging from 2021 to 2049 with a weighted average interest rate of 3.6%. BHE subsidiaries also issued debt in 2018, aggregating $2.3 billion with maturity dates ranging from 2020 to 2049. The proceeds from these financings were used to repay borrowings, to fund capital expenditures and for other general corporate purposes. Approximately $2.1 billion of BHE subsidiary term debt will mature in 2019. 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.
Berkshire’s common stock repurchase program was amended on July 17, 2018, permitting Berkshire to repurchase its Class A and Class B shares at prices below Berkshire’s intrinsic value, as conservatively determined by Warren Buffett, Berkshire’s Chairman of the Board and Chief Executive Officer, and Charlie Munger, Vice Chairman of the Board. The program allows share repurchases in the open market or through privately negotiated transactions and does not specify a maximum number of shares to be repurchased. The program is expected to continue indefinitely. 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. Financial strength and redundant liquidity will always be of paramount importance at Berkshire. Subsequent to the program amendment, in 2018, Berkshire repurchased shares of Class A and B common stock for an aggregate cost of approximately $1.3 billion.
Contractual Obligations
We are party to contracts associated with ongoing business and financing activities, which will result in cash payments to counterparties in future periods. Certain obligations are included in our Consolidated Balance Sheets, such as notes payable, which require future payments on contractually specified dates and in fixed and determinable amounts. Other obligations pertaining to the acquisition of goods or services in the future, such as minimum rentals under operating leases and certain purchase obligations not currently reflected in the financial statements, will be recognized in future periods as the goods are delivered or services are provided. Beginning in 2019, operating lease obligations will be included in the consolidated balance sheet upon the adoption of a new accounting pronouncement. The timing and amount of the payments under certain contracts, such as insurance and reinsurance contracts, are contingent upon the outcome of future events. Actual payments will likely vary, perhaps materially, from the estimated liabilities currently recorded in our Consolidated Balance Sheet.
A summary of our contractual obligations as of December 31, 2018 follows (in millions). Actual payments will likely vary, perhaps significantly, from estimates reflected in the table.
| Estimated payments due by period | ||||||||||||||||||||
| Total | 2019 | 2020-2021 | 2022-2023 | After 2023 | ||||||||||||||||
| Notes payable and other borrowings, including interest | $ | 153,059 | $ | 15,840 | $ | 17,777 | $ | 20,341 | $ | 99,101 | ||||||||||
| Operating leases | 9,013 | 1,360 | 2,415 | 1,580 | 3,658 | |||||||||||||||
| Purchase obligations (1) | 47,264 | 15,709 | 8,181 | 6,078 | 17,296 | |||||||||||||||
| Unpaid losses and loss adjustment expenses (2) | 110,292 | 22,204 | 25,329 | 14,613 | 48,146 | |||||||||||||||
| Life, annuity and health insurance benefits (3) | 34,362 | 1,461 | (82) | 322 | 32,661 | |||||||||||||||
| Other | 15,589 | 628 | 1,748 | 4,876 | 8,337 | |||||||||||||||
| Total | $ | 369,579 | $ | 57,202 | $ | 55,368 | $ | 47,810 | $ | 209,199 | ||||||||||
| (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. |
|---|
| (3) | Amounts represent estimated undiscounted benefits, net of estimated future premiums, as applicable. |
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Management’s Discussion and Analysis (Continued)
Critical Accounting Policies
Certain accounting policies require us to make estimates and judgments 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. A discussion of our principal accounting policies that required the application of significant judgments as of December 31, 2018 follows.
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, 2018 were approximately $110 billion, of which 84% related to GEICO and the Berkshire Hathaway Reinsurance Group. Additional information regarding significant uncertainties inherent in the processes and techniques of these businesses follows.
GEICO
GEICO predominantly writes private passenger auto insurance. As of December 31, 2018, GEICO’s gross unpaid losses were $19.5 billion. Claim liabilities, net of reinsurance recoverable were $18.6 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, 2018, 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 2017 decreased $222 million during 2018, which produced a corresponding increase to pre-tax earnings. We modified the assumptions used to estimate liabilities at December 31, 2018 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, 2018. 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.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
Berkshire Hathaway Reinsurance Group (“BHRG”)
BHRG’s liabilities for unpaid losses and loss adjustment expenses derive primarily from reinsurance contracts issued through NICO and General Re. 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 reliable 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.
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, 2018 follows (in millions).
| General Re | NICO | Total | ||||||||||||||||||||||||||||||||||
| Property | Casualty | Total | Property | Casualty | Total | Property | Casualty | Total | ||||||||||||||||||||||||||||
| Reported case liabilities | $ | 1,682 | $ | 6,310 | $ | 7,992 | $ | 3,903 | $ | 3,194 | $ | 7,097 | $ | 5,585 | $ | 9,504 | $ | 15,089 | ||||||||||||||||||
| IBNR liabilities | 1,657 | 7,126 | 8,783 | 2,550 | 4,440 | 6,990 | 4,207 | 11,566 | 15,773 | |||||||||||||||||||||||||||
| Gross unpaid losses and loss adjustment expenses | 3,339 | 13,436 | 16,775 | 6,453 | 7,634 | 14,087 | 9,792 | 21,070 | 30,862 | |||||||||||||||||||||||||||
| Reinsurance recoverable | 285 | 668 | 953 | 27 | 182 | 209 | 312 | 850 | 1,162 | |||||||||||||||||||||||||||
| Net unpaid losses and loss adjustment expenses | $ | 3,054 | $ | 12,768 | $ | 15,822 | $ | 6,426 | $ | 7,452 | $ | 13,878 | $ | 9,480 | $ | 20,220 | $ | 29,700 | ||||||||||||||||||
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.
