We maintain our executive offices at MacArthur Place in Santa Ana, California. This office campus consists of five office buildings, a technology center and a two-story parking structure, totaling approximately 490,000 square feet. Three office buildings, totaling approximately 210,000 square feet, and the fixtures thereto and underlying land, are subject to a deed of trust and security agreement securing payment of a promissory note evidencing a loan made in October 2003, to our principal title insurance subsidiary in the original sum of $55.0 million. This loan is payable in monthly installments of principal and interest, is fully amortizing and matures November 1, 2023. The outstanding principal balance of this loan was $25.8 million as of December 31, 2016.
This Management’s Discussion and Analysis contains certain financial measures that are not presented in accordance with generally accepted accounting principles (“GAAP”), including adjusted information and other revenues, adjusted personnel costs, adjusted other operating expenses and adjusted depreciation and amortization expense, in each case excluding the effects of recent acquisitions. The Company is presenting these non-GAAP financial measures because they provide the Company’s management and readers of this Annual Report on Form 10-K with additional insight into the operational performance of the Company relative to earlier periods. The Company does not intend for these non-GAAP financial measures to be a substitute for any GAAP financial information. In this Annual Report on Form 10-K, these non-GAAP financial measures have been presented with, and reconciled to, the most directly comparable GAAP financial measures. Readers of this Annual Report on Form 10-K should use these non-GAAP financial measures only in conjunction with the comparable GAAP financial measures.
Provision for policy 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 is generally determined by applying a rate (the loss provision rate) to total title insurance premiums and escrow fees. The Company’s management estimates the loss provision rate at the beginning of each year and reassesses the rate quarterly to ensure that the resulting incurred but not reported (“IBNR”) loss reserve and known claims reserve included in the Company’s consolidated balance sheets together reflect management’s best estimate of the total costs required to settle all IBNR and known claims. If the ending IBNR reserve is not considered adequate, an adjustment is recorded.
The volume and timing of title insurance claims are subject to cyclical influences from real estate and mortgage markets. Title policies issued to lenders constitute a large portion of the Company’s title insurance volume. These policies insure lenders against losses on mortgage loans due to title defects in the collateral property. Even if an underlying title defect exists that could result in a claim, often, the lender must realize an actual loss, or at least be likely to realize an actual loss, for title insurance liability to exist. As a result, title insurance claims exposure is sensitive to lenders’ losses on mortgage loans, and is affected in turn by external factors that affect mortgage loan losses, particularly macroeconomic factors.
Title insurance policies are long-duration contracts with the majority of the claims reported to the Company within the first few years following the issuance of the policy. Generally, 70% to 80% of claim amounts become known in the first six years of the policy life, and the majority of IBNR reserves relate to the six most recent policy years. Changes in expected ultimate losses and corresponding loss rates for recent policy years are considered likely and could result in a material adjustment to the IBNR reserves. Based on historical experience, management believes a 50 basis point change to the loss rates for recent policy years, positive or negative, is reasonably likely given the long duration nature of a title insurance policy. For example, if the expected ultimate losses for each of the last six policy years increased or decreased by 50 basis points, the resulting impact on the Company’s IBNR reserve would be an increase or decrease, as the case may be, of $110.1 million. A material change in expected ultimate losses and corresponding loss rates for older policy years is also possible, particularly for policy years with loss ratios exceeding historical norms. The estimates made by management in determining the appropriate level of IBNR reserves could ultimately prove to be materially different from actual claims experience.
“Other” for 2015 included recoveries of $23.8 million on reinsured losses related to a large commercial title claim.
The provision transferred from IBNR title claims related to current year increased by $1.5 million in 2016 from 2015 and decreased by $16.4 million in 2015 from 2014 and payments, net of recoveries, related to current year increased by $1.2 million in 2016 from 2015 and decreased by $11.0 million in 2015 from 2014, reflecting variability in claims volumes characteristic of a policy year during its first year of development. In addition, 2014 experienced a higher level of fraud losses when compared to 2016 and 2015.
Activity in the reserve for IBNR title claims is summarized as follows:
The provision related to current year decreased by $18.2 million, or 9.6%, in 2015 from 2014. This decrease was attributable to a lower current year loss rate in 2015 when compared to 2014, partly offset by a 13.0% increase in title premiums and escrow fees in 2015 from 2014. The current year loss rate in 2015 was 4.2% compared to 5.3% in 2014.
For further discussion of title provision recorded in 2016, 2015 and 2014, see Results of Operations, pages 38 and 39.
The fair values of debt securities were based on the market values obtained from independent pricing services that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other market information and price quotes from well-established independent broker-dealers. The independent pricing services monitor market indicators, industry and economic events, and for broker-quoted only securities, obtain quotes from market makers or broker-dealers that they recognize to be market participants. The pricing services utilize the market approach in determining the fair value of the debt securities held by the Company. The Company obtains an understanding of the valuation models and assumptions utilized by the services and has controls in place to determine that the values provided represent fair value. The Company’s validation procedures include comparing prices received from the pricing services to quotes received from other third party sources for certain securities with market prices that are readily verifiable. If the price comparison results in differences over a predefined threshold, the Company will assess the reasonableness of the changes relative to prior periods given the prevailing market conditions and assess changes in the issuers’ credit worthiness, performance of any underlying collateral and prices of the instrument relative to similar issuances. To date, the Company has not made any material adjustments to the fair value measurements provided by the pricing services.
Typical inputs and assumptions to pricing models used to value the Company’s U.S. Treasury bonds, municipal bonds, foreign government bonds, governmental agency bonds, governmental agency mortgage-backed securities and U.S. and foreign corporate debt securities include, but are not limited to, benchmark yields, reported trades, broker-dealer quotes, credit spreads, credit ratings, bond insurance (if applicable), benchmark securities, bids, offers, reference data and industry and economic events. For mortgage-backed securities, inputs and assumptions may also include the structure of issuance, characteristics of the issuer, collateral attributes and prepayment speeds. Non-agency mortgage-backed securities and certain U.S. and foreign corporate debt securities were not actively traded and there were fewer observable inputs available requiring the use of more judgment in determining their fair values, which resulted in their classification as Level 3.
For 2016, the Company chose to forego the qualitative assessment and performed a quantitative impairment test and, based on the results, determined that the fair values of its reporting units exceeded their carrying amounts and, therefore, no additional analysis was required. The Company chose to perform qualitative assessments for 2015 and 2014, the results of which supported the conclusion that the fair values of the Company’s reporting units were not more likely than not less than their carrying amounts and, therefore, a quantitative impairment test was not considered necessary. As a result, the Company did not record any goodwill impairment losses for 2016, 2015 or 2014.
