WESCO FINANCIAL CORPORATION
LETTER TO SHAREHOLDERS
To Our Shareholders:
Consolidated ""normal'' net operating income (i.e., before irregularly occurring
items shown in the table below) for the calendar year 1998 decreased to
$37,622,000 ($5.28 per share) from $38,262,000 ($5.38 per share) in the previous
year.
Consolidated net income (i.e., after irregularly occurring items shown in the
table below) decreased to $71,803,000 ($10.08 per share) from $101,809,000
($14.30 per share) in the previous year.
Wesco has three major subsidiaries: (1) Wesco-Financial Insurance Company
(""Wes-FIC''), headquartered in Omaha and engaged principally in the reinsurance
business, (2) The Kansas Bankers Surety Company (""KBS''), owned by Wes-FIC
and specializing in insurance products tailored to midwestern banks, and (3)
Precision Steel, headquartered in Chicago and engaged in the steel warehousing and
specialty metal products businesses. Consolidated net income for the two years just
(1)
ended breaks down as follows (in 000s except for per-share amounts) :
Year Ended
December 31, 1998 December 31, 1997
Per Per
Wesco Wesco
Amount Share(2) Amount Share(2)
""Normal'' net operating income of:
Wes-FIC and KBS insurance businessesIIIIIIIIIII $34,654 $ 4.87 $ 33,507 $ 4.71
Precision Steel businesses IIIIIIIIIIIIIIIIIIIIIII 3,154 .44 3,622 .51
All other ""normal'' net operating income (loss)(3) III (186) (.03) 1,133 .16
37,622 5.28 38,262 5.38
Realized net securities gains IIIIIIIIIIIIIIIIIIIIIII 33,609 4.72 62,697 8.80
Gain on sales of foreclosed propertiesIIIIIIIIIIIIII 572 .08 850 .12
Wesco consolidated net income IIIIIIIIIIIIIIIIIII $71,803 $10.08 $101,809 $14.30
(1) All Ngures are net of income taxes.
(2) Per-share data is based on 7,119,807 shares outstanding. Wesco has had no dilutive capital stock equivalents.
(3) After deduction of interest and other corporate expenses, and costs and expenses associated with foreclosed real estate
previously charged against Wesco's former Mutual Savings and Loan Association subsidiary. Income was from ownership
of the Wesco headquarters oCce building, primarily leased to outside tenants, interest and dividend income from cash
equivalents and marketable securities owned outside the insurance subsidiaries, and, in 1997, the reduction of loss
reserves provided in prior years against possible losses on sales of foreclosed real estate.
This supplementary breakdown of earnings diAers somewhat from that used in
audited Nnancial statements which follow standard accounting convention. The
supplementary breakdown is furnished because it is considered useful to
shareholders.
Wesco-Financial Insurance Company (""Wes-FIC'')
Wes-FIC's normal net income for 1998 was $34,654,000, versus $33,507,000 for
1997. The Ngures include $4,987,000 in 1998 and $6,044,000 in 1997 contributed by
The Kansas Bankers Surety Company (""KBS''), owned by Wes-FIC since 1996. KBS
is discussed in the section, ""The Kansas Bankers Surety Company,'' below.
At the end of 1998 Wes-FIC retained about $24 million in invested assets, oAset
by claims reserves, from its former reinsurance arrangement with Fireman's Fund
Group. This arrangement was terminated August 31, 1989. However, it will take a
long time before all claims are settled, and, meanwhile, Wes-FIC is being helped
over many years by proceeds from investing ""Ooat.''
We previously informed shareholders that Wes-FIC had entered into the busi-
ness of super-cat reinsurance through retrocessions from the Insurance Group of
Berkshire Hathaway, Wesco's ultimate parent. Wes-FIC's entry into the super-cat
reinsurance business early in 1994 followed the large augmentation of its claims-
paying capacity caused by its merger with Mutual Savings, the former savings and
loan subsidiary of Wesco. In 1994, in recognition of Wes-FIC's sound Nnancial
condition, Standard and Poor's Corporation assigned to Wes-FIC the highest possible
claims-paying-ability rating: AAA.
