Letter to Shareholders

# 2005 Letter to Shareholders ## To the Shareholders of Berkshire Hathaway Inc. We gained $5.6 billion in net worth during 2005, which increased the per-share book value of both our Class A and Class B stock by 6.4%. Over the last 41 years, book value has grown from $19 to $55,824, a rate of 21.5% compounded annually. ## Hurricane Katrina The big event of 2005 was Hurricane Katrina, which produced the largest insured loss in history. Our share of this loss was approximately $2.5 billion, and it reduced our float by about $1.5 billion. Despite this massive hit, Berkshire's financial strength remained unimpaired. In fact, our ability to pay claims without any financial strain gave us a competitive advantage. When catastrophes strike, policyholders want to be certain that their insurer can pay. Berkshire's fortress-like balance sheet provides that certainty. > "We will never play financial Russian roulette with funds entrusted to us, even if the revolver has 100 chambers and only one bullet." ## The Dangers of Leverage Leverage is a two-edged sword. In good times, it magnifies gains. In bad times, it magnifies losses—and can lead to ruin. Consider a hypothetical example. If you have $100 million of assets and $90 million of liabilities, your net worth is $10 million. A 10% decline in asset values reduces your net worth to zero—a 100% loss. A 15% decline makes you insolvent. Now consider the same $100 million of assets with no debt. A 10% decline reduces your net worth by 10%. A 15% decline reduces it by 15%. You remain solvent and can wait for recovery. [[Charlie Munger]] and I have always preferred the second approach. We will never risk permanent loss of capital for the sake of higher short-term returns. Berkshire's aversion to leverage has served us well through many crises. ## Derivatives Derivatives are dangerous. They allow enormous leverage to be created with minimal capital. They can produce gains for years, only to suddenly deliver catastrophic losses. We have a small derivatives position that we inherited from Gen Re. We are gradually reducing this position, but it takes time. The notional value of these contracts is large, but the actual risk is much smaller because many of the contracts offset each other. The problem with derivatives is not just the leverage they create. The bigger problem is that they can create systemic risk. A derivatives failure at one institution can trigger failures at others, creating a chain reaction. The financial system has become dangerously interconnected. ## Insurance Operations [[GEICO]] had an excellent year. Premium volume grew significantly, and we gained market share. Our low-cost model continues to attract price-sensitive consumers. [[Ajit Jain]] continues to build our reinsurance operation. He has created a unique business that takes on risks that no one else will touch—but only when the price is right. Ajit's discipline and creativity have generated enormous value for Berkshire. Our **insurance float** now exceeds $50 billion. This float is available for investment at no cost, provided we maintain underwriting discipline. The combination of free float and disciplined underwriting makes insurance Berkshire's most valuable business. ## The Importance of Financial Strength In the insurance business, financial strength is a competitive advantage. When a major loss occurs, policyholders with weak insurers may wait years for payment—or may never receive it. Berkshire's policyholders know we will pay promptly and in full. This reputation for financial strength allows us to win business that other insurers cannot. We can charge premium prices because customers value certainty. In a crisis, the weak flee to the strong. Berkshire will always be among the strong. ## Looking Forward We will continue to follow the same principles that have guided us for decades: 1. **Maintain financial strength** — We will never risk insolvency 2. **Buy wonderful businesses at fair prices** — Quality matters more than price 3. **Retain earnings** — We prefer to reinvest rather than pay dividends 4. **Avoid leverage** — We will not borrow against our portfolio These principles may seem conservative. But in a world full of risks, conservatism is not a vice—it is a necessity. Warren E. Buffett February 2006