- Management’s Discussion and Analysis of Financial Condition and Results of Operations.
We paid off $54.8 million in bank debt during 2009 and refinanced remaining bank debt that could have been called at any time by the banks. This debt restructure was accomplished by issuing $65.0 million in senior convertible notes, which also had the effect of extending the maturity of the debt to October 15, 2014 if not earlier converted into shares of our Common Stock. Our market share in title insurance continued to increase during 2009. Our combined real estate information services returned to profitability for 2009 marking a substantial improvement from 2008. We continued refining our agency network through the addition of higher quality, better performing agents and the cancelation of underperforming agents to grow revenue and reduce risk.
Initiatives to lower our mid-office cost structure and improve productivity remain on track as we expanded utilization of Regional Production Centers (RPC) during 2009. In December, approximately 47% of our direct title order volume was processed by RPCs, with significant savings being realized on a cost-per-file basis. We expect to continue expanding utilization of these centers during 2010.
We believe the real estate market will remain challenging in 2010, and that while sales of both new and existing homes will likely improve compared to 2009, residential refinance volumes are forecast to decline. Commercial sales and refinance activity are expected to improve in 2010 compared to 2009, although much of that improvement is likely to be distressed driven.
Provisions for title losses, as a percentage of title operating revenues, were 11.3%, 11.2% and 8.5% for the years ended December 31, 2009, 2008 and 2007, respectively. Actual loss payment experience, including the impact of large losses, is the primary reason for increases or decreases in our loss provision. A change of 100 basis points in this percentage, a reasonably likely scenario based on our historical loss experience, would have increased or decreased our provision for title losses and pretax operating results approximately $16.2 million for the year ended December 31, 2009.
Our method for recording the reserves for title losses on both an interim and annual basis begins with the calculation of our current loss provision rate, which is applied to our current premiums resulting in a title loss expense for the period. This loss provision rate is set to provide for losses on current year policies and is determined using moving average ratios of recent actual policy loss payment experience (net of recoveries) to premium revenues.
At each quarter end, our recorded reserve for title losses begins with the prior period’s reserve balance for claim losses, adds the current period provision to that balance and subtracts actual paid claims, resulting in an amount that our management compares to its actuarially-based calculation of the ending reserve balance to provide for future title losses. The actuarially-based calculation is a paid loss development calculation where loss development factors are selected based on company data and input from our third-party actuaries. We also obtain input from third-party actuaries in the form of a reserve analysis utilizing generally accepted actuarial methods. While we are responsible for determining our loss reserves, we utilize this actuarial input to assess the overall reasonableness of our reserve estimation. If our recorded reserve amount is within a reasonable range (+/- 3.1%) of our actuarially-based reserve calculation and the actuary’s point estimate, but not at the point estimate, our management assesses the major factors contributing to the different reserve estimates in order to determine the overall reasonableness of our recorded reserve, as well as the position of the recorded reserves relative to the point estimate and the estimated range of reserves. The major factors considered can change from period to period and include items such as current trends in the real estate industry (which management can assess although there is a time lag in the development of this data for use by the actuary), the size and types of claims reported and changes in our claims management process. If the recorded amount is not within a reasonable range of our third-party actuary’s point estimate, we will adjust the recorded reserves in the current period and reassess the provision rate on a prospective basis. Once our reserve for title losses is recorded, it is reduced in future periods as a result of claims payments and may be increased or reduced by revisions to our estimate of the overall level of required reserves.
Large claims (those exceeding $1.0 million on a single claim), including large title losses due to independent agency defalcations, are analyzed and reserved for separately due to the higher dollar amount of loss, lower volume of claims reported and sporadic reporting of such claims. Large title losses due to independent agency defalcations typically occur when the independent agency misappropriates funds from escrow accounts under its control. Such losses are usually discovered when the independent agency fails to pay off an outstanding mortgage loan at closing (or immediately thereafter) from the proceeds of the new loan. Once the previous lender determines that its loan has not been paid off timely, it will file a claim against the title insurer. It is at this point that the title insurance underwriter is alerted to the potential theft and begins its investigation. As is industry practice, these claims are considered a claim on the newly issued title insurance policy since such policy insures the holder (in this case, the new lender) that all previous liens on the property have been satisfied. Accordingly, these claim payments are charged to policy loss expense. These incurred losses are typically more severe in terms of dollar value compared with traditional title policy claims because the independent agency is often able over time to conceal misappropriation of escrow funds relating to more than one transaction through the constant volume of funds moving through its escrow accounts. As long as new funds continue to flow into escrow accounts, an independent agent can mask one or more defalcations. In declining real estate markets, lower transaction volumes result in a lower incoming volume of funds, making it more difficult to cover up the misappropriation with incoming funds. Thus, when the defalcation is discovered, it often relates to several transactions. In addition, the overall decline in an independent agency’s revenues, profits and cash flows increases the agency’s incentive to improperly utilize the escrow funds from real estate transactions.
