BERKSHIRE HATHAWAY INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Results of Operations
Net earnings attributable to
Third Quarter First Nine Months 2012 2011 2012 2011 Insurance - underwriting $ 392 $ 1,089 $ 1,065 $ 261 Insurance - investment income 733 783 2,592 2,730 Railroad 937 766 2,440 2,063 Utilities and energy 438 372 1,029 888 Manufacturing, service and retailing * 991 836
2,870 2,183
Finance and financial products 108 103
332 309
Other (200 ) (137 )
(544 ) (325 )
Investment and derivative gains/losses 521 (1,534 ) 489 (903 )
Net earnings attributable to
* Includes earnings of Lubrizol from the acquisition date of
Through our subsidiaries, we engage in a number of diverse business activities. Our operating businesses are managed on an unusually decentralized basis. There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by our corporate headquarters in the day-to-day business activities of the operating businesses. Our senior corporate management team participates in and is ultimately responsible for significant capital allocation decisions, investment activities and the selection of the Chief Executive to head each of the operating businesses. It also is responsible for establishing and monitoringBerkshire's corporate governance efforts, including, but not limited to, communicating the appropriate "tone at the top" messages to its employees and associates, monitoring governance efforts at the operating businesses, and participating in the resolution of governance-related issues as needed. The business segment data (Note 17 to the Consolidated Financial Statements) should be read in conjunction with this discussion. In 2012, insurance underwriting activities generated after-tax earnings of$392 million for the third quarter and$1,065 million for the first nine months. In the first nine months of 2012, the aggregate impact of catastrophe losses, changes in retroactive reinsurance liabilities and foreign currency gains and losses was relatively insignificant. Insurance underwriting earnings for the third quarter of 2011 included an after-tax gain of$855 million from the reduction in estimated liabilities related to retroactive reinsurance contracts which was primarily attributable to lower than expected loss experience of one ceding company and from reductions in certain reinsurance contract liabilities that are settled in foreign currencies due to changes in currency exchange rates. During the first nine months of 2011, our reinsurance operations also incurred insurance losses of approximately$1.3 billion , after tax, from several significant catastrophe events, most of which occurred in the first quarter. Our railroad and utilities and energy businesses continued to generate significant earnings in 2012. Earnings from our manufacturing, service and retailing businesses in 2012 increased significantly over 2011 due primarily to the acquisition ofThe Lubrizol Corporation ("Lubrizol"), which was completed onSeptember 16, 2011 . Lubrizol's results are fully included for the third quarter and first nine months of 2012 and for the post-September 16 periods of 2011, as a component of manufacturing, service and retailing businesses in the preceding table. Excluding the impact of Lubrizol, earnings from our manufacturing, service and retailing businesses were mixed, reflecting modest improvements in building and construction in the U.S., and deterioration in several foreign markets affecting certain of our manufacturing and service operations. In the third quarter and first nine months of 2012, investment and derivative gains/losses included after-tax losses from derivative contracts of$76 million and$119 million , respectively. In 2011, derivative contracts produced after-tax losses of$1,587 million in the third quarter and$1,531 million in the first nine months. In the third quarter of 2012, we also recognized after-tax investment gains of$597 million from sales of securities and repayments of certain loan portfolios. In the second quarter of 2011, we recognized an after-tax gain of approximately$806 million from the redemption of our investment in Goldman Sachs 10% Preferred Stock. We believe that realized investment gains/losses are often meaningless in terms of understanding our reported results or evaluating our economic performance. The timing and magnitude of investment and derivative gains and losses has caused and will likely continue to cause significant volatility in our periodic earnings.
Insurance-Underwriting
We engage in both primary insurance and reinsurance of property and casualty 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: (1)GEICO , (2)General Re , (3)Berkshire Hathaway Reinsurance Group ("BHRG") and (4)Berkshire Hathaway Primary Group .General Re and BHRG also reinsure life and health risks. 21
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Insurance-Underwriting (Continued)
Our management views insurance businesses as possessing two distinct operations - underwriting and investing. Underwriting decisions are the responsibility of the unit managers; investing decisions, with limited exceptions, are the responsibility ofBerkshire's Chairman and CEO,Warren E. Buffett . Accordingly, we evaluate the performance of underwriting operations without any allocation of investment income or investment gains/losses. Our periodic underwriting results are affected significantly by changes in estimates for unpaid losses and loss adjustment expenses, including amounts established for loss occurrences in prior years. In the first nine months of 2012, we recorded net reductions of approximately$150 million with respect to unpaid losses on retroactive reinsurance contracts. In the third quarter of 2011, we reduced unpaid losses related to certain retroactive reinsurance contracts by approximately$875 million . In addition, the timing and amount of catastrophe losses can produce significant volatility in our periodic underwriting results, particularly with respect to BHRG andGeneral Re . Incurred losses from catastrophes occurring in the first nine months of 2012 were relatively insignificant. In the first nine months of 2011, we recorded aggregate pre-tax provisions for estimated catastrophe losses of approximately$2 billion arising from several events, including the earthquakes inJapan andNew Zealand , as well as weather related events inAustralia and the U.S. Our periodic underwriting results may also include significant foreign currency transaction gains and losses arising from the changes in the valuations of certain non-U.S. Dollar denominated reinsurance liabilities as a result of foreign currency exchange rate fluctuations. In recent years, currency exchange rates have been volatile and the resulting impact on our underwriting results has been significant. A key marketing strategy followed by all of our insurance businesses is the maintenance of extraordinary capital strength. Statutory surplus of our insurance businesses was approximately$95 billion atDecember 31, 2011 . This superior capital strength creates opportunities to negotiate and enter into insurance and reinsurance contracts specially designed to meet the unique needs of insurance and reinsurance buyers. Underwriting results of our insurance businesses are summarized as follows. Amounts are in millions. Third Quarter First Nine Months 2012 2011 2012 2011
Underwriting gain (loss) attributable to:
GEICO $ 435 $ 114 $
714
General Re 154 148
373 (46 )
Berkshire Hathaway Reinsurance Group (102 ) 1,375
320 (322 )
Berkshire Hathaway Primary Group 121 58
243 168
Pre-tax underwriting gain 608 1,695
1,650 410
Income taxes and noncontrolling interests 216 606 585 149 Net underwriting gain $ 392 $ 1,089 $ 1,065 $ 261 GEICO ThroughGEICO , we primarily write private passenger automobile insurance, offering coverages to insureds in all 50 states and theDistrict of Columbia .GEICO's policies are marketed mainly by direct response methods in which customers apply for coverage directly to the company via the Internet or over the telephone. This is a significant element in our strategy to be a low-cost auto insurer. In addition, we strive to provide excellent service to customers, with the goal of establishing long-term customer relationships.GEICO's underwriting results are summarized below. Dollars are in millions. Third Quarter First Nine Months 2012 2011 2012 2011 Amount % Amount % Amount % Amount % Premiums earned $ 4,240 100.0 $ 3,907 100.0 $ 12,388 100.0 $ 11,400 100.0
Losses and loss adjustment expenses 3,011 71.0 3,100
79.3 9,089 73.4 8,707 76.4 Underwriting expenses
794 18.7 693
17.8 2,585 20.8 2,083 18.3
Total losses and expenses 3,805 89.7 3,793
97.1 11,674 94.2 10,790 94.7
Pre-tax underwriting gain $ 435 $ 114 $ 714 $ 610 22
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Insurance -Underwriting (Continued)
GEICO (Continued) Premiums earned in the third quarter and first nine months of 2012 increased$333 million (8.5%) and$988 million (8.7%), respectively, compared to premiums earned in the corresponding 2011 periods. The growth in premiums earned for voluntary auto was 8.7% as a result of a 5.9% increase in policies-in-force and a 2.8% increase in average premium per policy over the past twelve months. Voluntary auto new business sales in the first nine months of 2012 declined slightly compared with 2011. Voluntary auto policies-in-force atSeptember 30, 2012 were approximately 547,000 greater than atDecember 31, 2011 . Losses and loss adjustment expenses incurred in the third quarter of 2012 declined$89 million (2.9%) and increased$382 million (4.4%) in the first nine months compared to the corresponding 2011 periods. The loss ratio (the ratio of losses and loss adjustment expenses incurred to premiums earned) was 73.4% in the first nine months of 2012 and 76.4% in the first nine months of 2011. In 2012, losses and loss adjustment expenses reflected no significant changes in collision and physical damage frequencies, a sharp decline in comprehensive frequencies (due to lower catastrophe losses) and modestly higher average claims severities in most of the significant coverage categories. In the first nine months of 2012, bodily injury severities generally increased in the two to four percent range versus 2011, while physical damage severities increased in the three to five percent range. In 2012, catastrophe losses were$15 million in the third quarter and$151 million in the first nine months. In 2011, catastrophe losses were$116 million in the third quarter and$240 million in the first nine months. Underwriting expenses incurred in the third quarter and first nine months of 2012 increased$101 million (14.6%) and$502 million (24.1%), respectively, over underwriting expenses incurred in the third quarter and first nine months of 2011. The increases were primarily the result of a change in U.S. GAAP concerning deferred policy acquisition costs ("DPAC").DPAC represents the underwriting costs that are eligible to be capitalized and expensed as premiums are earned over the policy period. Upon adoption of the new accounting standard as ofJanuary 1, 2012 ,GEICO ceased deferring a large portion of its direct advertising costs. The new accounting standard was adopted on a prospective basis and as a result,DPAC recorded as ofDecember 31, 2011 is being amortized to expense over the remainder of the related policy periods and policy acquisition costs related to policies written and renewed afterDecember 31, 2011 are being deferred at lower levels than in the past. The new accounting standard forDPAC does not impact the cash basis periodic underwriting costs or our assessment ofGEICO's underwriting performance. However, the new accounting standard accelerates the timing of when certain underwriting costs are recognized in earnings. We estimate thatGEICO's underwriting expenses for the first nine months of 2012 would have been about$410 million less had we computedDPAC under the prior accounting standard and that, as a result,GEICO's expense ratio (the ratio of underwriting expenses to premiums earned) in 2012 would have been less than in 2011. The effect of transitioning to this new accounting standard was substantially completed as ofSeptember 30, 2012 .
