This Management’s Discussion and Analysis contains the financial measure adjusted debt to capitalization ratio that is not presented in accordance with generally accepted accounting principles (“GAAP”), as it excludes the effect of secured financings payable. The Company is presenting this non-GAAP financial measure because it provides the Company’s management and readers of this Annual Report on Form 10-K with additional insight into the financial leverage of the Company. The Company does not intend for this non-GAAP financial measure to be a substitute for any GAAP financial information. In this Annual Report on Form 10-K, this non-GAAP financial measure has been presented with, and reconciled to, the most directly comparable GAAP financial measure. Readers of this Annual Report on Form 10-K should use this non-GAAP financial measure only in conjunction with the comparable GAAP financial measure.
The Company’s title insurance and services segment issues title insurance policies on residential and commercial property in the United States and offers similar or related products and services internationally. This segment also provides closing and/or escrow services; accommodates tax-deferred exchanges of real estate; provides products, services and solutions designed to mitigate risk or otherwise facilitate real estate transactions; maintains, manages and provides access to title plant data and records; provides appraisals and other valuation-related products and services; provides lien release, document custodial and default-related products and services; and provides warehouse lending services and banking, trust and wealth management services. The Company, through its principal title insurance subsidiary and such subsidiary’s affiliates, transacts its title insurance business through a network of direct operations and agents. Through this network, the Company issues policies in the 49 states that permit the issuance of title insurance policies, the District of Columbia and certain United States territories. The Company also offers title insurance, closing services and similar or related products and services, either directly or through third parties in other countries, including Canada, the United Kingdom, Australia, South Korea and various other established and emerging markets.
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. In uncertain economic times, such as those currently being experienced as a result of the coronavirus pandemic, an even larger change is more likely. As examples, 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 $134.3 million, and if expected ultimate losses for those same years were to fluctuate by 100 basis points, the resulting impact would be $268.5 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.
The provision for title insurance losses, expressed as a percentage of title insurance premiums and escrow fees, was 5.0% for the year ended December 31, 2020 and 4.0% for the years ended December 31, 2019 and 2018, respectively. The current year rate of 5.0% reflects an ultimate loss rate of 4.5% for the current policy year and a net increase in the loss reserve estimates for prior policy years of 0.5% or $26.2 million.
For further discussion of title provision recorded in 2020, 2019 and 2018, see Results of Operations, page 42.
Fair value of investment portfolio. The Company categorizes the fair values of its debt and equity securities 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 each security in the Company’s investment portfolio was based on management’s assessment of the transparency and reliability of the inputs used to estimate the fair values at the measurement date. See Note 17 Fair Value Measurements to the consolidated financial statements for a more detailed description of the three-level hierarchy and a description for each level.
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 values 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 values. 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 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.
The Company recognized impairment losses, net of reversals, of $3.2 million resulting from credit-related factors during 2020. The Company did not recognize any impairment losses related to its debt securities for 2019 and 2018.
The Company chose to forego qualitative assessments for its title insurance and home warranty reporting units for 2020 and performed quantitative impairment tests. Based on the results of these tests, the Company determined that the fair values for both reporting units exceeded their carrying amounts and, therefore, no additional analysis was required. The results of the Company’s qualitative assessments in 2019 and 2018 for its title insurance and home warranty reporting units supported the conclusion that their fair values were not more likely than not less than their carrying amounts and, therefore, a quantitative impairment test was not considered necessary. As a result of the Company’s annual goodwill impairment assessments for the title insurance and home warranty reporting units, the Company did not record any goodwill impairment losses for 2020, 2019 or 2018.
Impairment of property and equipment. 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. In connection with the Company’s decision in the third quarter of 2020 to sell the property and casualty insurance business, it recognized impairment losses on its software of $17.6 million for 2020. See Note 2 Disposition of the Property and Casualty Insurance Business to the consolidated financial statements for further information on the disposition of the business. Impairment losses on property and equipment for 2019 primarily related to impairments of $6.0 million on internally developed software. Impairment losses on property and equipment for 2018 were insignificant.
Impairment of lease assets. Management recognizes an impairment loss when the carrying amount of a lease asset is not recoverable and exceeds its fair value. The carrying amount is considered not recoverable if it exceeds the sum of the undiscounted future cash flows that are directly associated with, and that are expected to arise as a result of, the use and eventual disposition of the lease asset. An impairment loss is measured as the amount by which the carrying amount of a lease asset exceeds its fair value. Impairment losses related to the Company’s commercial real estate may occur if the Company ceased using all, or a portion of, a leased property while a contractual obligation remains. Impairment losses related to commercial real estate leases were $1.0 million and $7.5 million for 2020 and 2019, respectively. Prior to 2019, operating lease commitments were not recognized as assets on the balance sheet. For further information on the Company’s leasing arrangements see Note 1 Basis of Presentation and Significant Accounting Policies and Note 7 Leases to the consolidated financial statements.