Internal controls relating to independent agencies include, but are not limited to, pre-signing and periodic audits, site visits and reconciliations of policy inventories and premiums. The audits and site visits cover examination of the escrow account bank reconciliations and an examination of a sample of closed transactions. In some instances, we are limited in our scope by attorney agents who cite client confidentiality. Certain states have mandated a requirement for annual reviews of all agents by their underwriter. We also determine whether our independent agencies have appropriate internal controls as defined by the American Land Title Association and Stewart. However, even with adequate internal controls in place, their effectiveness can be circumvented by collusion or improper management override at the independent agencies. To aid in the selection of agencies to review, Stewart has developed an agency risk model that aggregates data from different areas to identify possible problems. This is not a guarantee that all agencies with deficiencies will be identified. In addition, we are typically not the only underwriter for which an independent agency issues policies, and agencies may not always provide complete financial records for our review.
Our accruals for revenues on unreported policies from agencies were not material to our consolidated assets or stockholders’ equity at December 31, 2009 and 2008. The differences between the amounts our agencies have subsequently reported to us compared to our estimated accruals are substantially offset by any differences arising from prior years’ accruals and have been immaterial to consolidated assets and stockholders’ equity during each of the three prior years. We believe our process provides the most reliable estimate of the unreported revenues on policies and appropriately reflects the trends in agency policy activity.
Our evaluation of goodwill is normally completed annually in the third quarter using June 30 balances, but an evaluation may also be made whenever events may indicate impairment. This evaluation is based on a combination of a discounted cash flow analysis (DCF) and market approaches that incorporate market multiples of comparable companies and our own market capitalization. The DCF model utilizes historical and projected operating results and cash flows, initially driven by estimates of changes in future revenue levels, and risk-adjusted discount rates. Our projected operating results are primarily driven by anticipated mortgage originations, which we obtain from projections by industry experts. Fluctuations in revenues, followed by our ability to appropriately adjust our employee count and other operating expenses, are the primary reasons for increases or decreases in our projected operating results. Our market-based valuation methodologies utilize (i) market multiples of earnings and/or other operating metrics of comparable companies and (ii) our market capitalization and a control premium based on market data and factors specific to our ownership and corporate governance structure. To the extent that our future operating results are below our projections, or in the event of continued adverse market conditions, an interim review for impairment may be required, which may result in an impairment of goodwill.
Operations. Our business has two main operating segments: title insurance-related services and real estate information (REI). These segments are closely related due to the nature of their operations and common customers.
Our primary business is title insurance and settlement-related services. We close transactions and issue title policies on homes and commercial and other real properties located in all 50 states, the District of Columbia and international markets through policy-issuing offices and agencies. We also provide post-closing lender services, loan modification services, loan default services, automated county clerk land records, property ownership mapping, geographic information systems, property information reports, document preparation, background checks and expertise in Internal Revenue Code Section 1031 tax-deferred property exchanges.
Trends and order counts. For the three years ended December 31, 2009, mortgage interest rates (30-year, fixed-rate) have fluctuated from a monthly high of 6.7% in July 2007 to a monthly low of 4.8% in April 2009. In 2009, mortgage originations increased 25.1% primarily due to low interest rates, which caused refinancing originations to increase 30.6% during the same period. Although interest rates were also low in 2008, the effects of the collapsed subprime mortgage lending market and limited availability of credit caused mortgage originations to decrease 32.8% in 2008. During 2009, sales of new homes decreased 24.5%, while sales of existing homes increased 5.1%. In 2008, sales of new and existing homes decreased 37.2% and 13.1%, respectively.
We are subject to administrative actions and litigation relating to the basis on which premium taxes are paid in certain states. Additionally, we have received various other inquiries from governmental regulators concerning practices in the insurance industry. Many of these practices do not concern title insurance and we do not anticipate that the outcome of these inquiries will materially affect our consolidated financial condition or results of operations.
We are also subject to various other administrative actions and inquiries into our conduct of business in certain of the states in which we operate. While we cannot predict the outcome of the various regulatory and administrative matters, we believe that we have adequately reserved for these matters referenced above and that any outcome will not materially affect our consolidated financial condition or results of operations.