ThroughGeneral Re , we conduct a reinsurance business offering property and casualty and life and health coverages to clients worldwide. We write property and casualty reinsurance inNorth America on a direct basis throughGeneral Reinsurance Corporation and internationally throughGermany -basedGeneral Reinsurance AG and other wholly-owned affiliates. Property and casualty reinsurance is also written through brokers with respect to Faraday inLondon . Life and health reinsurance is written inNorth America throughGeneral Re Life Corporation and internationally throughGeneral Reinsurance AG .General Re strives to generate underwriting profits in essentially all of its product lines. Our management does not evaluate underwriting performance based upon market share and our underwriters are instructed to reject inadequately priced risks. The timing and magnitude of catastrophe and large individual losses has produced and is expected to continue to produce significant volatility inGeneral Re's periodic underwriting results.General Re's underwriting results are summarized in the following table. Amounts are in millions. Premiums earned Pre-tax underwriting gain (loss) Third Quarter First Nine Months Third Quarter First Nine Months 2012 2011 2012 2011 2012 2011 2012 2011 Property/casualty $ 727 $ 750 $ 2,164 $ 2,220 $ 118 $ 114 $ 354 $ (169 ) Life/health 718 688 2,178 2,099 36 34 19 123 $ 1,445 $ 1,438 $ 4,342 $ 4,319 $ 154 $ 148 $ 373 $ (46 ) Property/casualty Property/casualty premiums earned in the third quarter and first nine months of 2012 declined$23 million (3.1%) and$56 million (2.5%), respectively, versus the corresponding 2011 periods. Excluding the effects of foreign currency exchange rate changes, premiums earned in the first nine months of 2012 increased$34 million (1.5%). Price competition in most property and casualty lines persists and the volume of business written in recent years has been less than our capacity. Our underwriters continue to exercise discipline by not accepting offers to write business where prices are deemed inadequate. We remain prepared to increase premium volumes should market conditions improve. 23
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Insurance -Underwriting (Continued)
General Re (Continued) Property/casualty (Continued) Property/casualty operations produced net underwriting gains of$118 million and$354 million in the third quarter and the first nine months of 2012, respectively. For the first nine months of 2012, underwriting results included net underwriting gains of$343 million from property business and$11 million from casualty/workers' compensation business. The property underwriting results during the first nine months of 2012 reflected an absence of significant catastrophe losses during the year as well as underwriting gains from the run-off of prior years' business, including reductions of liabilities established for prior years' catastrophe losses. The underwriting gains from casualty/workers' compensation business included favorable run-off of prior years' business, offset in part by$79 million of loss reserve discount accretion and deferred charge amortization. The property/casualty operations generated underwriting gains of$114 million in the third quarter of 2011 and underwriting losses of$169 million for the first nine months of 2011. In 2011, the property business produced underwriting gains of$86 million in the third quarter and net underwriting losses of$267 million for the first nine months. In 2011, property underwriting results included catastrophe losses of$126 million in the third quarter and$787 million in the first nine months related to a number of events including the earthquakes inJapan andNew Zealand and various tornado and other weather related loss events inthe United States ,Europe andAustralia . The casualty/workers' compensation business generated underwriting gains of$98 million for the first nine months of 2011, reflecting overall reductions in estimated prior years' casualty loss reserves. Life/health Premiums earned in 2012 increased$30 million (4.4%) in the third quarter and$79 million (3.8%) in the first nine months over the premiums earned in the corresponding 2011 periods. Adjusting for the effects of foreign currency exchange rate changes, premiums earned in the first nine months of 2012 increased$211 million (10.1%) versus 2011, which was primarily attributable to increased non-U.S. life business. Life/health operations produced net underwriting gains of$36 million in the third quarter of 2012 and$19 million during the first nine months of 2012. Underwriting results in 2012 reflected favorable claims experience across most regions inEurope and reductions in estimated liabilities related to the 2011 earthquakes inNew Zealand andJapan . However, in 2012, underwriting results were negatively impacted by greater than expected claims frequency and duration in the individual and group disability business inAustralia and to a lesser extent, by increased losses in the U.S. health business. In 2011, life/health operations produced underwriting gains of$34 million in the third quarter and$123 million for the first nine months. The third quarter underwriting gains were driven by lower than expected mortality in our international operations. Underwriting results in the first nine months of 2011 were negatively affected by losses attributable to the earthquakes inJapan andNew Zealand and losses attributable to increased frequency and severity of life claims in the U.S.