Employee benefit plans. The Company recognizes the overfunded or underfunded status of its funded defined benefit pension and unfunded supplemental benefit plans as an asset or liability on its consolidated balance sheets and recognizes changes in the funded status in the year in which changes occur, through accumulated other comprehensive loss. The funded status is measured as the difference between the fair value of plan assets and benefit obligation (the projected benefit obligation for pension plans and the accumulated postretirement benefit obligation for the other postretirement plans). Actuarial gains and losses and prior service costs and credits that have not been recognized as a component of net periodic benefit cost previously are recorded as a component of accumulated other comprehensive loss. Plan assets and obligations are measured annually as of December 31.
The assumptions that have had the most significant impact to net periodic costs are the discount rate and expected long-term rate of return on plan assets. The discount rate assumption reflects the yield available on high-quality, fixed-income debt securities that match the expected timing of the benefit obligation payments. Assumptions for the expected long-term rate of return on assets of the funded defined benefit pension plans are based on future expectations for returns for each asset class based on the calculated market-related value of plan assets and the effect of periodic target asset allocation rebalancing, adjusted for the payment of reasonable expenses of the plans from plan assets. See Note 13 Employee Benefit Plans to the consolidated financial statements for discussion of the termination of the Company’s funded defined benefit pension plans.
Weighted-average actuarial assumptions used to determine benefit obligations for the plans at December 31, 2016 and 2015, were as follows:
In October 2016, the FASB issued updated guidance to amend the consolidation guidance on how a reporting entity that is the single decision maker of a variable interest entity should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that variable interest entity. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2016, with early adoption permitted. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.
According to the Mortgage Bankers Association’s February 15, 2017 Mortgage Finance Forecast (the “MBA Forecast”), residential mortgage originations in the United States (based on the total dollar value of the transactions) increased 12.6% in 2016 when compared with 2015. According to the MBA Forecast, the dollar amount of purchase originations increased 9.6% and refinance originations increased 16.1%. This higher volume of domestic residential mortgage origination activity contributed to an increase in direct premiums and escrow fees for the Company’s direct title operations of 6.3% from domestic residential purchase transactions and 21.2% from domestic refinance transactions in 2016 when compared to 2015.
In May 2016, the Company’s board of directors terminated the Company’s funded defined benefit pension plans effective as of July 31, 2016. In connection with the termination, the pension plans offered an alternative lump sum distribution to certain participants. The Company recognized $66.3 million in settlement costs within the corporate segment during the fourth quarter of 2016 related to distributions of pension plan assets totaling $127.2 million to participants electing lump sum payments. The Company expects to complete the transfer of all remaining liabilities and administrative responsibilities related to the pension plans to one or more highly rated insurance companies by the end of the second quarter of 2017 and to recognize approximately $154 million in net unrealized losses within the corporate segment in the first half of 2017. Once the termination process is complete, the Company estimates an annual reduction of approximately $22 million in personnel costs related to the pension plans within the corporate segment, based on the level of these expenses for the year ended December 31, 2016. For further discussion of the pension termination including the recent and expected contribution amounts and the timing of pension termination expense to be recognized, see Note 13 Employee Benefit Plans to the consolidated financial statements.
Direct premiums and escrow fees increased $74.9 million, or 3.9%, in 2016 from 2015 and $231.4 million, or 13.6%, in 2015 from 2014. The increase in direct premiums and escrow fees in 2016 from 2015 was primarily due to an increase in domestic title orders closed by the Company’s direct title operations, partially offset by a decrease in domestic average revenues per order closed. The increase in direct premiums and escrow fees in 2015 from 2014 was primarily due to an increase in the domestic average revenues per order closed and an increase in domestic title orders closed by the Company’s direct operations. The domestic average revenues per order closed were $1,931, $2,012 and $1,886 for 2016, 2015 and 2014, respectively. The 4.0% decrease in average revenues per order closed in 2016 from 2015 was primarily due to a shift in the mix of direct revenues generated from higher premium commercial products to lower premium residential refinance products. The 6.7% increase in average revenues per order closed in 2015 from 2014 was primarily due to higher real estate values and a greater number of large commercial deals that closed when compared to the prior year, partially offset by an increase in the mix of direct revenues generated from lower premium residential refinance transactions. The Company’s direct title operations closed 958,400, 882,400 and 816,400 domestic title orders during 2016, 2015 and 2014, respectively. The 8.6% increase in orders closed in 2016 from 2015 and the 8.1% increase in orders closed in 2015 from 2014 were generally consistent with the changes in residential mortgage origination activity in the United States as reported in the MBA Forecast.
Agent premiums increased $188.4 million, or 9.0%, in 2016 from 2015 and $230.9 million, or 12.4%, in 2015 from 2014. Agent premiums are recorded when notice of issuance is received from the agent, which is generally when cash payment is received by the Company. As a result, there is generally a delay between the agent’s issuance of a title policy and the Company’s recognition of agent premiums. Therefore, full year agent premiums typically reflect mortgage origination activity from the fourth quarter of the prior year through the third quarter of the current year. The increase in agent premiums in 2016 from 2015 was generally consistent with the 2.9% increase in the Company’s direct premiums and escrow fees in the twelve months ended September 30, 2016 as compared with the twelve months ended September 30, 2015. The increase in agent premiums in 2015 from 2014 was generally consistent with the 16.9% increase in the Company’s direct premiums and escrow fees in the twelve months ended September 30, 2015 as compared with the twelve months ended September 30, 2014.
Information and other revenues increased $43.2 million, or 6.4%, in 2016 from 2015 and $15.0 million, or 2.3%, in 2015 from 2014. Excluding the $48.5 million impact of new acquisitions for the year ended December 31, 2016, information and other revenues decreased $5.3 million, or 0.8%, in 2016 compared to 2015. The decrease in 2016 from 2015, adjusted for the impact of new acquisitions, was due to lower demand for the Company’s default information products as a result of the decrease in domestic loss mitigation activities and lower revenue in the Company’s Australian operations due to the loss of a large customer, partially offset by higher demand for the Company’s title plant and data products. Excluding the $23.2 million impact of new acquisitions for the year ended December 31, 2015, information and other revenues decreased $8.2 million, or 1.2%, in 2015 compared to 2014. The decrease in 2015 from 2014, adjusted for the impact of new acquisitions, was due to lower demand for the Company’s default information products as a result of the decrease in domestic loss mitigation activities, partially offset by higher demand for certain of the Company’s non-insured services and products, which is directionally consistent with the increase in title insurance and services segment transaction volumes and revenue.
Net investment income increased $13.2 million, or 13.6%, in 2016 from 2015 and $37.7 million, or 63.1%, in 2015 from 2014. The increase in 2016 from 2015 was primarily attributable to higher interest income from the investment portfolio due to higher average balances in the title insurance and services segment’s debt securities portfolio in 2016 when compared to 2015. The increase in 2015 from 2014 was primarily attributable to higher interest income from the investment portfolio primarily due to higher average balances in the title insurance and services segment’s debt securities portfolio in 2015 when compared to 2014 and lower impairment losses related to investments accounted for using the equity method when compared to 2014. Net investment income for 2015 and 2014 included impairment losses recognized on investments accounted for using the equity method of $2.0 million and $22.5 million, respectively. No impairment losses were recognized on investments accounted for using the equity method in 2016.
