SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

 

For the fiscal year ended December 31, 2007 or

 

 

For the Transition period from          to          

 

Commission file number 1-4720

 

WESCO FINANCIAL CORPORATION

(Exact name of Registrant as Specified in its Charter)

 

(626) 585-6700

(Registrant’s Telephone Number, Including Area Code)

 

Securities registered pursuant to section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

None

(Title of Class)

 

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of voting and non-voting stock of the registrant held by non-affiliates of the registrant as of June 30, 2007 was: $515,783,000.

 

The number of shares outstanding of the registrant’s Capital Stock as of February 27, 2008 was: 7,119,807.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

 

PART I

 

 

GENERAL

 

Wesco Financial Corporation (“Wesco”) was incorporated in Delaware on March 19, 1959. Wesco engages in three principal businesses through its direct or indirect wholly owned subsidiaries:

 

 

Wesco’s operations also include, through another wholly owned subsidiary, MS Property Company (“MS Property”), management of owned commercial real estate in downtown Pasadena, California. MS Property began its operations in late 1993, upon transfer to it of real properties previously owned by Wesco and by a former savings and loan subsidiary of Wesco.

 

Since 1973, Wesco has been 80.1%-owned by Blue Chip Stamps (“Blue Chip”), a wholly owned subsidiary of Berkshire Hathaway Inc. (“Berkshire”). Thus, Wesco and its subsidiaries are controlled by Blue Chip and Berkshire. All of these companies may also be deemed to be controlled by Warren E. Buffett, who is Berkshire’s Chairman and Chief Executive Officer and economic owner of 28.1% of its stock. Wesco’s Chairman, President and Chief Executive Officer, Charles T. Munger, is also Vice Chairman of Berkshire, and consults with Mr. Buffett with respect to Wesco’s investment decisions, major capital allocations, and the selection of the chief executives to head each of its operating businesses, subject to ultimate approval of Wesco’s Board of Directors.

 

Wesco’s activities fall into three business segments — insurance, furniture rental and industrial. The insurance segment consists of the operations of Wes-FIC and KBS. The furniture rental segment consists of the operations of CORT. The industrial segment comprises Precision Steel’s steel service center and industrial supply operations. Wesco is also engaged in several activities not identified with the three business segments, including investment activity unrelated to the insurance segment, MS Property’s real estate activities, and parent company activities.

 

INSURANCE SEGMENT

 

Wes-FIC was incorporated in 1985 to engage in the property and casualty insurance and reinsurance business. Its insurance operations are managed by National Indemnity Company (“NICO”), which is headquartered in Omaha, Nebraska. To simplify discussion, the term “Berkshire Insurance Group” refers to NICO, General Reinsurance Corporation, and certain other wholly owned insurance subsidiaries of Berkshire, although Berkshire also includes in its insurance group the insurance subsidiaries that are 80.1%-owned through Berkshire’s ownership of Wesco.

 

Wes-FIC’s high statutory net worth (about $2.5 billion at December 31, 2007) has enabled Berkshire to offer Wes-FIC the opportunity to participate, from time to time, in contracts in which Wes-FIC effectively has reinsured certain property and casualty risks of unaffiliated property and casualty insurers. These arrangements have included “excess-of-loss” contracts such as “super-catastrophe reinsurance” contracts which subject the reinsurer to especially large amounts of losses from mega-catastrophes such as hurricanes or earthquakes. Super-catastrophe policies, which indemnify the ceding companies for all or part of covered losses in excess of large, specified retentions, have been subject to aggregate limits. Wes-FIC has also been

party to “quota-share” reinsurance, under which it shares in premiums and losses proportionately with the ceding company.

 

Wesco’s board of directors has authorized automatic acceptance of retrocessions of super-catastrophe reinsurance offered by the Berkshire Insurance Group provided the following guidelines and limitations are complied with: (1) in order not to delay the acceptance process, the retrocession is to be accepted without delay in writing in Nebraska by agents of Wes-FIC who are salaried employees of the Berkshire Insurance Group; (2) any ceding commission received by the Berkshire Insurance Group cannot exceed 3% of premiums, which is believed to be less than the Berkshire Insurance Group could get in the marketplace; (3) Wes-FIC is to assume 20% or less of the total risk; (4) the Berkshire Insurance Group must retain at least 80% of the identical risk; and (5) the aggregate premiums from this type of business in any twelve-month period cannot exceed 10% of Wes-FIC’s net worth. Occasionally, the Berkshire Insurance Group will also have an upper-level reinsurance interest with interests different from Wes-FIC’s, particularly in the event of one or more large losses. Although Wes-FIC has no active super-catastrophe reinsurance contracts in force, Wes-FIC may have opportunities to participate in such business from time to time in the future.

 

Following are some of the more significant reinsurance arrangements in which Wes-FIC has participated in recent years:

 

 

Effective January 1, 2008, Wes-FIC entered into a retrocession agreement with National Indemnity Company (“NICO”), a wholly owned indirect subsidiary of Berkshire Hathaway Inc., to assume 10% of NICO’s quota share reinsurance of Swiss Reinsurance Company and its property-casualty affiliates (“Swiss Re”). Under this retrocession agreement, Wes-FIC will assume 2% part of NICO’s 20% quota share reinsurance of all Swiss Re property-casualty risks incepting over the next five years on the same terms as NICO’s agreement with Swiss Re. If recent years’ volumes were to continue over the next five years, the annual written premium assumed under this retrocession agreement would be in the $300 million range, however actual premiums assumed over the five year period could vary significantly depending on market conditions and opportunities.

 

Wes-FIC is also licensed to write “direct,” or “primary” insurance business (as distinguished from reinsurance) in Nebraska, Utah and Iowa, and may write such insurance in the non-admitted excess and surplus lines market in several other states, but the volume written to date has been minimal.

In 1996, Wes-FIC purchased 100% of KBS. KBS, which writes primary insurance, provides specialized insurance coverage to more than 20% of the banks in the United States, mostly small and medium-sized banks in the Midwest. It is licensed to write business in 38 states. Its product line for financial institutions includes policies for crime insurance, check kiting fraud indemnification, Internet banking catastrophe theft insurance, directors and officers liability, bank employment practices, and bank insurance agents professional errors and omissions indemnity, as well as deposit guaranty bonds which insure deposits in excess of federal deposit insurance limits. KBS purchases reinsurance for indemnification against large losses. For several years, through 2005, 50% of a layer of loss exposure was ceded to an unaffiliated reinsurer and the other 50% to the Berkshire Insurance Group, on identical terms. A second layer was reinsured 70% with the same non-affiliate and 30% was retained by KBS. Since 2006, when the unaffiliated reinsurer declined to renew its contract with KBS, the Berkshire Insurance Group has reinsured the entire first layer of exposure itself. Another layer is 35%-retained by KBS and the other 65% is reinsured by the Berkshire Insurance Group, at market prices. In 2007, premiums of $3.5 million were ceded to the Berkshire Insurance Group, no losses were allocated to it, and $125,000 of loss reserves, which had been allocated to it in 2005, were reversed. In recent years, KBS has retained a greater proportion of the risks it has underwritten. By retaining a larger amount of risk than in the past, Wesco seeks satisfactory operating results over the long term in return for greater short-term volatility.

 

KBS markets its products in some states through exclusive, commissioned agents, and directly to insureds in other states. Inasmuch as the number of small Midwestern banks is declining as the banking industry consolidates, KBS relies for growth on an extraordinary level of service provided by its employees and agents, and on products such as deposit guaranty bonds, which were introduced in 1993 and currently account for almost half of premiums written.

 

A significant marketing advantage enjoyed by the Berkshire Insurance Group, including Wesco’s insurance segment, is the maintenance of exceptional capital strength. The combined statutory surplus of Wesco’s insurance businesses totaled approximately $2.5 billion at December 31, 2007. This capital strength creates opportunities for Wes-FIC to participate in reinsurance and insurance contracts not necessarily available to many of its competitors.

 

Management of Wesco believes that an insurer in the reinsurance business must maintain a large net worth in relation to annual premiums in order to remain solvent when called upon to pay claims when a loss occurs. In this respect, Wes-FIC and KBS are competitively well positioned, inasmuch as their net premiums written for calendar 2007 amounted to only 2% of their combined statutory surplus, compared to an industry average of 90% based on figures reported for 2006 by A.M. Best Company, a nationally recognized statistical rating organization for the insurance industry. Standard & Poor’s Corporation, in recognition of Wes-FIC’s strong competitive position as a member of the Berkshire Insurance Group and its unusual capital strength, has assigned its highest rating, AAA, to Wes-FIC’s claims-paying ability. This rating recognizes the commitment of Wes-FIC’s management to a disciplined approach to underwriting, conservative reserving, and Wes-FIC’s extremely strong capital base.

 

Insurance companies are subject to regulation by the departments of insurance of the various states in which they write policies as well as the states in which they are domiciled and, in the case of KBS, because of its business of insuring banks, by the Department of the Treasury. Regulations relate to, among other things, capital requirements, shareholder and policyholder dividend restrictions, reporting requirements, annual audits by independent accountants, periodic regulatory examinations and limitations on the risk exposures that can be retained, as well as the size and types of investments that can be made.

 

Because it is operated by NICO, Wes-FIC has no employees of its own. KBS has 18 employees.

 

FURNITURE RENTAL SEGMENT

 

CORT is the nation’s largest provider of rental furniture, accessories and related services in the “rent-to-rent” (as opposed to “rent-to-own”) segment of the furniture industry. CORT rents high-quality furniture to corporate and individual customers who desire flexibility in meeting their temporary office, residential or trade show furnishing needs, and who typically do not seek to own such furniture. In addition,

CORT sells previously rented furniture through company-owned clearance centers, thereby enabling it to regularly renew its inventory and update styles. CORT’s network of facilities (in 32 states and the District of Columbia) comprises 86 showrooms, 75 clearance centers and 74 warehouses, as well as eight websites, including www.cort.com.

 

CORT’s rent-to-rent business is differentiated from rent-to-own businesses primarily by the terms of the rental arrangements and the type of customer served. Rent-to-rent customers generally desire high-quality furniture to meet temporary needs, have established credit, and pay on a monthly basis. Typically, these customers do not seek to acquire the property on a permanent basis. In a typical rent-to-rent transaction, the customer agrees to rent furniture for a minimum of three months, subject to extension by the customer on a month-to-month basis. By contrast, rent-to-own arrangements are generally made by customers lacking established credit whose objective is the eventual ownership of the property. These transactions are typically entered into on a month-to-month basis and may require weekly rental payments.

 

CORT’s customer base includes primarily Fortune 500 companies, small businesses, professionals, and owners and operators of apartment communities. CORT’s management believes its size, national presence, brand awareness, consistently high level of customer service, product quality, breadth of selection, depth and experience of management, and efficient clearance centers have been key contributors to the company’s success. CORT offers a wide variety of office and home furnishings, including commercial panel systems, televisions, housewares and accessories. CORT emphasizes its ability to furnish an apartment, home or entire suite of offices with high-quality furniture, housewares and accessories in two business days. CORT’s objective is to build upon these core competencies and competitive advantages to increase revenues and market share. Key to CORT’s growth strategies are:

 

 

In order to capitalize on the significant profit potential available from longer average rental periods and the higher average monthly rent typically available for office products, CORT’s strategy is to place greater emphasis on growth in rentals of office furniture while maintaining its premier position in residential furniture rental. In order to promote longer office lease terms, CORT offers lower rates on leases when lease terms exceeds six months. A significant portion of CORT’s residential furniture rentals are derived from corporate relocations and temporary assignments, as new and transferred employees of CORT’s corporate customers enter into leases for residential furniture. Thus, CORT offers its corporate rental customers a way to reduce the costs of corporate relocation and travel while developing residential business with new and transferred employees. CORT also provides short-term rentals for trade shows and conventions. Its www.corttradeshow.com website assists in providing information to and gathering leads from prospects.