Through BHRG, we underwrite excess-of-loss reinsurance and quota-share coverages on property and casualty risks for insurers and reinsurers worldwide. BHRG's business includes catastrophe excess-of-loss reinsurance and excess primary and facultative reinsurance for large or otherwise unusual property risks referred to as individual risk. BHRG also writes retroactive reinsurance, which provides indemnification of losses and loss adjustment expenses with respect to past loss events. Other multi-line business refers to other property and casualty business written on both a quota-share and excess basis and includes a quota-share contract withSwiss Reinsurance Company Ltd. ("Swiss Re") covering a 20% share of substantially all of Swiss Re's property/casualty contracts incepting betweenJanuary 1, 2008 andDecember 31, 2012 . We currently do not anticipate that the Swiss Re quota-share contract will be renewed or extended. BHRG also underwrites life reinsurance and annuity risks. BHRG's underwriting results are summarized in the table below. Amounts are in millions. Premiums earned Pre-tax underwriting gain/loss Third Quarter First Nine Months Third Quarter First Nine Months 2012 2011 2012 2011 2012 2011 2012 2011
Catastrophe and individual risk
278 104 649 1,923 (48 ) 750 (160 ) 495
Other multi-line property/casualty 1,341 1,012 3,734
3,055 (85 ) 609 311 (621 ) Life and annuity 744 531 2,000 1,522 (55 ) (19 ) (173 ) (66 ) $ 2,578 $ 1,839 $ 6,983 $ 7,051 $ (102 ) $ 1,375 $ 320 $ (322 ) 24
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Insurance -Underwriting (Continued)
Premiums earned in the third quarter and first nine months of 2012 from catastrophe and individual risk contracts exceeded premiums earned in the corresponding 2011 periods by$23 million (12%) and$49 million (9%), respectively. Catastrophe reinsurance premiums written in the third quarter and first nine months of 2012 were approximately 20% greater than premiums written in the comparable 2011 periods. The level of business written in a given period will vary significantly due to changes in market conditions and management's assessment of the adequacy of premium rates. In recent years, we have generally constrained the volume of business written as premium rates have not been attractive enough to warrant increasing volume. However, we have the capacity and will to write substantially more business when appropriate pricing can be obtained. Catastrophe and individual risk underwriting results for the first nine months of 2012 reflected no significant losses from catastrophe events. Catastrophe and individual risk underwriting results for the first nine months of 2011 included estimated losses of$454 million , which were attributable to the earthquakes inJapan andNew Zealand . The timing and magnitude of losses produces extraordinary volatility in periodic underwriting results of this business. Premiums earned under retroactive reinsurance contracts in the first nine months of 2012 primarily derived from four new contracts. In the first nine months of 2011 premiums earned included approximately$1.7 billion from a single reinsurance contract withEaglestone Reinsurance Company , a subsidiary of American International Group, Inc. ("AIG"). Under the contract, we agreed to reinsure the bulk of AIG's U.S. asbestos liabilities. The AIG agreement provides for a maximum limit of indemnification of$3.5 billion . Retroactive reinsurance policies generally provide very large, but limited, indemnification of losses and loss adjustment expenses with respect to past loss events. Such losses are recognized at the estimated ultimate amount and are usually expected to be paid over long periods of time. At the inception of a contract, deferred charge assets are recorded as the excess, if any, of the estimated ultimate losses over the premiums earned. Deferred charge balances are subsequently amortized over the estimated claims payment period using the interest method, which reflects estimates of the timing and amount of loss payments. Deferred charge balances are also adjusted to reflect changes in the timing and amount of actual and re-estimated future loss payments. The recurring periodic amortization of deferred charges and deferred charge adjustments resulting from changes to the estimated timing and amount of loss payments are included in earnings as a component of losses and loss adjustment expenses. The underwriting results from retroactive policies in 2012 and 2011 reflected the recurring periodic amortization of deferred charges. In 2012, amortization charges were partially offset by net reductions in estimated unpaid losses of about$150 million with respect to contracts written in prior years. During the third quarter of 2011, we recognized a net reduction in estimated unpaid losses with respect to contracts written in prior years of approximately$875 million , which was primarily attributable to lower than expected loss experience related to one contract. AtSeptember 30, 2012 andDecember 31, 2011 , unamortized deferred charges for all of BHRG's retroactive contracts were approximately$3.8 billion and$4.0 billion , respectively. Gross unpaid losses from retroactive reinsurance contracts were approximately$18.3 billion atSeptember 30, 2012 , compared to approximately$18.8 billion as ofDecember 31, 2011 . Premiums earned in the third quarter and first nine months of 2012 from other multi-line property and casualty business increased$329 million (33%) and$679 million (22%), respectively, over the corresponding 2011 periods. Premiums earned in the third quarter and first nine months of 2012 included$848 million and$2,408 million , respectively, from the Swiss Re quota-share contract. Premiums earned in the third quarter and first nine months of 2011 from this contract were$686 million and$2,061 million , respectively. In 2012, premiums earned also included increased amounts earned under other quota-share contracts. There were no significant catastrophe loss events in 2012. We incurred catastrophe losses of$724 million in the first nine months of 2011, which were primarily in connection with the Swiss Re quota-share contract and arose primarily from the earthquakes inJapan andNew Zealand . In 2012, other multi-line property and casualty underwriting results also included foreign currency transaction losses of$118 million in the third quarter and$81 million in the first nine months arising from the conversion of certain reinsurance liabilities denominated in foreign currencies into U.S. Dollars. In the comparable periods of 2011, we recorded foreign currency transaction gains of$434 million and$41 million , respectively. The foreign currency transaction gains and losses reflected the volatility in exchange rates, primarily between the U.S. Dollar and the Swiss Franc andU.K. Pound Sterling . Life and annuity premiums earned in the third quarter and first nine months of 2012 increased$213 million (40%) and$478 million (31%), respectively, over premiums earned in the comparable 2011 periods. Substantially all of the increases were attributable to new annuity contracts. Underwriting losses in 2012 from the life and annuity business were$55 million for the third quarter and$173 million for the first nine months. During the first nine months of 2012, the life reinsurance business produced underwriting losses of$56 million in 2012 versus underwriting gains of$11 million in the comparable prior year period. The underwriting losses 25
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Insurance -Underwriting (Continued)
in 2012 were attributed to higher than expected mortality. The annuity business generated underwriting losses of$117 million in the first nine months of 2012 and$77 million in the comparable prior year period. Annuity underwriting losses reflect the periodic discount accretion of the discounted liabilities established for such contracts as well as adjustments for mortality experience. AtSeptember 30, 2012 andDecember 31, 2011 , annuity liabilities were approximately$2.7 billion and$2.1 billion , respectively.
Our primary insurance group consists of a wide variety of independently managed insurance businesses that principally write liability coverages for commercial accounts. These businesses include:Medical Protective Corporation andPrinceton Insurance Company (acquired as ofDecember 30, 2011 ), providers of professional liability insurance to physicians, dentists and other healthcare providers;National Indemnity Company's primary group, writers of commercial motor vehicle and general liability coverages;U.S. Investment Corporation , whose subsidiaries underwrite specialty insurance coverages; a group of companies referred to internally as "Berkshire Hathaway Homestate Companies," providers of commercial multi-line insurance, including workers' compensation;Central States Indemnity Company , a provider of credit and disability insurance to individuals nationwide through financial institutions; Applied Underwriters, a provider of integrated workers' compensation solutions; and BoatU.S., a writer of insurance for owners of boats and small watercraft. Premiums earned in the third quarter and first nine months of 2012 by our various primary insurers increased$127 million (28%) and$325 million (25%), respectively, over the corresponding prior year amounts. The increases in premiums earned in 2012 were primarily due to increased volume of workers' compensation insurance from the Berkshire Hathaway Homestate Companies and premiums fromPrinceton Insurance Company . Premium volume of certain of our primary insurers continues to be constrained by market conditions. We have the capacity and desire to write substantially more volume when market conditions improve. For the first nine months, our primary insurers produced underwriting gains of$243 million in 2012 and$168 million in 2011. Underwriting gains as percentages of premiums earned in the first nine months were approximately 15% in 2012 and 13% in 2011. Insurance-Investment Income A summary of net investment income of our insurance operations follows. Amounts are in millions. Third Quarter First Nine Months 2012 2011 2012 2011 Investment income before income taxes and noncontrolling interests $ 976 $ 1,038 $ 3,421 $ 3,703 Income taxes and noncontrolling interests 243 255 829 973 Net investment income $ 733 $ 783 $ 2,592 $ 2,730 Investment income consists of interest and dividends earned on cash and investments of our insurance businesses. Pre-tax investment income in the third quarter and first nine months of 2012 declined$62 million (6%) and$282 million (8%) from investment income earned in the comparable 2011 periods. The declines in investment income in 2012 reflected the redemptions in 2011 of our investments in Goldman Sachs 10% Preferred Stock (insurance subsidiaries held 87% of the$5 billion aggregate investment) and in General Electric 10% Preferred Stock ($3 billion aggregate investment). Dividends earned by our insurance subsidiaries from these investments were$75 million in the third quarter and$416 million in the first nine months of 2011. Investment income in the 2012 periods reflected dividends earned from our investment in Bank of America 6% Preferred Stock (insurance subsidiaries hold 80% of the$5 billion aggregate investment) and increased dividend rates with respect to several of our common stock holdings. Our investment income over the remainder of 2012 will continue to be negatively affected by the aforementioned redemptions, given the comparatively lower yields currently available from new investment opportunities. We also continue to hold significant cash and cash equivalent balances earning near zero yields. However, our management believes that maintaining ample liquidity is paramount and strongly insists on safety over yield with respect to cash and cash equivalents. Invested assets derive from shareholder capital and reinvested earnings as well as net liabilities under insurance contracts or "float." The major components of float are unpaid losses, life, annuity and health benefit liabilities, unearned premiums and other liabilities to policyholders less premiums and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated$72.0 billion atSeptember 30, 2012 and$70.6 billion atDecember 31, 2011 . For the first nine months of 2012 and 2011, the cost of float, as represented by the ratio of our underwriting gain or loss to average float, was negative as our insurance group generated a net underwriting gain in each period. 26
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Insurance-Investment Income (Continued)
A summary of cash and investments held in our insurance businesses follows. Other investments include our investments in Wrigley, Dow Chemical and Bank of America preferred stock as well as warrants to acquire common shares of Goldman Sachs, General Electric and Bank of America (see Note 6 to the Consolidated Financial Statements). Amounts are in millions. September 30, December 31, 2012 2011 Cash and cash equivalents $ 25,004 $ 21,571 Equity securities 86,697 75,759 Fixed maturity securities 29,661 29,899 Other investments 14,980 13,111 $ 156,342 $ 140,340 Fixed maturity investments as ofSeptember 30, 2012 were as follows. Amounts are in millions. Amortized Unrealized Fair cost gains/losses value U.S. Treasury, U.S. government corporations and agencies $ 2,546 $ 37 $ 2,583 States, municipalities and political subdivisions 2,642 187 2,829 Foreign governments 9,978 305 10,283 Corporate bonds, investment grade 5,205 831 6,036 Corporate bonds, non-investment grade 4,384 1,296 5,680 Mortgage-backed securities 1,964 286 2,250 $ 26,719 $ 2,942 $ 29,661 All U.S. government obligations are rated AA+ or Aaa by the major rating agencies and approximately 85% of all state, municipal and political subdivisions, foreign government obligations and mortgage-backed securities are rated AA or higher. Non-investment grade securities represent securities that are rated below BBB- or Baa3. Foreign government securities include obligations issued or unconditionally guaranteed by national or provincial government entities.