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Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
Berkshire Hathaway Reinsurance Group (“BHRG”) (Continued)
With respect to General Re, 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’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, 2018, our case loss estimates exceeded ceding company estimates by approximately $2.0 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 IBNR liabilities, General Re considers 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.
NICO generally establishes reinsurance claim liabilities on a contract-by-contract basis determined from 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 adjusted upward or downward over time to reflect case losses reported versus expected case losses, which we use to form revised 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 known major catastrophe events.
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.
BHRG’s estimated ultimate net losses for prior years’ loss events were reduced $469 million in 2018, 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 $365 million. Property losses incurred during any given period may be more volatile because of the effect of catastrophe and large individual property loss events. In addition, we lowered estimated ultimate losses for prior years’ casualty events $104 million in 2018, reflecting reduced estimates for workers’ compensation and other casualty coverages, partially offset by an increase in estimates for asbestos, environmental and other latent injury claims.
General Re’s reported losses for prior years’ workers’ compensation claims were less than expected. After reevaluating expected remaining IBNR estimates, liabilities were reduced by $117 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 of approximately $1 billion in General Re’s workers’ compensation IBNR liabilities, producing a corresponding decrease in pre-tax earnings. We believe it is reasonably possible for these assumptions to increase at these rates.
We reduced estimated ultimate losses for prior years’ events for other casualty losses, excluding asbestos, environmental, and other latent injury claims, by $132 million in 2018, reflecting lower than expected reported losses. For General Re’s 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 $800 million. While we believe it is reasonably possible for these assumptions to increase at these rates, more likely outcomes are less than $800 million given the diversification in worldwide business.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Property and casualty losses (Continued)
Berkshire Hathaway Reinsurance Group (“BHRG”) (Continued)
Estimated ultimate liabilities for asbestos, environmental and other latent injury claims were increased approximately $145 million in 2018, which produced a corresponding reduction in pre-tax earnings. Net liabilities for such claims, excluding amounts assumed under retroactive reinsurance contracts, were approximately $1.7 billion at December 31, 2018. We may use industry-wide loss experience data and informed judgment when internal loss data is of limited reliability in making estimates for such losses. 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 16 years as of December 31, 2018.
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, 2018 were as follows (in millions).
| Gross unpaid losses | Deferred charges | Liabilities, net of deferred charges | ||||||||||
| December 31, 2018 | $ | 41,834 | $ | 14,104 | $ | 27,730 |
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 $55 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 $41.8 billion estimated liability at December 31, 2018.
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.
Certain of our retroactive reinsurance contracts include asbestos, environmental and other latent injury claims. Our estimated liabilities for such claims were approximately $13.1 billion at December 31, 2018. 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.
We reduced estimated ultimate liabilities for prior years’ retroactive reinsurance contracts by $341 million in 2018, which after the changes in related deferred charge assets, resulted in pre-tax earnings of $185 million. In 2018, we paid losses and loss adjustment expenses of approximately $1.4 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, 2018, we currently estimate that amortization expense in 2019 will approximate $1.2 billion.
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Table of Contents
Management’s Discussion and Analysis (Continued)
Other Critical Accounting Policies
Our Consolidated Balance Sheet at December 31, 2018 included goodwill of acquired businesses of $81.0 billion. We evaluate goodwill for impairment at least annually and we conducted our most recent annual review during the fourth quarter of 2018. 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, 2018, approximately 68% 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 also 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, 2018 and 2017 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, 2018 | ||||||||||||||||
| Investments in equity securities | $ | 172,757 | 30% increase | $ | 224,584 | 11.7% | ||||||||||
| 30% decrease | 120,930 | (11.7) | ||||||||||||||
| Equity index put option contract liabilities | 2,452 | 30% increase | 1,131 | 0.3 | ||||||||||||
| 30% decrease | 5,362 | (0.7) | ||||||||||||||
| 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) |
| (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 also issue debt in the ordinary course of business to fund business operations, business acquisitions and for other general purposes. We attempt to maintain high credit ratings, in order to minimize the cost of our debt. We infrequently 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, 2018 and 2017. We assumed that the interest rate changes occur immediately and uniformly to each category of instrument 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, 2018 | ||||||||||||||||||||
| Assets: | ||||||||||||||||||||
| Investments in fixed maturity securities | $ | 19,898 | $ | 20,260 | $ | 19,549 | $ | 19,214 | $ | 18,891 | ||||||||||
| Loans and finance receivables | 16,377 | 17,006 | 15,844 | 15,318 | 14,823 | |||||||||||||||
| Liabilities: | ||||||||||||||||||||
| Notes payable and other borrowings: | ||||||||||||||||||||
| Insurance and other | 35,361 | 37,559 | 33,380 | 31,691 | 30,208 | |||||||||||||||
| Railroad, utilities and energy | 66,422 | 73,063 | 60,840 | 56,107 | 52,063 | |||||||||||||||
| Equity index put option contracts | 2,452 | 2,669 | 2,249 | 2,057 | 1,877 | |||||||||||||||
| 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 | 41,762 | 43,937 | 39,844 | 38,140 | 36,619 | |||||||||||||||
| Railroad, utilities and energy | 70,538 | 77,091 | 64,582 | 59,730 | 55,581 | |||||||||||||||
| Equity index put option contracts | 2,172 | 2,460 | 1,911 | 1,676 | 1,465 |
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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, 2018 and 2017 follows (in millions).
| 2018 | 2017 | |||||||
| Euro-denominated debt included in net earnings | $ | 289 | $ | (655) | ||||
| Net liabilities under certain reinsurance contracts included in net earnings | 207 | (295) | ||||||
| Foreign currency translation included in other comprehensive income | (1,424) | 2,151 |
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