 

The furniture rental business is dependent on economic cycles, and the recent softening of the housing sector could contribute to a weakening of the furniture rental business. Because CORT has made several selective acquisitions since it was purchased by Wesco, it is believed that CORT is now well positioned to benefit from domestic job growth and any corresponding economic expansion.

 

CORT provides a nation-wide apartment locator service through its websites (www.cort.com, www.relocationcentral.com and www.apartmentsearch.com) customer call centers and walk-in locations. The apartment locator service, which was begun in 2001 as CORT’s Relocation Central Corporation subsidiary and marketed to individuals, has not operated profitably since inception. In order to trim operating costs, its operations were reorganized and, by yearend 2004, absorbed into CORT’s. CORT’s apartment locator service, which was originally intended mainly to lead to increased furniture rentals, now relies more on Internet traffic and less on walk-in locations. In consideration of its national presence and expertise in filling a need of the business community, late in 2006 CORT began marketing its relocation service, designed

specifically for renters, to Fortune 2000 companies as a comprehensive, seamless solution to their employee-relocation needs. In addition to providing rental furniture, CORT provides assistance with all aspects of employee rental-related relocations, services which include guided city tours, arranging for movers, locating temporary or long-term housing, assisting with settling in and other ancillary services. Through its network of foreign contacts, CORT also provides such services internationally. Although the relocation business is competitive, it is believed that CORT is well positioned to expand these services due not only to its national presence and liquidity, but also because the business reputation of Berkshire Hathaway gives it entrée to the offices of many prospective customers, and thus a competitive advantage.

 

In January 2008, CORT expanded its operations to the United Kingdom through the purchase of Roomservice Group, a small regional provider of furniture rental and relocation services.

 

The rent-to-rent segment of the furniture rental industry is highly competitive. There are several large regional competitors, as well as a number of smaller regional and local rent-to-rent competitors. In addition, numerous retailers offer residential and office furniture under rent-to-own arrangements. It is believed that the principal competitive factors in the furniture rental industry are product value, furniture condition, the extent of furniture selection, terms of the rental agreement, speed of delivery, exchange privileges, options to purchase, deposit requirements and customer service.

 

The majority of CORT’s furniture sales revenue is from its clearance center sales. The remaining furniture sales revenue is derived principally from lease conversions and sales of new furniture. The sale of previously leased furniture allows CORT to control inventory quantities and to maintain inventory quality at showroom level. On average, furniture is typically sold through the clearance centers three years after its initial purchase. With respect to sales of furniture through its clearance centers, CORT competes with numerous new and used furniture retailers, some of which are larger than CORT. Wesco management believes that price and value are CORT’s principal competitive advantages in this activity.

 

CORT has approximately 2,450 full-time employees, including 62 union members. Management considers labor relations to be good.

 

INDUSTRIAL SEGMENT

 

Precision Steel and one of its subsidiaries operate steel service centers in the Chicago and Charlotte metropolitan areas. The service centers buy stainless steel, low carbon sheet and strip steel, coated metals, spring steel, brass, phosphor bronze, aluminum and other metals, cut these metals to order, and sell them to a wide variety of customers.

 

The service center business is highly competitive. Precision Steel’s annual sales volume of approximately 20 thousand tons of flat rolled products compares with the domestic steel service industry’s annual volume for all shapes of products (flat rolled, bar, wire, structural, plate, tubular steel, etc.) of approximately 60 million tons. Precision Steel competes not only with other service centers but also with mills that supply metal to service centers, original equipment manufacturers and end-users. Sales competition exists in the areas of price, quality, availability and speed of delivery. Because it is willing to sell in relatively small quantities, Precision Steel has been able to compete in geographic areas distant from its service center facilities. Competitive pressure has been intensified by economic cycles and a shift to production abroad and an increasing tendency of domestic manufacturers to use less costly materials in making parts.

 

Precision Brand Products, Inc. (“Precision Brand”), a wholly owned subsidiary of Precision Steel that is also located in the Chicago area, manufactures shim stock and other toolroom specialty items, and distributes a line of hose clamps and threaded rod. These products are sold under the Precision Brand and DuPage names nationwide, generally through industrial distributors. This business is highly competitive, and Precision Brand’s sales represent a very small share of the market.

 

Steel service raw materials are obtained principally from major domestic steel mills, and their availability had generally been good until approximately four years ago, when the market drifted into near chaos caused by shortages. Consolidation and downsizing at the mill level has resulted in extended lead times and has given the producing mills unprecedented authority in the marketplace regarding pricing and the

establishment of minimum order requirements and other restrictions. Precision Steel’s service centers continue to maintain extensive inventories in order to meet customer demand for prompt deliveries; typically, processed metals are delivered to the customer within one or two weeks. Precision Brand normally maintains inventories adequate to allow for off-the-shelf service to customers within 24 hours.

 

The industrial segment businesses are subject to economic cycles and other factors, but are not dependent on a few large customers. The backlog of steel service orders increased to $4.9 million at December 31, 2007 from $4.1 million at December 31, 2006.

 

There are 197 full-time employees engaged in the industrial segment businesses, 40% of whom are members of unions. Management considers labor relations to be good.

 

ACTIVITIES NOT IDENTIFIED WITH A BUSINESS SEGMENT

 

Certain of Wesco’s activities are not identified with any business segment. These include investment activity unrelated to the insurance segment, management of owned commercial real property, a portion of which it is redeveloping, and parent company activities.

 

Six full-time employees are engaged in the activities of Wesco and MS Property.

 

AVAILABLE INFORMATION

 

Wesco’s Forms 10-K, 10-Q and 8-K, and amendments thereto, may be accessed soon after they are electronically filed with the Securities and Exchange Commission (“SEC”), through Wesco’s website, www.wescofinancial.com, or the SEC’s website, www.sec.gov.

 

 

In addition to the factors affecting specific business operations identified in connection with the description of these operations and their financial results elsewhere in this report, we invite your attention to the considerations and risk factors described below. The risk factors could cause Wesco’s actual results to differ materially from the forward-looking and other statements contained in this report and in the other periodic reports and other filings Wesco makes with the SEC, as well as in news releases, annual reports and other communications that Wesco makes from time to time.

 

An investment in Wesco is not an investment in Berkshire Hathaway.

 

From time to time there is an erroneous report by an analyst or reporter that an investor wishing to purchase Berkshire Hathaway common stock can simply purchase shares of Wesco stock at a lower price. Berkshire Hathaway is the parent of Wesco. Wesco’s operations differ significantly from those of Berkshire Hathaway, and its shares may trade at a significantly different price relative to its intrinsic value than do those of Berkshire Hathaway. In addition to the risk factors affecting Wesco’s operations, Berkshire Hathaway has risk factors of its own. Investors wishing to have investment exposure to Berkshire Hathaway cannot accomplish this by purchasing Wesco shares. They should carefully read Berkshire Hathaway’s published financial statements and filings with the SEC.

 

Wesco is dependent for its investment and all other capital allocation decisions on a few key people.

 

Investment decisions and all other capital allocation decisions are made for Wesco’s businesses by Charles T. Munger, Chairman of the Board of Directors, President and CEO of Wesco, and Vice Chairman of the Board of Directors of Berkshire Hathaway, age 84, in consultation with Warren E. Buffett, Chairman of the Board of Directors and CEO of Berkshire Hathaway, age 77. If for any reason the services of those key personnel, particularly Mr. Buffett, were to become unavailable to Wesco, there could be a materially adverse effect on Wesco. However, Berkshire’s Board of Directors has agreed on a replacement for Mr. Buffett should a replacement be needed currently. Its Board continually monitors this matter and could alter its current view in the future.

Unless Wesco can reinvest a large amount currently invested in cash equivalents at attractive returns, future returns on shareholders’ equity will probably be less than those of the past.

 

Wesco’s consolidated balance sheet reflects total assets of $3.1 billion as of yearend 2007. Of that amount, more than $550 million has been invested in cash equivalents and fixed-maturity investments since early in 2003. Although Wesco’s consolidated investments in cash-equivalent and fixed-maturity investments have declined significantly from the $1.3 billion owned one year ago, due principally to Wesco’s investment of $802 million, net, in marketable equity securities during the latter part of 2007, unless significant additional amounts can be attractively reinvested in acquisitions, equity securities or other long-term instruments of the type that have been principally responsible for the long-term growth of Wesco’s shareholders’ equity, future returns on shareholders’ equity will probably be less than those of the past. Due to the current size of Wesco and its parent, Berkshire Hathaway, Wesco’s opportunities for growing shareholders’ equity are unlikely to be as attractive as in the past.

 

Wesco’s Wes-FIC subsidiary is dependent upon the Berkshire Insurance Group for its management and personnel, and for opportunities to participate with the Group in reinsurance contracts representing essentially the entirety of its reinsurance business, as well as a significant portion of its insurance business to date.

 

Since the incorporation of Wes-FIC in 1985, Wesco’s insurance and reinsurance business, other than that conducted by its Kansas Bankers Surety subsidiary, has been limited principally to participation with members of the Berkshire Insurance Group in contracts for the reinsurance of risks of unaffiliated property and casualty insurance companies. Wes-FIC’s operations are managed by National Indemnity Company, a member of the Berkshire Insurance Group; it has no employees of its own. In the event the Berkshire Insurance Group were to cease operating Wes-FIC’s business or to significantly curtail Wes-FIC’s participation with it in reinsurance contracts, Wes-FIC would be required to look elsewhere for personnel who would conduct and manage its operations, and/or seek to continue its insurance business in a different manner, possibly by acquisition. Inasmuch as Wesco and its subsidiaries, including Wes-FIC, are also subsidiaries of Berkshire Hathaway through Berkshire Hathaway’s 80.1%-ownership of Wesco, Wesco does not foresee a time when Berkshire Hathaway would not continue operating its insurance business.

 

Wesco’s tolerance for risk in its insurance businesses may result in a high degree of volatility in periodic reported earnings.

 

Wes-FIC participates with members of the Berkshire Insurance Group in certain reinsurance contracts in which significant risk is periodically assumed. The Berkshire Insurance Group has indicated that it continues to be willing to assume more risk than any other insurer has knowingly taken on. Although Wes-FIC’s reinsurance currently in force does not subject it to super-catastrophe risks, it has procedures in place for the immediate acceptance of participations in catastrophic excess of loss reinsurance, which could subject it to large amounts of losses from mega-catastrophes such as hurricanes or earthquakes, if offered to it by the Berkshire Insurance Group, so long as the Berkshire Insurance Group participates in such reinsurance activities to a greater degree. The tolerance for significant risks may in certain future periods result in significant losses. This policy may result in a high degree of volatility in Wesco’s periodic reported earnings.