Personnel costs increased $86.4 million, or 5.8%, in 2016 from 2015 and $153.9 million, or 11.5%, in 2015 from 2014. Excluding the $38.1 million impact of new acquisitions for the year ended December 31, 2016, personnel costs increased $48.3 million, or 3.2%, in 2016 compared to 2015. The increase in 2016, adjusted for the impact of new acquisitions, was primarily attributable to higher salary, incentive compensation, share based compensation, and employee benefits expense. The higher salary cost was due to an increase in average salaries and, to a lesser extent, higher average headcount. The increase in incentive compensation expense was due to higher commissions paid on higher revenues, partially offset by lower 401(k) savings plan matches. The higher share based compensation cost was due to increased restricted stock units granted to employees during the first quarter of 2016 associated with 2015 performance. The increase in employee benefits expense was primarily due to higher paid medical claims. Excluding the $19.3 million impact of new acquisitions for the year ended December 31, 2015, personnel costs increased $134.6 million, or 10.1%, in 2015 compared to 2014. The increase in 2015, adjusted for the impact of new acquisitions, was primarily attributable to higher incentive compensation costs, which include commissions, bonuses and 401(k) savings plan matches, due to higher revenue and profitability; higher salary expense due to higher headcount levels; and higher overtime and temporary labor costs driven by higher order volumes. Personnel costs included severance expense of $8.3 million, $5.6 million and $8.9 million for 2016, 2015 and 2014, respectively.
The Company continues to closely monitor order volumes and related staffing levels and intends to adjust staffing levels as considered necessary. The Company’s direct title operations opened 1,281,400, 1,261,700 and 1,155,500 domestic title orders in 2016, 2015 and 2014, respectively, representing an increase of 1.6% in 2016 from 2015 and an increase of 9.2% in 2015 from 2014.
The provision for policy losses and other claims, expressed as a percentage of title insurance premiums and escrow fees, was 5.5%, 6.6% and 7.1% for the years ended December 31, 2016, 2015 and 2014, respectively.
Depreciation and amortization expense increased $12.7 million, or 15.8%, in 2016 from 2015 and $2.5 million, or 3.3%, in 2015 from 2014. Excluding the $2.7 million impact of new acquisitions for the year ended December 31, 2016, depreciation and amortization expense increased $10.0 million, or 12.4%, in 2016 compared to 2015. The increase in 2016 was primarily attributable to amortization expense associated with internally developed technology and purchased software licenses. Excluding the $2.4 million impact of new acquisitions for the year ended December 31, 2015, depreciation and amortization expense increased $0.1 million, or 0.1%, in 2015 compared to 2014.
The profit margins for the title insurance business reflect the high cost of performing the essential services required before insuring title, whereas the corresponding revenues are subject to regulatory and competitive pricing restraints. Due to this relatively high proportion of fixed costs, title insurance profit margins generally improve as closed order volumes increase. Title insurance profit margins are affected by the composition (residential or commercial) and type (resale, refinancing or new construction) of real estate activity. Title insurance profit margins are also affected by the percentage of title insurance premiums generated by agency operations. Profit margins from direct operations are generally higher than from agency operations due primarily to the large portion of the premium that is retained by the agent. The pre-tax margins were 11.7%, 10.2% and 8.7% for the years ended December 31, 2016, 2015 and 2014, respectively.
Direct premiums increased $31.1 million, or 8.2%, in 2016 from 2015 and $26.5 million, or 7.5%, in 2015 from 2014. The increases were driven by higher premiums earned in the home warranty business. The increase in 2016 from 2015 in the home warranty business was in its real estate, direct to consumer and renewal channels and was driven by an increase in the price charged for home warranty residential service contracts and an increase in the number of contracts issued. The increase in 2015 from 2014 in the home warranty business was attributable to its real estate, direct to consumer and renewal channels and was driven by an increase in the number of home warranty residential service contracts issued.
Information and other revenues increased $7.7 million, or 242.0%, in 2016 from 2015 and $0.9 million, or 40.7%, in 2015 from 2014. The increase in 2016 was primarily due to a change in how the Company reports installment fees related to home warranty residential service contracts. Beginning in 2016, the Company reported installment fees in information and other revenues, while prior to 2016, the Company reported installment fees as a reduction in other operating expenses. This change resulted in an increase to information and other revenues and an increase to other operating expenses of $7.5 million in 2016 when compared to 2015.
Net investment income increased $0.6 million, or 7.1%, in 2016 from 2015 and $1.6 million, or 21.4%, in 2015 from 2014. The increases were primarily attributable to higher interest income from the investment portfolio due to a higher average yield and higher average balances in the specialty insurance segment’s debt securities portfolio when compared to prior years.
The provision for home warranty claims, expressed as a percentage of home warranty premiums, was 60.7% in 2016, 56.5% in 2015 and 53.3% in 2014. The increase in rate in 2016 from 2015 was primarily attributable to higher contract servicing costs due to an increase in the frequency of higher cost claims related to increased equipment and replacement costs and less efficient claims management. The increase in rate in 2015 from 2014 was primarily attributable to higher contract servicing costs due to an increase in the frequency of higher cost claims related to more severe weather conditions and less efficient claims management. The efficiency of claims management was adversely impacted by the increased level of claims opened in 2016 and 2015 as a result of the higher volume of home warranty residential service contracts outstanding in 2016 and 2015.
Premium taxes as a percentage of specialty insurance segment premiums were 1.7% in 2016, 1.8% in 2015 and 1.7% in 2014.
Depreciation and amortization expense was $0.4 million, $0.5 million and $2.8 million in 2016, 2015 and 2014, respectively. The decrease in 2015 was due to a noncompete asset that was fully amortized during 2014.
Cash provided by operating activities amounted to $489.4 million, $551.3 million and $360.6 million for the years ended December 31, 2016, 2015 and 2014, respectively, after claim payments, net of recoveries, of $463.0 million, $476.5 million and $469.8 million, respectively. The principal nonoperating uses of cash and cash equivalents for the year ended December 31, 2016 were purchases of debt and equity securities, capital expenditures, dividends to common stockholders and business acquisitions. The principal nonoperating uses of cash and cash equivalents for the year ended December 31, 2015 were purchases of debt and equity securities, capital expenditures and dividends to common stockholders. The principal nonoperating uses of cash and cash equivalents for the year ended December 31, 2014 were purchases of debt and equity securities, repayment of debt, business acquisitions, capital expenditures and dividends to common stockholders. The most significant nonoperating sources of cash and cash equivalents for the year ended December 31, 2016 were proceeds from the sales and maturities of debt and equity securities, increases in the deposit balances at the Company’s banking operations and net proceeds from the issuance of debt. The most significant nonoperating sources of cash and cash equivalents for the year ended December 31, 2015 were proceeds from the sales and maturities of debt and equity securities and increases in the deposit balances at the Company’s banking operations. The most significant nonoperating sources of cash and cash equivalents for the year ended December 31, 2014 were proceeds from the sales and maturities of debt and equity securities, increases in the deposit balances at the Company’s banking operations, proceeds from the issuance of debt and paydowns and net proceeds related to the sale of loans receivable. The net effect of all activities on total cash and cash equivalents was a decrease of $21.2 million, a decrease of $162.8 million, and an increase of $355.2 million for the years ended December 31, 2016, 2015 and 2014, respectively.