Railroad ("BNSF")
We acquired control of
Third Quarter First Nine Months 2012 2011 2012 2011 Revenues $ 5,343 $ 4,961 $ 15,407 $ 14,284 Operating expenses: Compensation and benefits 1,149 1,069 3,344 3,216 Fuel 1,089 1,089 3,286 3,124 Purchased services 601 571 1,784 1,667 Depreciation and amortization 475 454 1,408 1,350 Equipment rents 204 192 605 575 Materials and other 160 208 617 665 Total operating expenses 3,678 3,583 11,044 10,597 Interest expense 157 142 460 416 3,835 3,725 11,504 11,013 Pre-tax earnings 1,508 1,236 3,903 3,271 Income taxes 571 470 1,463 1,208 Net earnings $ 937 $ 766 $ 2,440 $ 2,063 Revenues during the third quarter and first nine months of 2012 were approximately$5.3 billion and$15.4 billion , respectively, representing increases of$382 million (8%) and$1,123 million (8%), respectively, over 2011. Overall, the increases in revenues in 2012 reflected higher average revenues per car/unit of approximately 2% for the third quarter and 4% for the first nine months as well 27
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Railroad ("BNSF") (Continued) as increases in cars/units handled ("volume") of 5% for the third quarter and 3% for the first nine months. Revenues in each period include fuel surcharges to customers under programs intended to recover incremental fuel costs when fuel prices exceed threshold fuel prices. Fuel surcharges decreased by 4% for the third quarter and increased 6% for the first nine months as compared to 2011, and are reflected in average revenue per car/unit. The increase in overall volume during the third quarter of 2012 included increases in consumer products (4%), industrial products (14%), coal (4%) and agricultural products (3%). The increase in overall volume during the first nine months of 2012 included increases in consumer products (5%) and industrial products (13%). Those increases were offset by declines in volume for coal (3%) and for agricultural products (3%). The consumer products volume increase was primarily attributable to higher domestic intermodal and automotive volume. Industrial products volume increased primarily as a result of increased shipments of petroleum products, as well as increased sand shipments. The increase in coal unit volume in the third quarter 2012 as compared to the third quarter 2011 was due to impacts of severe flooding along key coal routes during the third quarter of 2011. The overall decline in coal unit volume for the first nine months of 2012 was attributable to decreased coal demand as a result of low natural gas prices, a mild winter and spring and high utility stockpiles. Agricultural product volume increased during the third quarter of 2012 as compared to the third quarter of 2011 due to higher soybean shipments. Agricultural product volume decreased during the first nine months of 2012 compared to 2011 due to a decline in wheat and corn shipments for export partially offset by higher soybean and U.S. corn shipments. Operating expenses in 2012 for the third quarter and first nine months increased$95 million (3%) and$447 million (4%), respectively, compared to 2011. Compensation and benefits expenses in the third quarter and first nine months of 2012 increased$80 million and$128 million , respectively, compared to 2011 primarily reflecting volume-related increases. Fuel expenses in the third quarter of 2012 were the same as fuel expenses in 2011, while fuel expenses in the first nine months of 2012 increased$162 million (5%) over 2011 due to higher fuel prices and volume increases, partially offset by improved fuel efficiency. Fuel efficiency in the second and third quarters of 2011 was negatively impacted by severe weather conditions. Purchased services costs in the third quarter and first nine months of 2012 increased$30 million (5%) and$117 million (7%), respectively, compared to 2011 due primarily to higher volume-related costs, including purchased transportation forBNSF Logistics , a wholly-owned third-party logistics company, and increased equipment maintenance costs, partially offset by weather impacts in 2011. Interest expense in 2012 increased$15 million (11%) in the third quarter and$44 million (11%) in the first nine months versus 2011 due principally to higher average outstanding debt balances.
Utilities and Energy ("MidAmerican")
We hold an 89.8% ownership interest inMidAmerican Energy Holdings Company ("MidAmerican"), which operates an international energy business. MidAmerican's domestic regulated energy interests are comprised of two regulated utility companies, PacifiCorp and MidAmerican Energy Company ("MEC"). MidAmerican also owns two interstate natural gas pipeline companies. In theUnited Kingdom , MidAmerican owns two electricity distribution businesses, operating asNorthern Powergrid Holdings Company ("Northern Powergrid"). The rates that utility and natural gas pipeline companies charge customers for energy and other services are generally subject to regulatory approval. Rates are based in large part on the costs of business operations, including a return on capital. To the extent these operations are not allowed to include such costs in the approved rates, operating results will be adversely affected. In addition, MidAmerican also owns a diversified portfolio of independent power projects, including recently-acquired solar and wind projects, and the second-largest residential real estate brokerage firm inthe United States . Revenues and earnings from MidAmerican are summarized below. Amounts are in millions. Third Quarter First Nine Months Revenues Earnings Revenues Earnings 2012 2011 2012 2011 2012 2011 2012 2011 PacifiCorp $ 1,344 $ 1,209 $ 307 $ 233 $ 3,721 $ 3,446 $ 695 $ 606 MidAmerican Energy Company 836 873 109 112 2,431 2,667 209 230 Natural gas pipelines 209 208 51 64 706 711 261 262 Northern Powergrid 240 237 82 100 747 729 305 319 Real estate brokerage 378 290 31 22 986 774 65 35 Other 69 50 41 39 127 98 55 49 $ 3,076 $ 2,867 $ 8,718 $ 8,425 Earnings before corporate interest and income taxes 621 570 1,590 1,501 Corporate interest (79 ) (84 ) (241 ) (253 ) Income taxes and noncontrolling interests (104 ) (114 ) (320 ) (360 ) Net earnings attributable to Berkshire $ 438 $ 372 $ 1,029 $ 888 28
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Utilities and Energy ("MidAmerican") (Continued)
PacifiCorp's revenues in the third quarter and first nine months of 2012 increased$135 million (11%) and$275 million (8%), respectively, over revenues in the same periods of 2011. The revenue increases were primarily due to higher retail revenues of$105 million for the third quarter and$229 million for the first nine months. The increases in retail revenues were principally attributable to higher prices approved by regulators of$82 million for the third quarter and$191 million for the first nine months. In 2012 PacifiCorp also experienced higher customer load inUtah due to the impacts of hot weather, partially offset by lower industrial customer load inWyoming andOregon as certain large customers elected to self-generate their own power. PacifiCorp's earnings before corporate interest and taxes ("EBIT") in 2012 increased$74 million (32%) in the third quarter and$89 million (15%) in the first nine months compared to EBIT in the corresponding 2011 periods. The EBIT increases reflected increased operating earnings and lower interest expense. The increases in operating earnings in 2012 resulted from higher revenues (from rates and customer loads), partially offset by higher energy costs and other operating expenses, as well as increased depreciation and amortization from higher plant in service. MEC's revenues in the third quarter and first nine months of 2012 declined$37 million (4%) and$236 million (9%), respectively, compared to 2011. In 2012, MEC's regulated electric revenues increased 5% in the third quarter to$511 million . Regulated electric revenues were approximately$1.3 billion in the first nine months of 2012, which was relatively unchanged from 2011. In the third quarter and first nine months of 2012, regulated natural gas revenues declined$12 million and$121 million , respectively, versus 2011, reflecting lower average per-unit cost of natural gas sold and lower volumes. Gas volume declined 6% in the first nine months of 2012 versus 2011, attributable to unseasonably warm weather in the first half of the year. In 2012, nonregulated and other operating revenues declined$50 million for the third quarter and$137 million for the first nine months compared to 2011, due to generally lower electricity and natural gas prices and volumes. MEC's EBIT declined$3 million (3%) in the third quarter and$21 million (9%) in the first nine months of 2012 compared to 2011, which reflected lower operating earnings, partially offset by lower interest expense. In the third quarter and first nine months of 2012, regulated electric operating earnings were relatively unchanged from 2011. However, in the first nine months of 2012, regulated gas and nonregulated operating earnings declined$30 million versus 2011, as a