 

As described above in Item 1, Business, Wes-FIC recently entered into a substantial quota-share arrangement whereby Wes-FIC is reinsuring 2 per cent of essentially all of the property and casualty insurance business of a large insurer not affiliated with the Berkshire Insurance Group. This arrangement will significantly increase Wes-FIC’s premium volume, and thus, the potential for increased volatility and losses. In addition, as with all reinsurance arrangements, Wes-FIC does not control the underwriting of the primary insurer and relies on the primary insurer’s reputation and judgment in deciding what underlying risks to insure.

 

The degree of estimation error inherent in the process of estimating property and casualty insurance loss reserves may result in a high degree of volatility in periodic reported earnings.

 

In the insurance business, premiums are charged today for promises to pay covered losses in the future. The principal cost associated with premium revenue is claims. However, it will literally take decades before all losses that have occurred as of the balance sheet date will be reported and settled. Although Wesco believes that loss reserve balances are adequate to cover losses, Wesco will not truly know whether the premiums charged for the coverages provided are sufficient until well after the balance sheet date. Wesco’s objective is to generate underwriting profits over the long term. Estimating insurance claim costs is inherently imprecise. Wesco’s reserve estimates are subject to revision, so adjustments to reserve estimates can have a material effect on periodic reported earnings.

 

Wesco’s insurance subsidiaries’ investments are unusually concentrated.

 

Compared to other insurers, Wesco’s insurance subsidiaries may keep an unusually high percentage of their assets in common stocks and diversify their portfolios far less than is conventional. A significant decline in the stock market or in the price of major investees could produce a large decrease in Wesco’s shareholders’ equity, and could precipitate recognition of such losses in the statement of earnings. Decreases in values of equity investments could have a materially adverse effect on Wesco’s book value per share, and could affect the price at which Wesco shares are traded.

 

Each of Wesco’s operating businesses faces intense competitive pressures.

 

Each of Wesco’s operating businesses faces intense competitive pressures within its respective market. While Wesco’s businesses are managed with the objective of achieving sustainable growth over the long term through developing and strengthening competitive advantages, many factors, including market changes and technology, could erode or impede those competitive advantages.

 

The property and casualty insurance industry is highly competitive. Many insurers price their business more to provide immediate cash flow than profitability. Competition occurs not only with respect to price, but also to service, the ability to adapt to meet needs of customers as changes occur, reputation, and often, the need to satisfy customers’ expectations that insurers have sufficient capital strength to ensure that they will be viable when called upon to pay large losses in the future. Because of the disciplined underwriting standards of the Berkshire Insurance Group, Wes-FIC does not enter into insurance or reinsurance activities that do not provide the expectation of acceptable underwriting profitability. Thus, the volume of written premiums will continue to vary significantly from period to period.

 

CORT competes not only with regional and local furniture rental businesses, but also with furniture businesses offering “lease purchase” or “rent-to-own” programs, as well as with national, regional and local furniture retailers. Competitive factors include price, furniture style and condition, lease terms, speed of delivery and overall customer service.

 

Precision Steel’s annual sales volume is a small fraction of the domestic steel service industry’s. Precision Steel competes not only with other service centers, but also with mills that supply metal to the service centers. Sales competition exists in the areas of price, quality, availability, speed of delivery, and customer service. Competitive pressure has been intensified by imports, a shift to production abroad and an increasing tendency of domestic manufacturers to use less costly materials in making products. Precision Steel’s subsidiary’s toolroom specialty business also faces strong competition, mainly based on price.

 

In addition to the foregoing risk factors inherent in Wesco’s operations, Wesco’s shareholders face a market liquidity risk because the daily trading volume of Wesco’s shares on the American Stock Exchange is relatively low.

 

In addition to the risks facing Wesco in its business operations, investors wishing to purchase or sell shares of its capital stock face market price risks because the daily AMEX trading volume of Wesco’s shares is

relatively low. An order for the purchase or sale of a large number of Wesco shares could significantly affect the price at which the order is executed.

 

 

None.

 

 

CORT leases 16,212 square feet of office space in a multistory office building in Fairfax, Virginia, which it uses as its headquarters under a lease which will expire in 2012.

 

CORT carries out its rental, sales and warehouse operations in metropolitan areas in 32 states and the District of Columbia through 164 facilities, of which 17 were owned and the balance leased as of December 31, 2007. The leased facilities’ lease terms expire at dates ranging from 2008 to 2018. CORT has generally been able to extend expiration dates of its leases or obtain suitable alternative facilities on satisfactory terms. As leases expire, CORT has been eliminating redundant locations and decreasing the size of its showrooms, which as of yearend 2007 ranged in size from 1,200 to 10,388 square feet of floor space. Where locations are desirable, its management has been attempting to combine rental, clearance and warehouse operations rather than retain separate showrooms, because business and residential customers have been increasingly using the Internet. CORT regularly reviews the presentation and appearance of its furniture showrooms and clearance centers and periodically improves or refurbishes them to enhance their attractiveness to customers.

 

MS Property owns a business block in Pasadena, California situated between the city hall and a large shopping mall. The block’s improvements include a nine-story office building that was constructed in 1964 and has approximately 125,000 square feet of net rentable area, and a multistory garage with space for 420 vehicles. Of the 125,000 square feet of space in the office building, approximately 5,000 square feet are used by MS Property or leased to Blue Chip or Wesco at market rental rates. The remaining space is almost fully leased to outside parties, including Citibank (the ground floor tenant), law firms and others, under agreements expiring at dates extending to 2017. Adjacent to the building and garage is a parcel on which MS Property is nearing completion of a multi-story, 28-unit, luxury condominium building. MS Property is seeking city approval of its plans, at a later date, to build another multi-story luxury condominium building on a vacant parcel of land it owns in the next block.

 

MS Property also owns several buildings that are leased to various small businesses in a small shopping center in Southern California.

 

Wes-FIC’s place of business is the Omaha, Nebraska headquarters office of NICO.

 

KBS leases 5,100 square feet of office space in a multistory office building in Topeka, Kansas under a lease that expires June 30, 2012.

 

Precision Steel and its subsidiaries own three buildings housing their plant and office facilities, with usable area approximately as follows: 138,000 square feet in Franklin Park, Illinois; 63,000 square feet in Charlotte, North Carolina; and 59,000 square feet in Downers Grove, Illinois.

 

 

Wesco and its subsidiaries are not involved in any legal proceedings that are expected to result in detrimental financial impact material to its shareholders’ equity. However, see Note 9 to the accompanying consolidated financial statements for an explanation of an environmental matter involving Precision Steel and one of its subsidiaries that could materially impact consolidated net income in a particular fiscal period.

 

 

None.

 

PART II

 

 

Throughout 2006, Wesco’s capital stock was listed on the American Stock Exchange and on the NYSE Arca Exchange (previously, the Pacific Exchange). Effective as of yearend 2006, in order to reduce duplicative administrative burdens and costs, Wesco withdrew its shares from listing on the NYSE Arca Exchange.

 

The following table sets forth quarterly ranges of composite prices for American Stock Exchange trading of Wesco shares for 2007 and 2006, based on data reported by the American Stock Exchange, as well as cash dividends paid by Wesco on each outstanding share:

 

There were approximately 410 shareholders of record of Wesco’s capital stock as of the close of business on February 7, 2008. It is estimated that approximately 4,000 additional Wesco shareholders held shares of Wesco’s capital stock in street name at that date.

 

Wesco did not purchase any of its own equity securities during 2007.

 

 

Wesco Stock Performance Graph

 

The following graph compares the value at each subsequent yearend of $100 invested in Wesco capital stock on December 31, 2002 with identical investments in the Standard and Poor’s (“S&P”) 500 Stock Index and the S&P Property-Casualty Insurance Index, assuming reinvestment of dividends.

 

Comparison of Five Year Cumulative Return*

 

 

 

 

 

 

Set forth below and on the following page are selected consolidated financial data for Wesco and its subsidiaries. For additional financial information, attention is directed to Wesco’s audited 2007 consolidated financial statements appearing in Item 8 of this report. (Amounts are in thousands except for amounts per share.)

 

 

 

The reinsurance activities of Wesco’s insurance segment are managed by Berkshire Hathaway’s National Indemnity Company (“NICO”) subsidiary and represent participations in contracts in which NICO and other members of the Berkshire Insurance Group also participate. Financial information associated with these participations is identified in Wesco’s consolidated financial statements, as well as in Item 6, Selected Financial Data, as affiliated business.

 

 

In reviewing this item, attention is directed to Item 6, Selected Financial Data, and Item 1, Business.

 

OVERVIEW

 

The principal goal of Wesco’s management is to maximize gain in Wesco’s intrinsic business value per share over the long term. Accounting consequences do not influence business decisions, nor do fluctuations in annual net income. To accomplish desired growth, a high priority is placed on the purchases of companies having excellent economic characteristics, run by outstanding managers. Management strives also to invest

in common stocks of outstanding publicly traded companies at prices deemed reasonable. In the event that such investments are not available, as has often been the case in recent years, capital is preserved through investments principally in high-quality cash equivalents and securities of the U.S. Government and its agencies.

 

Wesco’s operating businesses are managed on a 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 Wesco’s management in the day-to-day business activities of the operating businesses. Wesco’s Chairman, President and Chief Executive Officer, Charles T. Munger, is also Vice Chairman of Berkshire Hathaway, and consults with Warren E. Buffett, Chairman and Chief Executive Officer of Berkshire Hathaway, with respect to Wesco’s investment decisions, major capital allocations, and the selection of the chief executives to head each of Wesco’s operating units, subject to ultimate approval of Wesco’s Board of Directors.

 

The operations of Wesco’s Wesco-Financial Insurance Company (“Wes-FIC”) subsidiary are managed by Berkshire Hathaway’s National Indemnity Company (“NICO”) subsidiary. Wes-FIC participates principally in reinsurance contracts in which NICO and other Berkshire Hathaway insurance subsidiaries participate in the reinsurance of property and casualty risks of unaffiliated insurance companies. Terms of Wes-FIC’s participation are essentially identical to those by which the other Berkshire Hathaway insurance subsidiaries participate, except as to the percentages of participation (see Item 1, Business, for further information). Financial information relative to these participations appearing in Item 6, Selected Financial Data, and in Wesco’s consolidated financial statements, is identified as affiliated business.

 

Financial Condition

 

Wesco continues to have a strong consolidated balance sheet at December 31, 2007, with relatively little debt. Liquidity, which has traditionally been high, has been higher than usual for the past several years due principally to sales, maturities and redemptions of fixed-maturity and other investments, and reinvestment of the proceeds, mainly in cash equivalents pending redeployment for the long term. In the latter half of 2007, $802 million, net, was invested in marketable equity securities. Principally as a result, the Company’s consolidated balance sheet reflects marketable equity securities with fair value of $1.919 billion as of yearend 2007, versus $1.041 billion as of yearend 2006.

 

Wesco’s equity investments are in strong, well-known companies. The practice of concentrating in a few issues, rather than diversifying, follows the investment philosophy of the chairmen-CEOs of Wesco and its parent, Berkshire Hathaway, who consult with respect to Wesco’s investments and major capital allocations. Wesco has no investments in subprime loans.

