Overview. As with all providers of real estate-related financial and informational services, the Company's revenues depend, in large part, upon the level of real estate activity and the cost and availability of mortgage funds. The majority of the Company's revenues for the title insurance and real estate information segments result from resales and refinancings of residential real estate, and to a lesser extent, from commercial transactions and the construction and sale of new properties. Revenues for the Company's home warranty segment result primarily from residential resale activity and do not benefit from refinancings. Traditionally, the greatest volume of real estate activity, particularly residential resale, has occurred in the spring and summer months. However, numerous actions taken by the Federal Reserve Board during 1992 and 1993 to stimulate economic recovery caused unusual fluctuations in the traditional pattern of real estate activity. During 1993, mortgage interest rates
fell to their lowest level in 25 years. This decline in rates caused an unprecedented volume of refinance transactions and the Company's title insurance and real estate information segments processed record order volumes. Due to inflationary concerns, the Federal Reserve Board began a succession of interest rate increases in February 1994. The resulting increase in mortgage interest rates adversely affected the Company's revenue base in the second half of 1994 (primarily the fourth quarter) as refinance activity came to a virtual halt. This, coupled with the persistently poor real estate economy in California and a return of the traditional seasonal real estate cycle, resulted in a low inventory of open transactions going into 1995. As a result, 1995 first quarter operating revenues experienced a 30% decline when compared with the same period of the prior year. In response to the severe decline in new orders, the Company instituted personnel reductions totaling 26% of the work force from March 1994 through February 1995. However, the cost-cutting measures lagged the revenue declines resulting in losses for the fourth quarter 1994 and the first quarter 1995. Mortgage interest rates peaked in January 1995 and decreased throughout the remainder of the year and into 1996, helped by an easing of monetary policy by the Federal Reserve Board. This decrease in mortgage interest rates, as well as increased consumer confidence, contributed significantly to an improved national real estate economy during the second half of 1995, and resulted in a 26% improvement in operating revenues when compared to the first half of 1995. This resurgence in real estate activity generated a high inventory of open transactions going into 1996, which together with the continuation of lower mortgage interest rates, the improved national real estate economy and the Company's successful integration of its diverse businesses, resulted in record revenues and strong profits for 1996.
Operating revenues. A summary by segment of the Company's operating revenues is as follows:
Real estate information operating revenues increased 69.3% in 1996 over 1995. This increase was primarily attributable to the same factors affecting title insurance mentioned above and, to a lesser extent, $11.3 million of operating revenues contributed by new acquisitions. Real estate information operating revenues increased 53.7% in 1995 over 1994. This increase was primarily attributable to $59.8 million of operating revenues contributed by new acquisitions.
Home warranty operating revenues increased 17.9% in 1996 over 1995 and 15.7% in 1995 over 1994. These increases were primarily attributable to improvements in certain of the residential resale markets in which this segment operates, successful geographic expansion, increased consumer awareness and an increase in the number of annual renewals.
Salaries and other personnel costs. A summary by segment of the Company's salaries and other personnel costs is as follows:
The Company's title insurance segment is labor intensive; accordingly, a major variable expense component is salaries and other personnel costs. This expense component is affected by two competing factors: the need to monitor personnel changes to match corresponding or anticipated new orders, and the need to provide quality service. In addition, the Company's growth in operations servicing builder and lender business has created ongoing fixed costs required to service accounts.
The premium split between underwriter and agents is in accordance with their respective agency contracts and can vary from region to region due to divergence's in real estate closing practices as well as rating structures. As a result, the percentage of title premiums retained by agents can vary due to the geographical mix of revenues from agency operations.
Other operating expenses. A summary by segment of the Company's other operating expenses is as follows:
Title insurance other operating expenses increased 16.2% in 1996 over 1995 and 1.8% in 1995 over 1994. These increases were primarily the result of the impact created by the changes in incremental costs (i.e., office supplies, document reproduction, messenger services, plant maintenance and title search costs) associated with the relative changes in title order volume. Also contributing to the increases were marginal price level increases, offset in part by successful cost-containment programs.
