(3) In 2005, we (1) recorded the recognition of deferred income of $33.8 million, or $20.0 million after taxes, (2) recorded the write-off of intangible and other long-lived assets of $39.1 million, or $23.2 million after taxes, and (3) incurred legal and settlement costs of $22.6 million, or $15.4 million after taxes.
(5) In 2003, we recorded exit and termination costs of $0.3 million, or $0.2 million after taxes. Additionally, we recorded title plant impairments of $4.9 million, or $3.2 million after taxes.
(6) In 2002, we recorded exit and termination costs of $13.4 million, or $8.7 million after taxes.
The following discussion and analysis of financial condition and results of operations is provided to enhance the understanding of, and should be read in conjunction with, Part I, Item 1, “Business” and our Consolidated Financial Statements and the related Notes. For information on risks and uncertainties related to our business that may make past performance not indicative of future results, or cause actual results to differ materially from any forward-looking statements made by us, see “Forward-Looking and Cautionary Statements,” and Part I, Item 1A, “Risk Factors.”
Our profit margins are affected by several factors, including the volume of real estate transactions and mortgage refinance activity, type of title policies issued and amount of liability insured. Volume is an important determinant of profitability because we, like any other real estate services company, have a significant level of fixed costs arising from personnel, occupancy costs and maintenance of title plants. While we utilize title orders opened as a forward-looking indicator of business volume, our results are impacted during times of increasing or decreasing volumes since we cannot immediately match our staffing requirements to changes in our business volumes. The amount of liability insured is also a determinant of profitability. Because premiums are based on the face amount of the policy, larger policies generate higher premiums although expenses of issuance do not necessarily increase in proportion to policy size. In addition, cancellations affect profitability because costs incurred both in opening and in processing orders typically are not offset by fees.
Our largest expense is commissions paid to agents. We regularly review the profitability of our agents, and adjust commission levels or cancel certain agents where profitability objectives are not being met and expand operations where acceptable levels of profitability are available. We continually monitor our operating expenses which are the sum of salaries and employee benefits, agency commissions and other expenses (exclusive of interest, amortization and certain other items) as a percentage of operating revenue.
In 2006, we will continue our evaluation and integration of acquisitions. We completed three acquisitions in the Title Operations segment during 2005 and will evaluate potential acquisition opportunities as they arise.
Our Lender Services segment provides services to regional and national lending institutions which complement those offered in our title insurance business. These services consist primarily of real estate tax processing and flood zone certifications, consumer mortgage credit reporting, default management services, and mortgage loan subservicing. With the exception of a portion of default management, the services provided by this segment are the result of businesses acquired by us during 2003 and 2004. In August 2003, we initially entered the credit information business for the mortgage lending industry through our acquisition of INFO1 Holding Company, Inc., a wholly-owned subsidiary of LACS. In October 2003, we entered the business of providing flood certification and real estate tax services to mortgage lenders by purchasing LATF, one of the largest tax and flood service companies in the United States. In December 2004, we purchased LoanCare, a mortgage loan subservicer. In addition, during 2004, we expanded the national scope of our businesses in these areas through the purchase of one flood certification business, four credit reporting businesses and one default management business.
products offered by the Title Operations segment and businesses included in Lender Services. We expect to continue expanding organically and by acquisition in this segment and to focus on the realization of cross-selling opportunities. During 2005, we made significant improvements to the sales and account management process to help client generation and retention activities. For example, we consolidated our sales force from five independent groups to two: one targeting servicing relationships, and the other origination relationships. We believe this change will leverage our top sales executives over a wider product set, and result in a stronger and more robust sales effort.
Our assessment business is managed by LandAmerica Assessment Corporation, our subsidiary that was acquired in 2002, and is headquartered in California. This business provides due diligence services to commercial customers throughout the United States, Canada, Mexico, the Caribbean and Europe. Revenue is recognized upon completion of the services to the customer.
Our commercial appraisal and valuation operation is run by our subsidiary LandAmerica Valuation Corporation, formerly known as LandAmerica Commercial Appraisal Corporation. This business is highly dependent on the commercial real estate market. A fee is charged based on the type and complexity of work performed.
In September 2004, we purchased BHW, headquartered in California, which provides and services home warranty contracts in California, Texas, Arizona, Colorado, Nevada, New Mexico, and Oklahoma. Fees charged by this business are deferred upon receipt and amortized over the life of the underlying contract which is generally one year.
This discussion and analysis of our financial condition and results of operations is based upon our accompanying Consolidated Financial Statements which have been prepared in accordance with accounting
principles generally accepted in the United States. We consider the following accounting estimates to be critical in preparing and understanding such statements. Actual results could differ from these estimates. Significant accounting policies are disclosed in Note 1 to the accompanying Consolidated Financial Statements.