The super-cat reinsurance business, in which Wes-FIC is engaged, continues to
be a very logical business for Wes-FIC. Wes-FIC has a large net worth in relation to
annual premiums being earned. And this is exactly the condition rationally required
for any insurance company planning to be a ""stand alone'' reinsurer covering super-
catastrophe risks it can't safely pass on to others sure to remain solvent if a large
super-catastrophe comes. Such a ""stand alone'' reinsurer must be a kind of Fort
Knox, prepared occasionally, without calling on any other reinsurers for help, to pay
out in a single year many times more than premiums coming in, as it covers losses
from some super catastrophe worse than Hurricane Andrew. In short, it needs a
balance sheet a lot like Wes-FIC's.
In connection with the retrocessions of super-cat reinsurance to Wes-FIC from
the Berkshire Hathaway Insurance Group, the nature of the situation as it has
evolved is such that Berkshire Hathaway, owning 100% of its Insurance Group and
only 80% of Wesco and Wes-FIC, does not, for some philanthropic reason, ordinarily
retrocede to Wes-FIC any reinsurance business that Berkshire Hathaway considers
desirable and that is available only in amounts below what Berkshire Hathaway
wants for itself on the terms oAered. Instead, retrocessions occur only occasionally,
under limited conditions and with some compensation to Berkshire Hathaway. Such
retrocessions ordinarily happen only when (1) Berkshire Hathaway, for some reason
(usually a policy of overall risk limitation), desires lower amounts of business than
are available on the terms oAered and (2) Wes-FIC has adequate capacity to bear
the risk assumed and (3) Wes-FIC pays a fair ceding commission designed to cover
part of the cost of getting and managing insurance business.
Generally, Berkshire Hathaway, in dealing with partly owned subsidiaries, tries
to lean over a little backward in an attempt to observe what Justice Cardozo called
""the punctilio of an honor the most sensitive,'' but it cannot be expected to make
large and plain giveaways of Berkshire Hathaway assets or business to a partially
owned subsidiary like Wes-FIC.
Given Berkshire Hathaway's unwillingness to make plain giveaways to Wes-FIC
and reductions in opportunities in the super-cat reinsurance market in recent years,
prospects are often poor for Wes-FIC's acquisition of retroceded super-cat
reinsurance.
Moreover, Wesco shareholders should continue to realize that super-cat rein-
surance is not for the faint of heart. A huge variation in annual results, with some very
unpleasant future years for Wes-FIC, is inevitable.
But it is precisely what must, in the nature of things, be associated with these
bad possibilities, with their huge and embarrassing adverse consequences in occa-
sional years, that makes Wes-FIC like its way of being in the super-cat business.
Buyers (particularly wise buyers) of super-cat reinsurance often want to deal with
Berkshire Hathaway subsidiaries (possessing as they do the highest possible credit
ratings and a reliable corporate personality) instead of other reinsurers less cautious,
straightforward and well endowed. And many competing sellers of super-cat reinsur-
ance are looking for a liberal ""intermediary's'' proNt, hard to get because they must
Nnd a ""layoA'' reinsurer both (1) so smart that it is sure to stay strong enough to pay
possible losses yet (2) so casual about costs that it is not much bothered by a liberal
proNt earned by some intermediary entity not willing to retain any major risk. Thus
the forces in place can rationally be expected to cause acceptable long-term results
for well-Nnanced, disciplined decision makers, despite horrible losses in some years
and other years of restricted opportunity to write business. And, again, we wish to
repeat that we expect only acceptable long-term results. We see no possibility for
bonanza.
It should also be noted that Wes-FIC, in the arrangements with the Insurance
Group of Berkshire Hathaway, receives a special business-acquisition advantage
from using Berkshire Hathaway's general reputation. Under all the circumstances,
the 3% ceding commission now being paid seems more than fair to Wes-FIC.