Provision for title losses and other claims. A summary by segment of the Company's provision for title losses and other claims is as follows:
Pretax profits. A summary by segment of the Company's pretax profits is as follows:
Premium taxes. A summary by pertinent segment of the Company's premium taxes is as follows:
Income taxes. The Company's effective income tax rate, which includes a provision for state income and franchise taxes for non-insurance subsidiaries, was 39.9% for 1996, 45.0% for 1995 and 41.2% for 1994. The decrease in the effective rate for the current year when compared with the prior year was primarily attributable to changes in the ratio of permanent differences to income before income taxes. The increase for 1995 when compared with 1994 was primarily due to increases in state income and franchise taxes which resulted from the Company's non-insurance subsidiaries' contribution to pretax profits. Information regarding items included in the reconciliation of the effective rate with the federal statutory rate is contained in Note 10 to the consolidated financial statements.
Cash provided by operating activities amounted to $88.3 million, $30.4 million and $53.9 million for 1996, 1995 and 1994, respectively, after claim payments of $78.0 million, $66.6 million and $87.6 million, respectively. The principal non-operating uses of cash and cash equivalents for the three-year period ended December 31, 1996, were for additions to the investment portfolio, capital expenditures, company acquisitions and the repayment of debt. The most significant nonoperating sources of cash and cash equivalents were from proceeds from the sales and maturities of certain investments, and in 1994, proceeds from the sale of property and equipment and proceeds from the issuance of debt. The net effect of all activities on total cash and cash equivalents was an increase of $27.5 million for 1996, a decrease of $8.3 million in 1995 and an increase of $23.9 million in 1994.
Notes and contracts payable as a percentage of total capitalization as of December 31, 1996, was 16.0% as compared with 19.1% as of the prior year end. The decrease was primarily attributable to an increase in the capital base due to the net income for the year, as well as a $5.9 million net decrease in debt. The Company maintains a $30.0 million revolving line of credit which remained unused as of December 31, 1996. This credit agreement is more fully described in Note 8 to the consolidated financial statements.
Pursuant to various insurance and other regulations, the maximum amount of dividends, loans and advances available to the Company in 1997 from its principal subsidiary, First American Title Insurance Company, is $49.7 million. Such restrictions have not had, nor are they expected to have, an impact on the Company's ability to meet its cash obligations.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The First American Financial Corporation and its subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
The Company considers cash equivalents to be all short-term investments which have an initial maturity of 90 days or less and are not restricted for statutory deposit or premium reserve requirements. The carrying amount for cash equivalents is a reasonable estimate of fair value due to the short-term maturity of these investments.
Depreciation on buildings and furniture and equipment is computed using the straight-line method over estimated useful lives of 25 to 45 and 3 to 10 years, respectively.
Title plants and other indexes are carried at original cost. Appraised values are used in conjunction with the acquisition of purchased subsidiaries. The costs of daily maintenance (updating) of these plants and other indexes are charged to expense as incurred. Because properly maintained title plants and other indexes have indefinite lives and do not diminish in value with the passage of time, no provision has been made for depreciation.
Goodwill recognized in business combinations is amortized over its estimated useful life ranging from 20 to 40 years. Other intangibles, which include customer lists, covenants not to compete and organization costs, are amortized over their estimated useful lives, ranging from 3 to 20 years. The Company continually reviews these assets for recoverability and impairment.
Deferred policy acquisition costs are directly related to the procurement of tax service and home warranty contracts. These costs are deferred and amortized to expense in the same pattern as contract fees are recognized as revenues.
Interest on loans with the Company's thrift subsidiary is recognized on the outstanding principal balance on the accrual basis. Loan origination fees and related direct loan origination costs are deferred and recognized over the life of the loan.
Pursuant to insurance and other regulations of the various states in which the Company's title insurance subsidiary, First American Title Insurance Company (FATICO), operates, the amount of dividends, loans and advances available to the parent company from FATICO is limited, principally for the protection of policyholders. Under such statutory regulations, the maximum amount of dividends, loans and advances available to the parent company from FATICO in 1997 is $49.7 million.
The amortized cost and estimated fair value of debt securities at December 31, 1996, by contractual maturities, are as follows:
The fair value of loans receivable was $54.3 million and $47.2 million at December 31, 1996 and 1995, respectively, and was estimated based on the discounted value of the future cash flows using the current rates being offered for loans with similar terms to borrowers of similar credit quality.
In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan." This standard was effective for 1995 and requires that an impaired loan be measured at the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, the loan may be valued based on its observable market price or the fair value of the collateral, if the loan is collateral dependent. Adoption of this standard did not have a materially adverse effect on the Company's financial condition or results of operations.
