Provision for title losses. The Company provides for title insurance losses by a charge to expense when the related premium revenue is recognized. The amount charged to expense (the loss rate), as well as the adequacy of the ending reserves, is determined by the Company based on historical experience and other factors, including changes and trends in the type of title insurance policies issued, the real estate market and the interest rate environment. Management monitors the adequacy of the estimated loss reserves on a quarterly basis using a variety of techniques, including actuarial models, and adjusts the loss rate as necessary.
Overview-The majority of the revenues in the Company’s title insurance and mortgage information segments depend, in large part, upon the level of real estate activity and the cost and availability of mortgage funds. Revenues for these segments result primarily from resales and refinancings of residential real estate and, to a lesser extent, from commercial transactions and the construction and sale of new housing. Over one-half of
Mortgage interest rates, which had been decreasing throughout 1997 and 1998, began to increase in the second quarter of 1999, causing a significant decline in refinance activity and residential resale orders. This, coupled with fourth quarter seasonal factors and Y2K concerns, resulted in a low inventory of open orders going into the first quarter of 2000. As a result of the low inventory of open orders going into the first quarter of 2000, and the relatively weak real estate economy present during the first half of 2000, revenues and profits during this period decreased significantly when compared with the same period of 1999. During the second half of 2000, real estate activity began to increase as a result of declining mortgage interest rates. New order counts in the latter part of the third quarter began to show favorable comparisons with the same period of 1999. This trend continued into the fourth quarter of 2000 and resulted in a significant increase in revenues and profits in the second half of 2000 when compared with the same period of 1999.
Financial Services. Operating revenues from direct title operations increased 23.3% in 2002 over 2001 and 35.1% in 2001 over 2000. The increase in 2002 over 2001 was due to a 20.8% increase in the number of title orders closed by the Company’s direct operations, coupled with a 2.0% increase in the average revenues per order closed. The increase in 2001 over 2000 was attributable to a 44.1% increase in the number of title orders
closed by the Company’s direct operations, offset in part by a 6.2% decrease in the average revenues per order closed. The Company’s direct title operations closed 1,696,100, 1,404,600 and 975,000 title orders during 2002, 2001 and 2000, respectively. The average revenues per order closed were $1,063, $1,042 and $1,111 for 2002, 2001 and 2000, respectively. The fluctuations noted in closed orders and average revenues per order closed were primarily attributable to the relative changes in real estate activity year-over-year, as mentioned above. Operating revenues from agency title operations increased 34.1% in 2002 over 2001 and 20.5% in 2001 over 2000. These increases were primarily attributable to the same factors affecting direct title operations compounded by the inherent delay in the reporting of transactions by agents.
Specialty insurance operating revenues increased 27.9% in 2002 over 2001 and decreased 2.7% in 2001 from 2000. The increase in 2002 over 2001 was primarily attributable to geographic expansion at the Company’s home warranty division and market share growth at the property and casualty insurance division. The decrease in 2001 from 2000 was primarily due to a $13.4 million reduction in revenues at the property and casualty insurance division as a result of the previously announced exit of the lender-placed homeowner’s insurance business.
Information Technology. Mortgage information operating revenues increased 17.8% in 2002 over 2001 and 32.2% in 2001 over 2000. These increases were primarily attributable to the same factors affecting title insurance mentioned above, as well as acquisition activity. Operating revenues of $14.9 million and $14.2 million were contributed by new acquisitions in 2002 and 2001, respectively. In addition, during the current year, the Company’s tax service division accelerated its amortization rates to reflect the increase in refinance activity, resulting in a $6.5 million increase in operating revenues.
Credit information operating revenues increased 10.4% in 2002 over 2001 and 26.3% in 2001 over 2000. These increases were primarily due to growth in demand for credit information in the housing sector, as well as acquisition activity. Operating revenues of $9.2 million and $12.5 million were contributed by new acquisitions in 2002 and 2001, respectively.
Screening information operating revenues increased 105.1% in 2002 over 2001 and 27.6% in 2001 over 2000. These increases were primarily attributable to $49.8 million and $9.7 million of operating revenues contributed by new acquisitions for the respective periods.
Investment and other income-Investment and other income totaled $89.8 million, $81.1 million and $54.8 million in 2002, 2001 and 2000, respectively, an increase of $8.7 million, or 10.8% in 2002 over 2001, and $26.3 million, or 47.9% in 2001 over 2000. The increase in 2002 over 2001 was primarily due to an $18.3 million increase in equity in earnings of unconsolidated affiliates, offset, in part, by a $9.6 million decrease in net interest and other income, primarily as a result of lower yields on cash equivalents and the Company’s investment portfolio due to the lower interest rate environment. The increase in 2001 over 2000 was primarily attributable to a $23.4 million increase in equity in earnings of unconsolidated affiliates and a $2.9 million increase in net interest and other income. See Note 9 to the consolidated financial statements for additional information.
Financial Services. The Company’s title insurance segment comprised 95.8% of total salaries and other personnel costs for the Financial Services group. The title insurance segment (primarily direct operations) is labor intensive; accordingly, a major variable expense component is salaries and other personnel costs. This expense component is affected by two competing factors: the need to monitor personnel changes to match corresponding or anticipated new orders, and the need to provide quality service. In addition, this segment’s growth in operations that specialize in builder and lender business has created ongoing fixed costs required to service accounts.
Information Technology. Personnel expenses in total for the Information Technology group increased 17.2% in 2002 over 2001 and 17.0% in 2001 over 2000. These increases were primarily due to personnel expenses associated with new acquisitions, costs incurred to service the increase in business volume and, in 2002, a $12.6 million increase in employee benefit costs. Personnel costs associated with new acquisitions totaled $19.1 million in 2002 and $13.3 million in 2001. From an efficiency standpoint, personnel costs for the Information Technology group as a percentage of operating revenues were 33.7% in 2002, 35.2% in 2001 and 39.2% in 2000.
Corporate. Corporate personnel expenses increased $17.9 million in 2002 over 2001 and $30.1 million in 2001 over 2000. The increase in 2002 over 2001 was primarily attributable to an increase of $13.3 million in employee benefit costs, increased technology personnel costs and higher general costs associated with the support effort needed to service the Company’s expanded national and international operations. The increase in 2001 over 2000 was primarily due to a reduction of $23.7 million in 2000 resulting from the restructuring of the Company’s pension plan.
Financial Services. The Company’s title insurance segment comprised 96.0% of total other operating expenses for the Financial Services group. Title insurance other operating expenses (principally direct operations) increased 23.3% in 2002 over 2001 and 30.3% in 2001 over 2000. These increases were primarily due to incremental costs (i.e., messenger costs, reproduction costs, title plant maintenance costs, etc.) associated with servicing the increases in total order volume and costs associated with new acquisitions. Other operating expenses associated with new acquisitions were $9.6 million in 2002 and $8.8 million in 2001. Title insurance other operating expenses as a percentage of title insurance operating revenues (net of agent retention) were 27.8% in 2002, 28.1% in 2001 and 28.5% in 2000.
Information Technology. Other operating expenses for the Information Technology group increased 21.1% in 2002 over 2001 and 16.1% in 2001 over 2000. These increases were primarily due to costs associated with
servicing the increases in business volume and costs associated with new acquisitions. Contributing to the increase in 2001 over 2000 were charges of $1.8 million relating to the restructuring of the Company’s field service division and impaired asset write-offs totaling $2.6 million at the appraisal division. Other operating expenses associated with new acquisitions were $57.0 million in 2002 and $31.3 million in 2001. Information Technology other operating expenses as a percentage of operating revenues were 39.3% in 2002, 39.7% in 2001 and 44.5% in 2000.
Corporate. Corporate other operating expenses increased $16.7 million in 2002 over 2001 and remained relatively constant in 2001 compared with 2000. The increase in 2002 over 2001 was primarily due to $15.0 million of technology expenses, primarily consulting and outsourcing costs, required to expand the Company’s e-commerce capabilities, and higher general costs associated with the support effort needed to service the Company’s expanded national and international operations.
The provision for specialty insurance losses reflects home warranty claims and property and casualty insurance claims. The provision for home warranty claims, expressed as a percentage of home warranty operating revenues, was 49.8% in 2002, 53.1% in 2001 and 52.8% in 2000. The rate decrease in 2002 from 2001 was primarily due to a decrease in the average cost per claim, which was primarily due to the elimination of higher-cost contractors that were servicing claims in new geographic areas. These higher-cost contractors in the new geographic areas resulted in the increase in claims rate in 2001 over 2000.
Income taxes-The Company’s effective income tax rate, which includes a provision for state income and franchise taxes for noninsurance subsidiaries, was 33.3%, 35.7% and 35.5% for 2002, 2001 and 2000, respectively. The differences in the effective tax rate were primarily due to changes in the ratio of permanent differences to income before income taxes and minority interests and changes in state income and franchise taxes resulting from fluctuations in the Company’s noninsurance subsidiaries’ contribution to pretax profits. Information regarding items included in the reconciliation of the effective rate with the federal statutory rate is contained in Note 10 to the consolidated financial statements.
Net income-Net income and per share information are summarized as follows (see Note 11 to the consolidated financial statements):
sources of cash and cash equivalents were proceeds from the issuance of the Company’s $210.0 million senior convertible debentures in 2001 (see Note 8 to the consolidated financial statements) and proceeds from the sales and maturities of certain investments. The net effect of all activities on total cash and cash equivalents was an increase of $255.6 million for 2002, $344.3 million for 2001 and a decrease of $49.1 million for 2000.
On October 12, 2001, the Company entered into a credit agreement that provided for a $200.0 million line of credit. This agreement supercedes the Company’s prior credit agreements and expires in October 2006. Under the terms of the new credit agreement, the Company is required to maintain minimum levels of capital and earnings and meet predetermined debt-to-capitalization ratios. The Company’s line of credit was unused at December 31, 2002.
Notes and contracts payable, as a percentage of total capitalization, was 20.7% as of December 31, 2002, as compared with 23.7% as of the prior yearend. This decrease was primarily attributable to the increase in the capital base primarily due to net income for the year. Notes and contracts payable are more fully described in Note 8 to the consolidated financial statements.
Off-balance sheet arrangements and contractual obligations. The Company administers escrow and trust deposits as a service to its customers. Escrow deposits totaled $5.6 billion and $3.0 billion at December 31, 2002 and 2001, respectively, of which $176.6 million and $140.4 million were held at certain of the Company’s subsidiaries. The remaining escrow deposits were held at third-party financial institutions. Trust deposits totaled $1.9 billion and $2.0 billion at December 31, 2002 and 2001, respectively, and were held at the Company’s trust subsidiary. Escrow and trust deposits are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the disposition of these deposits.
In addition, The Company facilitates tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code. As a facilitator and intermediary, the Company holds the proceeds from sales transactions until a qualified acquisition occurs. Like-kind exchange deposits totaled $978.0 million and $804.5 million at December 31, 2002 and 2001, of which $610.8 million and $467.0 million were held by the Company and managed by the Company’s registered investment management subsidiary. The remaining deposits were held at third-party financial institutions. The Company also facilitates tax-deferred reverse exchanges pursuant to Revenue Procedure 2000-37. These exchanges require the Company, using the customer’s funds, to acquire the qualifying property on behalf of the customer and take temporary title to the customer’s property until a qualifying acquisition occurs. Reverse exchange property totaled $154.6 million and $102.5 million at December 31, 2002 and 2001, respectively. Due to the structure utilized to facilitate these transactions, like-kind exchanges and reverse exchanges are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the transfers of property, disbursements of proceeds and the return on the proceeds at the agreed upon rate.
A summary, by due date, of the Company’s total contractual obligations at December 31, 2002, is as follows:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The First American Corporation and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 5 to the financial statements, in 2002 the Company changed its method of accounting for goodwill and other intangible assets.
On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets” (SFAS 144). This standard requires that the Company test long-lived assets for impairment whenever there are recognized events or changes in circumstances that could affect the carrying value of the long-lived assets. In accordance with SFAS 144, management uses estimated expected future cash flows (undiscounted and excluding interest costs) to measure the recoverability of long-lived assets held and used. As of December 31, 2002 and 2001, no indications of impairment were identified. SFAS 144 also requires that long-lived assets classified as for sale be carried at the lower of cost or market as of the date that the criteria established by SFAS 144 have been met. As of December 31, 2002 and 2001, no long-lived assets were classified as for sale.
Information Technology Group-In December 1999, the Company adopted Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (SAB). The SAB, which became effective January 1, 1999, applies to the Company’s tax service operations and requires the deferral of the tax service fee and the recognition of that fee as revenue ratably over the expected service period. The amortization rates applied to recognize the revenues assume a 10-year contract life and are adjusted to reflect prepayments. The Company reviews its tax service contract portfolio quarterly to determine if there have been changes in contract lives and/or changes in the number and/or timing of prepayments. Accordingly, the Company may adjust the rates to reflect current trends. Revenues earned by the other products in the Information Technology group are recognized at the time of delivery, as the Company has no significant ongoing obligation after delivery.
Pursuant to insurance and other regulations of the various states in which the Company’s insurance subsidiaries operate, the amount of dividends, loans and advances available to the Company is limited, principally for the protection of policyholders. Under such statutory regulations, the maximum amount of dividends, loans and advances available to the Company from its insurance subsidiaries in 2003 is $210.8 million.
The National Association of Insurance Commissioners established certain statutory accounting practices, which became effective January 1, 2001. Adoption of the practices did not have a material impact on the Company’s statutory financial condition or results of operations.
The fair value of debt and equity securities was estimated using quoted market prices. Sales of debt and equity securities resulted in realized gains of $2.2 million, $0.6 million and $2.2 million; and realized losses of $4.8 million, $0.6 million and $4.8 million for the years ended December 31, 2002, 2001 and 2000, respectively.
On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). This statement addresses financial accounting and reporting for goodwill and other intangibles and supercedes Accounting Principles Board Opinions No. 17, “Intangible Assets.” SFAS 142 addresses how goodwill and other intangible assets should be accounted for in the financial statements. Pursuant to SFAS 142, the Company’s goodwill and intangible assets that have indefinite lives will not be amortized but rather will be tested at least annually for impairment. SFAS 142 requires that goodwill and other intangible assets be allocated to various reporting units that are either operating segments or one reporting unit below the operating segment. The Company’s reporting units, for purposes of applying the provisions of SFAS 142, are title insurance, home warranty, property and casualty insurance, trust and other services, mortgage origination products and services, mortgage servicing products and services, property information services, conventional credit information, sub-prime credit information, pre-employment and drug screening, tenant screening and motor vehicle reporting.
The SFAS 142 impairment testing process includes two phases. The first phase (Test 1) compares the fair value of each reporting unit to its book value. The fair value of each reporting unit is determined by using discounted cash flow analysis, market approach valuations and third-party valuation advisors. If the fair value of the reporting unit exceeds its book value, the goodwill is not considered impaired and no additional analysis is required. However, if the book value is greater than the fair value, a second test (Test 2) must be completed to determine if the fair value of the goodwill exceeds the book value. The fair value of the goodwill is determined by discounted cash flow analysis and appraised values. If the fair value is less than the book value, an impairment is considered to exist and, in the initial year of adoption, will be recorded as a cumulative effect of a change in accounting principle.
The Company has determined that its flood zone database, which is included in “Title plants and other indexes,” is an intangible asset with an indefinite life. Accordingly, this asset in not amortized but rather tested annually for impairment by comparing the fair value of the database with its carrying value. In addition, the Company had $30.1 million of intangible assets included in “Other assets” at December 31, 2002, with definite lives ranging from 3 to 7 years. These assets, comprised primarily of customer lists and noncompete agreements, are being amortized in a manner consistent with periods prior to the adoption of SFAS 142.
therefore, no goodwill impairment was recorded. The annual test for impairment was again performed (using the September 30 valuation date) and the results were the same-each reporting unit had a fair value in excess of carrying value and no goodwill impairment was recorded.
The carrying value of the passbook accounts approximates fair value due to the short-term nature of this liability. The fair value of investment certificate accounts was $65.1 million and $77.0 million at December 31, 2002 and 2001, respectively, and was estimated based on the discounted value of future cash flows using a discount rate approximating current market for similar liabilities.
“Other” primarily represents reclassifications to the reserve for assets acquired in connection with claim settlements and purchase accounting adjustments related to company acquisitions. Claims activity associated with reinsurance is not material and, therefore, not presented separately. Current year payments include $79.8 million, $69.1 million and $61.0 million in 2002, 2001 and 2000, respectively, that relate to the Company’s non-title insurance operations.
In April 2001, the Company sold $210.0 million of 4.5% senior convertible debentures due 2008. The debentures are convertible into common shares of the Company at $28 per share. The Company may redeem some or all of the senior convertible debentures at any time on or after April 15, 2004. The Company has also issued debt that is convertible into shares of its common stock to finance certain acquisitions. This debt, which is included in “Other notes and contracts payable”, is convertible at the option of each note holder at a conversion price of $30 per share. The balance of this convertible debt was $28.9 million and $33.4 million at December 31, 2002 and 2001, respectively.
The aggregate annual maturities for notes and contracts payable in each of the five years after December 31, 2002, are as follows:
The exercise of stock options represents a tax benefit and has been reflected as a reduction of taxes payable and an increase to the additional paid-in capital account. The benefits recorded were $1.5 million, $2.6 million and $1.0 million for the years ended December 31, 2002, 2001 and 2000, respectively.
For the three years ended December 31, 2002, 2001 and 2000, 3.6 million, 2.8 million and 4.5 million options, respectively, were excluded from the weighted-average diluted common shares outstanding due to their antidilutive effect.
The Company has pension and other retirement benefit plans covering substantially all employees. The Company’s principal pension plan is a noncontributory, qualified, defined benefit plan with benefits based on the employee’s years of service and the highest five consecutive years’ compensation during the last ten years of employment. The Company’s policy is to fund all accrued pension costs. Contributions are intended to provide not only for benefits attributable to past service, but also for those benefits expected to be earned in the future. In December 2000, the Company amended its principal pension plan and certain other retirement plans. The primary impact of the amendment was to reduce future benefits accrued by employees by limiting credit for pay increases through December 31, 2001, and by limiting credit for years of service through December 31, 2005. As a result of amending the plans, the Company reduced its pension expense in 2000 by $5.0 million and recognized a one-time benefit of $34.3 million. The Company also has nonqualified, unfunded supplemental benefit plans covering certain key management personnel. Benefits under these plans are intended to be funded with proceeds from life insurance policies purchased by the Company on the lives of the executives.
The rate of increase in future compensation levels for the supplemental benefit plan of 4.5% and the weighted-average discount rates of 6.75% and 7.25%, respectively, were used in determining the actuarial present value of the projected benefit obligation at December 31, 2002 and 2001. The majority of pension plan assets are invested in U.S. government securities, time deposits and common stocks with a projected long-term rate of return of 9.0% and 10.0% at December 31, 2002 and 2001, respectively.
In December 2001, the Company established an employee stock purchase plan under which eligible employees may purchase common stock of the Company at 85% of the closing price on the last day of each month. There were 245,000 and 17,000 shares issued in connection with the plan for the years ending December 31, 2002 and 2001, respectively. At December 31, 2002, there were 2,738,000 shares reserved for future issuances.
Stock options outstanding and exercisable at December 31, 2002, are summarized as follows:
The Company leases certain office facilities, automobiles and equipment under operating leases, which, for the most part, are renewable. The majority of these leases also provide that the Company will pay insurance and taxes. In December 2000, the Company’s subsidiary, First American Real Estate Information Services, Inc. and, in 1999, the Company entered into sale-leaseback agreements with regard to certain furniture and equipment with a net book value of $30.7 million and $65.7 million, respectively. Proceeds from the sales, which amounted to $33.8 million and $80.1 million and gains of $3.1 million and $14.4 million for the years ended December 31, 2000 and 1999, respectively, have been included in “Deferred revenue” and will be amortized over the life of the leases. Under the agreements, the Company’s subsidiary and the Company agreed to lease the equipment for three to five years with minimum annual lease payments of $4.2 million and $9.3 million, respectively. At the end of the term of the leases, the Company has the option to acquire the equipment or return it to the lessor.
The change in unrealized gains on debt and equity securities includes reclassification adjustments of $2.6 million and $2.6 million of net realized losses for the years ended December 31, 2002 and 2000, respectively. There were no reclassification adjustments in 2001.
These lawsuits involved allegations that certain subsidiaries of the Company and certain of their competitors failed to turn over unclaimed property to the state of California on a timely basis; charged California home buyers and other escrow customers fees for services that were never performed or that cost less than the amount charged; and devised and carried out programs, known as earnings credits, with financial institutions to receive interest on escrow funds placed in demand deposits.
The settlements provide that they do not constitute an admission of liability or wrongdoing by the Company or any of its subsidiaries.
During the year ended December 31, 2002, the Company completed 28 acquisitions. In applying the purchase method of accounting, the Company undertakes a comprehensive review of the acquired entity to ensure that all identifiable assets and liabilities are properly recorded at their fair value. In determining fair value, the Company utilizes a variety of valuation techniques, including discounted cash flow analysis and outside appraisals, to the extent necessary, given materiality and complexity. All excess purchase price is appropriately recorded as goodwill. The useful lives for all assets recorded in purchase accounting are based on market conditions, contractual terms and other appropriate factors.
Assuming all of the current year acquisitions had occurred January 1, 2001, pro forma revenues, net income and net income per diluted share would have been $4.75 billion, $234.6 million and $2.88, respectively, for the year ended December 31, 2002; and $3.87 billion, $175.7 million and $2.29, respectively, for the year ended December 31, 2001. All pro forma results include interest expense on acquisition debt. The pro forma results are not necessarily indicative of the operating results that would have been obtained had the acquisitions occurred at the beginning of the periods presented, nor are they necessarily indicative of future operating results.
The Company, through its subsidiaries, is engaged in the business of providing business information and related products and services. The Company has seven reporting segments that fall within two primary business groups, financial services and information technology. The Financial Services group includes title insurance, specialty insurance and trust and other services. The title insurance and services segment issues residential and commercial title insurance policies, provides escrow services, equity loan services, tax-deferred exchanges and other related products. The specialty insurance segment issues property and casualty insurance policies and
Note B-Amount represents net $1,000,000 in purchase accounting adjustments and $2,471,000 reclassification from the reserve for assets acquired in connection with claim settlements.