Certainly and obviously, Berkshire Hathaway would not oAer terms so good to any
other entity outside the Berkshire Hathaway aCliated group.
Finally, we repeat an important disclosure about Wes-FIC's super-cat-reinsur-
ance-acquisition mechanics. It is impractical to have people in California make
complex accept-or-reject decisions for Wes-FIC when retrocessions of reinsurance
are oAered by the Berkshire Hathaway Insurance Group. But, happily, the Berkshire
Hathaway Insurance Group executives making original business-acquisition deci-
sions are greatly admired and trusted by the writer and will be ""eating their own
cooking.'' Under such circumstances, Wesco's and Wes-FIC's boards of directors, on
the writer's recommendation, have simply approved automatic retrocessions of
reinsurance to Wes-FIC as oAered by one or more wholly owned Berkshire
Hathaway subsidiaries. Each retrocession is to be accepted forthwith in writing in
Nebraska by agents of Wes-FIC who are at the same time salaried employees of
wholly owned subsidiaries of Berkshire Hathaway. Moreover, each retrocession will
be made at a 3%-of-premiums ceding commission. Finally, two conditions must be
satisNed: (1) Wes-FIC must get 20% or less of the risk (before taking into account
eAects from the ceding commission) and (2) wholly owned Berkshire Hathaway
subsidiaries must retain at least 80% of the identical risk (again, without taking into
account eAects from the ceding commission).
We will not ordinarily describe individual super-cat reinsurance contracts in full
detail to Wesco shareholders. That would be contrary to our competitive interest.
Instead, we will try to summarize reasonably any items of very large importance.
Will more reinsurance be later available to Wes-FIC through Berkshire
Hathaway subsidiaries on the basis and using the automatic procedure we have
above described? Well, we have often proved poor prognosticators. We can only say
that we hope so and that more reinsurance should come, albeit irregularly and with
long intermissions. No new contracts became available to Wes-FIC in 1998. As of
1998 yearend, the one remaining super-cat contract, plus one other contract, not a
super-cat contract, represented Wes-FIC's active reinsurance business.
We continue to examine other possible insurance-writing opportunities, and
also insurance company acquisitions, like and unlike the purchase of KBS.
Wes-FIC is now a very strong insurance company, with very low costs, and, one
way or another, in the future as in the past, we expect to continue to Nnd and seize at
least a few sensible insurance opportunities.
On super-cat reinsurance accepted by Wes-FIC to date (March 8, 1999) there
has been no loss whatsoever that we know of, but some ""no-claims'' contingent
commissions have been paid to original cessors of business (i.e., cessors not
including Berkshire Hathaway). Super-cat underwriting proNt of $1.4 million, before
taxes, beneNted 1998 earnings, versus $2.3 million in 1997. The balance of pre-tax
underwriting proNt amounted to $1.9 million for 1998 and $2.8 million for 1997.
These Ngures came mostly from favorable revision of loss reserves on the old
Fireman's Fund contract.
The Kansas Bankers Surety Company (""KBS'')
KBS, purchased by Wes-FIC in 1996 for approximately $80 million in cash,
contributed $4,987,000 to the normal net operating income of the insurance
businesses in 1998 and $6,044,000 in 1997, after reductions for goodwill amortiza-
tion under consolidated accounting convention of $782,000 each year. The results of
KBS have been combined with those of Wes-FIC, and are included in the foregoing
table in the category, "" 'normal' net operating income of Wes-FIC and KBS insurance
businesses.''
KBS was chartered in 1909 to underwrite deposit insurance for Kansas banks. Its
oCces are in Topeka, Kansas. Over the years its service has continued to adapt to the
changing needs of the banking industry. Today its customer base, consisting mostly
of small and medium-sized community banks, is spread throughout 25 mainly
midwestern states. In addition to bank deposit guaranty bonds which insure deposits
in excess of FDIC coverage, KBS also oAers directors and oCcers indemnity policies,
bank employment practices policies, bank annuity and mutual funds indemnity
policies and bank insurance agents professional errors and omissions indemnity
policies.