Provisions for title losses as a percentage of title operating revenues were 5.2 percent for 2005, 4.3 percent for 2004, and 5.3 percent for 2003. A change of 1 percent in this percentage would have changed the provision for title losses and pretax earnings by approximately $35.7 million for the year ended December 31, 2005. We review our loss provision rates periodically and adjust as experience develops or new information becomes known.
Claims payment experience has historically extended for more than 20 years after the issuance of a policy. Due to the length of time over which claim payments are made and regularly occurring changes in underlying economic conditions, these estimates are subject to variability. Our independent actuaries perform projections of required reserves at year-end and as considered necessary during the year. These projections are compared to recorded reserves to evaluate the adequacy of such recorded reserves and any necessary adjustments are included in current expenses.
Purchase Accounting and Goodwill and Long-Lived Assets Valuations-During the years ended December 31, 2005 and 2004, we completed 9 and 27 acquisitions, respectively. These acquisitions were intended to grow our title operations and expand our real estate transaction services portfolio. As a result of these acquisitions, we assigned fair values to the assets and liabilities purchased and increased the amount of goodwill and other intangibles recorded on our balance sheet. We utilize the services of an independent appraisal company to assist with the allocation of purchase price to acquired assets (including goodwill) and liabilities.
Deferred Tax Assets-Many deductions for tax return purposes cannot be taken until the expenses are actually paid, rather than when the expenses are recorded under Generally Accepted Accounting Principles (“GAAP”). In these circumstances, under GAAP, we accrue for the tax benefit expected to be received in future years if, in our judgment, it is “more likely than not” that we will receive such benefits. The most significant factor in this determination is the projected future timing and amounts of taxable income. If we determine that it is no longer “more likely than not” that an asset will be utilized, we would record a valuation allowance which would reduce net income in the period recorded. Deferred tax assets created from tax benefits expected to be realized at December 31, 2005 and 2004 relate primarily to policy and contract claims, goodwill, pension liability, deferred service arrangements, allowance for doubtful accounts, employee benefit plans, tax and flood claims and convertible debt offset by deferred tax liabilities primarily related to other intangibles, unrealized gains on our investment portfolio, title plants, fixed assets and capitalized system development software. Based upon our historical results of operations, our existing financial condition and our assessment of all other available evidence, we believe that these assets will more likely than not be realized. See Note 7 to the accompanying Consolidated Financial Statements.
Changing the discount rate or long-term rate of return would result in the following impact on the pension benefit liability:
The title insurance business is closely related to the overall level of residential and commercial real estate activity, which is generally affected by the relative strength or weakness of the United States economy. In addition, title insurance volumes fluctuate based on the effect that changes in interest rates have on the level of real estate activity. Periods of increasing interest rates usually have an adverse impact on real estate activity and therefore premium and fee revenue. In contrast, real estate activity usually increases when interest rates fall.
Prior to 2002, residential real estate activity has been generally slower in the winter, when fewer families buy or sell homes, with increased volumes in the spring and summer. Residential refinancing activity is generally more uniform throughout the seasons, but is subject to interest rate variability. We typically report our lowest revenue in the first quarter, with revenue increasing into the second quarter and through the third quarter. The fourth quarter customarily may be as strong as the third quarter, depending on the level of activity in the commercial real estate market. Due to an unusually low interest rate environment in the last three years, our results have not followed the typical seasonal patterns. In 2002, 2003 and 2004, our fourth quarter revenue was stronger than the third quarter. In 2002 and 2003, this increase was primarily due to an increase in commercial real estate activity and refinance activity. In 2004, the increase in fourth quarter revenue was due to an increase in commercial real estate activity and in other direct revenue. Revenue for 2005 was more in line with our typical historical results.
Portions of our Lender Services segment have seasonal trends similar to our Title Operations segment, particularly in our tax and flood and credit servicing businesses. However, due to the nature of the revenue deferrals made in this segment, as noted above, the impact on our results of operations will differ. In instances where we receive cash in advance for services for real estate tax payment and flood certification services, the revenue is deferred and amortized ratably over the anticipated life of the loan servicing. This ratable amortization has the impact of reducing the volatility in revenue related to this segment; however, loss of a customer may accelerate recognition of revenue in certain periods resulting in one-time volatility.