 

Results of Operations

 

Wesco’s consolidated net income has fluctuated from year to year, often significantly, as a result of the realization of gains on investments. Realized gains amounted to $24.2 million ($15.8 million, after taxes) for 2007 and $333.2 million ($216.6 million, after income taxes) for 2005. No gains or losses were realized in 2006. The investment gains realized in 2005 resulted principally from the exchange of common shares of the Gillette Company (“Gillette”) for common shares of The Procter & Gamble Company (“PG”) in connection with PG’s acquisition of Gillette in the fourth quarter of 2005. The amount, if any, of realized gain or loss in any year has no predictive value and variations in amount from year to year have no practical analytical value, particularly in view of the existence of substantial unrealized price appreciation in Wesco’s consolidated investment portfolio at each balance sheet date.

 

Wesco’s consolidated 2007 after-tax income, excluding realized investment gains, increased by $1.4 million for the year, due mainly to increased investment and underwriting income earned by the insurance businesses, significantly offset by increased operating expenses of the furniture rental business, as the Company’s CORT Business Services Corporation subsidiary expands and redirects the marketing of its rental relocation services from targeting individuals to targeting corporate clients.

FINANCIAL CONDITION

 

Wesco’s shareholders’ equity at December 31, 2007 was $2.53 billion ($356.03 per share), up $134.5 million from the $2.40 billion ($337.14 per share) at December 31, 2006. Shareholders’ equity included $381.0 million at December 31, 2007, and $345.0 million at December 31, 2006, representing appreciation in market value of investments, which is credited directly to shareholders’ equity, net of taxes, without being reflected in earnings. Because unrealized appreciation is recorded using market quotations, gains or losses ultimately realized upon sale of investments could differ substantially from recorded unrealized appreciation. The unrealized gain component amounted to 15.0% of shareholders’ equity at December 31, 2007, versus 14.4% one year earlier.

 

Wesco’s consolidated borrowings totaled $37.2 million at December 31, 2007 versus $38.2 million at December 31, 2006. Except as to $0.2 million at each yearend, these amounts related to a $100 million revolving credit facility used in CORT’s furniture rental business. In addition to this recorded debt, Wesco and its subsidiaries had $138.3 million of operating lease and other contractual obligations at December 31, 2007, versus $147.4 million one year earlier. (See the section on off-balance sheet arrangements and contractual obligations appearing below in this Item 7, as well as Note 7 to the accompanying consolidated financial statements, for additional information on debt.)

 

Wesco’s liability for unpaid losses and loss adjustment expenses at December 31, 2007 totaled $93.8 million versus $78.3 million at December 31, 2006. Wes-FIC enjoys Standard & Poor’s Corporation’s highest rating, AAA, with respect to its claims-paying ability.

 

RESULTS OF OPERATIONS

 

Wesco’s reportable business segments are organized in a manner that reflects how Wesco’s top management views those business activities. Wesco’s management views insurance businesses as possessing two distinct operations — underwriting and investing, and believes that “underwriting gain or loss” is an important measure of their financial performance. Underwriting gain or loss represents the simple arithmetic difference between the following line items appearing on the consolidated statement of income: (1) insurance premiums earned, less (2) insurance losses and loss adjustment expenses, and insurance underwriting expenses. Management’s goal is to generate underwriting gains over the long term. Underwriting results are evaluated without allocation of investment income.

 

The consolidated data in the second table in Item 6 are set forth essentially in the income statement format customary to generally accepted accounting principles (“GAAP”). Revenues, including realized net investment gains, are followed by costs and expenses, and a provision for income taxes, to arrive at net income. The following summary sets forth the after-tax contribution to GAAP net income of each business segment — insurance, furniture rental and industrial — as well as activities not considered related to such segments. Realized net investment gains are excluded from segment activities, consistent with the way Wesco’s management views the business operations. (Amounts are in thousands, all after income tax effect.)

 

 

In the following sections the data set forth in the foregoing summary on an after-tax basis are broken down and discussed.

Insurance Segment

 

Wesco engages in both primary insurance and reinsurance of property and casualty risks through Wesco-Financial Insurance Company (“Wes-FIC”) and The Kansas Bankers Surety Company (“KBS”). Their operations are conducted or supervised by wholly owned subsidiaries of Berkshire Hathaway, Wesco’s ultimate parent company. In reinsurance activities, defined portions of similar or dissimilar risks that other insurers or reinsurers have subjected themselves to in their own insuring activities are assumed. In primary insurance activities, defined portions of the risks of loss from persons or organizations that are directly subject to the risks are assumed. For purposes of the following discussion, the results have been disaggregated between reinsurance and primary insurance activities. Following is a summary of the insurance segment’s underwriting activities. (Amounts are in thousands.)

 

The nature of Wes-FIC’s participation in the aviation-related reinsurance contracts requires that estimates be made not only as to losses and expenses incurred, but also as to premiums written, due to a time lag in reporting by the ceding pools. In addition, periodic underwriting results can be affected significantly by changes in estimates for unpaid losses and loss adjustment expenses, including amounts established for occurrences in prior years. See the Critical Accounting Policies section of this discussion for information concerning the loss reserve estimation process.

 

Reinsurance premiums written for 2007 decreased by $0.4 million (1.0%), and earned reinsurance premiums increased by $1.7 million (5.0%), from the corresponding 2006 figures, despite the 33.3% increase in the level at which Wes-FIC participated in the hull and liability pools in 2007. As competition has intensified in the aviation market, the pools have experienced greater pricing pressures and have continued to exercise underwriting discipline by not writing policies where pricing was deemed inadequate with respect to the risks assumed. Written premiums for 2006 increased by 22.9%, and earned reinsurance premiums increased by 17.6%, from those of 2005. These increases were attributed principally to the 25%-higher level of participation in the hull and liability pools in 2006, as well as an increase in the volume of business written by the workers’ compensation pool. Intensifying competitive pressures, which negatively affected written premiums for 2006, more significantly affected written premiums for 2007.

 

Reinsurance activities have fluctuated from year to year as participations in reinsurance contracts have become available both through insurance subsidiaries of Berkshire and otherwise. See Item 1, Business, for information about Wes-FIC’s participation in a an additional quota-share reinsurance contract, expected to

significantly increase its premium volume over a five-year period beginning in 2008. The level of business written by Wes-FIC in future periods will also vary, perhaps materially, based upon market conditions and management’s assessment of the adequacy of premium rates.

 

Written primary insurance premiums decreased by $0.3 million in both 2007 and 2006, representing decreases of 1.6% for 2007 and 6.6% for 2006. KBS has experienced intensified price competition during the past approximately two years, and has reacted through the exercise of underwriting discipline.

 

Management believes that “underwriting gain or loss” is an important measure of financial performance of insurance companies. When stated as a percentage, the sum of insurance losses, loss adjustment expenses and underwriting expenses, divided by premiums, gives the combined ratio. A combined ratio of less than 100% connotes an underwriting profit and a combined ratio of greater than 100% connotes an underwriting loss. The ratio is figured on a pre-tax basis. Underwriting results of Wesco’s insurance segment have generally been favorable, but have fluctuated from year to year for various reasons, including competitiveness of pricing in terms of premiums charged for risks assumed, and volatility of losses incurred.

 

For 2007, 2006 and 2005, reinsurance generated underwriting gains of $2.2 million, $2.5 million and $6.9 million, representing combined ratios of 93.9%, 94.0% and 75.9%, all of which management considers to have been favorable. The figures for the two most recent years reflect the detrimental effects of increasingly competitive pressures which have resulted in the ongoing softening of prices in terms of premiums charged throughout those years. The 2006 figure also reflects less favorable claims experience in the latter half of the year, with respect to the hull and liability contracts, where Wes-FIC’s participation increased by 25 percent for that year. Had it not been for net favorable reserve development of $3.2 million in 2007, essentially all of which related to the aviation-related contracts, reinsurance activities for 2007 would have generated an underwriting loss of $1.3 million ($0.8 million, after taxes). The underwriting results for 2006 and 2005 also include net favorable (unfavorable) reserve development of ($0.4 million) for 2006, comprised of unfavorable development of $1.7 million attributable to the aviation-related contracts, partially offset by $1.3 million of favorable development for a contract whose coverage period ended in 1989, and $0.7 million for 2005, attributable to the aviation-related contracts. The 2005 figure also reflects estimated losses of $0.7 million, before taxes, related to Hurricane Katrina, which struck the Gulf Coast of the United States in the third quarter.

 

Combined ratios from primary insurance were 55.1%, 73.8% and 58.8% for 2007, 2006 and 2005, which management considers to have been favorable. In 2007, pre-tax underwriting results improved by $3.3 million (60.4%) and included net favorable reserve development of $3.6 million associated with estimates of losses recorded in several previous years, most notably, the reversal of a $1.9 million estimated loss recorded in 2005, following a recent court decision. In 2006, pre-tax underwriting results from primary insurance declined by $2.3 million (29.9%) from those of 2005. Underwriting results from primary insurance included net unfavorable loss development of $0.2 million and $0.6 million, before taxes, for 2006 and 2005, amounts not considered significant.

 

It should be noted that the profitability of a reinsurance or insurance arrangement is better assessed after all losses and expenses have been realized, perhaps many years after the coverage period, rather than for any given reporting period. No trends have been identified which directly relate to losses, other than the effects from the current trend of increasing competition, causing declining premium rates. Losses incurred by Wesco’s insurance segment, by their very nature, occur unexpectedly and fluctuate from period to period in both frequency and magnitude. Wesco’s insurers cede minimal amounts of their direct business, and as a result underwriting results may be volatile.

 

The income tax provision associated with the insurance segment’s underwriting activities for 2005 benefited by $2.3 million relating to the resolution of an issue raised in an examination of prior year income tax returns by the Internal Revenue Service.

 

Since September 11, 2001, the insurance industry has been particularly concerned about its exposure to claims resulting from acts of terrorism. In spite of partial relief provided to the insurance industry by the Terrorism Risk Insurance Act, enacted in 2002 and amended by the Terrorism Risk Extension Act of 2005, and

the Terrorism Risk Insurance Program Reauthorization Act of 2007, Wes-FIC is exposed to insurance losses from terrorist events. Wes-FIC’s (and thus Wesco’s) exposure to such losses from an insurance standpoint cannot be predicted. Management, however, does not believe it likely that, on a worst-case basis, Wesco’s shareholders’ equity would be severely impacted by future terrorism-related insurance losses under reinsurance or insurance contracts currently in effect. Losses from terrorism could, however, significantly impact Wesco’s periodic reported earnings.

 

Other industry concerns in recent years have included exposures to losses relating to environmental contamination and asbestos. Management currently believes such exposures to be minimal.

 

Following is a summary of investment income produced by Wesco’s insurance segment (in thousands of dollars).

 

Investment income of the insurance segment comprises dividends and interest earned principally from the investment of shareholder capital (including reinvested earnings) as well as float (principally, premiums received before payment of related claims and expenses). The $6.3 million (7.5%) increase in pre-tax investment income for 2007 reflected a $11.7 million increase in dividend income, attributable principally to the investment of $801.7 million, net, in equity securities in the latter part of 2007, partially offset by a decline in interest income resulting mainly from the use of interest-bearing cash equivalents and fixed-maturity investments for the purchase of the equity securities. The increase of $27.6 million (49.3%) in investment income for 2006 was due principally to higher interest rates earned on short-term investments. Dividend income improved slightly.

 

Wesco continues to seek to invest cash balances in the purchase of businesses and in long-term equity holdings.