The principal change in KBS's operations in 1998 was a large reduction in
insurance premiums ceded to reinsurers, eAective January 1, 1998. The increased
volume of business retained (94% in 1998 versus 58% in 1997) accompanied
reduced underwriting income during 1998. However, KBS's combined ratio re-
mained much better than average for insurers, at 62.2% for 1998, versus 37.2% for
1997 and 29.3% for 1996, and we expect volatile but favorable long-term eAects
from increased insurance retained. Part of KBS's continuing insurance volume is now
ceded through reinsurance to other Berkshire subsidiaries under reinsurance arrange-
ments whereunder such other Berkshire subsidiaries take 50% and unrelated reinsur-
ers take the other 50%.
KBS is run by Donald Towle, President, assisted by 15 dedicated oCcers and
employees.
Precision Steel
The businesses of Wesco's Precision Steel subsidiary, headquartered in the
outskirts of Chicago at Franklin Park, Illinois, contributed $3,154,000 to normal net
operating income in 1998, compared with $3,622,000 in 1997. The decrease in proNt
occurred as revenues decreased 2%, despite a 5% increase in pounds of product
sold, and was attributable mainly to expenditures necessitated to upgrade computers
and computer systems to ensure that Precision Steel's order-taking and other data
processing systems continue to function accurately beyond December 31, 1999.
Under the skilled leadership of David Hillstrom, Precision Steel's businesses in
1998 continued to provide an excellent return on resources employed.
Tag Ends from Savings and Loan Days
All that now remains outside Wes-FIC but within Wesco as a consequence of
Wesco's former involvement with Mutual Savings, Wesco's long-held savings and
loan subsidiary, is a small real estate subsidiary, MS Property Company, that holds tag
ends of assets and liabilities with a net book value of about $13 million. MS Property
Company's results of operations, immaterial versus Wesco's present size, are in-
cluded in the foregoing breakdown of earnings within ""all other 'normal' net
operating income (loss).''
Of course, the main tag end from Wesco's savings and loan days is
28,800,000 shares of Freddie Mac, purchased by Mutual Savings for $72 million at a
time when Freddie Mac shares could be lawfully owned only by a savings and loan
association. This holding, with a market value of $1.9 billion at yearend 1998, now
reposes in Wes-FIC.
All Other ""Normal'' Net Operating Income or Loss
All other ""normal'' net operating income or loss, net of interest paid and general
corporate expenses, decreased to an after-tax loss of $186,000 in 1998 from an after-
tax proNt of $1,133,000 in 1997. Sources were (1) rents ($2,921,000 gross) from
Wesco's Pasadena oCce property (leased almost entirely to outsiders, including
California Federal Bank as the ground Ooor tenant), and (2) interest and dividends
from cash equivalents and marketable securities held outside the insurance subsidi-
aries, less (3) costs and expenses of liquidating tag-end foreclosed real estate.
Income in 1998 was lower because (1) reversals of reserves for possible losses on
sales of such tag end real estate, expensed in prior years, beneNted earnings by about
$1.1 million in 1997, and (2) lower dividends were received in 1998 after forced
conversion of preferred stock of Citigroup Inc. (""Citigroup'') into lower-dividend-
paying common stock. The 1998 and 1997 ""other 'normal' net operating income or
loss'' Ngures also include intercompany charges for interest expense ($102,000 and
$172,000 after taxes, respectively) on borrowings from Wes-FIC. This intercompany
interest expense does not aAect Wesco's consolidated net income inasmuch as the
same amount is included as interest income in Wes-FIC's ""normal'' net operating
income.