A summary of our operating revenue at December 31, 2005, 2004 and 2003 is as follows:
Closed orders from direct title operations were 975,000 in 2005 with an average fee per closed order (which includes title insurance premiums and other revenue related to completed transactions by direct operations) of approximately $1,657, compared to 918,500 in 2004 with an average fee per closed order of approximately $1,522. Closed orders from acquisitions were approximately 28,000 in 2005. Before the impact of acquisitions, the decrease in the number of title policies issued by our direct operations in 2005 was due to lower refinance transactions as compared to 2004. The reduction in refinancing transactions shifted the mix of business toward fewer refinancing title polices, which tend to have lower premiums per policy, and more purchase title policies which tend to have higher premiums per policy. In addition, the increase in commercial activity and increases in home prices also served to increase the average fee per closed order in 2005.
Closed orders from direct title operations were 918,500 and 1,110,200 during 2004 and 2003, respectively. The reduction in refinancing transactions in 2004 resulted in a decrease in the number of title policies issued by our direct operations compared to 2003. The average fee per closed order in 2004 was approximately $1,522, compared to an average fee per closed order in 2003 of approximately $1,238. Closed orders from acquisitions completed during 2004 and 2003 were approximately 26,000 in 2004. The reduction in refinancing transactions changed the mix of business toward fewer refinancing title policies and more purchase title policies, which have more revenue per policy associated with them. In addition, the increase in commercial activity also served to increase the average fee per closed order in 2004.
We anticipate that Title Operations segment revenue will decrease in 2006 from 2005 levels due to expected lower refinance and home purchase activity resulting from anticipated higher interest rates.
Operating revenue in Corporate and Other increased by approximately $22.1 million, or 60.5 percent, from 2004 over 2003. The increase in revenue in 2004 over 2003 is primarily due to the acquisitions in residential inspection, commercial appraisal and assessment and home warranty businesses.
Investment and other income was $88.7 million in 2005, $71.8 million in 2004 and $52.1 million in 2003. Investment and other income increased $16.9 million, or 23.5 percent, in 2005 compared to 2004. The Financial Services segment generated $8.6 million of additional investment income during 2005 compared to 2004, which was due to higher balances in the portfolio of loans receivable and investments and higher returns. The remaining increase in investment and other income was due to increased yields and higher invested balances in our remaining investment portfolio. Investment and other income increased $19.7 million, or 37.8 percent, in 2004 compared to 2003 and is primarily due to the acquisition of Centennial in December 2003 which resulted in increased interest income of $19.4 million in 2004. Our investment earnings are primarily derived from our fixed maturity securities as well as loans receivable related to Centennial.
Net realized investment gains totaled $4.2 million in 2005, $5.8 million in 2004 and $8.5 million in 2003. The decrease in net realized investment gains from 2004 to 2005 was primarily due to higher interest rates and repositioning of our investment portfolio toward equity securities and responding to market changes. The decrease in net realized investment gains from 2003 to 2004 was primarily due to the timing of the repositioning of a portion of our investments to fund, in part, the acquisitions of LATF and LACS.
A summary of our salaries and employee benefits expenses is as follows:
Title Operations-Our Title Operations segment accounted for approximately 86.0 percent of our total salaries and other personnel expenses in 2005. In particular, the non-agency or direct operations portion of the Title Operations segment is labor intensive and, as a result, salaries and employee benefits are a significant component of variable expense for this segment. We manage personnel expenses to reflect changes in the level of activity in the real estate market. As a result, our employee base expands and contracts over time. In order to manage personnel costs more effectively throughout the real estate cycle, we use temporary or part time employees where appropriate to staff operations so that we can respond promptly to changes in real estate activity. We continuously monitor personnel levels in connection with changes in real estate transaction volumes. Depending on the speed and severity of change in real estate activity, we may not be able in the short run to match decreasing levels of title orders with reduced staffing levels. As a result, in periods of declining activity, personnel costs as a percentage of revenue, may increase.
Salaries and employee benefit expenses in the Title Operations segment increased $124.8 million, or 14.9 percent, in 2005 over 2004. The addition of personnel as the result of acquisitions completed during 2005 and 2004 increased salary and employee benefit expenses by $24.8 million for 2005. Before the impact of these acquisitions, increased salary and employee benefit expenses in 2005 primarily related to compensation increases associated with the increase in operating revenue and increased staffing as a result of higher commercial and buy/sell activity which is more labor intensive than refinance activity. Average full time equivalent (“FTE”) counts were 11,017 (including 392 related to acquisitions) in 2005 versus 10,144 (including 1,195 related to acquisitions) in 2004. The increase in FTEs was as a result of increased buy/sell and commercial transactions year over year which tend to be more labor intensive than refinance transactions.
Corporate and Other-Salary and employee benefit expenses for the Corporate and Other segment increased $12.2 million, or 18.3 percent, in 2005 over 2004. Incremental salary and employee benefit expenses from acquisitions completed during 2005 and 2004 were approximately $9.5 million in 2005. Salaries and benefit expenses increased $17.0 million in 2004, or 34.3 percent, over 2003. Approximately half of the increase, or $8.0 million, was related to acquisitions, with the remainder due to increases at the corporate operations level due to continued infrastructure growth and compliance with the Sarbanes-Oxley Act.
There were no significant exit and termination costs in 2005. See Note 11 to the accompanying Consolidated Financial Statements.
In the first quarter of 2004, we announced plans to reduce our cost structure by at least $70.0 million on an annualized basis within existing operations. As a result of this initiative, we identified 61 offices that we would consolidate into other offices during 2004. We accrued $5.3 million for the facility downsizing costs of these offices in 2004 as well as $1.2 million in severance payments related to these office consolidations.
In 2003, we consolidated certain office space. We incurred charges of approximately $0.8 million in the fourth quarter of 2003 related to our decision to consolidate office space in two markets. This charge was offset by a reduction of $0.5 million related to the 2002 accrual.
Amortization expense increased by $4.2 million in 2005 compared to 2004 and $17.7 million in 2004 compared to 2003. These increases were the result of acquisitions by us in 2005 and 2004. Acquired businesses added $13.5 million to amortizable intangible assets in 2005 and $82.0 million in 2004. We are amortizing the intangible assets acquired as part of these businesses over their estimated useful lives.
Insurers are generally not subject to state income or franchise taxes. They are, however, subject to a “premium tax” on certain operating revenue, depending on the state. Tax rates and the amounts that are subject to tax vary from state to state. Premium taxes as a percentage of total title insurance revenue remained relatively constant during the last three years. This percentage was 1.2 percent for 2005, 1.3 percent for 2004 and 1.2 percent for 2003.
A summary of general, administrative and other expenses is as follows:
General and administrative expenses for the Title Operations segment increased by $28.4 million or 7.1 percent in 2004 as compared to 2003. This increase is primarily related to acquisitions that occurred during early 2004 and 2003 of $39.5 million and legal settlements of $9.2 million, partially offset by lower costs associated with lower business volumes.
Lender Services-General and administrative expenses for the Lender Services segment increased $2.3 million, or 3.3 percent, in 2005 from 2004 and $46.6 million, or 200.0 percent in 2004 from 2003. Before the impact of acquisitions completed during 2004, general and administrative expenses decreased 6.8 percent in 2005 over 2004 as a result of lower business volumes. The increase in general and administrative expenses in 2004 over 2003 was primarily due to the purchase of LATF and LACS in 2003.
Corporate and Other-General and administrative expenses in the Corporate and Other segment increased by $22.0 million, or 33.4 percent, in 2005 from 2004. The increase in these expenses is primarily related to the impact of acquisitions completed during 2005 and 2004 and increased expenses associated with higher volume in the commercial appraisal and assessment businesses. General and administrative expenses increased by $5.7 million, or 9.5 percent, in 2004 from 2003. The increase in these expenses is primarily related to the impact of acquisitions completed during 2004 and 2003.
Lender Services-The Lender Services segment had pretax income (loss) of $(13.6) million in 2005, $2.0 million in 2004 and $(0.4) million in 2003. Pretax loss in 2005 reflects the write off of a portion of the customer relationship intangible related to the acquisition of our tax and flood business partially offset by acceleration of deferred revenue. Pretax (loss) income in 2004 and 2003 was impacted by the acquisitions made in the third and fourth quarters of 2003.
We evaluate the results of our Lender Services segment on the basis of pretax income before net revenue deferrals and amortization (“PRBDA”). Adjusted operating revenue represents operating revenue adjusted for the impact of net revenue deferrals. PRBDA margin represents PRBDA divided by operating revenue adjusted for net revenue deferrals. PRBDA and PRBDA margin are not measures of performance defined by GAAP and should not be considered in isolation or as a substitute for operating income or cash flows provided by operating
As noted above, our operating results and cash flows are heavily dependent on the real estate market, particularly in the Title Operations segment. While we have continued to diversify our products and services portfolio over the last several years, a significant downturn in the real estate market would adversely impact our cash flows. Our business is labor intensive. Changes to the real estate market are monitored closely, and staffing levels are adjusted accordingly. There is typically a lag between changes in the real estate market and changes in personnel levels resulting in higher personnel costs in periods where the real estate market declines in advance of headcount reductions. The Lender Services segment provides real estate tax payment and flood certification services for the life of loans for which we receive cash at loan closing. This revenue related to the long-term servicing is deferred and amortized over the life of the loan. As a result, our cash flows in the Lender Services segment are greater than reported earnings. Revenue, cash receipts and loans in our Financial Services segment are dependent on the ability of the bank to attract deposits and qualified commercial customers. We believe that our product diversification efforts along with our management of operating expenses and significant working capital position will aid our ability to manage cash resources through declines in the real estate market.
Amendments to the Plan effective December 31, 2004 to cease future accruals to the retirement plan accounts of all Plan participants (other than annual interest credits on account balances), to cause the accrued benefits of participants to be fully vested as of December 31, 2004 and to limit participation in the Plan to those individuals who were participants as of December 31, 2004. There were conforming changes to our Benefit Restoration Plan.
Based on these changes, we anticipate a reduction in company-wide pension expense of approximately $9.1 million in 2006. We anticipate a contribution of between $10.0 million and $20.0 million to the Plan in 2006. Additionally, we anticipate that our contribution requirements after 2006 will decline.
The Board of Directors approved one-year authorization programs allocating $40.0 million for 2003 and $50.0 million for 2004 to repurchase up to 1,250,000 shares or 7 percent of our existing common stock over the following twelve months. During the first three quarters of 2004, we repurchased the entire 1,250,000 authorized shares for 2004. As a result, in December 2004, the Board of Directors approved a program expiring February 2006 which authorized us to repurchase up to 1,000,000 additional shares at a cost not to exceed $60.0 million. During the fourth quarter 2005, we fully executed the share repurchase program announced in December 2004. In October 2005, the Board of Directors approved a program expiring at the end of July 2007 to repurchase an additional 1,250,000 shares.
Centennial maintains an allowance for loan losses related to our loans receivable. During 2005, we did not experience a significant change in the underlying components of the allowance for loan losses or the balance in total. There have been no significant changes in the underlying rationale for our provision for loan losses or significant changes in asset quality.
We administer escrow and trust deposits as a service to our customers. These deposits totaled $3.1 billion and $2.8 billion at December 31, 2005 and 2004, respectively. Our escrow and trust deposits are not considered assets and are not included in the accompanying balance sheets. However, we remain contingently liable for the disposition of these deposits. We have begun depositing a portion of these escrow and trust deposits in Centennial. Of the $3.1 billion in escrow, we have deposited $200 million in Centennial and those assets and liabilities have been reflected on the accompanying Consolidated Financial Statements.
Additionally, we facilitate tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code. As a facilitator and intermediary, we hold the proceeds from sales transactions until a qualified acquisition occurs. These deposits totaled $1,111.7 million and $1,399.7 million at December 31, 2005 and 2004, respectively. Similarly, we also facilitate tax-deferred reverse exchanges pursuant to Revenue Procedure 2000-37. These exchanges require us, using the customer’s funds, to acquire qualifying property on behalf of the customer and take temporary title to the customer’s property until a qualifying acquisition occurs. Reverse property exchanges totaled $409.4 million and $470.3 million at December 31, 2005 and 2004, respectively. Due to the structure utilized to facilitate these transactions, like-kind exchanges and reverse exchanges are not considered assets of LandAmerica and are not included in the accompanying consolidated balance sheets. However, we remain contingently liable for the transfers of property, disbursement of proceeds and the return on the proceeds at the agreed upon rate.
As of December 31, 2005, we had a policy and contract claims reserve of $697.6 million. The amounts and timing of these obligations are estimated and are not set contractually. Nonetheless, based on historical insurance claim experience, we anticipate the above payment patterns. While we believe that historical loss payments are a reasonable source for projecting future claim payments, there is significant inherent uncertainty in this payment pattern estimate. Changes in claim reporting patterns, claim settlement patterns, judicial decisions, legislation, economic conditions and other factors could affect the timing and amount of actual claims payments.
The following table provides information about our financial instruments that are sensitive to changes in interest rates. For investment securities and loans receivable, the table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Actual cash flows could differ from the expected amounts.
Additionally, we have interest bearing passbook and certificate of deposit liabilities of $347.2 million bearing interest at an average rate of 4.0 percent at December 31, 2005 which are subject to change based on short-term United States interest rates and availability of funds. A 10 percent change in the interest rate for deposits would affect income before income taxes by approximately $0.4 million annually. The remaining $200.0 million of deposit liabilities related to escrow balances are non interest bearing.
Our Consolidated Financial Statements and Notes thereto are included elsewhere in this Annual Report on Form 10-K and are incorporated by reference herein. See Item 15 of Part IV.