In January 2017, the FASB issued updated guidance intended to simplify how an entity tests goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Under the updated guidance, an entity will perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and will recognize an impairment loss for the amount by which the carrying amount exceeds the reporting unit’s fair value, with the loss recognized limited to the total amount of goodwill allocated to that reporting unit. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019. The adoption of this guidance, effective January 1, 2020, did not have a material impact on the Company’s consolidated financial statements.
In June 2016, the FASB issued updated guidance intended to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The updated guidance replaces the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires the consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019. The adoption of this guidance on a modified-retrospective basis, effective January 1, 2020, did not have a material impact, except for the disclosure requirements, on the Company’s consolidated financial statements. See Note 1 Basis of Presentation and Significant Accounting Policies, Note 4 Debt and Equity Securities and Note 5 Allowance for Credit Losses - Accounts Receivable to the consolidated financial statements for further information on the Company’s credit losses.
The Company’s total revenues for 2020 were $7.1 billion, which reflected an increase of $884.6 million, or 14.3%, when compared with $6.2 billion for 2019. This increase was primarily attributable to increases in direct premiums and escrow fees of $328.3 million, or 12.3%, agent premiums of $386.3 million, or 16.3%, and information and other revenue of $225.5 million, or 28.6%, offset by a decline in investment income of $94.1 million, or 29.8%. The Company’s total revenues for 2020 also included $105.0 million of net realized investment gains compared to $66.4 million for the prior year. The increase in direct premiums and escrow fees attributable to the title insurance and services segment was $301.9 million, or 13.8%. Direct premiums and escrow fees in the title insurance and services segment from domestic residential refinance and residential purchase transactions increased $340.5 million, or 113.2%, and $98.2 million, or 10.4%, respectively, in 2020 when compared to 2019. Direct premiums and escrow fees in the title insurance and services segment from commercial transactions decreased $128.9 million, or 16.8%, when compared to 2019.
According to the Mortgage Bankers Association’s January 20, 2021 Mortgage Finance Forecast (the “MBA Forecast”), residential mortgage originations in the United States (based on the total dollar value of the transactions) increased 58.6% in 2020 when compared with 2019. According to the MBA Forecast, the dollar amount of purchase originations increased 16.2% and refinance originations increased 109.0%. This volume of domestic residential mortgage origination activity contributed to increases in direct premiums and escrow fees for the Company’s direct title operations of 10.4% from domestic residential purchase transactions and 113.2% from domestic refinance transactions in 2020 when compared to 2019.
In addition to the Company’s innovative activities, other participants in the real estate industry are seeking to innovate in ways that could impact the Company’s businesses. These participants include certain of the Company’s sources of business, competitors and ultimate customers. Innovations by these participants may change the demand for the Company’s products and services, the manner in which the Company’s products and services are ordered or fulfilled and the revenue or profitability derived from the products and services. The Company has made and will likely continue to make high-risk, illiquid investments in some of these participants, typically during their early- and growth-stages. If any of these companies do not succeed, the Company could lose and/or be required to impair all or part of its investment in the unsuccessful company. While the risk of failure or impairment for these investments is greater during periods of economic uncertainty, such as that currently being experienced in the United States, the Company is aware of certain circumstances involving one or more of these investments and currently expects that within the next several quarters it will realize a gain on one or more of these investments and those gain(s), either individually or in the aggregate, could be material to the Company’s financial results in any particular period. Whether the Company realizes such future gain(s), and the amount and, consequently, the materiality of such gain(s), is dependent upon a number of factors in addition to the condition of the general economy, including the general availability of capital, the performance of and volatility in the public markets, changes in the condition of the real estate industry, changes in the competitive environment for such participants and changes in the operational and financial performance of such participants. These investments could also facilitate efforts that ultimately disrupt the Company’s business or enable competitors. Accordingly, the Company’s efforts to anticipate and participate in these transformations could require significant additional investment and management attention and may not succeed. Subject to the foregoing, the ultimate degree to which these and other innovations in the real estate industry will impact the Company’s business and results of operations is uncertain.
The coronavirus pandemic and responses to it have created significant volatility, uncertainty and disruption in the broader economy. The extent to which the coronavirus pandemic impacts the Company’s business, operations and financial results will depend on numerous factors that the Company may not be able to accurately predict, including: the duration and scope of the pandemic and restrictions and responses to it; governmental, business and individual actions that have been and continue to be taken in response to the pandemic; the ongoing impact of the pandemic on economic activity and actions taken in response, including the efficacy of governmental relief efforts; the availability and efficacy of vaccines; the effect on participants in real estate transactions and the demand for the Company’s products and services, including as a result of higher unemployment, business closures and economic uncertainty; and the Company’s ability to sell and provide its services and solutions, including as a result of illness, travel restrictions, governmental closure orders and partial or full closures of business and government offices.