The Company continually assesses its capital allocation strategy, including decisions relating to dividends, stock repurchases, capital expenditures, acquisitions and investments. In August 2016, the Company’s board of directors approved an increase in the Company’s quarterly cash dividend to 34 cents per common share, representing a 31% increase from the prior level of 26 cents per common share. The dividend increase became effective beginning with the September 2016 dividend. In January 2017, the Company’s board of directors approved a first quarter cash dividend of 34 cents per common share. Management expects that the Company will continue to pay quarterly cash dividends at or above the current level. The timing, declaration and payment of future dividends, however, falls within the discretion of the Company’s board of directors and will depend upon many factors, including the Company’s financial condition and earnings, the capital requirements of the Company’s businesses, restrictions imposed by applicable law and any other factors the board of directors deems relevant from time to time.
Holding company. First American Financial Corporation is a holding company that conducts all of its operations through its subsidiaries. The holding company’s current cash requirements include payments of principal and interest on its debt, taxes, payments in connection with employee benefit plans, dividends on its common stock and other expenses. The holding company is dependent upon dividends and other payments from its operating subsidiaries to meet its cash requirements. The Company’s target is to maintain a cash balance at the holding company equal to at least twelve months of estimated cash requirements. At certain points in time, the actual cash balance at the holding company may vary from this target due to, among other factors, the timing and amount of cash payments made and dividend payments received. Pursuant to insurance and other regulations under which the Company’s insurance subsidiaries operate, the amount of dividends, loans and advances available to the holding company is limited, principally for the protection of policyholders. As of December 31, 2016, under such regulations, the maximum amount of dividends, loans and advances available to the holding company from its insurance subsidiaries in 2017, without prior approval from applicable regulators, was $761.8 million. However, the timing and amount of dividends paid by the Company’s insurance subsidiaries to the holding company falls within the discretion of each insurance subsidiary’s board of directors and will depend upon many factors, including the level of total statutory capital and surplus required to support minimum financial strength ratings by certain rating agencies. Such restrictions have not had, nor are they expected to have, an impact on the holding company’s ability to meet its cash obligations.
As of December 31, 2016, the holding company’s sources of liquidity included $221.5 million of cash and cash equivalents and $540.0 million available on the Company’s revolving credit facility. Management believes that liquidity at the holding company is sufficient to satisfy anticipated cash requirements and obligations for at least the next twelve months.
Notes and contracts payable as a percentage of total capitalization was 19.6% and 17.4% at December 31, 2016 and 2015, respectively. Notes and contracts payable are further described in Note 9 Notes and Contracts Payable to the consolidated financial statements.
Investment portfolio. The Company maintains a high quality, liquid investment portfolio that is primarily held at its insurance and banking subsidiaries. As of December 31, 2016, 92% of the Company’s investment portfolio consisted of fixed income securities, of which 60% were United States government-backed or rated AAA and 94% were rated or classified as investment grade. Percentages are based on the estimated fair values of the securities. Credit ratings reflect published ratings obtained from S&P, DBRS, Inc., Fitch Ratings, Inc. and Moody’s. If a security was rated differently among the rating agencies, the lowest rating was selected. For further information on the credit quality of the Company’s investment portfolio at December 31, 2016, see Note 3 Debt and Equity Securities to the consolidated financial statements.
Capital expenditures. Capital expenditures primarily consist of software development costs, additions to property and equipment, additions to title plants and purchases of real estate data. Capital expenditures were $132.3 million, $127.6 million and $99.4 million for the years ended December 31, 2016, 2015 and 2014, respectively. The increase in 2016 from 2015 primarily related to the Company’s adoption of the change in accounting treatment for internal-use software licenses in 2016, partially offset by lower spending in property and equipment, software, title plants, and real estate data. The increase in 2015 from 2014 primarily reflected increased spending in 2015 on software, real estate data, title plants and property and equipment. The increase in software in 2015 was mainly driven by the Company’s effort to comply with the Consumer Financial Protection Bureau’s TILA-RESPA integrated disclosure rule.
Off-balance sheet arrangements. The Company administers escrow deposits and trust assets as a service to its customers. Escrow deposits totaled $6.8 billion and $6.6 billion at December 31, 2016 and 2015, respectively, of which $2.6 billion was held at the Company’s federal savings bank subsidiary, First American Trust, FSB. The escrow deposits held at First American Trust, FSB are temporarily invested in cash and cash equivalents and debt securities, with offsetting liabilities included in deposits in the accompanying consolidated balance sheets. The remaining escrow deposits were held at third-party financial institutions.
The Company facilitates tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code and tax-deferred reverse exchanges pursuant to Revenue Procedure 2000-37. As a facilitator and intermediary, the Company holds the proceeds from sales transactions and takes temporary title to property identified by the customer to be acquired with such proceeds. Upon the completion of each such exchange, the identified property is transferred to the customer or, if the exchange does not take place, an amount equal to the sales proceeds or, in the case of a reverse exchange, title to the property held by the Company is transferred to the customer. Like-kind exchange funds held by the Company totaled $2.0 billion and $2.8 billion at December 31, 2016 and 2015, respectively. The like-kind exchange deposits are held at third-party financial institutions and, due to the structure utilized to facilitate these transactions, the proceeds and property are not considered assets of the Company and, therefore, are not included in the accompanying consolidated balance sheets. All such amounts are placed in deposit accounts insured, up to applicable limits, by the Federal Deposit Insurance Corporation. The Company could be held contingently liable to the customer for the transfers of property, disbursements of proceeds and the returns on such proceeds.
At December 31, 2016 and 2015, the Company was contingently liable for guarantees of indebtedness owed by affiliates and third parties to banks and others totaling $7.1 million and $8.2 million, respectively. The guarantee arrangements relate to promissory notes and other contracts that contingently require the Company to make payments to the guaranteed party upon the failure of debtors to make scheduled payments according to the terms of the notes and contracts. The Company’s maximum potential obligation under these guarantees totaled $7.1 million and $8.2 million at December 31, 2016 and 2015, respectively, and is limited in duration to the terms of the underlying indebtedness. The Company has not incurred any costs as a result of these guarantees and has not recorded a liability on its consolidated balance sheets related to these guarantees at December 31, 2016 and 2015.