 

Wesco’s insurance subsidiaries, as a matter of practice, maintain liquidity in amounts which exceed by wide margins expected near-term requirements for payment of claims and expenses. As a result, it would be unlikely that any unanticipated payment of claims or expenses would require the liquidation of investments at a loss. Wesco does not attempt to match long-term investment maturities to estimated durations of claim liabilities.

 

Reference is made to the table of contractual obligations appearing on page 30.

Furniture Rental Segment

 

Following is a summary of the results of operations of CORT Business Services Corporation (“CORT”), Wesco’s furniture rental segment. (Amounts are in thousands.)

 

 

Furniture rental revenues for 2007 increased $3.4 million (1.0%) from those of 2006, after increasing $20.8 million (6.9%) for 2006 from those of 2005. Excluding rental revenues from trade shows and locations not in operation throughout each year, rental revenues for 2007 decreased 0.6% from those of 2006, following an increase of approximately 4.9% in the preceding year. The number of furniture leases outstanding at yearend 2007 was 5.7% lower than at yearend 2006, following a decline of 5.1% in the preceding year. The decrease in the number of outstanding leases continues a trend that developed late in 2006, believed to be due principally to non-renewals of leases generated in the aftermath of hurricanes Katrina and Rita, increased energy prices, and customer uncertainty as to future economic conditions. Despite the continued decline in the number of furniture leases outstanding, furniture rental revenues have grown due mainly to increased demand for events and tradeshows and improved pricing.

 

Furniture sales revenues for 2007 decreased $7.8 million (11.3%) from those of 2006, following a decrease in 2006 of $2.8 million (3.9%) from those of 2005. The decreases are believed to be attributed principally to the continued softening of the housing market and higher energy prices that have contributed to an industry-wide decline in retail furniture sales.

 

Service fees for 2007 increased $0.3 million (5.3%) after a decreasing $1.6 million (19.5%) in 2006 from those reported for 2005. Traditionally, the furniture segment has concentrated the marketing efforts of its relocation services towards individual residential customers. Late in 2006, CORT began a new initiative to expand the variety of its relocation services, and it redirected the thrust of this activity toward providing these services to corporate relocation departments for their relocating employees in need of temporary or longer-term housing. Although initial traction has been slow, management is hopeful that the expansion of facilities and personnel devoted to rental relocation services, as well as the change in focus of its relocation activities, will result in profitable long-term revenue growth.

 

Cost of rentals, sales and fees amounted to 23.1% of revenues for 2007, versus 25.4% for 2006, and 26.6% for 2005. The decrease in costs as percentages of revenues have been due principally to improvement in revenue mix, with a larger percentage of each successive year’s revenue attributable to furniture rentals, which has a higher margin than furniture sales.

 

Selling, general, administrative and interest expenses (“operating expenses”) for the segment were $270.8 million for 2007, up 6.0% from the $255.4 million incurred for 2006, following an increase of 1.3% from the $252.1 million incurred for 2005. The increase in operating expenses in 2007 was due principally to

an increase in advertising and personnel-related costs associated with the rental relocation service as CORT continues to redirect and expand its marketing efforts to target corporate clients.

 

Income before income taxes for the furniture rental segment amounted to $33.9 million in 2007, versus $43.3 million in 2006, and $29.8 million in 2005. The 21.7% decrease in pre-tax operating results for 2007 was principally attributable to the significant increase in operating expenses, offset somewhat by increased gross profits resulting from changes in revenue mix. The improvement in 2006 resulted significantly from increasing revenues, change in revenue mix, and the continued focus on controlling operating expenses.

 

Industrial Segment

 

Following is a summary of the results of operations of the industrial segment, consisting of the businesses of Precision Steel and its subsidiaries. (Amounts are in thousands.)

 

 

The operations of the industrial segment have suffered a variety of ongoing difficulties for a number of years, including periodic economic downturns, a shift of production by many customers from domestic to overseas facilities, intensifying competitive pressures among service centers for remaining domestic business, unprecedented ability of the major steel producers in recent years to raise prices and establish minimum order quantities, following consolidation in the industry, and intensified competitive pressures for product from suppliers and for sales.

 

In addition to a decline in the number of orders placed in recent years, there has also been a trend towards smaller-sized orders. The severity of the impact of the foregoing factors on Wesco’s industrial segment is demonstrated by the significant decline in sales volume, in terms of pounds sold, from an average of 68 million pounds annually, over the three-year period of 1998 through 2000, to an average of 44 million pounds annually, over the most recent three-year period. Average industrial segment revenues have not declined as significantly, principally because many customers have generally accepted higher prices as Wesco’s industrial segment has struggled to maintain its margins.

 

In 2005 competition for sales intensified and prices softened, but remained substantially higher than in the early 2000’s. The year 2006 started out well. Volume, in terms of pounds sold for the first quarter, increased by 9.9% over the comparable figure for the first quarter for 2005; however, as the year progressed, increasing competitive pressures and a slowdown in domestic manufacturing activity caused volume to decline and, by yearend, volume for the year was 0.4% lower than in 2005. Segment revenues for the year, however, increased by $1.7 million (2.8%). Approximately half of the increase in revenues was attributable to a large sale of toolroom supplies to a single customer. Excluding that transaction, segment revenues for 2006 increased by $0.8 million (1.3%) over those of 2005.

 

As 2007 progressed, demand slowed, and customers became more resistant to higher prices, primarily specialty stainless steel products, which in one year period increased on average by approximately 40%, based principally on mill surcharges for chromium and nickel, as global demand for these basic commodities remained high. Revenues for the year decreased by $1.7 million (2.7%) from those of 2006. Excluding from 2006 revenues the extraordinarily large sale of toolroom supplies to the single customer, revenues for 2007 decreased by $0.8 million (1.3%) as compared with those of 2006. Sales volume, in terms or pounds sold, decreased by approximately 14%. As a result of the decline in volume somewhat offset by higher steel prices, income from operations declined by $0.4 million for 2007.

 

As explained in Note 9 to the consolidated financial statements, Precision Steel and a subsidiary are involved in environmental litigation. Management anticipates that additional provisions and legal fees with respect to environmental remediation may be required in the future. However, as of December 31, 2007, it was not possible to reasonably estimate the amount, if any, of additional costs or a range of costs, that may be required in connection with the matter. Although management does not anticipate that the ultimate impact of such provisions and costs, net of future insurance recoveries, if any, will be material in relation to Wesco’s shareholders’ equity, it believes that the effect on industrial segment and consolidated net income in any given period could be material.

 

Unrelated to Business Segment Operations

 

Wesco’s consolidated earnings included net realized investment gains of $24.2 million ($15.8 million, after taxes) for 2007, and $332.5 million ($216.1 million, after taxes) for 2005. Of the latter amount, $216.1 million, after taxes, resulted from Wesco’s non-cash exchange of common shares of The Gillette Company (“Gillette”) for common shares of The Procter & Gamble Company (“PG”) in connection with the purchase of Gillette by PG in the fourth quarter. The $332.5 million excess of fair value of the shares exchanged over Wesco’s original cost basis was recorded by Wesco as a realized investment gain on October 1, the date of the transaction, as required under generally accepted accounting principles. Although the gain had a material impact on Wesco’s reported earnings for the fourth quarter of 2005, there was no effect on shareholders’ equity. Wesco carried its investment in Gillette at market value with unrealized gains reflected, net of potential income tax effect, in the net unrealized appreciation component of its shareholders’ equity, as of September 30, 2005. Federal income taxes are not currently payable as a result of the exchange. No investment gains or losses were realized in 2006.

 

Management’s principal goal is to maximize gain in Wesco’s intrinsic business value per share over the long term. Accounting consequences do not influence business decisions. There is no particular strategy as to the timing of sales of investments. Investments may be sold for a variety of reasons, including (1) the belief that prospects for future appreciation of a particular investment are less attractive than the prospects for reinvestment of the after-tax proceeds from its sale, or (2) the desire to generate funds for an acquisition or repayment of debt. Investment gains may also derive from non-cash exchanges of securities for other investment securities as a result of merger activity involving the investees.

 

Other nonsegment items include mainly (1) rental income from owned commercial real estate and (2) dividend and interest income from marketable securities and cash equivalents owned outside the insurance subsidiaries, reduced by real estate and general and administrative expenses. In the fourth quarter of 2005, Wesco and its MS Property Company subsidiary reduced their liabilities for deferred income taxes by an aggregate of $4.9 million. That amount is reflected as a reduction of income tax expense of activities unrelated to business segments.

 

* * * *

 

Consolidated revenues, expenses and net income reported for any period are not necessarily indicative of future results in that they are subject to significant variations in amount and timing of (1) participations in reinsurance contracts with members of the Berkshire Insurance Group, such as the quota-share arrangement described in Item 1, Business, which is expected to significantly increase the business of the insurance segment for a five-year period beginning in 2008, (2) investment gains and losses, or (3) unusual nonoperating items. In addition, consolidated revenues, expenses and net income are subject to external conditions, such as terrorist activity, and changes in the economy.

 

Wesco is not presently suffering from inflation, but its business operations have potential exposure, particularly in the insurance and industrial segments. Large unanticipated changes in the rate of inflation could adversely impact the insurance business, because premium rates are established well in advance of expenditures. Precision Steel’s businesses are competitive and operate on tight gross profit margins, making their earnings susceptible to inflationary and deflationary cost changes; the impact, though not material in relation to Wesco’s consolidated net income, may be significant to that of the industrial segment, due particularly to the segment’s use of LIFO inventory accounting.

OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS

 

Neither Wesco nor any of its subsidiaries has off-balance sheet arrangements other than the unrecorded contractual obligations discussed below. Nor do they have any insurance obligations for which estimated provisions have not been made in the accompanying consolidated financial statements or notes thereto.

 

Wesco and its subsidiaries have contractual obligations associated with ongoing business activities, which will result in cash payments in future periods. Certain obligations, such as notes payable, accrued interest, and unpaid insurance losses and loss adjustment expenses, are reflected in the accompanying consolidated financial statements. In addition, Wesco and its subsidiaries have entered into long-term contracts to acquire goods or services in the future, which are not currently reflected in the consolidated financial statements and will be reflected in future periods as the goods are delivered or services provided. A summary of contractual obligations as of December 31, 2007 follows. (Amounts are in thousands.)

 

 

 

 

CRITICAL ACCOUNTING POLICIES AND PRACTICES

 

Wesco’s consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States (“GAAP”). The significant accounting policies and practices followed by Wesco are set forth in Note 1 to the accompanying consolidated financial statements. Following are the accounting policies and practices considered by Wesco’s management to be critical to the determination of consolidated financial position and results of operations.

 

Use of Estimates in Preparation of Financial Statements

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported revenues and expenses during the period reported upon. In particular, estimates of unpaid losses and loss adjustment expenses for property and casualty insurance are subject to considerable estimation error due to the inherent uncertainty in projecting ultimate claim amounts that will be reported and settled over a period of many years. The estimates and assumptions are based on management’s evaluation of the relevant facts and circumstances using information available at the time such estimates and assumptions are made. The amounts of such assets, liabilities, revenues and expenses included in the consolidated financial statements may differ significantly from those that might result from use of estimates and assumptions based on facts and circumstances not yet available. Although Wesco’s management does not believe such changes in estimates would have a materially adverse effect on shareholders’ equity, they could produce a material effect on results of operations in a reporting period.