In January 2009, an action was filed by individuals against Stewart Title Guaranty Company, Stewart Title of California, Inc., Cuesta Title Company and others in the Superior Court of California for the County of San Luis Obispo alleging that the plaintiffs have suffered damages relating to loans they made through Hurst Financial Corporation to an individual named Kelly Gearhart and entities controlled by Gearhart. Gearhart and Hurst have filed for bankruptcy. Thereafter, several other lawsuits, including a lawsuit filed by several hundred individuals, were filed in San Luis Obispo Superior Court making similar allegations. The defendants vary from case to case, but Stewart Information Services Corporation, Stewart Title of California and Stewart Title Insurance Company have also been sued in some or all of the cases. Each of the complaints alleges some combination of the following purported causes of action: breach of contract, negligence, fraud, aiding and abetting fraud, breach of fiduciary duty, breach of implied covenant of good faith and fair dealing, financial elder abuse, violation of California Business and Professions Code Section 17200, conversion, conspiracy, alter ego and declaratory relief. We have demurred to the complaints in the actions where its responses to the complaints have been due, and the Court has sustained our demurrers while granting plaintiffs leave to amend. We intend to vigorously defend ourselves against the allegations. We do not believe that the outcome of these matters will materially affect our consolidated financial condition or results of operations.
A comparison of our results of operations for 2009 with 2008 and 2008 with 2007 follows. Factors contributing to fluctuations in results of operations are presented in the order of their monetary significance and we have quantified, when necessary, significant changes. Results from our REI segment are included in year-to-year discussions as those amounts are immaterial in relation to consolidated totals. When relevant, we have discussed our REI segment’s results separately.
Direct orders closed increased 9.3% in 2009, although the average revenue per closing decreased 12.6% in 2009. The increase in direct orders closed and decrease in average revenue per closing continue to be driven by a shift in the mix of orders, with the year ended December 31, 2009 experiencing fewer large commercial closings, lower home prices and many more residential refinancing closings than in 2008. On average, title insurance premium rates for refinancings are 60% of the title premium revenue of a similarly priced sale transaction. The number of direct closings, excluding large commercial policies, increased 2.0% in 2009 and decreased 24.6% in 2008. The average revenue per closing, excluding large commercial policies, decreased 6.6% in 2009 and was unchanged in 2008.
Revenues from independent agencies increased $142.3 million, or 17.7%, in 2009 and decreased $237.5 million, or 22.8%, in 2008. The increase in 2009 is largely due to the addition of new higher-remitting, lower-risk agencies, as well as significant increases in revenues from existing agencies, primarily in certain real estate markets which experienced an increase in transaction volumes. In 2009, the largest increases in revenues from agencies were in California, Pennsylvania, Michigan and New Jersey, partially offset by decreases in Florida and Texas. The decrease in 2008 was primarily due to the impact of a combined reduction in home sales and prices in most markets and the overall decline in business related to market conditions. The largest decreases in revenues from agencies in 2008 were in Florida, New York, Pennsylvania, Virginia, Georgia and California.
Investment income. Investment income decreased $8.3 million, or 28.5%, and $6.9 million, or 19.2%, in 2009 and 2008, respectively. The decrease in 2009 was primarily due to decreases in the average invested balances and, to a lesser extent, decreases in yields. The decrease in 2008 was primarily due to decreases in average invested balances and yields.
Included in investment and other gains (losses) - net in the consolidated statements of operations, retained earnings and comprehensive earnings for the year ended December 31, 2007 was a $5.6 million gain from the sale of real estate. The real estate was owned by one of our consolidated subsidiaries, which has shareholders with significant noncontrolling interests.
Employee costs. Our employee costs and certain other operating expenses are sensitive to inflation. Employee costs for the combined business segments decreased $72.3 million, or 13.1%, in 2009 and $135.3 million, or 19.6%, in 2008. The number of persons we employed at December 31, 2009, 2008 and 2007 was approximately 6,100, 6,300 and 8,500, respectively.
Other operating expenses. Other operating expenses for the combined business segments decreased $75.1 million, or 20.6%, and $45.3 million, or 11.0%, in 2009 and 2008, respectively. The decrease in 2009 was primarily due to lower business promotion costs, rent and other occupancy expenses, litigation, certain REI expenses, insurance, premium taxes, travel, technology costs, bad debt expenses, delivery fees, auto and airplane expenses, telephone, professional fees, general supplies and copy supplies. Other operating expenses were favorably impacted in 2009 by credits of $5.9 million relating to the reversal of an accrual for a legal matter resolved in our favor and a change in estimate for another legal matter. The decreases in other operating expenses were due to closing of offices, reduction in discretionary expenditures, implementation of title search and production efficiencies company-wide through our regional production center initiative and the benefits from our back-office centralization initiatives in the areas of human resources, finance and accounting, procurement and information technology.
In 2008, acquisitions increased other operating expenses approximately $1.4 million. The remaining fluctuation in other operating expenses in 2008 resulted from decreases in our outside search fees, business promotions, rent and other occupancy costs, technology costs and certain REI expenses, partially offset by increases in litigation, insurance and bad debts.