result of lower volume-related regulated natural gas margins and lower nonregulated electric margins. Natural gas pipelines' revenues in the third quarter and first nine months of 2012 were relatively unchanged from 2011. In 2012, natural gas revenues increased from expansion projects and from higher transportation and storage rates in certain markets, but were substantially offset by lower volumes of gas and condensate liquids sales (which are offset in cost of sales) and lower allowances for equity funds used during construction. In the third quarter of 2012, EBIT declined$13 million (20%) compared to 2011, which was primarily attributable to higher operating expenses and depreciation. In the first nine months of 2012, EBIT also reflected higher revenues from the aforementioned expansion projects, partially offset by increased depreciation, and operating expenses.Northern Powergrid's revenues in the third quarter and first nine months of 2012 increased$3 million (1%) and$18 million (2%), respectively, over the comparable 2011 periods, due primarily to higher distribution revenues partially offset by currency-related declines from a stronger U.S. Dollar in 2012. Excluding currency related impacts, distribution revenues increased$36 million in the first nine months of 2012, reflecting higher tariff rates ($67 million ), partially offset by a favorable movement in regulatory provisions in 2011 ($29 million ).Northern Powergrid's EBIT in the third quarter and first nine months of 2012 declined$18 million (18%) and$14 million (4%), respectively, from EBIT in the corresponding 2011 periods. In 2012, EBIT was negatively impacted by increases in pension expense ($11 million for the third quarter and$33 million for the first nine months) and distribution operating expenses ($8 million for the third quarter and$18 million for the first nine months), which more than offset the increases in distribution revenues. Real estate brokerage revenues in the third quarter and first nine months of 2012 increased$88 million (30%) and$212 million (27%), respectively, over the same periods in 2011. In 2012, revenues included$41 million in the third quarter and$82 million in the first nine months from businesses acquired in 2012. The increases in revenues also reflected a 15% year-to-date increase in closed sales transactions from existing businesses. Real estate brokerage EBIT in the third quarter and first nine months of 2012 increased$9 million (41%) and$30 million (86%), respectively, over the comparable 2011 periods. The increases in earnings reflected the impact of business acquisitions in 2012 as well as the aforementioned increase in closed sales transactions. 29
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Manufacturing, Service and Retailing
A summary of revenues and earnings of our manufacturing, service and retailing businesses follows. Amounts are in millions.
Third Quarter First Nine Months Revenues Earnings Revenues Earnings 2012 2011 2012 2011 2012 2011 2012 2011 Marmon $ 1,795 $ 1,800 $ 293 $ 257 $ 5,451 $ 5,255 $ 869 $ 752 McLane Company 9,534 8,708 130 124 26,611 24,919 305 311 Other manufacturing 6,776 5,358 921 652 20,277 15,112 2,738 1,739 Other service 2,128 1,914 256 281 6,327 5,963 744 768 Retailing 712 679 33 31 2,196 2,093 127 108 $ 20,945 $ 18,459 $ 60,862 $ 53,342 Pre-tax earnings 1,633 $ 1,345 4,783 $ 3,678 Income taxes and noncontrolling interests 642 509 1,913 1,495 $ 991 $ 836 $ 2,870 $ 2,183 Marmon Through Marmon, we operate approximately 150 manufacturing and service businesses that function independently within eleven diverse business sectors. Marmon's revenues for the third quarter and first nine months of 2012 were approximately$1.8 billion and$5.5 billion , respectively, which resulted in comparatively flat revenues versus the third quarter of 2011 and a 3.7% increase over the first nine months of 2011. In the third quarter, revenue increases attributable to bolt-on acquisitions in the Crane Services, Highway Technologies, Engineered Wire & Cable and Distribution Services sectors were substantially offset by the impact of lower copper prices in theBuilding Wire and Flow Products sectors. However, through nine months of 2012, significant organic revenue growth has occurred within the Distribution Services, Transportation Services & Engineered Products (TSEP), Highway Technologies and Water Treatment sectors. Despite falling steel prices, Distribution Services has increased market share in their market niches, driving nine month revenues up 8% over 2011. Higher rail fleet utilization and higher rental rates provided most of the TSEP growth, while sulfur equipment installations in theMiddle East provided the balance. Commercial and heavy haul trailers have driven the revenue increases in Highway Technologies, while water treatment projects for the Canadian Tar Sands area provided growth in Water Treatment. These increases were somewhat offset by revenue declines in the Flow Products andBuilding Wire sectors due to the persistent slowdown in commercial construction. Retail Fixtures continues to suffer from a reduction in volume from a major customer, which resulted in a 21% decline in revenues in the first nine months of 2012. Pre-tax earnings for the third quarter and first nine months of 2012 were$293 million and$869 million , respectively, which represented increases of 14.0% and 15.6% over the comparable 2011 periods. About one-fourth of the overall increase in pre-tax earnings in the first nine months was attributable to the recent business acquisitions. Excluding the effects of these acquisitions, seven of the eleven Marmon business sectors produced increased pre-tax earnings in the first nine months of 2012 compared to 2011. Among the sectors reporting the largest dollar increases in pre-tax earnings were Distribution Services, TSEP, Highway Technologies and Water Treatment as a result of the aforementioned increases in revenues. In addition, Engineered Wire & Cable year-to-date earnings rose 37%, attributable to restructuring actions that took place in 2011 in the utility and commodity businesses, along with growth in their specialty wire niche markets. Flow Products,Building Wire and Retail Store Fixtures, reported lower pre-tax earnings in the third quarter and the first nine months of 2012 consistent with the revenue declines previously discussed. In 2012, pre-tax earnings as a percent of revenues were 16.3% in the third quarter and 15.9% for the first nine months versus 14.3% for both comparable periods in 2011. The improvement in operating results in 2012 reflects the continued emphasis of Marmon's business model, which fosters margin growth. Consistent with this model, most of the growth in 2012 was in higher margin sectors that focus on niche markets. In addition, improvements in revenues and pre-tax earnings also generally reflect continued strength in some of Marmon's end markets, recent new product introductions and ongoing efforts to control overhead costs.
ThroughMcLane , we operate a wholesale distribution business that provides grocery and non-food products to retailers, convenience stores and restaurants.McLane's business is marked by high sales volume and very low profit margins.McLane's significant customers include Wal-Mart, 7-Eleven and Yum! Brands. A curtailment of purchasing by Wal-Mart or another of its significant customers could have a material adverse impact onMcLane's periodic revenues and earnings. In 2010,McLane acquired Empire Distributors, based inGeorgia andNorth Carolina , andHorizon Wine and Spirits Inc. , based inTennessee . Empire and Horizon are wholesale distributors of distilled spirits, wine and beer. OnAugust 24, 2012 ,McLane completed the acquisition ofMeadowbrook Meat Company, Inc. ("MBM"). MBM is based inRocky Mount, North Carolina and is a large customized foodservice distributor for national restaurant chains with annual sales of approximately$6 billion . MBM's revenues and results of operations are included inMcLane beginning as of the acquisition date. 30
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Manufacturing, Service and Retailing (Continued)
McLane Company (Continued)McLane's revenues in the third quarter and first nine months of 2012 were approximately$9.5 billion and$26.6 billion , respectively, representing increases of$826 million (9.5%) and$1,692 million (6.8%), respectively, over revenues in comparable 2011 periods. Revenues in the 2012 periods included$536 million from MBM. In addition, grocery revenues increased 3.7% and foodservice revenues increased 7.5% in the first nine months of 2012. Pre-tax earnings in the third quarter and first nine months of 2012 increased$6 million (4.8%) and decreased$6 million (1.9%), respectively, compared to earnings in the prior year periods. In 2012,McLane's grocery division produced lower earnings as result of lower gross margins and higher personnel and depreciation expense, which on a year to date basis more than offset increased earnings attributable to MBM, foodservice and beverage operations.
