primarily 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, in recent years, interest rate adjustments by the Federal Reserve Board, as well as other economic factors, have caused unusual fluctuations in the traditional pattern of real estate activity. During 1994 the Federal Reserve Board raised interest rates. This, coupled with the persistently poor real estate economy in California and the effects 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. However, the cost-cutting measures lagged the revenue declines, resulting in losses for the first quarter 1995. Mortgage interest rates peaked in January 1995 and decreased throughout the remainder of the year and into 1996. This decrease, as well as increased consumer confidence, contributed significantly to an improved national real estate economy during the second half of 1995, and resulted in a 26% improvement in operating revenues when compared to the first half of 1995. This resurgence in real estate activity generated a high inventory of open transactions going into 1996, which, together with the continuation of lower mortgage interest rates, the improved national real estate economy (including the beginnings of a recovery in California) and the Company's successful integration of its diverse businesses, resulted in strong revenues and profits for 1996. These favorable conditions continued into 1997, contributing to record-setting residential resale transactions, an increase in new home sales and renewed commercial activity. In addition, stability in the marketplace prompted an increase in refinance and home equity transactions, primarily towards the latter part of the year. These factors, as well as market share increases in all of the Company's primary business segments, culminated in 1997 being the best year overall in the Company's history.
Real estate information operating revenues increased 34.3% in 1997 over 1996 and 69.3% in 1996 over 1995. These increases were primarily attributable to the same factors affecting title insurance mentioned above and $53.8 million and $11.3 million of operating revenues contributed by new acquisitions in 1997 and 1996, respectively.
SALARIES AND OTHER PERSONNEL COSTS--A summary by segment of the Company's salaries and other personnel costs is as follows:
Real estate information personnel expenses increased 32.4% in 1997 over 1996 and 56.8% in 1996 over 1995. These increases were primarily attributable to costs incurred servicing the increase in business volume, costs associated with in-house development of new electronic communications delivery systems for information-based products, and approximately $20.7 million and $8.6 million of costs attributable to company acquisitions for 1997 and 1996, respectively.
Home warranty personnel expenses increased 26.0% in 1997 over 1996 and 17.6% in 1996 over 1995. These increases were primarily due to the additional personnel required to service the increased business volume in the states this segment currently services, as well as new geographic expansion and modest salary increases.
OTHER OPERATING EXPENSES--A summary by segment of the Company's other operating expenses is as follows:
Real estate information other operating expenses increased 56.7% in 1997 over 1996 and 53.3% in 1996 over 1995. These increases were primarily attributable to costs incurred servicing the increased business activity, as well as $33.5 million and $7.0 million of other operating costs relating to acquisitions in 1997 and 1996, respectively, offset in part by cost- containment programs. Contributing to the increases were costs incurred developing and enhancing new electronic communications delivery systems for information-based products and costs associated with assimilating and expanding this segment's increased operations.
The provision for title insurance losses expressed as a percentage of title insurance operating revenues was 3.6% in 1997, 4.6% in 1996, and 6.6% in 1995. These decreases reflect an ongoing improvement in the Company's claims experience. The provision for home warranty losses as a percentage of home warranty operating revenues was 58.3% in 1997, 60.1% in 1996 and 58.0% in 1995. These fluctuations were primarily attributable to the relative changes in the average number of claims per contract experienced during these periods.
Interest--Interest expense increased 108.4% in 1997 over 1996 and decreased 23.2% in 1996 when compared with 1995. The increase in 1997 was primarily due to $5.7 million of interest expense related to the Company's junior subordinated deferrable interest debentures, offset in part by a 23.7% reduction in the average outstanding debt balance. The decrease in 1996 was primarily attributable to a 13.5% reduction in the average outstanding debt balance and a reduced interest rate option on the Company's variable rate indebtedness. For descriptions of the Company's borrowings under its bank credit agreement and its junior subordinated deferrable interest debentures, see Notes 8 and 13 to the consolidated financial statements, respectively.
The increases in corporate expenses were primarily attributable to increased costs associated with supporting the overall growth of the Company's businesses, as well as additional unallocated interest expense for 1997 associated with the Company's junior subordinated deferrable interest debentures, and certain unallocated expenses in 1996 associated with employee benefit plans.
Cash provided by operating activities amounted to $111.2 million, $112.8 million and $38.5 million for 1997, 1996 and 1995, respectively, after claim payments of $81.6 million, $78.0 million, $66.6 million, respectively. The principal non-operating uses of cash and cash equivalents for the three-year period ended December 31, 1997, were for additions to the investment portfolio, capital expenditures, company acquisitions and the repayment of debt. The most significant nonoperating sources of cash and cash equivalents were proceeds from the sales and maturities of certain investments and, in 1997, proceeds from the issuance of junior subordinated deferrable interest debentures. The net effect of all activities on total cash and cash equivalents were increases of $8.1 million and $27.5 million for 1997 and 1996, respectively, and a decrease of $8.3 million for 1995.