Investments

 

The appropriate classifications of investments in securities with fixed maturities and marketable equity securities are established at the time of purchase and reevaluated as of each balance sheet date. There are three permissible classifications: held-to-maturity, trading and available-for-sale. In recent years, all equity and fixed-maturity investments have been classified as available-for-sale and carried at fair value, with unrealized gains and losses, net of applicable deferred income taxes, reported as a separate component of shareholders’ equity.

 

Rental Furniture

 

Rental furniture consists principally of residential and office furniture which is available for rental or, if no longer up to rental standards or excessive in quantity, for sale. Rental furniture is carried at cost, less accumulated depreciation calculated primarily on a declining-balance basis over 3 to 5 years using estimated salvage values of 25 to 40 percent of original cost.

 

Revenue Recognition

 

Insurance premiums are stated net of amounts ceded to reinsurers and are recognized as earned revenues in proportion to the insurance protection provided, which in most cases is pro rata over the term of each contract. Premiums are estimated with respect to certain reinsurance contracts written during the period where reports from ceding companies for the period are not contractually due until after the balance sheet date. Unearned insurance premiums are deferred in the liability section of the consolidated balance sheet. Certain costs of acquiring insurance premiums — commissions, premium taxes, and other — are deferred and charged to income as the premiums are earned.

 

Furniture rentals are recognized as revenue proportionately over the rental contract period; rentals received in advance are deferred in the liability section of the consolidated balance sheet. Related costs comprise the main element of cost of products and services sold on the consolidated income statement and include depreciation expense, repairs and maintenance and inventory losses.

 

Losses and Loss Adjustment Expenses

 

Liabilities for unpaid insurance losses and loss adjustment expenses represent estimates of the ultimate amounts payable under property and casualty reinsurance and insurance contracts related to losses occurring on or before the balance sheet date. Liabilities for insurance losses are comprised of estimates for reported claims (“case reserves”); and reserve development on reported claims and estimates for claims that have not yet been reported (some of which may not be reported for many years), which together are also referred to as “incurred-but-not-reported” reserves (“IBNR” reserves). The liability for unpaid losses includes significant estimates for these claims and include estimates reported by ceding insurers. Loss reserve estimates reflect past loss experience, adjusted as appropriate when losses are reasonably expected to deviate from experience.

 

Provisions for losses and loss adjustment expenses are reported in the consolidated statement of income after deducting estimates of amounts that will be recoverable under reinsurance contracts. Reinsurance contracts do not relieve the ceding companies of their obligations to indemnify policyholders with respect to the underlying insurance contracts. Ceded reinsurance losses recoverable (“ceded reserves”) are reflected in the accompanying Consolidated Balance Sheets as a component of accounts receivable.

 

Depending on the type of loss being estimated, the timing and amount of loss payments are subject to a great degree of variability and are contingent, among other factors, upon the timing of the claim reporting by cedants and insureds, and the determination and payment of the ultimate loss amounts through the loss adjustment process. Judgments and assumptions are necessary in projecting the ultimate amounts payable in the future with respect to loss events that have occurred.

 

The time period between the claim occurrence date and payment date of the loss is referred to as the “claim tail.” Property claims usually have fairly short claim tails, and, absent litigation, are reported and

settled within a few months or years after occurrence. Casualty losses usually have very long claim tails. Casualty claims can be more susceptible to litigation and can be more significantly affected by changing contract interpretations and the legal environment, which contributes to extended claim tails. Claim tails for reinsurers may be further extended due to delayed reporting by ceding insurers or reinsurers due to contractual provisions or reporting practices. Actual ultimate loss settlement amounts are likely to differ from amounts recorded at the balance sheet date. Changes in estimates, referred to as “loss development,” are recorded as a component of losses incurred in the period of change. Wes-FIC and KBS do not use consultants to assist in reserving activities.

 

Following is a summary of Wesco’s consolidated liabilities for insurance losses and loss adjustment expenses and related reinsurance recoverables (in thousands of dollars).

 

 

 

 

The techniques and processes employed in estimating loss reserves are differentiated between reinsurance and primary insurance.

 

Reinsurance — Historically, Wes-FIC’s property and casualty loss reserves derive from individual risk, multi-line and catastrophe reinsurance policies. However, Wes-FIC’s reinsurance activity in recent years has consisted almost exclusively of participations in aviation-related pools that are underwritten and managed by a wholly owned indirect subsidiary of Wesco’s parent company, Berkshire Hathaway Inc.

 

Non-aviation reinsurance reserve amounts were less than 10% of Wesco’s gross consolidated reserves as of December 31, 2007 and December 31, 2006 (mostly in IBNR reserves) and primarily related to a quota-share contract that has been in runoff for more than 10 years, under which Wes-FIC continues to make loss payments. Such amounts reflected loss estimates reported by the ceding companies and additional IBNR reserves estimates by Wes-FIC management, which were mainly a function of reported losses from ceding companies, anticipated loss ratios for the contract period, and management’s judgment as to the loss reserving adequacy of the ceding companies.

 

Gross aviation loss reserves were approximately $67 million at December 31, 2007 and $50 million at December 31, 2006 ($44 million and $39 million, net of reinsurance, at those dates), of which gross IBNR reserves were approximately $23 million and $18 million, respectively. Losses from aviation coverages generally have reasonably short tails with respect to the property components. The claim tail for the liability coverage can be somewhat longer, especially when litigation results. The case reserving process for aviation risks is believed to involve less uncertainty than for many other types of insurance, because loss events tend to become known and reported relatively soon after the events occur. The material judgments underlying the loss reserving by the aviation pools’ manager assume that future loss patterns (incurred and paid) will be similar to those of the past. The aviation pools’ manager establishes case and IBNR reserves and manages the claims settlement process, including payment of the related claims. Wes-FIC is allocated its share of these amounts, monthly. The pools’ manager has considerable experience with aviation insurance and claims. Wes-FIC management reviews reported claim amounts for reasonableness and has historically accepted the amounts without further adjustment, except for adjustments made for minor reporting delays.

Wes-FIC management is represented at regular meetings and presentations held by the pools’ manager, and Wesco believes that Wes-FIC is able to closely monitor and assess the pools’ manager’s judgments concerning reserves.

 

Considerable judgment is required to evaluate claims and estimate claims liabilities in connection with reinsurance contracts. As further data become available, the liabilities are reevaluated and adjusted as appropriate. Additionally, reported claims are in various stages of the settlement process. Each claim is settled individually based upon its merits, and some take years to settle, especially if legal action is involved. Actual ultimate claims amounts are likely to differ from amounts recorded at the balance sheet date.

 

Primary insurance — Loss reserves from Wesco’s primary insurance activities derive from individual risk policies written by KBS, which primarily provides specialty coverages for financial institutions. Reserve amounts are comprised of case estimates and estimates of IBNR reserves, which approximated $7 million at both yearends of 2007 and 2006. Because of the relatively low number (or frequency) of losses and potential for higher severity (or amount per claim), KBS management is familiar with and closely monitors each claim. Losses generally are expected to have a relatively short reporting and claim tail due to the nature of the claims. KBS provides deposit guaranty bonds, which insure deposits in excess of federal deposit insurance limits, crime insurance, check kiting fraud indemnification, Internet banking catastrophe theft insurance, directors and officers liability, bank employment practices, as well as bank insurance agents professional errors and omissions indemnity. As a result, reserves are primarily developed from case estimates, reducing the need for extended actuarial studies and broad estimates of IBNR of the nature typically performed by large primary insurers whose business volume requires such procedures for the development of their loss data. A range of reserve amounts as a result of changes in underlying assumptions is not prepared.

 

Goodwill

 

Goodwill of acquired businesses represents the excess of the cost of acquired entities (principally CORT) over the fair values assigned to assets acquired and liabilities assumed. The Company accounts for goodwill in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which requires the Company to test goodwill for impairment annually or whenever events or changes in circumstances indicate that the carrying values may not be recoverable. Annual impairment tests are performed in the fourth quarter of each year using a variety of methods that require that certain assumptions and estimates be made regarding economic factors and future profitability. Impairments, if any, are charged to earnings.

 

Realized investment gains and losses

 

Realized investment gains and losses, determined on a specific-identification basis, are included in the consolidated statement of income, as are provisions for other-than-temporary declines in market or estimated fair value, when applicable. Factors considered in judging whether an impairment is other than temporary include: the financial condition, business prospects and creditworthiness of the issuer, the length of time that fair value has been less than cost, the relative amount of the decline, and Wesco’s ability and intent to hold the investment until the fair value recovers.

 

 

Wesco’s consolidated balance sheet contains substantial liquidity as well as substantial amounts of investments whose estimated fair (carrying) values are subject to market risks. Its fixed-maturity investments are backed by the U.S. Government and its agencies. Values of marketable equity securities are subject to fluctuations in their stock market prices, and values of securities with fixed maturities are subject to changes in interest rate levels. Apart from investments, the consolidated balance sheet at December 31, 2007 did not contain significant assets or liabilities with values subject to these or other potential market exposures such as

changes in commodity prices or foreign exchange rates. Wesco does not utilize derivatives to manage market risks.

 

EQUITY PRICE RISK

 

Wesco’s consolidated balance sheet at December 31, 2007 contained $1.92 billion of marketable equity securities stated at market value, up from $1.04 billion one year earlier. The increase was due principally to the purchase of $802 million, net, of marketable equity securities in the latter part of 2007. Net unrealized appreciation increased $55 million during 2007. The carrying values of Wesco’s equity securities are exposed to market price fluctuations, which may be accentuated by the concentration existing in the equity portfolio. (At December 31, 2007, four investments comprised 87% of the carrying value of the consolidated equity securities portfolio.) The four largest holdings of the consolidated group at December 31, 2007 ($1.68 billion, combined) were common stocks of The Procter & Gamble Company, The Coca-Cola Company, Kraft Foods Inc. and Wells Fargo & Company, of which the first three have significant global operations and thus are subject to changes in foreign currency exchange rates, and the latter has significant mortgage-lending operations and is exposed to the weakening domestic credit market caused mainly by accelerating weakness in the domestic housing market.

 

Strategically, Wesco strives to invest in businesses that possess excellent economics, with able and honest management, at sensible prices. Wesco’s management prefers to invest a meaningful amount in each investee, resulting in concentration. Most equity investments are expected to be held for long periods of time; thus, Wesco’s management is not ordinarily troubled by short-term price volatility with respect to its investments provided that the underlying business, economic and management characteristics of the investees remain favorable. Wesco strives to maintain above-average levels of shareholders’ equity as well as much liquidity to provide a margin of safety against short-term equity price volatility.

 

The carrying values of investments subject to equity price risks are based on quoted market prices. Market prices are subject to fluctuation and, consequently, the amount realized upon the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from perceived changes in the underlying economic characteristics of the investee, the relative prices of alternative investments, or general market conditions. Furthermore, amounts realized upon the sale of a particular security may be adversely affected if a relatively large quantity of the security is being sold.

 

The following table summarizes Wesco’s equity price risks as of December 31, 2007 and 2006. It shows the effects of a hypothetical 30% overall increase or decrease in market prices of marketable equity securities owned by the Wesco group on total recorded market value and, after tax effect, on Wesco’s shareholders’ equity at each of those dates. (Amounts are in thousands.)

 

 

The 30% hypothetical changes in market values assumed in preparing the tables do not reflect what could be considered best- or worst-case scenarios. Actual results could be much worse or better due both to the nature of equity markets and the aforementioned concentration existing in Wesco’s equity investment portfolio.

INTEREST RATE RISK

 

Wesco’s consolidated balance sheet at December 31, 2007 contained $527 million of cash and cash equivalents and $39 million of securities with fixed maturities stated at fair value, versus $1.26 billion of cash and cash equivalents and $82 million of securities with fixed maturities one year earlier. Consequently, market value risks with respect to interest-rate movements or other factors as of December 31, 2007 are considered insignificant.

 

The fair values of Wesco’s fixed-maturity investments fluctuate in response to changes in market interest rates. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values. Fair values of Wesco’s investments may also be affected by the creditworthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions. Wesco, as a matter of practice, invests only in fixed-maturity securities of the highest quality. As of yearend 2007, its fixed-maturity investments consisted of securities of the U.S. Treasury and of agencies of the U.S. Government.

 

FORWARD-LOOKING STATEMENTS

 

Certain written or oral representations of management stated in this annual report or elsewhere constitute “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995, as contrasted with statements of historical fact. Forward-looking statements include statements which are predictive in nature, or which depend upon or refer to future events or conditions, or which include words such as expects, anticipates, intends, plans, believes, estimates, may, or could, or which involve hypothetical events. Forward-looking statements are based on information currently available and are subject to various risks and uncertainties that could cause actual events or results to differ materially from those characterized as being likely or possible to occur. Such statements should be considered judgments only, not guarantees, and Wesco’s management assumes no duty, nor has it any specific intention, to update them.

 

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 Wesco’s actual performance and future events and actions to differ materially from those expressed in or implied by such forward-looking statements include, but are not limited to those risks reported in Item 1A, Risk Factors, but also to the occurrence of one or more catastrophic events such as acts of terrorism, hurricanes, or other events that cause losses insured by Wesco’s insurance subsidiaries, changes in insurance laws or regulations, changes in income tax laws or regulations, and changes in general economic and market factors that affect the prices of investment securities or the industries in which Wesco and its affiliates do business.

 

 

Following is an index to financial statements and related schedules of Wesco appearing in this report:

 

 

 

Listed below are financial statement schedules required by the SEC to be included in this report. The data appearing therein should be read in conjunction with the consolidated financial statements and notes thereto of Wesco and report of independent registered public accounting firm referred to above. Schedules not

included with these financial statement schedules have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.

 

 

 

Not applicable, as there were no such changes or disagreements.

 

 

An evaluation was performed under the supervision and with the participation of the Company’s management, including Charles T. Munger, its Chief Executive Officer and Jeffrey L. Jacobson, its Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of December 31, 2007. Based on that evaluation, Messrs. Munger and Jacobson concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported as specified in the rules and forms of the Securities Exchange Commission, and are effective to ensure that information required to be disclosed by Wesco in the reports it files or submits under the Exchange Act, as amended, is accumulated and communicated to Wesco’s management, including Messrs. Munger and Jacobson, as appropriate, to allow timely decisions regarding required disclosure.

 

There has been no change in the Company’s internal control over financial reporting during the fiscal quarter ended December 31, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

In Part I, Item 4 (“Controls and Procedures”) of each of Wesco’s Forms 10-Q filed for the quarters ended March 31, 2007, June 30, 2007 and September 30, 2007, we mistakenly referred to an evaluation of Wesco’s disclosure controls and procedures as of December 31, 2006, when separate evaluations were actually conducted as of the end of each quarter under report. Based on those three separate evaluations, Wesco’s Chief Executive Officer and Chief Financial Officer concluded that Wesco’s disclosure controls and procedures were effective as of March 31, 2007, June 30, 2007 and September 30, 2007.

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Wesco’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) under the Exchange Act. The internal control system of Wesco and its subsidiaries is designed to provide reasonable assurance regarding the preparation and fair presentation of Wesco’s published consolidated financial statements. Under the supervision and with the participation of our management, including Charles T. Munger, our principal executive officer, and Jeffrey L. Jacobson, our principal financial officer, we conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007 as required by Rule 13a-15(c) under the Exchange Act. In making this assessment, we used the criteria set forth in the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, we concluded that Wesco’s internal control over financial reporting was effective as of December 31, 2007.

Wesco’s independent registered public accounting firm has audited our internal control over financial reporting as of December 31, 2007. Their report begins on Page 39.

 

WESCO FINANCIAL CORPORATION

 

Pasadena, California

February 27, 2008

 

 

None.

 

PART III

 

 

The information set forth in the sections “Election of Directors,” “Executive Officers,” “Corporate Governance” and “Code of Business Conduct and Ethics” appearing in the definitive combined notice of annual meeting and proxy statement of Wesco for its annual meeting of shareholders scheduled to be held May 7, 2008 (the “2008 Proxy Statement”) is incorporated herein by reference.

 

 

The information set forth in the sections “Compensation of Executive Officers,” “Compensation Discussion and Analysis” and “Director Compensation” in the 2008 Proxy Statement is incorporated herein by reference. All such compensation is cash compensation; Wesco neither has, nor is considering having, any stock option plan or other equity compensation arrangement.

 

 

The information set forth in the sections “Voting Securities and Principal Holders Thereof,” “Security Ownership of Certain Beneficial Owners and Management” and “Section 16(A) Beneficial Ownership Reporting Compliance” in the 2008 Proxy Statement is incorporated herein by reference.

 

 

Certain information set forth in the sections “Election of Directors,” “Voting Securities and Principal Holders Thereof,” “Compensation of Executive Officers,” “Director Compensation,” “Corporate Governance” and “Compensation Discussion and Analysis” in the 2008 Proxy Statement is incorporated herein by reference.

 

 

The information set forth in the section “Independent Registered Public Accounting Firm” in the 2008 Proxy Statement is incorporated herein by reference.

 

 

The following exhibits (listed by numbers corresponding to Table 1 of Item 601 of Regulation S-K) are filed as part of this Annual Report on Form 10-K or are incorporated herein by reference:

 

3a — Articles of incorporation of Wesco (filed as exhibit 3a to Wesco’s Form 10-K for the year ended           December 31, 1999) and Bylaws of Wesco (filed as exhibit 3.2 to Wesco’s Form 8-K dated December 5, 2007 — Commission File No. 1-4720)

14 — Code of Ethics (may be accessed through Wesco’s website, www.wescofinancial.com.)

 

21  — List of subsidiaries

 

31(a) — Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (chief executive officer)

 

31(b) — Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (chief financial officer)

 

32(a) — Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (chief executive officer)

 

32(b) — Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (chief financial officer)

 

Instruments defining the rights of holders of long-term debt of Wesco and its subsidiaries are not being filed since the total amount of securities authorized by all such instruments does not exceed 10% of the total assets of Wesco and its subsidiaries on a consolidated basis as of December 31, 2007. Wesco hereby agrees to furnish to the Commission upon request a copy of any such debt instrument to which it is a party.

 

The index to financial statements and related schedules set forth in Item 8 of this report is incorporated herein by reference.

 

SIGNATURES

 

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

WESCO FINANCIAL CORPORATION

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of

Wesco Financial Corporation

Pasadena, California

 

We have audited the accompanying consolidated balance sheets of Wesco Financial Corporation and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the Index at Item 8. We also have audited the Company’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting, and for

its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedule and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Wesco Financial Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

Omaha, Nebraska

February 27, 2008

WESCO FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEET

(Dollar amounts in thousands)

 

 

See notes to consolidated financial statements.

WESCO FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF INCOME

(Dollar amounts in thousands except for amounts per share)

 

 

See notes to consolidated financial statements.

WESCO FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS

(Dollar amounts in thousands)

 

 

See notes to consolidated financial statements.

WESCO FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN
SHAREHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME

(Dollar amounts in thousands)

 

 

See notes to consolidated financial statements.

WESCO FINANCIAL CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(Dollar amounts in thousands except for amounts per share)

 

 

Nature of operations, basis of consolidation, and presentation

 

Wesco Financial Corporation (“Wesco”) is, indirectly, an 80.1%-owned subsidiary of Berkshire Hathaway Inc. (“Berkshire”). Wesco is a holding company. Its consolidated financial statements include the accounts of Wesco and its subsidiaries, all wholly owned. Its principal subsidiaries are Wesco-Financial Insurance Company (“Wes-FIC”), The Kansas Bankers Surety Company (“KBS”), CORT Business Services Corporation (“CORT”) and Precision Steel Warehouse, Inc. (“Precision Steel”). Further information regarding these businesses is contained in Note 11. Intercompany balances and transactions are eliminated in the preparation of the consolidated financial statements.

 

The operations of Wes-FIC are managed by Berkshire Hathaway’s National Indemnity Company (“NICO”) subsidiary. Historically, a significant part of Wes-FIC’s insurance business has derived from contracts with NICO and other wholly owned insurance subsidiaries of Berkshire. To simplify discussion, the term “Berkshire Insurance Group,” as used herein, refers to those companies, individually or collectively, although Berkshire also includes in its insurance group the insurance subsidiaries that are 80.1%-owned through Berkshire’s ownership of Wesco. Terms of Wes-FIC’s participation in the insurance contracts are essentially identical to those by which the other Berkshire Insurance Group members participate, except as to the relative percentages of their participation in the various contracts. Financial data appearing in the accompanying consolidated financial statements relative to business with the Berkshire Insurance Group is designated as affiliated business.

 

Accounting pronouncements not yet in effect

 

Wesco’s management does not believe than any accounting pronouncements issued to date by the Financial Accounting Standards Board or other applicable authorities and required to be adopted after yearend 2007 are likely to have a material effect on shareholders’ equity.

 

Use of estimates in preparation of financial statements

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported revenues and expenses during the period reported upon. In particular, estimates of unpaid losses and loss adjustment expenses for property and casualty insurance are subject to considerable estimation error due to the inherent uncertainty in projecting ultimate claim amounts that will be reported and settled over a period of many years. The estimates and assumptions are based on management’s evaluation of the relevant facts and circumstances using information available at the time such estimates and assumptions are made. The amounts of such assets, liabilities, revenues and expenses included in the consolidated financial statements may differ significantly from those that might result from use of estimates and assumptions based on facts and circumstances not yet available. Although Wesco’s management does not believe such changes in estimates would have a materially adverse effect on shareholders’ equity, they could produce a material effect on results of operations in a reporting period.

 

Cash equivalents

 

Cash equivalents consist of funds invested in U.S. Treasury Bills, money market accounts, and in other investments with a maturity of three months or less when purchased.

Investments

 

The appropriate classifications of investments in securities with fixed maturities and marketable equity securities are established at the time of purchase and reevaluated as of each balance sheet date. There are three permissible classifications: held-to-maturity, trading, and, when neither of those classifications is applicable, available-for-sale. In recent years, all equity and fixed-maturity investments have been classified as available-for-sale and carried at fair value, with unrealized gains and losses, net of applicable deferred income taxes, reported as a separate component of shareholders’ equity.

 

Realized investment gains and losses, determined on a specific-identification basis, are included in the consolidated statement of income, as are provisions for other-than-temporary declines in market or estimated fair value, when applicable. Factors considered in judging whether an impairment is other than temporary include: the financial condition, business prospects and creditworthiness of the issurer, the length of time that fair value has been less than cost, the relative amount of the decline, and Wesco’s ability and intent to hold the investment until the fair value recovers.

 

Accounts receivable

 

Substantially all accounts receivable are due from customers located within the United States. Accounts receivable are recorded net of an allowance for doubtful accounts, based on a review of specifically identified accounts in addition to an overall collectibility analysis. Judgments are made with respect to the collectibility of accounts receivable based on historical experience and current economic trends. Actual losses could differ from those estimates.

 

Rental furniture

 

Rental furniture consists principally of residential and office furniture which is available for rental or, if no longer up to rental standards, for sale. Rental furniture is carried at cost, less accumulated depreciation calculated primarily on a declining-balance basis over 3 to 5 years using estimated salvage values of 25 to 40 percent of original cost.

 

Goodwill of acquired businesses

 

Goodwill of acquired businesses represents the excess of the cost of acquired entities over the fair values assigned to assets acquired and liabilities assumed. The Company accounts for goodwill in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which requires the Company to test goodwill for impairment annually or whenever events or changes in circumstances indicate that the carrying values may not be recoverable. Annual impairment tests are performed in the fourth quarter of each year using a variety of methods that require that certain assumptions and estimates be made regarding economic factors and future profitability. Impairments, if any, are charged to earnings.

 

Inventories

 

Inventories of $8,473 and $7,942, included in other assets on the accompanying consolidated balance sheet at December 31, 2007 and 2006, are stated at the lower of last-in, first-out (“LIFO”) cost or market; under this method, the most recent costs are reflected in cost of products sold. The aggregate differences in values between LIFO cost and cost determined under the first-in, first-out (“FIFO”) methods were $10,915 and $9,169 as of December 31, 2007 and December 31, 2006, respectively. LIFO inventory accounting adjustments decreased income before income taxes by $1,695, $994 and $347 ($1,020, $598 and $208, after income taxes) for 2007, 2006 and 2005.

 

Dollar amounts in thousands except for amounts per share

Capitalized Construction Costs

 

Capitalized construction costs are included in other assets on the accompanying consolidated balance sheet at December 31, 2007 and 2006. Theses costs are associated with the acquisition, development and construction of a real estate project managed by MS Property Company, a Wesco subsidiary.

 

Revenue recognition

 

Insurance premiums are stated net of amounts ceded to reinsurers and are recognized as earned revenues in proportion to the insurance protection provided, which in most cases is pro rata over the term of each contract. Premiums are estimated with respect to certain reinsurance contracts written during the period where reports from ceding companies for the period are not contractually due until after the balance sheet date. Unearned insurance premiums are deferred and reflected in the liability section of the consolidated balance sheet. Certain costs of acquiring insurance premiums — commissions, premium taxes, and other — are deferred and charged to income as the premiums are earned.

 

Furniture rentals are recognized as revenue proportionately over the rental contract period; rentals received in advance are deferred in the liability section of the consolidated balance sheet. Costs related to furniture rentals comprise the main element of cost of products and services sold on the consolidated income statement and include depreciation expense, repairs and maintenance, and inventory losses.

 

Revenues from product sales are recognized upon passage of title to the customer, which coincides with customer pickup, product shipment, delivery or acceptance, depending on the sales arrangement. Revenues from services performed are recognized at the completion of the elements specified in the contract, which typically coincides with their being billed.

 

Interest income from investments in bonds and mortgage-backed securities is earned under the constant yield method and includes accrual of interest due as well as amortization of acquisition premiums and accruable discounts. In determining the constant yield for mortgage-backed securities, anticipated counterparty prepayments are estimated and evaluated periodically. Dividends from equity securities are earned on the ex-dividend date.

 

Losses and loss adjustment expenses

 

Liabilities for unpaid insurance losses and loss adjustment expenses represent estimates of the ultimate amounts payable under property and casualty reinsurance and insurance contracts related to losses occurring on or before the balance sheet date. Liabilities for insurance losses are comprised of estimates for reported claims (“Case reserves”); and reserve development on reported claims and estimates for claims that have not yet been reported (some of which may not be reported for many years), which together are also referred to as “incurred-but-not-reported” reserves (“IBNR” reserves). The liability for unpaid losses includes significant estimates for these claims and include estimates reported by ceding insurers. Loss reserve estimates reflect past loss experience, adjusted as appropriate when losses are reasonably expected to deviate from experience.

 

Considerable judgment is required to evaluate claims and estimate claims liabilities in connection with reinsurance contracts. As further data become available, the liabilities are reevaluated and adjusted as appropriate. Additionally, reported claims are in various stages of the settlement process. Each claim is settled individually based upon its merits, and some take years to settle, especially if legal action is involved. Actual ultimate claims amounts are likely to differ from amounts recorded at the balance sheet date.

 

Depending on the type of loss being estimated, the timing and amount of loss payments are subject to a great degree of variability and are contingent, among other factors, upon the timing of the claim reporting by cedants and insureds, and the determination and payment of the ultimate loss amounts through the loss adjustment process. Judgments and assumptions are necessary in projecting the ultimate amounts payable in the future with respect to loss events that have occurred.

 

Dollar amounts in thousands except for amounts per share

The time period between the claim occurrence date and payment date of the loss is referred to as the “claim tail.” Property claims usually have fairly short claim tails, and, absent litigation, are reported and settled within a few months or years after occurrence. Casualty losses usually have very long claim tails. Casualty claims can be more susceptible to litigation and can be more significantly affected by changing contract interpretations and the legal environment, which contributes to extended claim tails. Claim tails for reinsurers may be further extended due to delayed reporting by ceding insurers or reinsurers due to contractual provisions or reporting practices. Actual ultimate loss settlement amounts are likely to differ from amounts recorded at the balance sheet date. Changes in estimates, referred to as “loss development,” are recorded as a component of losses incurred in the period of change.

 

Provisions for losses and loss adjustment expenses are reported in the consolidated statement of income after deducting estimates of amounts that will be recoverable under reinsurance contracts. Reinsurance contracts do not relieve the ceding companies of their obligations to indemnify policyholders with respect to the underlying insurance contracts. Ceded reinsurance losses recoverable (“ceded reserves”) are reflected in the accompanying consolidated balance sheet as a component of accounts receivable.

 

Income taxes

 

Wesco and its subsidiaries join in the filing of consolidated Federal income tax returns of Berkshire Hathaway Inc. The consolidated Federal tax liability is apportioned among group members pursuant to methods that result in each member of the group paying or receiving an amount that approximates the increase or decrease in consolidated taxes attributable to that member. In addition, Wesco and its subsidiaries also file income tax returns in state and local jurisdictions as applicable.

 

Provisions for current income tax liabilities are calculated and accrued on income and expense amounts expected to be included in the income tax returns for the current year. Deferred income taxes are calculated under the liability method. Deferred income tax assets and liabilities are based on differences between the financial statement and tax bases of assets and liabilities at the current enacted tax rates.

 

Changes in deferred income tax assets and liabilities that are associated with components of other comprehensive income (essentially, unrealized investment gains and losses) are charged or credited directly to other comprehensive income. Otherwise, changes in deferred income tax assets and liabilities are included as a component of income tax expense. Changes in deferred income taxes and liabilities attributable to changes in enacted tax rates are charged or credited to income tax expense in the period of enactment. Valuation allowances are established for deferred tax assets where realization is not likely.

 

Assets and liabilities are established for uncertain tax positions taken or positions expected to be taken in income tax returns when such positions are judged to not meet the “more-likely-than-not” threshold based on the technical merits of the positions. Estimated interest and penalties related to uncertain tax positions are included as a component of income tax expense.

 

 

Following is a summary of investments in securities with fixed maturities:

 

 

At yearend 2007 and 2006, the estimated fair values of securities with fixed maturities contained unrealized gains of $1,267 and $633. Unrealized losses at yearend 2007 and 2006 totaled $145 and $15.

 

Dollar amounts in thousands except for amounts per share

Shown below are the amortized cost and estimated fair values of securities with fixed maturities at December 31, 2007, by contractual maturity dates.

 

 

Following is a summary of investments in marketable equity securities (all common stocks):

 

 

Total unrealized losses of equity securities at December 31, 2007 were $61,916, all of which related to securities in an unrealized loss position for less than twelve months as of that date. There were no unrealized losses at December 31, 2006.

 

Realized investment gains are summarized below.

 

 

Although the investments of Wesco and its subsidiaries are subject to market risks, derivatives are not utilized to manage risks.

 

 

Accounts receivable are comprised of the following:

 

 

Dollar amounts in thousands except for amounts per share

 

Following is a breakdown of rental furniture:

 

 

 

At yearends 2007 and 2006, the balance of goodwill carried as an asset on Wesco’s consolidated balance sheet amounted to $266,607, of which $239,616 related to Wesco’s acquisition of CORT, with the balance pertaining to the KBS acquisition. SFAS No. 142 requires that a two-step impairment test be performed annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. The first step of the test for impairment compares the book value of the Company’s reporting unit to its estimated fair value. The second step of the goodwill impairment test, which is only required when the net book value of the reporting unit exceeds the fair value, compares the implied fair value of goodwill to its book value to determine if an impairment is required.

 

Because fair value is believed to exceed book value, step two was not required. Fair value is estimated using a variety of techniques and considerable judgment is required. Under the income approach, the Company estimates the fair value of the reporting unit based on the present value of future cash flows. This approach is dependent on a number of factors including projections of future earnings and discount rates. Although management believes the determination was based on reasonably conservative estimates, results of future operations are uncertain and potential revisions to the projections of future earnings or discount rates, caused by adverse changes to the underlying long-term economics of the business, could lead to an impairment of all or a portion of goodwill in future periods.

 

 

The balances of unpaid losses and loss adjustment expenses are based upon estimates of the ultimate claim costs associated with property and casualty claim occurrences as of the balance sheet dates including estimates for IBNR claims. Considerable judgment is required to evaluate claims and establish estimated claim liabilities, particularly with respect to certain casualty or liability claims, which are typically reported over long periods of time and subject to changing judicial notions. The delay in claim reporting is exacerbated in reinsurance of liability or casualty claims as claim reporting by ceding companies is also delayed by contract terms.

 

Dollar amounts in thousands except for amounts per share

Following is a summary of liabilities for unpaid losses and loss adjustment expenses for each of the past three years:

 

 

 

 

Incurred losses “for all prior years,” commonly known as “reserve development,” represents the net amount of estimation error charged (credited) to earnings with respect to the liabilities established as of the beginning of the year. Reference is made to Note 11, Business Segment Data, for a summary of the principal insurance activities in which Wesco’s insurance segment has engaged in the past three years. During 2007, $7.1 million of net favorable reserve development was recorded, and included $3.6 million attributable to primary insurance and reflected, most notably, the reversal, following a favorable court decision, of a $1.9 million loss recorded in 2005. The 2007 favorable reserve development also included $3.2 million attributable to aviation-related reinsurance. During 2006, net adverse reserve development of $422 was attributed principally to $1,703 of unfavorable loss development of aviation-related reinsurance, partially offset by favorable development of $1,284 for a contract whose coverage period ended in 1989. During 2005, net favorable reserve development of $35 was credited to income and was attributed to $683 of favorable loss development of aviation-related reinsurance, less unfavorable development of $648 relating to primary insurance.

 

 

Following is a summary of notes payable, at year end: