The Company's home warranty subsidiary owns 1.7 acres of land in Van Nuys, California, which contains a 20,000 square foot office building, a 7,000 square foot warehouse and a parking lot.
- -------- Note A--See Note 10 to the consolidated financial statements for description of a change in accounting for income taxes.
OVERVIEW--As with all providers of real estate-related financial and informational services, the Company's revenues depend, in large part, upon the level of real estate activity and the cost and availability of mortgage funds. The majority of the Company's revenues for the title insurance and real estate information segments result from resales and refinancings of residential real estate, and to a lesser extent, from commercial transactions and the construction and sale of new properties. Revenues for the Company's home warranty segment result solely from residential resale activity and do not benefit from refinancings. Traditionally, the greatest volume of real estate activity, particularly residential resale, has occurred in the spring and summer months. However, numerous actions taken by the Federal Reserve Board during 1992 and 1993 to stimulate economic recovery caused unusual fluctuations in the traditional pattern of real estate activity. During 1993 mortgage interest rates fell to their lowest level in 25 years. This decline in rates caused an unprecedented volume of refinance transactions and the Company's title insurance and real estate information segments processed record order volumes. Due to inflationary concerns, the Federal Reserve Board began a succession of interest rate increases in February 1994. The resulting increase in mortgage interest rates adversely affected the Company's revenue base in the second half of 1994 (primarily the fourth quarter) as refinance activity came to a virtual halt. This, coupled with the persistently poor real estate economy in California and a return of the traditional seasonal real estate cycle, resulted in a low inventory of open transactions going into 1995. As a result, 1995 first quarter operating revenues experienced a 30% decline when compared with the same period of the prior year. In response to the severe decline in new orders, the Company instituted personnel reductions totaling 26% of the work force from March 1994 through February 1995. However, the cost cutting measures lagged the revenue declines resulting in a fourth quarter 1994 loss of $.25 per share and a first quarter 1995 loss per share of $1.11. Mortgage interest rates peaked in January 1995 and decreased throughout the remainder of the year and into 1996 helped by an easing of monetary policy by the Federal Reserve Board. During the last half of 1995, the national real estate markets improved and refinancing activity began to increase. These factors contributed to a 26% improvement in operating revenues in the last half of 1995 when compared to the first half of 1995 and resulted in earnings per share of $1.68 compared with a loss per share of $1.01.
Operating revenues from direct title operations decreased 8.0% in 1995 as compared with 1994. This decrease was primarily attributable to a 7.7% decrease in the number of title orders closed by the Company's direct operations. The Company's direct title operations closed 667,200 title orders during 1995, as compared with 722,900 title orders closed during 1994. This decrease was attributable to higher interest rates and inclement weather which resulted in reduced national real estate activity in the first half of 1995. Operating revenues from direct title operations decreased 11.0% in 1994 as compared with 1993. The decrease was primarily attributable to a 22.5% decline in the number of title orders closed, offset in part by an increase in the average revenues per order closed. The decrease in orders closed was due to a decline in refinance activity, the subsiding real estate economy in California (a state highly concentrated with direct title operations) and the return of the traditional,
Title insurance personnel expenses decreased 4.4% in 1995 from 1994. The decrease relates directly to the Company's intensified efforts during the latter part of 1994 and the beginning of 1995 to adjust personnel and related expense levels commensurate with new order counts. This cost-containment process stabilized the cost of the labor base at a more acceptable level as business improved during the second quarter 1995. This decrease was offset, in part, by acquisition activity and modest personnel increases in the second half of 1995. Personnel expenses increased 4.2% in 1994 over 1993. This increase was primarily attributable to the additional personnel needed to service the heavy volume of title orders (predominately refinance transactions) that continued through the end of 1993 into the first quarter of 1994 and, to a lesser extent, acquisition activity. This increase was partially offset by the effects of personnel reductions that commenced during the beginning of the second quarter 1994, and continued throughout the rest of 1994 in response to significantly reduced order counts; although, due to the costs associated with terminations, expense declines lagged behind personnel reductions.
Real estate information personnel expenses increased 60.1% in 1995 over 1994. This increase was primarily due to $20.0 million of personnel costs associated with acquisitions, and to a lesser extent, in-house development of a new electronic communications delivery system for information based products. This was offset in part by personnel reductions associated with the decline in new tax service contracts which began in the last half of 1994 and continued into the first half of 1995. Personnel expenses increased 34.9% in 1994 over 1993. This increase was primarily due to personnel costs incurred servicing the heavy volume of business during the first half of 1994, costs associated with developing new and enhancing existing computer software to better service customer needs and $2.9 million of costs attributable to company acquisitions. This increase was partially offset by a 13.8% reduction in personnel in the last half of 1994, although, due to personnel separation costs, expense declines lagged behind personnel reductions.
Home warranty personnel expenses increased 9.0% in 1995 over 1994 and 16.5% in 1994 over 1993. The increases were primarily due to the additional personnel required to service the increased business volume in the states the segment currently services, as well as new geographic expansion and modest salary increases. These increases were offset in part by ongoing efforts of management to maximize personnel efficiencies.
In December 1990, the Financial Accounting Standards Board (FASB) issued Statement No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." This standard became effective in 1993 and requires the Company to accrue the cost of providing postretirement health care and life insurance benefits over the service lives of employees. Compliance with this standard did not materially affect the Company's results of operations or financial condition. In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." This standard became effective in 1994 and requires employers to accrue an obligation if the benefits are attributable to service already rendered, the benefits accumulate or vest, payment is probable, and the amounts can be reasonably estimated. Compliance with the standard did not materially affect the Company's results of operations or financial condition.
The premium split between underwriter and agents is in accordance with their respective agency contracts and can vary from region to region due to divergencies in real estate closing practices as well as rating structures. The decrease in the percentage amount of title premiums retained by agents was the direct result of changes in the geographic mix of agency revenues.
Title insurance other operating expenses remained relatively constant for the last three years. The modest percentage changes noted are due in part to marginal price level increases by vendors and acquisition activity, partially offset by successful cost-containment programs. Other operating expenses were also impacted by changes in incremental costs (i.e., office supplies, document reproduction, messenger services, plant maintenance and title search costs) associated with the relative changes in open order counts.
December 1993 trust deed note, which was paid off in November of 1994, and a higher average interest rate, offset in part by a 3.7% decrease in the average outstanding debt balance. The Company, at its option, has a reduced interest rate option on the variable rate indebtedness portion of the Company's credit facility. This agreement is described in Note 8 to the consolidated financial statements.
PRETAX PROFITS--A summary by segment of the Company's pretax profits is as follows:
NET INCOME--Net income and per share information are summarized as follows:
Pursuant to various insurance and other regulations, the maximum amount of dividends, loans and advances available to the Company in 1996 from its principle subsidiary, First American Title Insurance Company, is $44.6 million. Such restrictions have not had, nor are they expected to have, an impact on the Company's ability to meet its cash obligations.
In our opinion, the consolidated financial statements and financial statement schedules listed in the index on page 22 present fairly, in all material respects, the financial position of The First American Financial Corporation and its subsidiaries at December 31, 1995 and 1994, and the results of their operations and their cash flows for each of the three fiscal years in the period ended December 31, 1995, in conformity with generally accepted accounting principles. 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 generally accepted auditing standards 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 the opinion expressed above.
As discussed in Note 10 to the consolidated financial statements, the Company changed its method of accounting for income taxes in fiscal year 1993.
The consolidated financial statements include the accounts of The First American Financial Corporation and all majority-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. Certain 1993 and 1994 amounts have been reclassified to conform with the 1995 presentation.
Realized gains and losses on investments are determined using the specific identification method. Unrealized gains or losses on debt and equity securities are included, net of related tax effects, as a separate component of stockholders' equity.
Depreciation on buildings and furniture and equipment is computed using the declining balance and straight-line methods over estimated useful lives of 25 to 45 and 3 to 10 years, respectively.
Goodwill recognized in business combinations is amortized over its estimated useful life ranging from 30 to 40 years. Other intangibles, which include customer lists, covenants not to compete and organization costs, are amortized over their estimated useful lives, ranging from 3 to 20 years.
Deferred policy acquisition costs are directly related to the procurement of home warranty and tax service contracts. These costs are deferred and amortized to expense in the same pattern as contract fees are recognized as revenues.
The Company provides for title insurance losses based upon its historical experience by a charge to expense when the related premium revenue is recognized. Historically, major claims (i.e., claims greater than $0.5 million) were charged to expense as they became known because the unique circumstances surrounding most major claims made it inherently impractical to predict the incidence and amount of such claims. In the fourth quarter 1995, the Company determined, with the assistance of an actuarial study, that sufficient major claims data now exists to reasonably estimate a reserve for incurred but not reported claims. Accordingly, the reserve for incurred but not reported claims at December 31, 1995, includes major claims. The inclusion of major claims did not have a material effect on the Company's financial condition or results of operations. Title insurance losses and other claims associated with ceded reinsurance are provided for as the company remains contingently liable in the event that the reinsurer does not satisfy its obligations. The reserve for known and incurred but not reported claims reflects management's best estimate of the total costs required to settle all claims reported to the Company and claims incurred but not reported. The process applied to estimate claims costs is subject to many variables, including changes and trends in the type of title insurance policies issued, the real estate market and the interest rate environment. It is reasonably possible that a change in the estimate will occur in the future.
Title premiums on policies issued directly by the Company are recognized on the effective date of the title policy and escrow fees are recorded upon close of the escrow. Revenues from title policies issued by independent agents are recorded when notice of issuance is received from the agent.
Title insurance and home warranty companies, like other types of insurers, are generally not subject to state income or franchise taxes. However, in lieu thereof, most states impose a tax based primarily on insurance premiums written. This premium tax is reported as a separate line item in the consolidated statements of income in order to provide a more meaningful disclosure of the taxation of the Company.
Taxes are based on income for financial reporting purposes and include deferred taxes applicable to temporary differences between the financial statement carrying amount and the tax basis of certain of the Company's assets and liabilities.
FATICO maintained statutory capital and surplus of $205.6 million and $212.5 million at December 31, 1995 and 1994, respectively. Statutory net income for the years ended December 31, 1995, 1994 and 1993 was $11.4 million, $15.5 million and $83.0 million respectively.
FATICO, domiciled in the state of California, prepares its statutory financial statements in accordance with prescribed accounting practices which include a variety of publications of the National Association of Insurance Commissioners, state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This standard requires that all debt and equity securities, other than those that the Company has the ability and intent to hold to maturity, be carried at fair value. The Company has classified its securities portfolio as available-for-sale and, in accordance with SFAS No. 115, has included fair value adjustments as a separate component of stockholders' equity, net of tax. Prior to January 1, 1994, the Company reported only its equity securities at fair value with adjustments included, net of tax, as a separate component of stockholders' equity.
Real estate loans are secured by properties located in Southern California. The average yields on the Company's loan portfolio for the years ended December 31, 1995 and 1994, were 12% and 11%, respectively. Average yields are affected by amortization of discounts on loans purchased from other institutions, prepayment penalties recorded as income, loan fees amortized to income, and the market interest rates charged by thrift and loan institutions.
In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan." SFAS No. 114 became effective in the current year. This standard requires that an impaired loan be measured at the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, the loan may be valued based on its observable market price or the fair value of the collateral, if the loan is collateral dependent. Adoption of this standard did not have a materially adverse effect on the Company's financial condition or results of operations.
The above amounts are net of valuation reserves of $11.2 million and $12.4 million at December 31, 1995 and 1994, respectively.
In March 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." This statement will become effective for the Company's 1996 fiscal year and requires companies to assess for potential impairments of long-lived assets and certain identifiable intangibles when there is evidence that events or changes in circumstances have made recovery of an asset's carrying value unlikely. The Company believes that adoption of this standard will not have a materially adverse effect on its financial condition or results of operations.
In February 1996, the Company further amended the credit agreement to provide for more favorable pricing for its LIBOR option. The applicable margins range from .50% to 1.00% depending on claims paying or financial strength ratings or the Company's adjusted leverage ratio. The amendment also provides for the elimination and/or relaxation of certain restrictive covenants.
The fair value of notes and contracts payable was $77.7 million and $86.0 million at December 31, 1995 and 1994, respectively, and was estimated based on the current rates offered to the Company for debt of the same remaining maturities. The weighted average interest rate for the Company's notes and contracts payable was 7 1/2% and 8% at December 31, 1995 and 1994, respectively.
Income taxes differ from the amounts computed by applying the Federal income tax rate of 35%. A reconciliation of this difference is as follows:
The Company has federal net operating loss carryforwards of approximately $3.6 million at December 31, 1995, that expire in 1999. The utilization of these net operating losses is limited to future federal taxable income of First American Real Estate Information Services, Inc., a wholly owned subsidiary of the Company. The utilization of the loss carryforward is also subject to limitations prescribed by Section 382 of the Internal Revenue Code.
The Company also has a Stock Bonus Plan for key employees pursuant to which 65,000, 55,000 and 46,000 common shares were awarded for 1995, 1994 and 1993, respectively, resulting in a charge to operations of $1.2 million, $1.9 million and $1.2 million respectively. The Plan, as amended December 9, 1992, provides that a total of up to 200,000 common shares may be awarded in any one year.
In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This standard was effective for 1993 and focuses principally on postretirement health care and life insurance benefits and requires accrual of the expected cost of providing those benefits over the service lives of the employees. Compliance with this standard did not have a materially adverse effect on the Company's financial condition or results of operations.
In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." This standard was effective for 1994 and focuses principally on benefits provided to former or inactive employees after employment but before retirement. Compliance with this standard did not have a materially adverse effect on the Company's financial condition or results of operations.
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 1994, the Company entered into a sale-leaseback agreement with regard to certain furniture and equipment with a net book value of $22.4 million. Proceeds from the sale amounted to $31.4 million and a gain of $9.0 million has been included in deferred revenue and will be amortized over the life of the lease. Under the agreement, the Company has agreed to lease the equipment for four years with minimum annual lease payments of $8.3 million.
Future minimum rental payments under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1995, are as follow (in thousands):
The case is now before the District Court for coordinated or consolidated pretrial proceedings with an action that was filed in the United States District Court for the Eastern District of Wisconsin. The Wisconsin federal action presents claims on behalf of a purported class of purchasers of title insurance in Wisconsin, and seeks damages and other forms of relief, similar to those involved in the federal action filed in Arizona, with respect to participation in the rating bureau in Wisconsin.
Corporate consists primarily of unallocated interest expense, minority interests, equity in earnings of affiliated companies, employee benefit contributions and personnel and other operating expenses associated with the Company's home office facilities.
The Company's primary business segments are cyclical in nature, with the spring and summer months historically being the strongest. However, interest rate adjustment by the Federal Reserve Board during the last few years have caused unusual fluctuations in the Company's quarterly operating results. See Management's Discussion and Analysis on page 15 of this report for further discussion of the Company's results of operations.
The aggregate annual maturities for notes and contracts payable in each of the five years after December 31, 1995, are $14,803,000, $14,450,000, $12,324,000, $10,667,000, and $7,302,000 respectively.
The parent company files a consolidated tax return with its subsidiary companies in which it owns 80% or more of the outstanding stock. The current and cumulative tax effects relating to the operations of the parent company are reflected in the accounts of First American Title Insurance Company.
Note A--Amount represents accounts written off, net of recoveries. Note B--Amount represents $10,023,000 in purchase accounting adjustments, net of a reclassification of $3,019,000 to the reserve for assets acquired in connection with claim settlements. Note C--Amount represents claim payments, net of recoveries. Note D--Amount represents elimination of reserve in connection with disposition and/or revaluation of the related asset. Note E--Amount represents elimination of reserve in connection with the expiration of the related temporary differences.