At December 31, 1996, the Company's borrowings under its amended bank credit agreement consisted of $6.8 million of fixed rate indebtedness ($7.6 million at December 31, 1995), maturing in April 1999 and bearing interest at 9.38% per annum; and $30.5 million of variable rate indebtedness ($41.6 million at December 31, 1995), maturing in October 2000 and bearing interest at the higher of Chase Manhattan Bank's prime lending rate or the federal funds rate plus 1/2%. The Company may, at its election, use a LIBOR interest rate option with margins from .50% to 1.00% depending on claims paying or financial strength ratings or the Company's adjusted leverage ratio. In addition, the amended credit agreement provides for a $30.0 million revolving line of credit which was unused at December 31, 1996, and expires on November 22, 1997.
$3.0 million. The Company has the right to prepay the variable rate indebtedness but may prepay the fixed rate indebtedness only with the consent of the holder thereof. In addition, pursuant to the terms of the credit agreement, the Company must satisfy a number of financial covenants and has agreed to be bound by certain restrictive covenants. These covenants include, among others, limitations on the incurrence of additional indebtedness and/or liens, as well as restrictions on defined investments, acquisitions, dispositions, payments of dividends and capital expenditures. Further, the Company is required to maintain minimum levels of capital and earnings and meet predetermined debt to equity ratios and fixed charge coverage ratios.
Income taxes differ from the amounts computed by applying the federal income tax rate of 35%. A reconciliation of this difference is as follows:
The Company has pension and other retirement benefit plans covering substantially all employees. The Company's principal pension plan, amended to be noncontributory effective January 1, 1995, is a qualified defined benefit plan with benefits based on the employee's years of service and the highest five consecutive years' compensation during the last ten years of employment. The Company's policy is to fund all accrued pension costs. Contributions are intended to provide not only for benefits attributable to past service, but also for those benefits expected to be earned in the future. The Company also has non-qualified unfunded supplemental benefit plans covering certain key management personnel. Benefits under these plans are intended to be funded with proceeds from life insurance policies purchased by the Company on the lives of the executives.
Net pension cost for the Company's pension and other retirement benefit plans includes the following components:
The rate of increase in future compensation levels for the plans of 4 1/2% and the weighted average discount rate of 7 3/4% were used in determining the actuarial present value of the projected benefit obligation at December 31, 1996 and 1995. The majority of pension plan assets are invested in U.S. government securities, time deposits and common stocks with projected long- term rates of return of 9%.
On April 24, 1996, the Company implemented The First American Financial Corporation 1996 Stock Option Plan ("The Stock Option Plan"). Under The Stock Option Plan, options are granted to purchase the Company's common stock at a price no less than the market value of the shares on the date of the grant. The maximum number of shares that may be subject to options is 1,250,000. Currently outstanding options become exercisable one to five years and expire 10 years from the grant date.
First American Title Insurance Company, along with the other defendants in these actions, entered into a settlement agreement with the plaintiffs to settle both actions. This settlement agreement was approved by the District Court on July 24, 1996. Compliance with this settlement agreement will not have a materially adverse effect on the Company's financial condition or results of operations.
The Company's operations include four reportable segments: title insurance, real estate information, home warranty and trust and banking. The title insurance segment issues policies which are insured statements of the condition of title to real property. The real estate information segment provides to lender customers the status of tax payments on real property securing their loans, credit information derived from at least two credit bureau
The title insurance and real estate information segments operate through networks of offices nationwide. The Company offers its title services through both direct operations and agents throughout the United States. It also provides title services abroad in Australia, the Bahama Islands, Bermuda, Canada, Guam, Mexico, Puerto Rico, the U.S. Virgin Islands and the United Kingdom. Home warranty services are available in Arizona, California, Nevada, North Carolina, South Carolina, Texas and Washington. The trust, banking and thrift businesses operate in Southern California.
Corporate consists primarily of unallocated interest expense, minority interest, equity in earnings of affiliated companies, employee benefit contributions and personnel and other operating expenses associated with the Company's home office facilities.
- ------- Note A--Amount represents accounts written off, net of recoveries. Note B--Amount represents a reclassification to the reserve for assets acquired in connection with claim settlements. Note C--Amount represents claim payments, net of recoveries. Note D--Amount represents elimination of reserve in connection with disposition and/or revaluation of the related asset. Note E--Amount represents elimination of reserve in connection with utilization of the related temporary differences.