Net investment income decreased $83.7 million, or 29.6%, in 2020 from 2019 and increased $59.6 million, or 26.7%, in 2019 from 2018. The decrease in 2020 from 2019 was primarily attributable to lower short-term interest rates, which drove lower income from the Company’s cash and investment portfolio, escrow balances and tax-deferred property exchange business. The increase in 2019 from 2018 was primarily attributable to higher average balances due primarily to strength in the Company’s commercial business and higher short-term interest rates, which drove higher income from the Company’s cash and investment portfolio, tax-deferred property exchange business and escrow balances.
Personnel costs increased $133.1 million, or 7.8%, in 2020 from 2019 and $29.9 million, or 1.8%, in 2019 from 2018. The increase in personnel costs in 2020 from 2019 was primarily attributable to the impact of new acquisitions, which totaled $37.0 million for 2020, and higher incentive compensation, salary, overtime and temporary labor expenses, partially offset by lower employee benefit expense. The increase in incentive compensation expense were due to higher revenue and profitability. The increases in salary expense were due to higher average salaries and higher headcount. The increases in overtime and temporary labor expenses were driven by higher volumes. The decreases in employee benefit expense were primarily due to the impact of lower expense related to the Company’s expected 401(k) saving plan match. The increase in personnel costs was also partially attributable to increased share-based compensation expense due to a higher dollar value of restricted stock units granted in the first quarter of 2020 related to 2019 performance. The increase in personnel costs in 2019 from 2018 was primarily attributable to higher incentive compensation, employee benefit and overtime expenses, partially offset by lower salary, payroll tax and severance expenses. The increase in incentive compensation expense was due to the Company’s higher profitability. The increase in employee benefit costs was due to a higher expected 401(k) savings plan match driven by improved financial results. The decrease in salary and payroll tax expense was driven by lower average headcount in 2019 when compared with 2018. Personnel costs included severance expenses of $5.6 million, $6.5 million and $15.2 million for 2020, 2019 and 2018, 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 1,470,900, 1,093,000 and 981,800 domestic title orders in 2020, 2019 and 2018, respectively, representing an increase of 34.6% in 2020 from 2019 and an increase of 11.3% in 2019 from 2018.
The provision for policy losses and other claims, expressed as a percentage of title insurance premiums and escrow fees, was 5.0% for the year ended December 31, 2020 and 4.0% for the years ended December 31, 2019 and 2018, respectively.
Interest expense increased $3.0 million, or 19.7%, in 2020 from 2019 and $7.7 million, or 102.6%, in 2019 from 2018. The increases were primarily attributable to higher interest paid on secured financings payable due to higher average balances outstanding. The increase in 2020 from 2019 was partially offset by lower interest paid related to customer deposits at the Company’s banking subsidiary, First American Trust, FSB, due to lower interest rates. The increase in 2019 from 2018 was also impacted by higher interest paid related to customer deposits at the Company’s banking subsidiary, First American Trust, FSB due to increases in average balances and higher interest rates paid.
Direct premiums increased $26.3 million, or 5.6%, in 2020 from 2019 and $16.5 million, or 3.6%, in 2019 from 2018. The increases were primarily attributable to higher premiums earned in the home warranty business driven by an increase in the number of home warranty residential service contracts issued and an increase in the average price charged per contract.
The provision for home warranty claims, expressed as a percentage of home warranty premiums, was 53.2% in 2020, 49.8% in 2019 and 53.8% in 2018. The increase in the claims rate in 2020 from 2019 was primarily attributable to higher claims frequency driven by claims in the appliance and plumbing trades likely due to the coronavirus pandemic. The decrease in rate in 2019 from 2018 was attributable to a decrease in the severity and frequency of claims. The decrease in the severity of home warranty claims was due to more efficient claims management, which was mainly driven by improved rates with contractors and more efficient allocation of claims to contractors.
The provision for property and casualty claims, expressed as a percentage of property and casualty insurance premiums, was 94.7% in 2020, 73.7% in 2019 and 82.3% in 2018. The increase in rate in 2020 from 2019 was primarily attributable to higher claim severity. The decrease in rate in 2019 from 2018 was primarily attributable to a decrease in the severity of claims, which was partially due to the wildfires that occurred in 2018. The 2019 provision also benefitted from recoveries received during 2019 related to wildfires that occurred in 2018.
Premium taxes as a percentage of specialty insurance segment premiums were 1.7% in 2020 and 1.6% in 2019 and 2018.
Net investment income totaled $14.2 million and $21.9 million in 2020 and 2019, respectively, and net investment losses totaled $3.1 million in 2018. The change in net investment income for all three years was primarily attributable to fluctuations in earnings on investments associated with the Company’s deferred compensation plan.