Notes and contracts payable as a percentage of total capitalization as of December 31, 1997, was 7.3% as compared with 16.0% as of the prior year end. The decrease was primarily attributable to an increase in the capital base due to the issuance of junior subordinated deferrable interest debentures, net income for the year, as well as a net decrease in debt. The Company maintains a $75.0 million revolving line of credit which remained unused as of December 31, 1997. Notes and contracts payable are more fully described in Note 8 to the consolidated financial statements.
Pursuant to various insurance and other regulations, the maximum amount of dividends, loans and advances available to the Company in 1998 from its principal subsidiary, First American Title Insurance Company, is $52.1 million. Such restrictions have not had, nor are they expected to have, an impact on the Company's ability to meet its cash obligations.
The Company is evaluating the Year 2000 issue as it relates to its internal computer systems and third party computer systems with which the Company interacts. The Company expects to incur internal staff costs as well as consulting and other expenses related to this issue; these costs will be expensed as incurred. At this time the Company is unable to reasonably estimate the total costs for this issue.
The First American Financial Corporation ("the Company"), through its subsidiaries, is engaged in the business of providing real estate-related financial and information services to real property buyers and mortgage lenders. These services include title insurance, tax monitoring, credit reporting, property data services, flood certification, field inspection services, appraisal services, mortgage loan servicing systems, mortgage document preparation and home warranties. The Company also provides investment, trust and thrift services.
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 1995 and 1996 amounts have been reclassified to conform with the 1997 presentation.
Equity securities are carried at fair value and consist primarily of investments in marketable common stocks of corporate entities in which the Company's ownership does not exceed 20%.
Deferred policy acquisition costs are directly related to the procurement of tax service and home warranty contracts. These costs are deferred and amortized to expense in the same manner as contract fees are recognized as revenues.
Revenues from tax service contracts are recognized over the estimated duration of the contracts as the related servicing costs are estimated to occur.
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share." SFAS No. 128 became effective for 1997 and requires the presentation of basic and diluted earnings per share on the face of the income statement. Basic earnings per share are computed by dividing net income available to common stockholders by the weighted-average number of
Real estate activity is cyclical in nature and is affected greatly by the cost and availability of long-term mortgage funds. Real estate activity and, in turn, the Company's revenue base, can be adversely affected during periods of high interest rates and/or limited money supply.
Pursuant to insurance and other regulations of the various states in which the Company's title insurance subsidiary, First American Title Insurance Company (FATICO), operates, the amount of dividends, loans and advances available to the parent company from FATICO is limited, principally for the protection of policyholders. Under such statutory regulations, the maximum amount of dividends, loans and advances available to the parent company from FATICO in 1998 is $52.1 million. Investments carried at $16.5 million were on deposit with state treasurers in accordance with statutory requirements for the protection of policyholders at December 31, 1997. FATICO maintained statutory capital and surplus of $210.3 million and $208.3 million at December 31, 1997 and 1996, respectively. Statutory net income for the years ended December 31, 1997, 1996 and 1995 was $35.9 million, $34.6 million and $11.4 million, respectively.
The fair value of loans receivable was $64.2 million and $54.3 million at December 31, 1997 and 1996, respectively, and was estimated based on the discounted value of the future cash flows using the current rates being offered for loans with similar terms to borrowers of similar credit quality.
The above amounts are net of valuation reserves of $11.1 million and $10.3 million at December 31, 1997 and 1996, respectively.
The fair value of notes receivable was $12.5 million and $10.1 million at December 31, 1997 and 1996, respectively, and was estimated based on the discounted value of the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit quality.
In April 1997, the Company paid off the variable rate indebtedness portion of the amended credit agreement with proceeds received from its junior subordinated interest debentures (see Note 13).
At December 31, 1997, the Company's remaining borrowings under its amended bank credit agreement consisted of fixed rate indebtedness of $5.3 million, maturing in April 1999 and bearing interest at 9.38% per annum.
Pursuant to the terms of the credit agreement, the Company is required to maintain minimum levels of capital and earnings and meet predetermined debt to capitalization ratios.
The aggregate annual maturities for notes and contracts payable in each of the five years after December 31, 1997, are as follows (in thousands):
The Company has pension and other retirement benefit plans covering substantially all employees. The Company's principal pension plan, amended to be noncontributory effective January 1, 1995, is a qualified defined benefit plan with benefits based on the employee's years of service and the highest five consecutive years' compensation during the last ten years of employment. The Company's policy is to fund all accrued pension costs. Contributions are intended to provide not only for benefits attributable to past service, but also for those benefits expected to be earned in the future. The Company also has nonqualified unfunded supplemental benefit plans covering certain key management personnel. Benefits under these plans are intended to be funded with proceeds from life insurance policies purchased by the Company on the lives of the executives.
The rate of increase in future compensation levels for the plans of 4 1/2% and the weighted average discount rates of 7 1/4% and 7 3/4% were used in determining the actuarial present value of the projected benefit obligation at December 31, 1997 and 1996, respectively. The majority of pension plan assets are invested in U.S. government securities, time deposits and common stocks with projected long-term rates of return of 9%.
The Company's principal profit sharing plan was amended effective January 1, 1995, to discontinue future contributions. The plans holds 2,192,000 and 2,391,000 shares of the Company's common stock, representing 13% and 14% of the total shares outstanding at December 31, 1997, and 1996 respectively.
The Company also has a Stock Bonus Plan for key employees pursuant to which 86,000, 75,000 and 98,000 common shares were awarded for 1997, 1996 and 1995, respectively, resulting in a charge to operations of $2.2 million, $1.3 million and $1.2 million, respectively. The Plan, as amended December 9, 1992, provides that a total of up to 450,000 common shares may be awarded in any one year.
The fair value of each option grant is estimated at the grant date using the Black-Scholes option-pricing method with the following weighted-average assumptions used for grants in 1997 and 1996, respectively: dividend yield of 1.2% and 1.9%; expected volatility of 38.1% and 41.0%; risk-free interest rate of 6.3% and 6.5%; and expected life of six years. The weighted-average fair value of options granted during 1997 and 1996 was $12.79 and $6.57, respectively.
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 1994, the Company entered into a sale-leaseback agreement with regard to certain furniture and equipment. Under the agreement, the Company 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, 1997, are as follows (in thousands):
On April 22, 1997, the Company issued and sold $100.0 million of 8.5% trust preferred securities, due in 2012, through its wholly owned subsidiary, First American Capital Trust I. In connection with the subsidiary's issuance of the preferred securities, the Company issued to the subsidiary trust 8.5% subordinated interest notes, due 2012. The sole assets of the subsidiary are and will be the subordinated interest notes. The Company's obligations under the subordinated interest notes and related agreements, taken together, constitute a full and unconditional guarantee by the Company of the subsidiary's obligations under the preferred securities. Distributions payable on the securities are included as interest expense in the Company's consolidated income statement.
Each Right will entitle its holder to purchase, at the Right's then-current exercise price, preferred share fractions (or other securities of the Company) having a value of twice the Right's exercise price. This amounts to the right to buy preferred share fractions of the Company at half price. Rights owned by the party triggering the exercise of Rights will be void and therefore will not be exercisable.
On January 15, 1998, the Company distributed a 3-for-2 common stock split in the form of a 50% stock dividend. This resulted in an increase of 5,791,492 common shares outstanding with the par value of these additional shares being capitalized by a transfer from additional paid-in capital to the common stock account. This stock split has been reflected in the consolidated statements of stockholders' equity on a retroactive basis as of December 31, 1994. In order to effect the stock split, the Company increased its authorized shares from 24,000,000 to 36,000,000. All references in the consolidated financial statements with regards to common stock, additional paid-in capital, number of shares of common stock and per share amounts have been restated to reflect the stock split.
On January 1, 1998, the Company formed a limited liability corporation ("LLC") with Experian Group ("Experian"). The purpose of the LLC is to combine certain operations of the Company's subsidiary, First American Real Estate Information Services, Inc., with Experian's Real Estate Solutions division ("RES"). The LLC is 80% owned by the Company and 20% owned by Experian. RES is a supplier of core real estate data, providing, among other things, property valuation information, title insurance, tax information and imaged title documents.
This business combination has been accounted for under the purchase method of accounting and, accordingly, the purchase price will be allocated to the assets acquired and liabilities assumed based on the estimated fair values at January 1, 1998. In addition, as a result of the transaction, the Company will recognize a pretax gain of $33.0 million in the first quarter 1998. The operating results of the LLC will be included in the Company's consolidated financial statements commencing January 1, 1998.
The Company's operations include four reportable segments: title insurance, real estate information, home warranty and trust and banking. The title insurance segment issues policies which are insured statements of the condition of title to real property. The real estate information segment provides to lender customers the status of tax payments on real property securing their loans, credit information derived from at least two credit bureau sources, flood zone determination reports which provide information on whether or not a property is in a special flood hazard area, as well as other real estate-related information services. The home warranty segment issues one-year warranties which protect homeowners against defects in home fixtures. The trust and banking segment provides full-service trust and depository services, accepts deposits and makes real estate secured loans.
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement is effective for 1998 and requires certain information about a company's operating segments and products and services. The Company believes that the adoption of SFAS No. 131 will not materially alter its segment disclosures and related information.
Corporate consists primarily of unallocated interest expense, minority interest, equity in earnings of affiliated companies and personnel and other operating expenses associated with the Company's home office facilities.
- -------- Note A--Amount represents accounts written off, net of recoveries. Note B--Amount represents $45,000 in purchase accounting adjustments, net of a reclassification of $4,678,000 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.
SCHEDULE V 3 OF 3 THE FIRST AMERICAN FINANCIAL CORPORATION AND SUBSIDIARY COMPANIES