Other manufacturing
Our other manufacturing businesses include several manufacturers of building products (Acme Building Brands,Benjamin Moore ,Johns Manville , Shaw and MiTek) and apparel (led by Fruit of the Loom which includes the Russell athletic apparel and sporting goods business and theVanity Fair Brands women's intimate apparel business). Also included in this group areForest River , a leading manufacturer of recreational vehicles, IMC Metalworking Companies ("ISCAR"), an industry leader in the metal cutting tools business with operations worldwide and CTB, a manufacturer of equipment and systems for the livestock and agricultural industries. Other manufacturing businesses also includeThe Lubrizol Corporation ("Lubrizol"), a specialty chemical manufacturer that we acquired onSeptember 16, 2011 . Lubrizol's revenues and earnings are included in other manufacturing revenues and earnings beginning as of that date. Revenues of other manufacturing businesses in the third quarter and first nine months of 2012 increased approximately$1.4 billion (26%) and$5.2 billion (34%) compared with the corresponding 2011 periods. Revenues from Lubrizol were approximately$1.5 billion in the third quarter and$4.7 billion in the first nine months of 2012, compared to$246 million for the fifteen day period endingSeptember 30, 2011 . In the third quarter and first nine months of 2012, we also experienced revenue increases of 29% and 25%, respectively, fromForest River , which were attributable to increased volume and average sales prices. For the first nine months of 2012, building products revenues increased 3% and apparel revenues increased 4% as compared with 2011, while revenues declined at IMC, CTB andScott Fetzer . Pre-tax earnings of our other manufacturing businesses in the third quarter and first nine months of 2012 were$921 million and$2,738 million , respectively, representing increases of$269 million (41%) and$999 million (57%), respectively, over the corresponding 2011 periods. Excluding the impact of Lubrizol, earnings of our other manufacturing businesses in 2012 increased$48 million (8%) in the third quarter and$157 million (9%) in the first nine months as compared to 2011. The increases were primarily attributable to increased earnings from building products, apparel andForest River , partially offset by lower earnings fromISCAR , CTB andScott Fetzer . In 2012, our building products businesses generally benefitted from increased housing construction, which overall, helped produce increased revenues and improved operating margins, particularly over the first six months of the year. Our apparel businesses benefitted from past pricing actions and stabilizing raw material costs. On the other hand, our other businesses that manufacture products that are primarily for commercial and industrial customers, particularly those with significant business in overseas markets, such as CTB andISCAR , were negatively impacted in 2012 by slowing economic conditions in certain of those markets.
Other service
Our other service businesses include NetJets, the world's leading provider of fractional ownership programs for general aviation aircraft and FlightSafety, a provider of high technology training to operators of aircraft. Among the other businesses included in this group are: TTI, a leading electronic components distributor; Business Wire, a leading distributor of corporate news, multimedia and regulatory filings;Pampered Chef , a direct seller of high quality kitchen tools;Dairy Queen , which licenses and services a system of over 6,100 stores that offer prepared dairy treats and food;Buffalo News and theBH Media Group , which includes theOmaha World-Herald acquired at the end of 2011, as well as 44 other daily and weekly newspapers and numerous other publications acquired in June and July of 2012; and businesses that provide management and other services to insurance companies. Revenues of our other service businesses in 2012 were$2,128 million in the third quarter and$6,327 million in the first nine months, representing increases of$214 million (11%) and$364 million (6%), respectively, over the corresponding 2011 periods. The increases in revenues in 2012 were primarily attributable to the inclusion of theBH Media Group and comparative revenue increases from TTI, principally due to bolt-on business acquisitions in 2012. Pre-tax earnings of$256 million in the third quarter and$744 million in the first nine months of 2012 decreased by$25 million (9%) and$24 million (3%), respectively, from earnings in the comparable prior year periods. NetJets' earnings in the third quarter of 2012 declined$30 million versus the third quarter of 2011, which largely offset much of the improvement in comparative earnings over the first six months. NetJets' results in the third quarter of 2012 were negatively impacted by lower gains on asset dispositions, increased depreciation expense and unfavorable foreign currency movements compared to the third quarter of 2011. TTI's earnings in the first nine months of 2012 declined 16% versus 2011 due primarily to weaker customer demand and intensifying price competition over the past year. 31
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Manufacturing, Service and Retailing (Continued)
Retailing
Our retailing operations consist of four home furnishings businesses (Nebraska Furniture Mart ,R.C. Willey ,Star Furniture andJordan's ), three jewelry businesses (Borsheims, Helzberg andBen Bridge ) and See's Candies. Revenues and pre-tax earnings in the third quarter of 2012 from the retailing businesses increased modestly over 2011. For the first nine months of 2012, revenues and pre-tax earnings increased$103 million (5%) and$19 million (18%), respectively, over 2011. Operating results in 2012 reflected increased revenues and earnings from our home furnishings retailers and relatively flat revenues and lower earnings from our jewelry retailers.
Finance and Financial Products
Our finance and financial products businesses include manufactured housing and finance ("Clayton Homes "), transportation equipment leasing ("XTRA"), furniture leasing ("CORT") as well as various miscellaneous financing activities. A summary of revenues and earnings from our finance and financial products businesses follows. Amounts are in millions. Third Quarter First Nine Months Revenues Earnings Revenues Earnings 2012 2011 2012 2011 2012 2011 2012 2011 Manufactured housing and finance $ 747 $ 764 $ 55
42 555 541 100 103 Other 65 41 81 68 183 173 268 264 $ 1,006 $ 995 $ 2,981 $ 2,899 Pre-tax earnings 175 147 527 480 Income taxes and noncontrolling interests 67 44 195 171 $ 108 $ 103 $ 332 $ 309Clayton Homes' revenues in the third quarter and first nine months of 2012 decreased$17 million (2%) and increased$58 million (3%), respectively, compared to the corresponding periods in 2011. In 2012, revenues from home sales in the third quarter were unchanged from 2011, reflecting a 5% increase in units sold offset by lower average selling prices. For the first nine months of 2012, home sales increased$103 million (10%), due primarily to increases in units sold partially offset by slightly lower average selling prices. Financial services revenues in 2012 declined$18 million (5%) from the third quarter and$45 million (4%) from the first nine months of 2011 as a result of lower interest income. Installment loan and finance receivable balances as ofSeptember 30, 2012 , were approximately$12.4 billion , a decline of approximately$450 million fromDecember 31, 2011 .Clayton Homes' pre-tax earnings in 2012 increased$18 million (49%) in the third quarter and$46 million (41%) in the first nine months over the corresponding 2011 periods. Operating results in 2012 reflected improvements in manufacturing and home sales from increased unit sales which improved operating and manufacturing efficiencies. In the first nine months 2012, earnings also benefited from lower insurance claims and a decline in credit losses. WhileClayton Homes' operating results continue to be affected by relatively soft housing markets, manufactured homes sold were higher in 2012 compared to 2011. However, manufactured housing programs continue to operate at a competitive disadvantage compared to traditional single family housing markets, which have been receiving significant interest rate subsidies from the U.S. government through government agency insured mortgages. For the most part, these subsidies are not available to factory built homes. Nevertheless,Clayton Homes remains the largest manufactured housing business inthe United States and we believe that it will continue to operate profitably, even under the prevailing conditions. In the first nine months of 2012, revenues ofCORT and XTRA increased$14 million (3%), while pre-tax earnings declined$3 million (3%) versus 2011. Results for the first nine months of 2012 reflected increased earnings ofCORT (attributable to increased rental income and higher operating margins) and lower earnings from XTRA (attributable to unchanged revenues, increased depreciation expense and lower foreign currency exchange gains). Earnings from our other finance business activities include investment income from a portfolio of fixed maturity and equity investments, and from a small portfolio of long-held commercial real estate loans, which had an aggregate carrying value of$435 million as ofJune 30, 2012 . During the third quarter of 2012, certain of these commercial real estate loans were repaid in full. OnOctober 1, 2012 , the remaining commercial real estate loans were repaid in full. In addition, other earnings include income from interest rate spreads charged toClayton Homes on borrowings (approximately$11.2 billion as ofSeptember 30, 2012 ) by aBerkshire financing subsidiary. The borrowings are used to fund the loans toClayton Homes . Corresponding charges for this interest spread are reflected inClayton Homes' earnings. In addition, other earnings for the first nine months include guaranty fee income of$26 million in 2012 and$31 million in 2011 from NetJets. Corresponding expenses are recorded by NetJets. 32
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Investment and Derivative Gains/Losses
A summary of investment and derivative gains and losses and other-than-temporary impairment losses on investments follows. Amounts are in millions.