Other operating expenses also include title plant expenses, repairs and maintenance, attorney fees, equipment rental, postage and title plant rent. Many of our operating expenses are fixed in nature, although some follow, to varying degrees, the changes in transaction volume and revenues.
Title loss provisions in 2007 included $33.4 million for large title claims, primarily related to independent agency defalcations and an adjustment to reserves of $5.0 million related to claims that may have been incurred but not yet reported to us, which resulted from the increase in the frequency of large claims. In addition, we recorded a reserve increase of $7.5 million related to higher than expected loss payment experience for policy years 2004 through 2006. As a result of this policy loss experience, we also increased our provision for year 2007 policies by approximately $8.2 million.
Our effective tax rate in 2008 was significantly impacted by a valuation allowance of $90.0 million against our deferred tax assets. The valuation allowance was established in accordance with current accounting standards due to the Company’s cumulative three-year operating losses.
Material contractual obligations consist primarily of notes payable, convertible senior notes, operating leases and estimated title losses. The timing above for payments of notes payable is based upon the contractually stated payment terms of each debt agreement. The convertible senior notes will mature in 2014 unless converted earlier.
Our principal sources of cash from operations are premiums on title policies, title service-related receipts and loan modification services. Our independent agencies remit cash to us net of their contractual retention. Our principal cash expenditures for operations are employee costs, operating costs and title claims payments.
Our improved cash flow from operations in 2009 was primarily due to the increase in revenues compared to 2008 and reductions in employee costs and other operating expenses, partially offset by an increase in claims payments.
Our business continues to be labor intensive, although we have made significant progress in automating our services. We have centralized order processing into Regional Production Centers, which allows us to more easily adjust staffing levels as order volumes fluctuate. This centralizing effort continues. There are time lags between changes in market conditions and staffing levels; therefore, employee costs do not change at the same rate as revenues change. Further, we incur costs based on total orders received, while our revenues are earned based on orders actually closed. A decline in closing ratios from historical trends will have an adverse impact on operating results and, consequently, on cash flows. We reduced our number of employees by approximately 200 and 2,200 during 2009 and 2008, respectively.
Capital expenditures were $11.0 million, $18.0 million, and $31.4 million in 2009, 2008, and 2007, respectively. Capital expenditures declined significantly from prior year levels since almost no new offices were opened in 2009 or 2008 due to poor economic conditions and we sharply curtailed spending in all other areas. We expect that capital expenditures will continue at the 2009 level as we continue to aggressively manage cash flow. We have no material commitments for capital expenditures.
During 2008, we purchased $241.5 million of investments from our exchanger funds (See Note 10 to consolidated financial statements). To fund these purchases, we drew $241.5 million under the related line of credit and pledged the investments to secure the line. Under the terms of the line of credit and related settlement agreement, we expect to repay it by June 30, 2010 by surrendering the related investments - pledged. Prior to June 30, 2010, any redemptions by the issuers of the investments owned by us would be utilized to reduce the line of credit. During 2009, issuers of the investments redeemed $24.3 million, reducing the principal amount of investments. The related line of credit was reduced by the proceeds from the investments redeemed and excess interest earned aggregating $25.0 million, which is included in cash flows from financing activities.
During 2007, we acquired $9.5 million of our common shares under a Board of Directors’ approved stock repurchase program. No such purchases were made in 2009 or 2008, or are anticipated for 2010.
Throughout 2009, we worked to increase title premium rates charged or modify agency splits. As of year-end, we had taken action to increase rates, after appropriate state regulatory review where required, in 23 states, and had completed rate hearings in other states. In addition, we had renegotiated agency splits with many of our independent agents, increasing the amount of premium retained by our underwriter. We anticipate improved operating results, and thus cash flow, in 2010 from the full year impact of these actions and will continue to seek rate increases or modify agency splits where possible.
Also positively impacting future revenues and cash flow is our increasing market share. Based on statistics published by the American Land Title Association, the market share of our family of underwriters increased from 11.8% for all of 2007 to 14.7% for the third quarter of 2009 (latest data available), an increase of over 25% in only 21 months.
Other-than-temporary impairments of investments. We recorded an other-than-temporary impairment of $1.3 million and $4.7 million in 2009 and 2008, respectively, relating to equity securities held for investment. For the year ended December 31, 2007, we did not record material other-than-temporary impairments of our investments.
Off-balance sheet arrangements. We do not have any material source of liquidity or financing that involves off-balance sheet arrangements, other than our contractual obligations under operating leases. We also routinely hold funds in segregated escrow accounts pending the closing of real estate transactions and have qualified intermediaries in tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code. The Company holds the proceeds from these transactions until a qualifying exchange can occur. See Note 18 to our accompanying consolidated financial statements.