Income taxes differ from the amounts computed by applying the federal income tax rate of 21%. A reconciliation of these differences is as follows:
The Company continually assesses its capital allocation strategy, including decisions relating to dividends, stock repurchases, capital expenditures, acquisitions and investments. During 2020, the Company’s board of directors approved two increases in the Company’s quarterly cash dividend. In January 2020, the quarterly cash dividend was increased to 44 cents per common share, representing a 5% increase from the prior level of 42 cents per common share. In November 2020, the quarterly cash dividend was increased to 46 cents per common share, representing another 5% increase. The dividend increase was effective beginning with the December 2020 dividend. 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, 2020, under such regulations, the maximum amount available to the holding company from its insurance subsidiaries in 2021, without prior approval from applicable regulators, was dividends of $555.4 million and loans and advances of $115.6 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.
Financing. In May 2020, the Company issued $450.0 million of 4.00% senior unsecured notes due in 2030. Interest is due semi-annually on May 15 and November 15, beginning November 15, 2020. The Company used a portion of the net proceeds from the sale to repay all borrowings outstanding under its credit facility, increasing the unused capacity thereunder to the full $700.0 million size of the facility.
First Canadian Title Company Limited, a Canadian title insurance and services company, maintains credit facilities with certain Canadian banking institutions. At December 31, 2020, no amounts were outstanding under these facilities.
The amounts presented exclude debt issuance costs and discounts on senior unsecured notes.
Trust assets held or managed by First American Trust, FSB totaled $4.4 billion and $4.2 billion at December 31, 2020 and 2019, respectively. Escrow deposits held at third-party financial institutions and trust assets 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 for the disposition of these assets.
In conducting its operations, the Company often holds customers’ assets in escrow, pending completion of real estate transactions and, as a result, the Company has ongoing programs for realizing economic benefits with various financial institutions. The results from these programs are included as income or a reduction in expense, as appropriate, in the consolidated statements of income based on the nature of the arrangement and benefit received.
Consolidated Statements of Comprehensive Income for the years ended December 31, 2020, 2019 and 2018
Consolidated Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018
I. Summary of Investments-Other than Investments in Related Parties as of December 31, 2020
IV. Reinsurance for the years ended December 31, 2020, 2019 and 2018
V. Valuation and Qualifying Accounts for the years ended December 31, 2020, 2019 and 2018
The principal considerations for our determination that performing procedures relating to the valuation of the IBNR loss reserve - title claims is a critical audit matter are the significant judgment by management when developing their estimate of the IBNR loss reserve, which in turn led to a high degree of auditor judgment, subjectivity and effort in performing procedures and evaluating audit evidence relating to the actuarial methods, which included significant assumptions related to loss development factors and expected loss rate. Also, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained.
Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s valuation of the IBNR loss reserve - title claims, including controls over the selection of actuarial methods and development of significant assumptions related to loss development factors and expected loss rate. For certain product lines, these procedures also included, among others, the involvement of professionals with specialized skill and knowledge to assist in developing an independent estimate of the IBNR loss reserve for title claims, on a test basis, and comparison of this independent estimate to management’s actuarially determined reserve. Developing the independent estimate involved testing the completeness and accuracy of data provided by management. For other product lines, procedures also included, among others, testing the completeness and accuracy of data provided by management and the involvement of professionals with specialized skill and knowledge to assist in evaluating the appropriateness of management’s actuarial methods and evaluating the reasonableness of assumptions related to loss development factors and expected loss rate used in those methods.
Accounts and accrued income receivable, less allowances of $13,994 and $12,676
Debt securities, includes pledged securities of $93,586 and $91,636 (amortized cost of $6,121,004 and $5,796,755; allowance for credit losses of $132 at December 31, 2020)
The coronavirus pandemic and responses to it have created significant volatility, uncertainty and disruption in the broader economy. The extent to which the coronavirus pandemic impacts the Company’s business, operations and financial results will depend on numerous factors that the Company may not be able to accurately predict, including: the duration and scope of the pandemic and restrictions and responses to it; governmental, business and individual actions that have been and will continue to be taken in response to the pandemic; the ongoing impact of the pandemic on economic activity and actions taken in response, including the efficacy of governmental relief efforts; the availability and efficacy of vaccines; the effect on participants in real estate transactions and the demand for the Company’s products and services, including as a result of higher unemployment, business closures and economic uncertainty; and the Company’s ability to sell and provide its services and solutions, including as a result of illness, travel restrictions, governmental closure orders and partial or full closures of business and government offices. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the financial statements, some of which consider the impact or expected impact of the coronavirus pandemic. Actual results could differ from the estimates and assumptions used due to the uncertainty created by the coronavirus pandemic, as well as other factors.
The Company considers cash equivalents to include all unrestricted short-term investments that have an initial maturity of 90 days or less.
The Company’s policy is to present accrued interest receivable on financial assets measured at amortized cost within accounts and accrued income receivable on the balance sheet. Accrued interest receivable at December 31, 2020 totaled $2.5 million. The Company has elected to not measure an allowance for credit losses for accrued interest receivable and maintains a policy that all receivables ninety days past due are written off as credit loss expense. Accounts are placed on non-accrual status, and accrual of interest is discontinued, when management determines that collectibility of contractual amounts is not reasonably assured. Payments of interest for accounts in non-accrual status are applied under the cost recovery method.