Third Quarter First Nine Months 2012 2011 2012 2011 Investment gains/losses $ 917 $ 100 $ 1,273 $ 1,488 Other-than-temporary impairment losses on investments - (8 ) (337 ) (514 ) Derivative gains/losses (118 ) (2,443 ) (184 ) (2,356 ) Gains/losses before income taxes and noncontrolling interests 799 (2,351 ) 752 (1,382 ) Income taxes and noncontrolling interests 278 (817 ) 263 (479 ) Net gains/losses $ 521 $ (1,534 ) $ 489 $ (903 ) Investment gains/losses arise primarily from the sale or redemption of investments. The timing of gains or losses from sales or redemptions can have a material effect on periodic earnings. Investment gains and losses usually have minimal impact on the periodic changes in our consolidated shareholders' equity since most of our investments are regularly recorded at fair value with the unrealized gains and losses included in shareholders' equity as a component of accumulated other comprehensive income. We believe the amount of investment gains/losses included in earnings in any given period typically has little analytical or predictive value. Our decisions to sell securities are not motivated by the impact that the resulting gains or losses will have on our reported earnings. Although our management does not consider investment gains and losses in a given period as necessarily meaningful or useful in evaluating periodic earnings, we are providing information to explain the nature of such gains and losses when they are reflected in earnings. Investment gains/losses for the first nine months of 2011 included a pre-tax gain of$1.25 billion from the redemption of our GS Preferred investment. Other-than-temporary impairment ("OTTI") losses in the first nine months of 2012 were attributable to our investments inTexas Competitive Electric Holdings bonds. In 2011, we recognized OTTI losses related to our investments in common stock of Kraft Foods and Wells Fargo. These OTTI losses had no impact whatsoever on the asset values recorded in our Consolidated Balance Sheets or on our consolidated shareholders' equity when the OTTI losses were recognized. The recognition of such losses in earnings rather than in accumulated other comprehensive income does not necessarily indicate that sales are imminent or planned and sales ultimately may not occur for a number of years. Furthermore, the recognition of OTTI losses does not necessarily indicate that the loss in value of the security is permanent or that the market price of the security will not subsequently increase to and ultimately exceed our original cost. We consider several factors in determining whether or not impairments are deemed to be other than temporary, including the current and expected long-term business prospects and if applicable, the creditworthiness of the issuer, our ability and intent to hold the investment until the price recovers and the length of time and relative magnitude of the price decline. Security prices may remain below cost for a period of time that may be deemed excessive from the standpoint of interpreting existing accounting rules, even though other factors suggest that the prices will eventually recover. As a result, accounting regulations may require that we recognize OTTI losses in earnings in instances where we may strongly believe that the market price of the impaired security will recover to at least our original cost and where we possess the ability and intent to hold the security until, at least, that time. As ofSeptember 30, 2012 , unrealized losses on our investments in equity securities (determined on an individual purchase lot basis) were$238 million . Unrealized losses averaged 7% of cost. In our judgment, the future earnings potential and underlying business economics of the issuers of these securities are favorable and we possess the ability and intent to hold these securities until their prices recover. Changing market conditions and other facts and circumstances may change the business prospects of these issuers as well as our ability and intent to hold these securities until their prices recover. In 2012, our derivative contracts generated pre-tax losses of$118 million in the third quarter and$184 million in the first nine months. In 2011, we incurred pre-tax losses of approximately$2.44 billion in the third quarter and$2.36 billion in the first nine months. In the third quarter and first nine months of 2012, our equity index put option contracts produced losses of$534 million and$1,018 million , respectively, which were due to lower interest rate assumptions, partially offset by increased index values. There were no new equity index put option contracts or settlements in either 2011 or 2012. In the third quarter of 2011, our equity index put option contracts produced pre-tax losses of approximately$2.1 billion . The losses reflected declines ranging from 11% to 23% in equity indexes covered under our contracts, and to a lesser degree from lower interest rate inputs. Our ultimate payment obligations, if any, under our remaining equity index put option contracts will be determined as of the contract expiration dates, which begin in 2018. 33
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Investment and Derivative Gains/Losses (Continued)
In the third quarter and first nine months of 2012, we recognized gains of$316 million and$827 million on credit default contracts, respectively. Such gains were attributable to narrower spreads and the passage of time (reduced time exposure), as well as from terminations of certain contracts in the third quarter. No new credit default contracts were written in 2011 or 2012. A significant portion of our risks related to non-investment grade corporate issuers expire in the fourth quarter of 2012, and all remaining exposures related to corporate issuers expire in 2013. The periodic changes in the fair values of these contracts can be significant, reflecting the volatility of underlying equity and credit markets. In 2011, our credit default contracts generated pre-tax losses of$247 million in the third quarter and$35 million in the first nine months. The losses in the third quarter were primarily related to our contracts involving corporate issuers, due to widening credit default spreads. There were no credit events affecting our contracts during the first nine months of 2011.
Financial Condition
Our balance sheet continues to reflect significant liquidity and a strong capital base. Our consolidated shareholders' equity atSeptember 30, 2012 was$184.6 billion , an increase of$19.8 billion fromDecember 31, 2011 . Consolidated cash and investments of insurance and other businesses approximated$174.9 billion atSeptember 30, 2012 including cash and cash equivalents of$41.8 billion , of which about$11.5 billion was held by the parent company. Otherwise, invested assets are held predominantly in our insurance businesses. OnJanuary 31, 2012 , we issued$1.7 billion of parent company senior unsecured notes, the proceeds of which were used to fund the repayment of$1.7 billion of notes that matured inFebruary 2012 . An additional$2.6 billion of parent company debt matures inFebruary 2013 . InSeptember 2011 , our Board of Directors authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the book value of the shares.Berkshire may repurchase shares at management's discretion. The repurchase program is expected to continue indefinitely, but does not obligateBerkshire to repurchase any dollar amount or number of Class A or Class B shares. Repurchases will not be made if they would reduceBerkshire's consolidated cash equivalent holdings below$20 billion . Financial strength and redundant liquidity will always be of paramount importance atBerkshire . To date, share repurchases have been insignificant. Our railroad, utilities and energy businesses (conducted by BNSF and MidAmerican) maintain very large investments in capital assets (property, plant and equipment) and will regularly make capital expenditures in the normal course of business. In the first nine months of 2012, MidAmerican's capital expenditures were$2.3 billion and BNSF's capital expenditures were$2.7 billion . For the remainder of 2012, BNSF's and MidAmerican's forecasted aggregate capital expenditures are estimated to be approximately$2.0 billion . Future capital expenditures are expected to be funded from cash flows from operations and debt issuances. In 2012, BNSF issued debt of$2.5 billion with maturities in 2022 and 2042, and its outstanding debt increased approximately$1.9 billion to $14.6 billion as ofSeptember 30, 2012 . In 2012, MidAmerican's new borrowings were approximately$2.5 billion and its aggregate outstanding borrowings increased approximately$1.2 billion to $21.1 billion as ofSeptember 30, 2012 . BNSF and MidAmerican have aggregate debt and capital lease maturities over the remainder of 2012 of about$900 million .Berkshire has committed untilFebruary 28, 2014 to provide up to$2 billion of additional capital to MidAmerican to permit the repayment of its debt obligations or to fund its regulated utility subsidiaries.Berkshire does not guarantee the repayment of debt issued by BNSF, MidAmerican or any of their subsidiaries. Assets of the finance and financial products businesses, which consisted primarily of loans and finance receivables, fixed maturity securities, other investments and cash and cash equivalents, were approximately$25.7 billion as ofSeptember 30, 2012 and$25.0 billion atDecember 31, 2011 . Liabilities were approximately$24.7 billion as ofSeptember 30, 2012 and$25.4 billion as ofDecember 31, 2011 . As ofSeptember 30, 2012 , notes payable and other borrowings of$13.4 billion included approximately$11.2 billion of notes issued byBerkshire Hathaway Finance Corporation ("BHFC"). In the first nine months of 2012,$2.7 billion of BHFC notes matured. In May andSeptember 2012 , BHFC issued$2.35 billion of new notes with maturities in 2017, 2022 and 2042. In the third quarter of 2012,$750 million of BHFC notes matured and an additional$3.45 billion will mature in 2013. We currently intend to issue additional new debt through BHFC to replace some or all of the upcoming debt maturities. The proceeds from the BHFC notes are used to finance originated and acquired loans ofClayton Homes . The full and timely payment of principal and interest on the BHFC notes is guaranteed byBerkshire . 34
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Financial Condition (Continued)
We regularly access the credit markets, particularly through our parent company and through our railroad, utilities and energy and finance and financial products businesses. Restricted access to credit markets at affordable rates in the future could have a significant negative impact on our operations. OnJuly 21, 2010 ,President Obama signed into law financial regulatory reform legislation, known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act"). The Reform Act reshapes financial regulations inthe United States by creating new regulators, regulating new markets and market participants and providing new enforcement powers to regulators. Virtually all major areas of the Reform Act are subject to extensive rulemaking proceedings being conducted both jointly and independently by multiple regulatory agencies, some of which have been completed and others that are expected to be finalized by the end of 2012 or in 2013. We are party to several equity index put option and credit default contracts as described in Note 12 to the Consolidated Financial Statements. With limited exception, these contracts contain no collateral posting requirements under any circumstances, including changes in either the fair value or intrinsic value of the contracts or a downgrade inBerkshire's credit ratings. Substantially all of these contracts were entered into prior toDecember 31, 2008 . AtSeptember 30, 2012 , the net liabilities recorded for such contracts were approximately$10.0 billion and our collateral posting requirements were$150 million . With respect to such collateral requirements, we receive the income attributable to such collateral or, in certain instances, interest credit from the counterparty. Although the ultimate outcome of the regulatory rulemaking proceedings described in the preceding paragraph cannot be predicted with certainty, we do not believe that the provisions of the Reform Act that concern collateral requirements apply to derivatives contracts that were entered into prior to the enactment of the Reform Act, as ours were. As such, although the Reform Act may adversely affect some of our business activities, it is not currently expected to have a material impact on our consolidated financial results or financial condition.
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 reflected in our Consolidated Balance Sheets, such as notes payable, require future payments on contractually specified dates and in fixed and determinable amounts. The timing and/or amount of the payment of other obligations, such as losses arising from unpaid property and casualty loss insurance contracts and credit default and equity index put option derivatives contracts, are contingent upon the outcome of future events. Actual payments will likely vary, perhaps significantly, from the liability estimates currently recorded in the Consolidated Balance Sheet. Other obligations pertain to the acquisition of goods or services in the future, which are not currently reflected in the financial statements, such as minimum rentals under operating leases. InJune 2012 , NetJets placed orders with certain manufacturers to acquire up to 425 aircraft with an estimated value of$9.6 billion . The aircraft purchases would be made to replace aircraft in its existing fleet, with deliveries expected to occur over an 8 year period beginning in 2014. The orders include cancellable commitments for 125 aircraft with an estimated cost of$2.8 billion and options to purchase an additional 300 aircraft, with respect to which, NetJets is not presently obligated to acquire. OnJune 28, 2012 ,Berkshire entered into an Asset Purchase Agreement (the "Agreement") withResidential Capital, LLC and certain of its affiliates (collectively, "ResCap"), which filed for relief under Chapter 11 of the U.S. Bankruptcy Code onMay 14, 2012 . Under the Agreement, the ResCap assets to be acquired represent various portfolios of first and second lien mortgage loans and other assets. The Agreement was subsequently approved by theU.S. Bankruptcy Court (the "Court"), which then ordered that an auction be conducted inOctober 2012 . The Agreement effectively established the minimum price for the portfolios of loans and obligatedBerkshire to acquire the ResCap loans, if no competing bidder in the auction process produced a bid that was deemed superior toBerkshire's bid. OnOctober 25, 2012 , the auction was held and the ResCap Board of Directors approvedBerkshire's bid of$1.5 billion as the highest and best bid for the ResCap loan portfolios. A sale approval hearing before the Court is scheduled to commence onNovember 19, 2012 . The aggregate consideration payable for the loan portfolios is subject to adjustment, primarily based on the level of loan principal amortizations up to the closing date, which is currently expected to occur in the first quarter of 2013. Except as noted above, our contractual obligations as ofSeptember 30, 2012 were not materially different from those disclosed in the "Contractual Obligations" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained inBerkshire's Annual Report on Form 10-K for the year endedDecember 31, 2011 . 35
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Critical Accounting Policies Certain accounting policies require us to make estimates and judgments regarding transactions that have occurred and ultimately will be settled several years in the future or concerning the recoverability of assets. Amounts recognized in the financial statements from such estimates are necessarily based on assumptions about numerous factors involving varying, and possibly significant, degrees of judgment and uncertainty. Accordingly, the amounts currently recorded in the financial statements may prove, with the benefit of hindsight, to be inaccurate. Reference is made to "Critical Accounting Policies" discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" included inBerkshire's Annual Report on Form 10-K for the year endedDecember 31, 2011 for additional discussion regarding these estimates. Our Consolidated Balance Sheet as ofSeptember 30, 2012 includes estimated liabilities for unpaid losses from property and casualty insurance and reinsurance contracts of$63.4 billion . Due to the inherent uncertainties in the process of establishing loss reserve amounts, the actual ultimate claim amounts will likely differ from the currently recorded amounts. A very small percentage change in estimates of this magnitude will result in a material effect on reported earnings. The effects from changes in these estimates are recorded as a component of losses incurred in the period of the change. Our Consolidated Balance Sheet as ofSeptember 30, 2012 includes goodwill of acquired businesses of$54.1 billion . We evaluate goodwill for impairment at least annually and conducted our most recent annual review during the fourth quarter of 2011. Although we believe that the goodwill reflected in the Consolidated Balance Sheet as ofSeptember 30, 2012 is not impaired, goodwill may subsequently become impaired as a result of changes in facts and circumstances affecting the valuation of the reporting unit. A goodwill impairment charge could have a material effect on periodic net earnings. Our Consolidated Balance Sheets include significant amounts of derivative contract liabilities that are measured at fair value. Our significant derivative contract exposures are concentrated in credit default and equity index put option contracts. These contracts were primarily entered into in over-the-counter markets and certain elements in the terms and conditions of such contracts are not standardized. In particular, we are not required to post collateral under most of our contracts. Furthermore, there is no source of independent data available to us showing trading volume and actual prices of completed transactions. As a result, the values of these liabilities are primarily based on valuation models, discounted cash flow models or other valuation techniques that are believed to be used by market participants. Such models or other valuation techniques may use inputs that are observable in the marketplace, while others are unobservable. Unobservable inputs require us to make certain projections and assumptions about the information that would be used by market participants in establishing prices. Considerable judgment may be required in making assumptions, including the selection of interest rates, default and recovery rates and volatility. Changes in assumptions may have a significant effect on values.
Information concerning new accounting pronouncements is included in Note 2 to the Consolidated Financial Statements.
Forward-Looking Statements
Investors are cautioned that certain statements contained in this document as well as some statements in periodic press releases and some oral statements ofBerkshire officials during presentations aboutBerkshire or its subsidiaries are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"). Forward-looking statements include statements which are predictive in nature, which depend upon or refer to future events or conditions, which include words such as "expects," "anticipates," "intends," "plans," "believes," "estimates" or similar expressions. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects and possible futureBerkshire actions, which may be provided by management, are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties and assumptions aboutBerkshire and its subsidiaries, economic and market factors and the industries in which we do business, among other things. These statements are not guaranties of future performance and we have no specific intention to update these statements. Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. The principal important risk factors that could cause our actual performance and future events and actions to differ materially from such forward-looking statements include, but are not limited to, changes in market prices of our investments in fixed maturity and equity securities, losses realized from derivative contracts, the occurrence of one or more catastrophic events, such as an earthquake, hurricane or act of terrorism that causes losses insured by our insurance subsidiaries, changes in laws or regulations affecting our insurance, railroad, utilities and energy and finance subsidiaries, changes in federal income tax laws, and changes in general economic and market factors that affect the prices of securities or the industries in which we do business. 36
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HANGER, INC. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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