During the fourth quarter of 2016, the Company identified certain title plant assets that were no longer being used and should have been previously written off, and certain capitalized software, title plant imaging, real estate data and investments related to title plant assets that were misclassified as title plant assets. As these errors primarily related to reporting periods prior to the Company’s June 2010 spin-off from its prior parent, which subsequently assumed the name CoreLogic, Inc. (“CoreLogic”), the Company corrected for these errors by revising retained earnings at December 31, 2013, 2014 and 2015 in the consolidated statements of equity, and revising title plants and other indexes, other investments, deferred income tax liabilities and retained earnings in the consolidated balance sheet at December 31, 2015. The impact of this revision, which has been consistently applied to all periods presented, included decreases to retained earnings, title plants and other indexes and deferred income tax liabilities of $8.5 million, $18.8 million and $5.1 million, respectively, and an increase to other investments of $5.2 million.
During 2015, the Company reclassified certain revenues and expenses related to closing protection letters and temporary labor costs and made comparable reclassifications to its consolidated statement of income for the year ended December 31, 2014. The impact to the Company’s title insurance and services segment for the year ended December 31, 2014 included a decrease to direct premiums and escrow fees and an increase to agent premiums of $25.8 million, increases to personnel costs and premiums retained by agents of $23.9 million and $1.2 million, respectively, and a decrease to other operating expenses of $25.1 million. The impact to the Company’s specialty insurance segment included an increase to personnel costs and a decrease to other operating expenses of $1.0 million for the year ended December 31, 2014.
Also during 2015, the Company identified certain non-risk based revenues included within direct premiums and escrow fees that should have been reflected in information and other. The Company corrected for this error by revising direct premiums and escrow fees and information and other in the consolidated statement of income for the year ended December 31, 2014. The impact of the revision to the Company’s title insurance and services segment included a decrease to direct premiums and escrow fees and an increase to information and other of $37.2 million for the year ended December 31, 2014.
When an equity security has been in an unrealized loss position and its fair value is less than 80% of cost for twelve consecutive months, the Company’s review of the security includes the above noted factors as well as other evidence that might exist supporting the view that the security will recover its value in the foreseeable future. If objective, substantial evidence does not indicate a likely recovery during that timeframe, the Company’s policy is that such losses are considered other-than-temporary and therefore an impairment loss is recorded. The Company did not record other-than-temporary impairment losses related to its equity securities for the years ended December 31, 2016, 2015 and 2014.
Management uses estimated future cash flows (undiscounted and excluding interest) to measure the recoverability of property and equipment whenever events or changes in circumstances indicate that the carrying value may not be fully recoverable. If the undiscounted cash flow analysis indicates that the carrying amount is not recoverable, an impairment loss is recorded for the excess of the carrying amount over its fair value. Impairment losses on property and equipment, which primarily related to impairments of internally developed software, were $5.2 million, $10.9 million and $1.2 million for the years ended December 31, 2016, 2015 and 2014, respectively.
Title plants and other indexes at December 31, 2016 included title plants of $529.2 million and capitalized real estate data of $35.1 million, and at December 31, 2015 included title plants of $509.6 million and capitalized real estate data of $26.5 million. Title plants are carried at original cost, with the costs of daily maintenance (updating) charged to expense as incurred. Because properly maintained title plants have indefinite lives and do not diminish in value with the passage of time, no provision has been made for depreciation or amortization. The Company analyzes its title plants at least annually for impairment. This analysis includes, but is not limited to, the effects of obsolescence, duplication, demand and other economic factors. Capitalized real estate data is initially recorded at cost and is amortized using the straight-line method over estimated useful lives of 3 to 15 years.
Amounts paid for acquisitions are allocated to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values at the date of acquisition. The excess of the fair value of purchase consideration over the fair values of the identifiable assets and liabilities is recorded as goodwill. Acquisition-related costs are expensed in the periods in which the costs are incurred. The results of operations of acquired businesses are included in the consolidated financial statements from the date of acquisition.
The Company’s primary means of providing share-based compensation is through the granting of restricted stock units (“RSUs”). RSUs granted generally have graded vesting and include a service condition; and for certain key employees and executives, may also include either a performance or market condition. RSUs receive dividend equivalents in the form of RSUs having the same vesting requirements as the RSUs initially granted.
The Company operates in other countries, including Canada, the United Kingdom, Australia, South Korea and various other established and emerging markets. The functional currencies of the Company’s foreign subsidiaries are generally their respective local currencies. The financial statements of foreign subsidiaries with local currencies that were determined to be the functional currency are translated into U.S. dollars as follows: assets and liabilities at the exchange rate as of the balance sheet date, equity at the historical rates of exchange, and income and expense amounts at average rates prevailing throughout the period. Translation adjustments resulting from the translation of the subsidiaries’ accounts are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. For those foreign subsidiaries where the U.S. dollar has been determined to be the functional currency, non-monetary assets and liabilities are translated using historical rates, while monetary assets and liabilities are translated at current rates, with remeasurement gains and losses included in other operating expenses. Gains and losses resulting from foreign currency transactions are included within other operating expenses.
The Company assumes and cedes large title insurance risks through reinsurance. Additionally, the Company’s property and casualty insurance business purchases reinsurance to limit risk associated with large losses from single events. In reinsurance arrangements, the primary insurer retains a certain amount of risk under a policy and cedes the remainder of the risk under the policy to the reinsurer. The primary insurer pays the reinsurer a premium in exchange for accepting this risk of loss. The primary insurer generally remains liable to its insured for the total risk, but is reinsured under the terms of the reinsurance agreement. The amount of premiums assumed and ceded is recorded as a component of direct premiums and escrow fees on the Company’s consolidated statements of income. The total amount of premiums assumed and ceded in connection with reinsurance was less than 1.0% of consolidated premium and escrow fees for each of the three years in the period ended December 31, 2016. See Note 8 Reserve for Known and Incurred But Not Reported Claims for discussion of recoveries related to a large commercial title claim during the year ended December 31, 2015. Payments and recoveries on reinsured losses for the Company’s title insurance and property and casualty businesses were immaterial during the years ended December 31, 2016 and 2014.
The Company administers escrow deposits and trust assets as a service to its customers. Escrow deposits totaled $6.8 billion and $6.6 billion at December 31, 2016 and 2015, respectively, of which $2.6 billion was held at the Company’s federal savings bank subsidiary, First American Trust, FSB. The escrow deposits held at First American Trust, FSB are temporarily invested in cash and cash equivalents and debt securities, with offsetting liabilities included in deposits in the accompanying consolidated balance sheets. The remaining escrow deposits were held at third-party financial institutions.
In August 2015, the FASB issued updated guidance relating to the Securities and Exchange Commission Staff Announcement at the June 18, 2015 Emerging Issues Task Force meeting on the presentation and subsequent measurement of debt issuance costs associated with line-of-credit arrangements. The updated guidance allows for the deferral and presentation of debt issuance costs as an asset which may be amortized ratably over the term of the line-of-credit arrangement, regardless of whether there are any related outstanding borrowings. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2015, with early adoption permitted. The adoption of this guidance had no impact on the Company’s consolidated financial statements.
In May 2015, the FASB issued updated guidance intended to eliminate the diversity in practice surrounding how investments measured at net asset value under the practical expedient with future redemption dates have been categorized in the fair value hierarchy. Under the updated guidance, investments for which fair value is measured at net asset value per share using the practical expedient should no longer be categorized in the fair value hierarchy. The updated guidance requires retrospective adoption for all periods presented and is effective for interim and annual reporting periods beginning after December 15, 2015, with early adoption permitted. The adoption of this guidance had no impact on the Company’s consolidated financial statements.
In April 2015, the FASB issued updated guidance intended to clarify the accounting treatment for cloud computing arrangements that include software licenses. Under the updated guidance, if a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2015, with early adoption permitted. The Company elected to adopt the updated guidance prospectively for all arrangements entered into or materially modified after the effective date. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements. The financial statement line items impacted by the adoption of the updated guidance include other intangible assets, net and depreciation and amortization. See Note 6 Other Intangible Assets for further information on the Company’s internal-use software licenses.
In February 2015, the FASB issued updated guidance which changes the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2015, with early adoption permitted. The adoption of this guidance had no impact on the Company’s consolidated financial statements.
In November 2016, the FASB issued updated guidance intended to reduce the diversity in practice on presenting restricted cash or restricted cash equivalents in the statement of cash flows. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2017, with early adoption permitted. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.
In March 2016, the FASB issued updated guidance intended to simplify and improve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of such awards as either equity or liabilities and classification on the statement of cash flows. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2016, with early adoption permitted. The Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.
Pursuant to insurance and other regulations under 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. As of December 31, 2016, under such regulations, the maximum amount of dividends, loans and advances available to the Company from its insurance subsidiaries in 2017, without prior approval from applicable regulators, was $761.8 million.
FATICO is domiciled in Nebraska and its statutory-based financial statements are prepared in accordance with accounting practices prescribed or permitted by the Nebraska Department of Insurance. The National Association of Insurance Commissioners’ (“NAIC”) Accounting Practices and Procedures Manual (“NAIC SAP”) has been adopted as a component of prescribed or permitted practices by the state of Nebraska. The state of Nebraska has adopted certain prescribed accounting practices that differ from those found in the NAIC SAP. Specifically, the timing of amounts released from the statutory premium reserve under Nebraska’s required practice differs from NAIC SAP resulting in total statutory capital and surplus that was lower by $69.6 million and $61.7 million at December 31, 2016 and 2015, respectively, than if reported in accordance with NAIC SAP. Additionally, for the year ended December 31, 2015, the state of Nebraska granted a permitted accounting practice to FATICO that differs from Nebraska’s prescribed accounting practice; specifically, the determination that a bulk reserve within the known claims reserve was not required resulting in total statutory capital and surplus that was higher by $58.9 million at December 31, 2015 than if reported in accordance with Nebraska’s prescribed practice. For the year ended December 31, 2016, FATICO elected to follow the prescribed practice and recorded a bulk reserve within the known claims reserve resulting in a decrease to total statutory capital and surplus of $145.7 million at December 31, 2016.
Sales of debt and equity securities resulted in realized gains of $30.7 million, $8.7 million and $34.1 million and realized losses of $9.7 million, $10.0 million and $9.1 million for the years ended December 31, 2016, 2015 and 2014, respectively.
As of December 31, 2016, the estimated fair value of total debt securities in an unrealized loss position included $12.0 million of bank loans, all of which was non-investment grade; $39.2 million of high yield corporate debt securities, all of which was non-investment grade; and $38.0 million of emerging market debt securities, of which $6.1 million was non-investment grade.
The credit ratings in the above tables reflect published ratings obtained from Standard & Poor’s Rating Services, DBRS, Inc., Fitch Ratings, Inc. and Moody’s Investor Services, Inc. If a security was rated differently among the rating agencies, the lowest rating was selected. Governmental agency mortgage-backed securities are not rated by any of the ratings agencies; however, these securities have been included in the above table in the “A- Ratings or higher” category because the payments of principal and interest are guaranteed by the governmental agency that issued the security.
A summary of the changes in the carrying amount of goodwill, by operating segment, for the years ended December 31, 2016 and 2015, is as follows:
For further discussion about the Company’s acquisitions in 2016 and 2015, see Note 20 Business Combinations.
Amortization expense for finite-lived intangible assets was $15.4 million, $9.3 million and $12.6 million for the years ended December 31, 2016, 2015 and 2014, respectively.
The provision for title insurance losses, expressed as a percentage of title insurance premiums and escrow fees, was 5.5%, 6.6% and 7.1% for the years ended December 31, 2016, 2015 and 2014, respectively.
As of December 31, 2016, the IBNR claims reserve for the title insurance and services segment was $888.1 million, which reflected management’s best estimate. The Company’s internal actuary determined a range of reasonable estimates of $718.5 million to $938.3 million. The range limits are $169.6 million below and $50.2 million above management’s best estimate, respectively, and represent an estimate of the range of variation among reasonable estimates of the IBNR reserve. Actuarial estimates are sensitive to assumptions used in models, as well as the structures of the models themselves, and to changes in claims payment and incurral patterns, which can vary materially due to economic conditions, among other factors.
The prior year rate of 6.6% reflected an ultimate loss rate of 4.2% for policy year 2015 and a $93.1 million net increase in loss reserve estimates for prior policy years. The increase in loss reserve estimates for prior policy years was primarily attributable to a change in methodology used by the Company’s internal actuary to estimate total ultimate losses. Previously, the internal actuary’s model did not separate claims experience for large title claims from normal title claims activity. With this change in methodology, the model began to separate claims experience for large title claims from normal title claims activity when developing reserve estimates. As a result, loss reserve estimates for prior policy years increased, primarily for policy years 2004 through 2007. The change in methodology was implemented due to the increased frequency of large title claims experienced over the prior several years and the volatility associated with the timing and severity of large title claims. The Company accounted for this change in methodology as a change in accounting estimate.
The 2014 rate of 7.1% reflected an ultimate loss rate of 5.3% for policy year 2014 and a net increase in loss reserve estimates for prior policy years of $64.1 million. The increase in loss reserve estimates for prior policy years reflected claims development above expected levels during 2014, primarily from domestic commercial policies. The reserve strengthening associated with domestic commercial policies was $41.4 million and was primarily attributable to several large commercial claims, net of anticipated recoveries, mainly from mechanics liens, and primarily related to policy years 2003, 2005 and 2007. Other factors, including a large international commercial claim from policy year 2004, also contributed to the net increase in loss reserve estimates for prior policy years.