If the Company intends to sell a debt security in an unrealized loss position or determines that it is more likely than not that the Company will be required to sell a debt security before it recovers its amortized cost basis, the debt security is impaired and it is written down to fair value with all losses recognized in earnings. As of December 31, 2020, the Company did not intend to sell any debt securities in an unrealized loss position and it is not more likely than not that the Company will be required to sell any debt securities before recovery of their amortized cost basis.
The Company recognized impairment losses, net of reversals, of $3.2 million resulting from credit-related factors for the year ended December 31, 2020. The Company did not recognize any impairment losses related to its debt securities for the years ended December 31, 2019 and 2018.
The Company has elected to measure equity investments in which it does not exercise significant influence over the investee and without readily determinable fair values at cost, less impairment, adjusted up or down for any observable price changes from orderly transactions for the identical or a similar investment of the same issuer. The carrying values of these investments are written down, or impaired, to fair value when a qualitative assessment indicates that the fair value is less than the carrying value. In making the determination as to whether an individual investment is impaired, the Company assesses such qualitative factors as the current and expected financial condition of each relevant entity, the market conditions in the industry in which the entity operates and the entity’s anticipated ability to generate sufficient cash flows.
The Company’s secured financings receivable are collateralized by mortgage loans on residential real estate. Collections of the receivable balance occur upon sale of the underlying mortgage loan to investors in the secondary market, generally within 30 days and more typically in less than 10 days. No allowance for credit losses has been recorded due to, among other factors, the Company typically identifying investors in the underlying mortgage loans prior to making advances, the short-term nature of these receivables, the underlying mortgage loans are predominantly Qualified Mortgages (QM) and due to the receivable having no history of significant prior credit losses. Interest income is recorded on an accrual basis during the period the principal balance remains outstanding.
Buildings and furniture and equipment are initially recorded at cost and are generally depreciated using the straight-line method over estimated useful lives ranging from 5 to 40 years and from 2 to 15 years, respectively. Leasehold improvements are initially recorded at cost and are amortized over the lesser of the remaining term of the respective lease or the estimated useful life, using the straight-line method. Computer software developed for internal use and for use with the Company’s products is amortized over estimated useful lives ranging from 3 to 15 years using the straight-line method. Software development and implementation costs, which include certain payroll-related costs of employees directly associated with developing or implementing software and payments to third parties directly associated with developing or implementing software are capitalized during the application development or implementation stage until the software is ready for its intended use.
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.
The Company is, generally, a lessee in leases of commercial real estate, including office buildings and office space, and also certain equipment. Most of the Company’s leases of commercial real estate include one or more options to renew, with renewal terms that can extend the lease term from one to five years, and some leases include options to terminate the lease within the first year.
In connection with its lease commitments, the Company recognizes a lease liability equal to the present value of future lease payments discounted using its incremental borrowing rate and recognizes a lease asset equal to the lease liability, adjusted for any prepaid or accrued lease payments, lease incentives and initial direct costs.
The Company excludes any leases with an initial term of 12 months or less from recognition on the balance sheet and for which lease expense is recognized on a straight-line basis over the lease term.
Management recognizes an impairment loss when the carrying amount of a lease asset is not recoverable and exceeds its fair value. The carrying amount is considered not recoverable if it exceeds the sum of the undiscounted future cash flows that are directly associated with, and that are expected to arise as a result of, the use and eventual disposition of the lease asset. An impairment loss is measured as the amount by which the carrying amount of a lease asset exceeds its fair value. Impairment losses related to the Company’s commercial real estate may occur if the Company ceased using all, or a portion of, a leased property while a contractual obligation remains. Impairment losses related to commercial real estate leases were $1.0 million and $7.5 million for the years ended December 31, 2020 and 2019, respectively. Prior to 2019, operating lease commitments were not recognized as assets on the balance sheet.
For further information on the Company’s leasing arrangements see Note 7 Leases.
Title plants and other indexes included title plants of $536.3 million and $530.5 million and capitalized real estate data of $48.5 million and $49.2 million at December 31, 2020 and 2019, respectively. Title plants are carried at 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 ranging from 5 to 15 years.
Amounts paid for acquisitions are allocated to the tangible and intangible assets acquired and liabilities assumed and are 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.
In connection with the Company’s decision in the third quarter of 2020 to sell the property and casualty insurance business, it recognized impairment losses on its finite-lived intangible assets - customer relationships of $3.2 million for the year ended December 31, 2020.
The Company’s management uses the IBNR point estimate from the in-house actuary’s analysis and other relevant information concerning claims to determine what it considers to be the best estimate of the total amount required for the IBNR reserve.
Premiums on title policies issued directly by the Company are recognized on the effective date of the title policy and escrow fees are recorded upon close of the escrow.
Revenues from title policies issued by agents are recorded when notice of issuance is received from the agent, which is generally when cash payment is received by the Company.
