Berkshire Hathaway 2009 Annual Report Download - page 86

Management’s Discussion (Continued)
Property and casualty losses (Continued)
BHRG (Continued)
A significant number of our reinsurance contracts are expected to have a low frequency of claim occurrence combined with
a potential for high severity of claims. These include property losses from catastrophes, terrorism and aviation risks under
catastrophe and individual risk contracts. Loss reserves related to catastrophe and individual risk contracts were approximately
$1.1 billion at December 31, 2009, a decline of about $200 million from December 31, 2008. In 2009 and 2008, loss reserves
for prior years’ events declined by approximately $280 million and $200 million, respectively, which produced corresponding
increases to pre-tax earnings each year. Reserving techniques for catastrophe and individual risk contracts generally rely more
on a per-policy assessment of the ultimate cost associated with the individual loss event rather than with an analysis of the
historical development patterns of past losses. Catastrophe loss reserves are provided when it is probable that an insured loss has
occurred and the amount can be reasonably estimated. Absent litigation affecting the interpretation of coverage terms, the
expected claim-tail is relatively short and thus the estimation error in the initial reserve estimates usually emerges within 24
months after the loss event.
Other reinsurance reserve amounts are generally based upon loss estimates reported by ceding companies and IBNR
reserves that are primarily a function of reported losses from ceding companies and anticipated loss ratios established on an
individual contract basis, supplemented by management’s judgment of the impact on each contract of major catastrophe events
as they become known. Anticipated loss ratios are based upon management’s judgment considering the type of business
covered, analysis of each ceding company’s loss history and evaluation of that portion of the underlying contracts underwritten
by each ceding company, which are in turn ceded to BHRG. A range of reserve amounts as a result of changes in underlying
assumptions is not prepared.
Derivative contract liabilities
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. For these reasons, we classify our credit default and equity
index put option contracts as Level 3 measurements under GAAP.
The fair values of our high yield credit default contracts are primarily based on indications of bid/ask pricing data. The bid/
ask data represents non-binding indications of prices for which similar contracts would be exchanged. Pricing data for the high
yield index contracts is obtained from one to three sources depending on the particular index. For the single name and municipal
issuer credit default contracts, our fair values are generally based on credit default spread information obtained from a widely
used reporting source. We monitor and review pricing data for consistency as well as reasonableness with respect to current
market conditions. We generally base estimated fair value on the ask prices (the average of such prices if more than one
indication is obtained). We make no significant adjustments to the pricing data referred to above. Further, we make no
significant adjustments to fair value for non-performance risk. We concluded that the values produced from this data (without
adjustment) reasonably represented the value for which we could have transferred these liabilities. However, our contract terms
(particularly the lack of collateral posting requirements) likely preclude any transfer of the contracts to third parties.
Accordingly, prices in a current actual settlement or transfer could differ significantly from the fair values used in the financial
statements. We do not operate as a derivatives dealer and currently we do not utilize offsetting strategies to hedge these
contracts. We intend to allow our credit default contracts to run off to their respective expiration dates.
Pricing data for newer high yield credit default contracts tends to vary little among the different pricing sources, which we
believe indicates that trading of such contracts is relatively active. As contracts age towards their expiration dates, the variations
in pricing data can widen, which we believe is indicative of less active markets. However, the impact of such variations is
partially mitigated by shorter remaining durations, lower exposures due to losses paid to date and by the relatively greater
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