As of December 31, 2016, the projected ultimate loss ratios for policy years 2016, 2015 and 2014 were 4.5%, 4.1% and 4.8%, respectively.
A reconciliation of the net incurred and paid claims development tables to the liability for claims and claim adjustment expense at December 31, 2016, is as follows:
The following is supplementary information about average historical claims duration for the Company’s specialty insurance segment as of December 31, 2016:
4.60% senior unsecured notes due November 15, 2024, effective interest rate
4.30% senior unsecured notes due February 1, 2023, effective interest rate
Other notes and contracts payable with maturities through 2032, weighted-average interest rate of 5.26% and 4.21% at December 31, 2016 and 2015, respectively
The weighted-average interest rate for the Company’s notes and contracts payable was 4.10% and 4.51% at December 31, 2016 and 2015, respectively.
In September 2016, the Company borrowed $160.0 million under the credit facility to fund acquisitions and to partially fund its obligation in connection with the termination of its funded defined benefit pension plans. At December 31, 2016, outstanding borrowings under the facility totaled $160.0 million at an interest rate of 2.52%. See Note 20 Business Combinations for further discussion of the Company’s acquisitions, and see Note 13 Employee Benefit Plans for further discussion of the Company’s pension termination.
The credit agreement includes an expansion option that permits the Company, subject to satisfaction of certain conditions, to increase the revolving commitments and/or add term loan tranches (“Incremental Term Loans”) in an aggregate amount not to exceed $150.0 million. Incremental Term Loans, if made, may not mature prior to the revolving commitment termination date, provided that amortization may occur prior to such date.
For the years ended December 31, 2016, 2015 and 2014, domestic and foreign pretax income from continuing operations before noncontrolling interests was $416.5 million and $61.1 million, $383.5 million and $49.3 million, and $301.8 million and $48.8 million, respectively.
The Company’s effective income tax rates (income tax expense as a percentage of income before income taxes) were 28.1% for 2016, 33.3% for 2015 and 33.2% for 2014. The differences in the effective tax rates are typically due to changes in state and foreign income taxes resulting from fluctuations in the Company’s noninsurance and foreign subsidiaries’ contributions to pretax income and changes in the ratio of permanent differences to income before income taxes. In addition, the 2016 rate reflects the resolution of certain tax authority examinations and tax credits claimed in current and prior years. The 2015 rate includes a benefit for the release of valuation allowances previously provided against certain foreign net operating losses and other deferred tax assets. The 2014 rate reflects non-recurring tax benefits resulting from certain adjustments to the Company’s state and non-U.S. tax accounts.
The exercise of stock options and vesting of RSUs represent a tax benefit that has been reflected as a reduction of taxes payable and an increase to equity. The benefits recorded were $3.4 million and $9.5 million for the years ended December 31, 2016 and 2015, respectively.
In connection with the Company’s June 2010 spin-off from CoreLogic, it entered into a tax sharing agreement which governs the Company’s and CoreLogic’s respective rights, responsibilities and obligations for certain tax-related matters. At December 31, 2016 and 2015, the Company had a net payable to CoreLogic of $16.3 million and $36.5 million, respectively, related to tax matters prior to the spin-off. This amount is included in the Company’s consolidated balance sheets in accounts payable and accrued liabilities. The decrease during the current year was primarily the result of the effective settlement of tax positions for years prior to the spin-off.
At December 31, 2016, the Company had available a foreign tax credit carryover of $4.1 million. The Company expects to utilize this credit within the carryover period.
The Company evaluates the realizability of its deferred tax assets by assessing the valuation allowance and adjusts the allowance, if necessary. The factors used to assess the likelihood of realization include the Company’s forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. The ability or failure to achieve forecasted taxable income in the applicable taxing jurisdictions could affect the ultimate realization of deferred tax assets. Based on future operating results in certain jurisdictions, it is possible that the current valuation allowance positions of those jurisdictions could be adjusted in the next 12 months.
As of December 31, 2016, 2015 and 2014, the liability for income taxes associated with uncertain tax positions was $18.1 million, $23.8 million and $24.1 million, respectively. The net decreases in the liabilities during 2016, 2015 and 2014 were primarily attributable to activity related to examinations conducted by various taxing authorities. The liabilities could be reduced by $5.7 million as of December 31, 2016, and by $3.4 million as of December 31, 2015 and 2014, due to offsetting tax benefits associated with the correlative effects of potential adjustments, including timing adjustments and state income taxes. The net amounts of $12.4 million, $20.4 million and $20.7 million as of December 31, 2016, 2015 and 2014, respectively, if recognized, would favorably affect the Company’s effective tax rate.
The Company’s continuing practice is to recognize interest and penalties, if any, related to uncertain tax positions in income tax expense. As of December 31, 2016, 2015 and 2014, the Company had accrued $4.1 million, $9.7 million and $8.9 million, respectively, of interest and penalties (net of tax benefits of $1.8 million, $4.1 million and $3.7 million, respectively) related to uncertain tax positions.
The Company, or one of its subsidiaries, files income tax returns in the U.S. federal jurisdiction, various state jurisdictions, and various non-U.S. jurisdictions. The primary non-federal jurisdictions are California, Canada, India and the United Kingdom. During 2016, the Company concluded U.S. federal income tax examinations for calendar years 2005 through 2013. The Company is generally no longer subject to U.S. federal, state and non-U.S. income tax examinations by taxing authorities for years prior to 2005.
The First American Financial Corporation 401(k) Savings Plan (the “Savings Plan”) allows for employee-elective contributions up to the maximum amount as determined by the Internal Revenue Code. The Company makes discretionary contributions to the Savings Plan based on profitability, as well as the contributions of participants. Effective July 1, 2015, participants in the Savings Plan can no longer make additional investments in common stock of the Company. The Savings Plan held 2,695,000 shares and 3,129,000 shares of the Company’s common stock, representing 2.5% and 2.9% of the Company’s total common shares outstanding at December 31, 2016 and 2015, respectively.
The Company maintains a deferred compensation plan for certain employees that allows participants to defer up to 100% of their salary, commissions and certain bonuses. Participants can allocate their deferrals among a variety of investment crediting options (known as “deemed investments”). The term deemed investments means that the participant has no ownership interest in the funds they select; the funds are only used to measure the gains or losses that will be attributed to each participant’s deferral account over time. Participants can elect to have their deferral balance paid out while they are still employed or after their employment ends. The deferred compensation plan is exempt from most provisions of the Employee Retirement Income Security Act (“ERISA”) because it is only available to a select group of management and highly compensated employees and is not a qualified employee benefit plan. To preserve the tax-deferred savings advantages of a nonqualified deferred compensation plan, federal law requires that it be unfunded or informally funded. Participant deferrals, and any earnings on those deferrals, are general unsecured obligations of the Company. The Company informally funds the deferred compensation plan through a tax-advantaged investment known as variable universal life insurance. Deferred compensation plan assets are held as an asset of the Company within a special trust, called a “Rabbi Trust.” At December 31, 2016 and 2015, the value of the assets in the Rabbi Trust of $78.9 million and $73.1 million, respectively, and the unfunded liabilities of $82.5 million and $76.3 million, respectively, were included in the consolidated balance sheets in other assets and pension costs and other retirement plans, respectively.
In May 2016, the Company’s board of directors terminated the Company’s funded defined benefit pension plan known as the First American Financial Corporation Pension Plan, effective as of July 31, 2016. The pension plan was closed to new entrants effective December 31, 2001 and amended to “freeze” all benefit accruals as of April 30, 2008. Also, in May 2016, a subsidiary of the Company terminated its small regional funded defined benefit pension plan effective as of August 31, 2016. The Company expects the termination of both pension plans to occur over a similar timeframe. Upon completion of these terminations, the Company will have no remaining funded defined benefit pension plan obligations. All financial impacts discussed below reflect the termination of both pension plans.
The pension plans offer participants annuity payments based on a number of factors and, for certain participants, an alternative lump sum distribution option. During 2016, the Company received certain regulatory approvals needed to terminate the pension plans and offered lump sum distributions to certain participants, which were settled by the pension plans in the fourth quarter. The Company made additional cash contributions in 2016 above scheduled amounts of $84.8 million to sufficiently fund the pension plans. The Company will ensure that sufficient funds are available to purchase group annuity contracts from one or more highly rated insurance companies to pay and administer future benefit payments, and complete other transactions required to terminate the pension plans in a manner that fully meets its obligations to all participants. While the Company expects to make an additional cash contribution of approximately $23 million in the first half of 2017, the actual amount will depend upon changes in interest rates, pension plan asset returns and other factors. The Company also expects to pay other termination related expenses.
Certain aspects of the transactions required to terminate the pension plans and settle its obligations are subject to regulatory review.
Net periodic cost related to the Company’s funded defined benefit pension and unfunded supplemental benefit plans includes the following components:
Weighted-average actuarial assumptions used to determine costs for the plans for the years ended December 31, 2016 and 2015, were as follows:
The discount rate assumption used for the Company’s benefit plans reflects the yield available on high-quality, fixed-income debt securities that match the expected timing of the benefit obligation payments.
Assumptions for the expected long-term rate of return on assets of the funded defined benefit pension plans are based on future expectations for returns for each asset class based on the calculated market-related value of plan assets and the effect of periodic target asset allocation rebalancing, adjusted for the payment of reasonable expenses of the plan from plan assets. The expected long-term rate of return on assets was selected from within a reasonable range of rates determined by (1) historical actual and expected returns for the asset classes and (2) projections of inflation over the long-term period during which benefits are payable to plan participants. The Company believes the assumptions are appropriate based on the investment mix and long-term nature of the plan’s investments. The use of expected long-term returns on plan assets may result in recognized pension income that is greater or less than the actual returns of those plan assets in any given year. Over time, however, the expected long-term returns are designed to approximate the actual long-term returns, and therefore result in a pattern of income and cost recognition that more closely matches the pattern of the services provided by the employees.
A summary of the asset allocations for the funded defined benefit pension plans is as follows:
The following table presents the fair value of plan assets as of December 31, 2016 and 2015:
(b) Investments in a guaranteed deposit fund with holdings in insurance contracts. These investments are valued at contract value of the fund including contributions and earnings, less applicable costs and liabilities, as provided by the administrator of the fund.
The Company categorizes its assets and liabilities carried at fair value using a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the Company (observable inputs) and the Company’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The hierarchy for inputs used in determining fair value maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. The hierarchy level assigned to the assets and liabilities is based on management’s assessment of the transparency and reliability of the inputs used to estimate the fair values at the measurement date. The three hierarchy levels are defined as follows:
The following tables present a summary of the changes in the fair values of Level 3 assets measured on a recurring basis for the years ended December 31, 2016 and 2015:
The First American Financial Corporation 2010 Incentive Compensation Plan (the “Incentive Compensation Plan”), effective May 28, 2010, permits the granting of stock options, stock appreciation rights, restricted stock, RSUs, performance units, performance shares and other stock-based awards. Eligible participants in the Incentive Compensation Plan include the Company’s directors and officers, as well as other employees. At December 31, 2016, 4.2 million shares of common stock remain available to be issued from either authorized and unissued shares or previously issued shares acquired by the Company, subject to certain annual limits based on the type of award granted. The Incentive Compensation Plan terminates 10 years from the effective date unless cancelled prior to that date by the Company’s board of directors.
As of December 31, 2016, there was $26.8 million of total unrecognized compensation cost related to unvested RSUs that is expected to be recognized over a weighted-average period of 2.3 years. The fair value of RSUs is generally based on the market value of the Company’s shares on the date of grant. The total fair value of shares vested and not distributed for the years ended December 31, 2016, 2015 and 2014 was $25.9 million, $20.3 million and $18.2 million, respectively.
No stock options were exercised during the year ended December 31, 2016. The total intrinsic value of stock options exercised for the years ended December 31, 2015 and 2014 was $9.7 million and $7.0 million, respectively. Intrinsic value represents the difference between the fair market value of the Company’s common stock on the date of exercise and the exercise price of each option.
The following table presents a summary of the changes in each component of AOCI for the years ended December 31, 2016, 2015 and 2014:
Future minimum rental payments under operating leases that have initial noncancelable lease terms in excess of one year as of December 31, 2016 are as follows:
The Company also guarantees the obligations of certain of its subsidiaries. These obligations are included in the Company’s consolidated balance sheets as of December 31, 2016 and 2015.
Cruz v. First American Financial Corporation, et al., filed on November 25, 2015 and pending in the Superior Court of the State of California, County of Orange,
Weber v. Interthinx, Inc., et al., filed on April 17, 2015 and pending in the United States District Court for the Eastern District of Missouri.
overcharged or improperly charged fees for products and services, conspired to fix prices, participated in the conveyance of illusory property interests, denied home warranty claims, and gave items of value to builders, brokers and others as inducements to refer business in violation of certain laws, such as consumer protection laws and laws generally prohibiting unfair business practices, and certain obligations, including
Downing v. First American Title Insurance Company, et al., filed on July 26, 2016 and pending in the United States District Court for the Northern District of Georgia,
Kaufman v. First American Financial Corporation, et al., filed on December 21, 2007 and pending in the Superior Court of the State of California, County of Los Angeles,
McCormick v. First American Real Estate Services, Inc., et al., filed on December 31, 2015 and pending in the Superior Court of the State of California, County of Orange,
Income before income taxes and equity in undistributed earnings of subsidiaries