The Company also offers an employee stock purchase plan that allows eligible employees the option to purchase common stock of the Company at 85% of the lower of the closing price on either the first or last day of each offering period. The offering periods are three-month periods beginning on January 1, April 1, July 1 and October 1 of each fiscal year. The Company recognizes an expense in the amount equal to the value of the 15% discount and look-back feature over the three-month offering period.
The Company recognizes the underfunded status of its unfunded supplemental benefit plans as a liability on its consolidated balance sheets. Actuarial gains and losses and prior service costs and credits that have not been previously recognized as a component of net periodic benefit cost are recorded as a component of accumulated other comprehensive income/loss. Plan obligations are measured annually as of December 31.
The Company operates in other countries, including Canada, the United Kingdom, South Korea and Australia. 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 during the period. Translation adjustments resulting from the translation of the subsidiaries’ accounts are included in accumulated other comprehensive income/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 regularly reviews the financial strength of third-party financial institutions where escrow deposits are held and, based on this review and the fact that all amounts are placed in deposit accounts insured, up to applicable limits, by the Federal Deposit Insurance Corporation, does not expect any credit losses; therefore the Company has not recorded a liability for credit losses.
In August 2018, the FASB issued updated guidance as part of its disclosure framework project intended to improve the effectiveness of disclosures in the notes to the financial statements. The updated guidance eliminates, adds and modifies certain disclosure requirements related to fair value measurements. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019. Except for the disclosure requirements, the adoption of this guidance, effective January 1, 2020, did not have a material impact on the Company’s consolidated financial statements.
In the third quarter of 2020, the Company initiated a plan to sell its property and casualty insurance business. As a result of this decision, the Company remeasured the assets and liabilities of its property and casualty insurance business at estimated fair value, less costs to sell, and recorded impairment losses to goodwill, other intangible assets, property and equipment and other assets totaling $54.9 million for the year ended December 31, 2020. The impairment losses are included in impairments on disposition of business on the consolidated statements of income and in the operating results of the specialty insurance segment. In the fourth quarter of 2020, the Company, as a result of the sale process, determined to pursue a book transfer rather than a sale. As a result, the assets and liabilities of the property and casualty insurance business, which were previously classified as held for sale, have been reclassified as held and used on the Company’s consolidated balance sheet at December 31, 2020.
Investments totaling $114.8 million and $111.5 million were on deposit with state treasurers in accordance with statutory requirements for the protection of policyholders at December 31, 2020 and 2019, respectively.
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, 2020, under such regulations, the maximum amount available to the Company from its insurance subsidiaries in 2021, without prior approval from applicable regulators, was dividends of $555.4 million and loans and advances of $115.6 million.
The Company’s principal title insurance subsidiary, First American Title Insurance Company (“FATICO”), maintained total statutory capital and surplus of $1.5 billion as of December 31, 2020 and 2019. Statutory net income for the years ended December 31, 2020, 2019 and 2018 was $501.6 million, $473.6 million and $258.4 million, respectively. FATICO was in compliance with the minimum statutory capital and surplus requirements as of December 31, 2020.
Sales of debt securities resulted in realized gains of $18.2 million, $12.1 million and $3.3 million, realized losses of $3.5 million, $6.1 million and $20.3 million, and proceeds of $758.9 million, $1.1 billion and $1.3 billion for the years ended December 31, 2020, 2019 and 2018, respectively.
Activity in the allowance for credit losses on debt securities for the year ended December 31, 2020 is summarized as follows:
In determining credit losses on its debt securities in an unrealized loss position, the Company considers certain factors that may include, among others, severity of the unrealized loss, security type, industry sector, credit rating, profitability and stock performance.
The composition of the investment portfolio at December 31, 2020, by credit rating, is as follows:
The credit ratings in the above tables reflect published ratings obtained from globally recognized securities rating agencies. 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- or higher” rating category because the payments of principal and interest are guaranteed by the governmental agency that issued the security.
Future minimum lease payments under operating and finance leases with noncancelable lease terms, as of December 31, 2020, are summarized as follows:
Information related to lease terms and discount rates is summarized as follows:
Cash paid for amounts included in the measurement of lease liabilities:
Operating lease assets obtained in exchange for new operating lease liabilities
A summary of the changes in the carrying amount of goodwill, by reportable segment, for the years ended December 31, 2020 and 2019, is as follows:
Estimated amortization expense for finite-lived intangible assets for the next five years is summarized as follows:
Current year payments, net of recoveries, include $250.0 million, $211.4 million and $228.3 million for the years ended December 31, 2020, 2019 and 2018, respectively, that relate to the Company’s specialty insurance segment. Prior year payments, net of recoveries, include $57.2 million, $41.7 million and $56.7 million for the years ended December 31, 2020, 2019 and 2018, respectively, that relate to the Company’s specialty insurance segment.
The current year rate of 5.0% reflects an ultimate loss rate of 4.5% for the current policy year and a net increase in the loss reserve estimates for prior policy years of 0.5%, or $26.2 million.