Net Securities Gains and Losses
Wesco's earnings contained securities gains of $33,609,000, after income taxes,
for 1998, versus $62,697,000, after taxes, for 1997. The entire 1998 Ngure resulted
from sales of marketable securities. Of the 1997 Ngure, only $93,000 was realized
through the sale of securities; the balance, $62,604,000, resulted from the exchange
of the preferred and common shares of Salomon Inc (""Salomon'') owned by Wesco
for preferred and common shares of The Travelers Group Inc. (""Travelers'') late in
1997 in connection with the merger of Salomon with a subsidiary of Travelers.
Accounting standards require that the fair (market) value of shares received in such
an exchange be recorded as the new cost basis as of the date of the exchange, with
the diAerence, after appropriate reserves for future income tax on the gain, recog-
nized in the Nnancial statements as a realized after-tax gain. For income tax purposes
the exchange is recorded at the original cost of the securities exchanged; no gain is
reported on the tax return until the securities are sold.
Although the realized gains materially impacted Wesco's reported earnings for
each year, they had a very minor impact on Wesco's shareholders' equity. Inasmuch as
the greater portion of each year's realized gains had previously been reOected in the
unrealized gain component of Wesco's shareholders' equity, those amounts were
merely switched from unrealized gains to retained earnings, another component of
shareholders' equity.
Convertible Preferred Stockholdings
At the end of 1998, Wesco and its subsidiaries owned $20,000,000, at original
cost, in convertible preferred stock which by merger of Travelers and Citicorp late in
1998 became convertible preferred stock of Citigroup. The Travelers preferred stock,
itself, was received in 1997 (see the preceding section) in exchange for the Wesco
group's remaining shares of Salomon preferred stock, which originally cost
$20,000,000, and whose cost was adjusted upwards to $45,000,000 as of the date of
the exchange. The issue requires redemption at par value of $20,000,000 on
October 31, 1999, if not converted to 892,105 shares of common stock before that
date. The investment is carried on Wesco's consolidated balance sheet at fair value
of $44,000,000 as of December 31, 1998, the approximate market value of the
common shares at that date, with the $1,000,000 diAerence between its adjusted cost
and market value deducted from shareholders' equity, net of income tax eAect,
without aAecting reported net income, according to accounting convention. The
convertible preferred stock was obtained at the same time Wesco's parent corpora-
tion, Berkshire Hathaway, obtained additional amounts of the same stock at the same
price per share.
Through yearend 1997, Wesco's consolidated Nnancial statements reOected an
investment in 9.25% convertible preferred stock of US Airways Group, Inc., acquired
by Wesco at par of $12,000,000 in 1989; that Ngure was adjusted down to
$3,000,000 when we decided in 1994 that an other-than-temporary decline in the
value of its stock had occurred. Early in 1998, US Airways called the preferred stock
for redemption. Prior to the eAective date, Wesco converted its preferred stock
investment to 309,718 shares of US Airways common stock and sold the latter for
$21,738,000, realizing a gain of $18,738,000 for Nnancial statement purposes
($12,180,000 after taxes). For tax return purposes, however, only $9,738,000 of gain
($6,330,000 after taxes) will be realized, because the $9,000,000 writedown in 1994
was not deductible.
Consolidated Balance Sheet And Related Discussion
As indicated in the accompanying Nnancial statements, Wesco's net worth
increased, as accountants compute it under their conventions, to $2.22 billion ($312
per Wesco share) at yearend 1998 from $1.76 billion ($248 per Wesco share) at
yearend 1997.
The $459.5 million increase in reported net worth in 1998 was the result of three
factors: (1) $395.8 million resulting from continued net appreciation of investments
after provision for future taxes on capital gains; plus (2) $71.8 million from 1998 net
income; less (3) $8.1 million in dividends paid.
The foregoing $312-per-share book value approximates liquidation value assum-
ing that all Wesco's non-security assets would liquidate, after taxes, at book value.
Probably, this assumption is too conservative. But our computation of liquidation
value is unlikely to be too low by more than two or three dollars per Wesco share,
because (1) the liquidation value of Wesco's consolidated real estate holdings
(where interesting potential now lies almost entirely in Wesco's equity in its oCce
property in Pasadena) containing only 125,000 net rentable square feet, and
(2) unrealized appreciation in other assets (primarily Precision Steel) cannot be
large enough, in relation to Wesco's overall size, to change very much the overall
computation of after-tax liquidating value.
Of course, so long as Wesco does not liquidate, and does not sell any
appreciated assets, it has, in eAect, an interest-free ""loan'' from the government
equal to its deferred income taxes on the unrealized gains, subtracted in determining
its net worth. This interest-free ""loan'' from the government is at this moment
working for Wesco shareholders and amounted to about $127 per Wesco share at
yearend 1998.
However, some day, perhaps soon, major parts of the interest-free ""loan'' must
be paid as assets are sold. Therefore, Wesco's shareholders have no perpetual
advantage creating value for them of $127 per Wesco share. Instead, the present
value of Wesco's shareholders' advantage must logically be much lower than $127
per Wesco share. In the writer's judgment, the value of Wesco's advantage from its
temporary, interest-free ""loan'' was probably about $30 per Wesco share at yearend
1998.
After the value of the advantage inhering in the interest-free ""loan'' is estimated,
a reasonable approximation can be made of Wesco's intrinsic value per share. This
approximation is made by simply adding (1) the value of the advantage from the
interest-free ""loan'' per Wesco share and (2) liquidating value per Wesco share.
Others may think diAerently, but the foregoing approach seems reasonable to the
writer as a way of estimating intrinsic value per Wesco share.
Thus, if the value of the advantage from the interest-free tax-deferral ""loan''
present was $30 per Wesco share at yearend 1998, and after-tax liquidating value
was then about $312 per share (Ngures that seem rational to the writer), Wesco's
intrinsic value per share would become about $342 per share at yearend 1998, up
25% from intrinsic value as guessed in a similar calculation at the end of 1997. And,
Nnally, this reasonable-to-this-writer, $342-per-share Ngure for intrinsic per share
value of Wesco stock should be compared with the $354? per share price at which
Wesco stock was selling on December 31, 1998. This comparison indicates that
Wesco stock was then selling about 4% above intrinsic value.
As Wesco's unrealized appreciation has continued to grow in frothy markets for
securities, it should be remembered that it is subject to market Ouctuation, possibly
dramatic on the downside, with no guaranty as to its ultimate full realization.
Unrealized after-tax appreciation represents 76% of Wesco's shareholders' equity at
1998 yearend), versus 73% and 70% one and two years earlier.
Business and human quality in place at Wesco continues to be not nearly as
good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an
equally-good-but-smaller version of Berkshire Hathaway, better because its small
size makes growth easier. Instead, each dollar of book value at Wesco continues
plainly to provide much less intrinsic value than a similar dollar of book value at
Berkshire Hathaway. Moreover, the quality disparity in book value's intrinsic merits
has, in recent years, been widening in favor of Berkshire Hathaway.
All that said, we make no attempt to appraise relative attractiveness for invest-
ment of Wesco versus Berkshire Hathaway stock at present stock-market quotations.
We are not now pessimists, on a long-term basis, about business expansion.
Despite present super-ebullient markets for entire businesses, making it hard for
Wesco to Nnd attractive opportunities, we do not believe that such opportunities will
never come.
On January 13, 1999 Wesco increased its regular dividend from 28Y cents per
share to 29Y cents per share, payable March 10, 1999, to shareholders of record as
of the close of business on February 10, 1999.
This annual report contains Form 10-K, a report Nled with the Securities and
Exchange Commission, and includes detailed information about Wesco and its
subsidiaries as well as audited Nnancial statements bearing extensive footnotes. As
usual, your careful attention is sought with respect to these items.
Charles T. Munger
Chairman of the Board
March 8, 1999