To date, the Company has not experienced an increase in title claims as a result of the coronavirus pandemic. Incurred title claims for the year ended December 31, 2020 were lower by 12.4% when compared with the same period of the prior year, and significantly below the Company’s actuarial expectation. However, title claims generally increase when economic conditions deteriorate. Due to the economic uncertainty in connection with the coronavirus pandemic and responses to it, the Company increased its calendar year loss rate from 4.0% in 2019 to 5.0% in 2020.
A reconciliation of the net incurred and paid claims development tables to the liability for claims and claim adjustment expense at December 31, 2020, is as follows:
4.00% senior unsecured notes due May 15, 2030, effective interest rate of 4.05%
4.60% senior unsecured notes due November 15, 2024, effective interest rate of 4.60%
Other notes and contracts payable with maturities through 2024, weighted-average interest rate of 4.28% and 4.02% at December 31, 2020 and 2019, respectively
The Company’s effective income tax rates (income tax expense as a percentage of income before income taxes) were 24.1%, 21.6%, and 21.9% for the years ended December 31, 2020, 2019, and 2018, respectively. The effective tax rates differ from the federal statutory rate as a result of state and foreign income taxes for which the Company is liable, as well as permanent differences between amounts reported for financial statement purposes and taxable income. In addition, the effective tax rate for the year ended December 31, 2020 reflected the impairment of nondeductible goodwill relating to the Company’s specialty insurance segment and a benefit from foreign tax law changes. The effective tax rate for the year ended December 31, 2019 also reflected the resolution of state tax matters from prior years. The effective tax rate for 2018 also reflected an adjustment made to the Company’s initial 2017 estimates for the comprehensive tax reform legislation known as the Tax Cuts and Jobs Act.
The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was signed into law on March 27, 2020. The CARES Act allows employers to defer payment of a portion of payroll taxes otherwise due on wages paid between the enactment date and December 31, 2020 and remit the deferred payroll taxes in equal amounts on December 31, 2021 and December 31, 2022. Under this provision of the CARES Act, the Company deferred $49.4 million in payroll taxes for 2020 and has recorded the tax impact of $11.5 million as a deferred tax asset.
At December 31, 2020, the Company had available a $6.5 million foreign tax credit carryover, net of a valuation allowance. 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 makes adjustments to the allowance as necessary. The factors used by the Company to assess the likelihood of realization include its forecast of future taxable income and available tax planning strategies that could be implemented to realize its deferred tax assets. The Company’s ability or failure to achieve forecasted taxable income in the applicable taxing jurisdictions could affect the ultimate realization of its deferred tax assets. At December 31, 2020 and 2019, the Company carried a valuation allowance of $9.4 million and $9.8 million, respectively, against its deferred tax assets. Of this amount, $8.1 million and $8.8 million, respectively, related to net operating losses; the remaining $1.3 million and $1.0 million, respectively, related to other deferred tax assets. The decrease in the overall valuation allowance during 2020 was primarily due to the release of valuation allowance previously provided against certain foreign net operating losses and other 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 during the next 12 months.
The Company’s continuing practice is to recognize interest and penalties, if any, related to uncertain tax positions in income tax expense. Accrued interest and penalties, net of tax benefits, related to uncertain tax positions were not material as of December 31, 2020 and 2019. As of December 31, 2018, the Company had accrued interest and penalties, net of tax benefits, of $5.8 million 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. As of December 31, 2020, the Company is generally no longer subject to U.S. Federal income tax examinations for years prior to 2017, and, for state and non-U.S. jurisdictions, income tax examinations for years prior to 2014.
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. The Savings Plan held 1.8 million shares and 2.0 million shares of the Company’s common stock, representing 1.7% and 1.8% of the Company’s total common shares outstanding at December 31, 2020 and 2019, respectively. Effective July 1, 2015, participants in the Savings Plan can no longer make additional investments in common stock of the Company.
The principal components of employee benefit costs are summarized as follows:
Net periodic benefit costs related to the Company’s unfunded supplemental benefit pension plans included the following components:
Net actuarial loss and prior service credit for the unfunded supplemental benefit plans expected to be amortized from accumulated other comprehensive income/loss into net periodic cost over the next fiscal year include an expense of $6.8 million and a credit of $1.3 million, respectively.
The weighted-average discount rate assumption used to determine the projected benefit obligation for the Company’s unfunded supplemental benefits plans at December 31, 2020 and 2019, was as follows:
Level 1-Valuations based on unadjusted quoted market prices in active markets for identical assets or liabilities.
The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments not measured at fair value as of December 31, 2020 and 2019:
The Company measures the fair value of certain assets on a non-recurring basis when events or changes in circumstances indicate that the carrying amount may not be recoverable. These assets generally include goodwill, title plants and other indexes, other intangible assets, property and equipment and cost and equity-method investments.
In connection with the Company’s decision in the third quarter of 2020 to sell the property and casualty insurance business, the Company recognized impairment losses of $34.2 million, $17.6 million and $3.2 million to goodwill, property and equipment and other intangible assets, respectively, for the year ended December 31, 2020. The impairment charges were determined based on fair values utilizing Level 3 unobservable inputs. See Note 2 Disposition of the Property and Casualty Insurance Business for further information on the disposition of the business.
The First American Financial Corporation 2010 Employee Stock Purchase Plan (the “ESPP”) allows eligible employees the option to purchase common stock of the Company at 85% of the lower of the closing price on either the first or last day of each quarterly offering period. There were 523,000, 391,000 and 363,000 shares issued in connection with this plan for the years ended December 31, 2020, 2019 and 2018, respectively. At December 31, 2020, there were 1.1 million shares reserved for future issuances.
The following table summarizes the costs associated with the Company’s share-based compensation plans:
The following table summarizes RSU activity for the year ended December 31, 2020:
The following table presents the other comprehensive income (loss) reclassification adjustments for the years ended December 31, 2020, 2019 and 2018:
Amounts are components of net periodic cost. See Note 16 Employee Benefit Plans for additional details.
It is, however, often not possible to assess the probability of loss. Lawsuits that are putative class actions require a plaintiff to satisfy a number of procedural requirements before proceeding to trial. These requirements include, among others, demonstration to a court that the law proscribes in some manner the Company’s activities, the making of factual allegations sufficient to suggest that the Company’s activities exceeded the limits of the law and a determination by the court-known as class certification-that the law permits a group of individuals to pursue the case together as a class. In certain instances, the Company may also be able to compel the plaintiff to arbitrate its claim on an individual basis. If these procedural requirements are not met, either the lawsuit cannot proceed or, as is the case with class certification or compelled arbitration, the plaintiffs lose the financial incentive to proceed with the case (or the amount at issue effectively becomes de minimis). Frequently, a court’s determination as to these procedural requirements is subject to appeal to a higher court. As a result of, among other factors, ambiguities and inconsistencies in the laws applicable to the Company’s business and the uniqueness of the factual issues presented in any given lawsuit, the Company often cannot determine the probability of loss until a court has finally determined that a plaintiff has satisfied applicable procedural requirements.
Furthermore, for putative class actions, it is often impossible to estimate the possible loss or a range of loss amounts, even where the Company has determined that a loss is reasonably possible. Generally class actions involve a large number of people and the effort to determine which people satisfy the requirements to become plaintiffs-or class members-is often time consuming and burdensome. Moreover, these lawsuits raise complex factual issues which result in uncertainty as to their outcome and, ultimately, make it difficult for the Company to estimate the amount of damages which a plaintiff might successfully prove. In addition, many of the Company’s businesses are regulated by various federal, state, local and foreign governmental agencies and are subject to numerous statutory guidelines. These regulations and statutory guidelines often are complex, inconsistent or ambiguous, which results in additional uncertainty as to the outcome of a given lawsuit-including the amount of damages a plaintiff might be afforded-or makes it difficult to analogize experience in one case or jurisdiction to another case or jurisdiction.
Antao Properties LLC vs. First American Title Insurance Company, filed on November 6, 2019 and pending in the United States District Court for the Middle District of Florida,
In addition, the Company and its Board of Directors and certain executives are parties to a shareholder derivative action, Hollett vs. Gilmore, et al., filed on November 25, 2020 and pending in the United States District Court for the Central District of California. The allegations arise out of the information security incident that occurred during the second quarter of 2019 and the resulting legal proceedings and disclosures made at the time of the incident. While the ultimate disposition is not yet determinable, the Company does not believe it will have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
The Company also is a party to non-ordinary course lawsuits other than those described above. With respect to these lawsuits, the Company has determined either that a loss is not reasonably possible or that the estimated loss or range of loss, if any, will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
During the year ended December 31, 2020, the Company completed acquisitions for an aggregate purchase price of $397.6 million, which were funded through cash on hand and additional borrowings of $120.0 million under the Company’s credit facility. For acquisitions in which the Company has not completed its purchase price allocation, preliminary fair value estimates for the assets acquired and liabilities assumed have been recorded. These acquisitions have been included in the Company’s title insurance and services segment.
The Company’s specialty insurance segment issues property and casualty insurance policies and sells home warranty products. The property and casualty insurance business provides insurance coverage to residential homeowners and renters for liability losses and typical hazards such as fire, theft, vandalism and other types of property damage. This business is licensed to issue policies in all 50 states and the District of Columbia. The majority of policy liability is in the western United States, including approximately 59% in California. The home warranty business provides residential service contracts that cover residential systems, such as heating and air conditioning systems, and certain appliances against failures that occur as the result of normal usage during the coverage period. This business currently operates in 35 states and the District of Columbia.
Selected financial information about the Company’s operations, by segment, for the years ended December 31, 2020, 2019 and 2018, is as follows:
Domestic and foreign long-lived assets, by segment, as of December 31, 2020, 2019 and 2018, are as follows: