Each of our business segments uses our executive offices in Santa Ana, California. This office campus consists of five office buildings, a technology center and a two-story parking structure, totaling approximately 490,000 square feet. Three office buildings, totaling approximately 210,000 square feet, and the fixtures thereto and underlying land, are subject to a deed of trust and security agreement securing payment of a promissory note evidencing a loan made in October 2003, to our principal title insurance subsidiary in the original sum of $55 million. This loan is payable in monthly installments of principal and interest, is fully amortizing and matures November 1, 2023. The outstanding principal balance of this loan was $15.7 million as of December 31, 2019.
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. For example, 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 a corresponding increase or decrease of $125.8 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 rates 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 transferred from IBNR title claims related to current year increased by $2.0 million in 2019 from 2018 and increased by $0.3 million in 2018 from 2017 and payments, net of recoveries, related to current year increased by $2.0 million in 2019 from 2018 and decreased by $0.5 million in 2018 from 2017, reflecting variability in claims volumes characteristic of a policy year during its first year of development.
“Other” primarily includes foreign currency translation gains and losses and ceded reinsurance claims.
The provision related to current year increased by $8.9 million, or 5.1%, in 2019 from 2018 and decreased by $1.8 million, or 1.0%, in 2018 from 2017, respectively, and were attributable to increases in title premiums and escrow fees in 2019 from 2018 and decreases in title premiums and escrow fees in 2018 from 2017, respectively.
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 15 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 Company did not recognize any other-than-temporary impairment losses related to its debt securities for 2019, 2018 and 2017.
Impairment of equity investments. The carrying values of equity investments in which the Company exercises significant influence but does not control, and is not the primary beneficiary, are accounted for under the equity method of accounting. The carrying values of these investments are written down, or impaired, to fair value when a decline in value is considered to be other-than-temporary. In making the determination as to whether an individual investment is impaired, the Company assesses the current and expected financial condition of each relevant entity, including, but not limited to, the anticipated ability of the entity to make its contractually required payments to the Company (with respect to debt obligations to the Company), the results of valuation work performed with respect to the entity, the entity’s anticipated ability to generate sufficient cash flows and the market conditions in the industry in which the entity is operating.
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. Impairment losses on property and equipment primarily related to impairments of internally developed software of $6.0 million for 2019. Impairment losses on property and equipment were not material for 2018 and 2017.
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 $7.5 million for 2019. 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 5 Leases to the consolidated financial statements.
Employee benefit plans. 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 loss. Plan obligations are measured annually as of December 31.
A substantial portion of the revenues for the Company’s title insurance and services segment results from the sale and refinancing of residential and commercial real estate. In the Company’s specialty insurance segment, revenues associated with the initial year of coverage in both the home warranty and property and casualty operations are impacted by volatility in residential purchase transactions. Traditionally, the greatest volume of real estate activity, particularly residential purchase activity, has occurred in the spring and summer months. However, changes in interest rates, as well as other changes in general economic conditions in the United States and abroad, can cause fluctuations in the traditional pattern of real estate activity.
According to the Mortgage Bankers Association’s January 17, 2020 Mortgage Finance Forecast (the “MBA Forecast”), residential mortgage originations in the United States (based on the total dollar value of the transactions) increased 23.4% in 2019 when compared with 2018. According to the MBA Forecast, the dollar amount of purchase originations increased 5.2% and refinance originations increased 70.4%. 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 0.7% from domestic residential purchase transactions and 66.1% from domestic refinance transactions in 2019 when compared to 2018.
During 2019, the level of domestic title orders opened per day by the Company’s direct title operations increased 11.3% when compared to 2018. Residential refinance opened orders per day increased by 51.0%, residential purchase opened orders per day decreased by 1.6% and commercial opened orders per day were flat in 2019 when compared to 2018.
In addition to the Company’s innovative activities, other participants in the real estate and mortgage industries 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. Accordingly, the Company’s efforts to anticipate and participate in these transformations could require significant additional investment and may not succeed, resulting in a reduction in market share, reduced profitability and/or a loss of invested funds. 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.
Additionally, the Company continues to monitor developments in its regulatory environment. Currently, federal officials are discussing various potential changes to laws and regulations that could impact the Company’s businesses, including the reform of government-sponsored enterprises such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) and data privacy regulations, among others. Changes in these areas, and more generally in the regulatory environment in which the Company and its customers operate, could impact the volume of mortgage originations in the United States and the Company’s competitive position and results of operations.
The provision for policy losses and other claims, expressed as a percentage of title insurance premiums and escrow fees, was 4.0% for the years ended December 31, 2019, 2018 and 2017.
Insurers generally are not subject to state income or franchise taxes. However, in lieu thereof, a premium tax is imposed on certain operating revenues, as defined by statute. Tax rates and bases vary from state to state; accordingly, the total premium tax burden is dependent upon the geographical mix of operating revenues. The Company’s noninsurance subsidiaries are subject to state income tax and do not pay premium tax. Accordingly, the Company’s total tax burden at the state level for the title insurance and services segment is composed of a combination of premium taxes and state income taxes. Premium taxes as a percentage of title insurance premiums and escrow fees were 1.4% for the years ended December 31, 2019, 2018 and 2017.
Interest expense increased $7.7 million, or 102.6%, in 2019 from 2018 and $4.0 million, or 113.1%, in 2018 from 2017. The increases were primarily attributable to higher interest paid on secured financings payable and higher interest paid related to customer deposits at the Company’s banking subsidiary, First American Trust, FSB. The increases in interest paid on secured financings payable and on customer deposits were due to increases in average balances and higher interest rates paid.
The provision for home warranty claims, expressed as a percentage of home warranty premiums, was 49.8% in 2019, 53.8% in 2018 and 53.5% in 2017. 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 slight increase in rate in 2018 from 2017 was primarily attributable to an increase in claims severity, mostly offset by a decrease in claims frequency. The increase in claims severity was primarily due to higher claims management costs driven in part by the mix of claims.
The provision for property and casualty claims, expressed as a percentage of property and casualty insurance premiums, was 73.7% in 2019, 82.3% in 2018 and 85.0% in 2017. 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 current year provision also benefitted from recoveries received during 2019 related to wildfires that occurred in 2018 and 2017. The decrease in rate in 2018 from 2017 was primarily attributable to the occurrence of one event in 2018 compared with two events in 2017 with losses exceeding property and casualty’s reinsurance retention limit of $5.0 million for each event. During the fourth quarter of 2018 there was one wildfire in California that exceeded the reinsurance retention limit compared to two separate wildfires during the fourth quarter of 2017 that exceeded the reinsurance retention limit.
Corporate personnel costs and other operating expenses were $62.3 million, $35.6 million and $216.6 million in 2019, 2018 and 2017, respectively. The increase in 2019 from 2018 was primarily attributable to higher expense related to the Company’s deferred compensation plan. The decrease in personnel costs and other operating expenses in 2018 from 2017 was primarily attributable to pension settlement costs that the Company recognized related to the termination of its funded defined benefit pension plans of $152.4 million in 2017.
The Company’s inter-segment eliminations were not material for the years ended December 31, 2019, 2018 and 2017.
Income taxes differ from the amounts computed by applying the federal income tax rates of 21% for 2019 and 2018 and 35.0% for 2017. A reconciliation of these differences is as follows:
The Company’s effective income tax rates (income tax expense as a percentage of income before income taxes) were 21.6% for 2019, 21.9% for 2018 and 5.3% for 2017. The differences in the effective tax rates year over year are typically due to changes in state and foreign income taxes resulting from fluctuations in the Company’s noninsurance and foreign subsidiaries’ contributions to pretax income and changes in the ratio of permanent differences to income before income taxes. In addition, the tax rate for 2019 reflects the resolution of state tax matters from prior years. The Company’s effective tax rate for 2018 also includes a reduction in the federal tax rate from 35% to 21% as a result of the 2017 comprehensive tax reform legislation known as the Tax Cuts and Jobs Act (the “Tax Reform Act”). In addition, the Company’s effective tax rate for 2018 reflects the adjustment made to its initial 2017 estimates for the Tax Reform Act. The Company’s effective tax rate for 2017 reflects the estimated impact of the Tax Reform Act, state tax benefits relating to the termination of the Company’s pension plan, and the release of reserves relating to tax positions taken on prior year tax returns.
Cash requirements. The Company generates cash primarily from the sale of its products and services and investment income. The Company’s current cash requirements include operating expenses, taxes, payments of principal and interest on its debt, capital expenditures, dividends on its common stock, and may include business acquisitions, investments in unconsolidated entities and repurchases of its common stock. Management forecasts the cash needs of the holding company and its primary subsidiaries and regularly reviews their short-term and long-term projected sources and uses of funds, as well as the asset, liability, investment and cash flow assumptions underlying such forecasts. Based on the Company’s ability to generate cash flows from operations, its liquid-asset position and amounts available on its revolving credit facility, management believes that its resources are sufficient to satisfy its anticipated operational cash requirements and obligations for at least the next twelve months.
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, 2019, under such regulations, the maximum amount available to the holding company from its insurance subsidiaries in 2020, without prior approval from applicable regulators, was dividends of $508.9 million and loans and advances of $110.3 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.
As of December 31, 2019, the holding company’s sources of liquidity included $341.7 million of cash and cash equivalents and $540.0 million available on the Company’s revolving credit facility. Management believes that liquidity at the holding company is sufficient to satisfy anticipated cash requirements and obligations for at least the next twelve months.
FirstFunding, Inc., a specialized warehouse lender to correspondent mortgage lenders, maintains secured warehouse lending facilities with several banking institutions. At December 31, 2019, outstanding borrowings under these facilities totaled $278.4 million.
First American Trust, FSB, a federal savings bank, maintains a secured line of credit with the Federal Home Loan Bank and federal funds lines of credit with certain correspondent institutions. In addition, First American Trust, FSB is a party to master repurchase agreements under which securities may be loaned or sold. At December 31, 2019, no amounts were outstanding under any of these facilities.
First Canadian Title Company Limited, a Canadian title insurance and services company, maintains credit facilities with certain Canadian banking institutions. At December 31, 2019, no amounts were outstanding under these facilities.
Contractual obligations. A summary of the Company’s contractual obligations at December 31, 2019, due by period, is as follows:
Off-balance sheet arrangements. The Company administers escrow deposits and trust assets as a service to its customers. Escrow deposits totaled $7.3 billion and $7.6 billion at December 31, 2019 and 2018, respectively, of which $3.2 billion and $3.6 billion, respectively, were held at First American Trust, FSB. The escrow deposits held at First American Trust, FSB are temporarily invested in cash and cash equivalents and debt securities, with offsetting liabilities included in deposits in the accompanying consolidated balance sheets. The remaining escrow deposits were held at third-party financial institutions.
I. Summary of Investments-Other than Investments in Related Parties as of December 31, 2019
III. Supplementary Insurance Information as of December 31, 2019 and 2018 and for the years ended December 31, 2019, 2018 and 2017
IV. Reinsurance for the years ended December 31, 2019, 2018 and 2017
We have audited the accompanying consolidated balance sheets of First American Financial Corporation and its subsidiaries (the “Company”) as of December 31, 2019 and 2018, and the related consolidated statements of income, comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2019, including the related notes and financial statement schedules listed in the accompanying index (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
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, including 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.
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, many of which products, services and solutions involve the use of real property-related data; maintains, manages and provides access to title plant data and records; and provides appraisals and other valuation-related products and services, lien release and document custodial services, warehouse lending services, default-related products and services, evidence of title, 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.
The Company considers cash equivalents to be all short-term investments that have an initial maturity of 90 days or less and are not restricted.
The Company maintains investments in debt securities in accordance with certain statutory requirements for the funding of statutory premium reserves and state deposits. At December 31, 2019 and 2018, the fair values of such investments totaled $91.6 million and $111.0 million, respectively. See Note 2 Statutory Restrictions on Investments and Stockholders’ Equity for additional discussion of the Company’s statutory restrictions.
As a result of its security-level review, the Company did not recognize any other-than-temporary impairment losses considered to be credit related for the years ended December 31, 2019, 2018 and 2017. It is possible that the Company could recognize additional other-than-temporary impairment losses on securities it owns at December 31, 2019 if future events or information cause it to determine that a decline in fair value is other-than-temporary.
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, which is acquired or developed for internal use and for use with the Company’s products, is amortized over estimated useful lives ranging from 2 to 15 years using the straight-line method. Software development costs, which include certain payroll-related costs of employees directly associated with developing software in addition to incremental payments to third parties, are capitalized from the time technological feasibility is established until the software is ready for use.
On January 1, 2019, the Company adopted updated accounting guidance which requires lessees in leasing arrangements to recognize a lease asset and a liability to make lease payments on the balance sheet. 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 has elected the practical expedient for its leases of commercial real estate whereby it does not separately account for nonlease components (e.g., common-area maintenance costs) from the associated lease components (e.g., fixed payments including rent, real estate taxes and insurance costs) and instead accounts for both components as a single lease component for purposes of recognizing lease assets and liabilities. Variable lease costs, which include any variable lease and nonlease components and rents that vary based on changes to an index or rate, are expensed as incurred.
The Company has also elected the practical expedient which allows for leases with an initial term of 12 months or less to be excluded from recognition on the balance sheet and for which lease expense is recognized on a straight-line basis over the lease term.
For further information on the Company’s leasing arrangements see Note 5 Leases.
Title plants and other indexes included title plants of $530.5 million and $530.4 million and capitalized real estate data of $49.2 million and $47.1 million at December 31, 2019 and 2018, 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.
The Company is required to perform an annual goodwill impairment assessment for each reporting unit for which goodwill has been allocated. Those reporting units include title insurance, home warranty and property and casualty insurance. The Company’s trust and other services reporting unit has no allocated goodwill and is, therefore, not assessed for impairment. The Company has elected to perform this annual assessment in the fourth quarter of each fiscal year or sooner if circumstances indicate possible impairment. Based on accounting guidance, the Company has the option to perform a qualitative assessment to determine if the fair value is more likely than not (i.e., a likelihood of greater than 50%) less than the carrying amount as a basis for determining whether it is necessary to perform a quantitative impairment test, or may choose to forego a qualitative assessment and perform a quantitative impairment test. The qualitative factors considered in this assessment may include macroeconomic conditions, industry and market considerations, overall financial performance as well as other relevant events and circumstances as determined by the Company. The Company evaluates the weight of each factor to determine whether it is more likely than not that impairment may exist. If the results of the qualitative assessment indicate the more likely than not threshold was not met, the Company may choose not to perform the quantitative impairment test. If, however, the more likely than not threshold is met, the Company will perform a quantitative test as required and discussed below.
The Company chose to perform qualitative assessments for its title insurance and home warranty reporting units and performed a quantitative impairment test for its property and casualty insurance reporting unit for 2019, 2018 and 2017. The results of the Company’s qualitative assessments 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. Based on the results of its quantitative impairment tests, the Company determined that the fair value of its property and casualty insurance reporting unit exceeded the carrying amount and, therefore, no additional analysis was required. As a result of the Company’s annual goodwill impairment assessments, the Company did not record any goodwill impairment losses for 2019, 2018 or 2017.
For recent policy years at early stages of development (generally the last three years), IBNR is generally estimated using a combination of expected loss rate and multiplicative loss development factor calculations. For more mature policy years, IBNR generally is estimated using multiplicative loss development factor calculations. The expected loss rate method estimates IBNR by applying an expected loss rate to total title insurance premiums and escrow fees, and adjusting for policy year maturity using estimated loss development patterns. Multiplicative loss development factor calculations estimate IBNR by applying factors derived from loss development patterns to losses realized to date. The expected loss rate and loss development patterns are based on historical experience and the relationship of the history to the applicable policy years.
The volume and timing of title insurance claims are subject to cyclical influences from both the real estate and mortgage markets. Title policies issued to lenders constitute a large portion of the Company’s title insurance volume. These policies insure lenders against losses on mortgage loans due to title defects in the collateral property. Even if an underlying title defect exists that could result in a claim, often, the lender must realize an actual loss, or at least be likely to realize an actual loss, for a title insurance liability to exist. As a result, title insurance claims exposure is sensitive to lenders’ losses on mortgage loans and is affected in turn by external factors that affect mortgage loan losses, particularly macroeconomic factors.
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. A material change in expected ultimate losses and corresponding loss rates for older policy years is also possible, particularly for policy years with loss rates 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.
Premiums on property and casualty insurance policies and home warranty contracts are generally recognized ratably over the 12-month duration of the policy or contract.
The Company applies the optional exemptions allowed under accounting guidance whereby the Company is not required to disclose either the transaction price allocated to performance obligations that are unsatisfied as of the end of the period or an explanation as to when the Company expects to recognize the related revenue. Such contracts generally include performance obligations that are contingent upon the closing of a real estate transaction or include variable consideration based on order volumes and have remaining contract terms of generally less than three years. The Company is allowed to apply the optional exemptions to its remaining performance obligations due to 1) the performance obligation is part of a contract that has an original duration of one year or less, 2) the associated revenue being recognized is based on the Company’s right to invoice for the value of the product or service delivered, 3) the associated variable consideration is being allocated entirely to wholly unsatisfied performance obligations or 4) immateriality.
The Company also applies the practical expedient allowed under accounting guidance whereby it can disregard the impact to the transaction price of the effects of a significant financing component for arrangements where the Company expects the period between delivery of the product or service and customer payment to be one year or less. In addition, the Company applies the practical expedient whereby it recognizes the incremental costs of obtaining a contract as an expense when incurred if the amortization period for the asset that the Company otherwise would have recognized is one year or less.
The Company’s primary means of providing share-based compensation is through the granting of restricted stock units (“RSUs”). RSUs granted generally have graded vesting features and include a service condition; and for certain key employees and executives, may also include either a performance or market condition. RSUs receive dividend equivalents in the form of RSUs having the same vesting requirements as the RSUs initially granted.
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 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’s title insurance business assumes and cedes large title insurance risks through reinsurance and its property and casualty insurance business purchases reinsurance to limit risk associated with large losses from single events. Additionally, the Company has limited reinsurance arrangements related to certain products offered through its international operations. In reinsurance arrangements, the primary insurer retains a certain amount of risk under a policy and cedes the remainder of the risk under the policy to the reinsurer. The primary insurer pays the reinsurer a premium in exchange for accepting this risk of loss. The primary insurer generally remains liable to its insured for the total risk, but is reinsured under the terms of the reinsurance agreement. The amount of premiums assumed and ceded is recorded as a component of direct premiums and escrow fees on the Company’s consolidated statements of income. The total amount of premiums assumed and ceded in connection with reinsurance was less than 1.0% of consolidated premium and escrow fees for each of the three years in the period ended December 31, 2019. Payments and recoveries on reinsured losses for the Company’s title insurance business were immaterial during the years ended December 31, 2019, 2018 and 2017. For information related to payments on reinsured losses for the Company’s property and casualty insurance business see Note 9 Reserve for Known and Incurred But Not Reported Claims.
The Company facilitates tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code and tax-deferred reverse exchanges pursuant to Revenue Procedure 2000-37. As a facilitator and intermediary, the Company holds the proceeds from sales transactions and takes temporary title to property identified by the customer to be acquired with such proceeds. Upon the completion of each such exchange, the identified property is transferred to the customer or, if the exchange does not take place, an amount equal to the sales proceeds or, in the case of a reverse exchange, title to the property held by the Company is transferred to the customer. Like-kind exchange funds held by the Company totaled $3.0 billion and $2.7 billion at December 31, 2019 and 2018, respectively. The like-kind exchange deposits are held at third-party financial institutions and, due to the structure utilized to facilitate these transactions, the proceeds and property 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 to the customer for the transfers of property, disbursements of proceeds and the returns on such proceeds.
In February 2016, the Financial Accounting Standards Board (“FASB”) issued updated guidance that requires the rights and obligations associated with leasing arrangements to be reflected on the balance sheet in order to increase transparency and comparability among organizations. Under the updated guidance, lessees are required to recognize a right-of-use asset and a liability to make lease payments and disclose key information about leasing arrangements. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2018. The Company adopted the updated guidance using the modified retrospective transition approach and initially applied the guidance on January 1, 2019. Upon adoption, the Company recognized deferred gains of $1.3 million on previous sale and operating leaseback transactions as a cumulative-effect adjustment to retained earnings. The Company elected to adopt the package of practical expedients allowed under the guidance, which was applied to all leases as of the adoption date. The package of practical expedients included (1) entities could choose not to reassess whether any expired or existing contracts are or contain leases, (2) entities could choose not to reassess the lease classification for any expired or existing leases, and (3) entities could choose not to reassess initial direct costs for any existing leases. For further information on the Company’s leasing arrangements see Leases within this note and Note 5 Leases.
In August 2018, the FASB issued updated guidance that is intended to reduce potential diversity in practice in accounting for the costs of implementing cloud computing arrangements (i.e., hosting arrangements) that are service contracts. The updated guidance aligns the requirements for capitalizing implementation costs for these arrangements with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software and hosting arrangements that include an internal-use software license. 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. 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.
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, 2019, under such regulations, the maximum amount available to the Company from its insurance subsidiaries in 2020, without prior approval from applicable regulators, was dividends of $508.9 million and loans and advances of $110.3 million.
FATICO is domiciled in Nebraska and its statutory-based financial statements are prepared in accordance with accounting practices prescribed or permitted by the Nebraska Department of Insurance. The National Association of Insurance Commissioners’ (“NAIC”) Accounting Practices and Procedures Manual (“NAIC SAP”) has been adopted as a component of prescribed or permitted practices by the state of Nebraska. The state of Nebraska has adopted certain prescribed accounting practices that differ from those found in the NAIC SAP. Specifically, the timing of amounts released from the statutory premium reserve under Nebraska’s required practice differs from NAIC SAP resulting in total statutory capital and surplus that was lower by $235.5 million and $209.0 million at December 31, 2019 and 2018, respectively, than if reported in accordance with NAIC SAP.
Statutory accounting principles differ in some respects from GAAP, and these differences include, but are not limited to, non-admission of certain assets (principally limitations on deferred tax assets, goodwill, capitalized furniture and equipment, capitalized software, and premiums and other receivables 90 days past due), reporting of bonds at amortized cost, the lack of recognition of right-of-use assets and lease liabilities on the balance sheet for lease commitments in which the Company is a lessee, changes in the fair values of equity securities, amortization of goodwill, deferral of premiums received as statutory premium reserve, supplemental reserve (if applicable) and exclusion of the incurred but not reported claims reserve.
Sales of debt securities resulted in realized gains of $12.1 million, $3.3 million and $5.4 million, realized losses of $6.1 million, $20.3 million and $16.4 million, and proceeds of $1.1 billion, $1.3 billion and $821.0 million for the years ended December 31, 2019, 2018 and 2017, respectively.
Gross unrealized losses on investments in debt securities are as follows:
Based on the Company’s review of its debt securities in an unrealized loss position at December 31, 2019, it determined that the losses were primarily the result of changes in interest rates, which were considered to be temporary, rather than a deterioration in credit quality. The Company does not intend to sell and it is not more likely than not that the Company will be required to sell these securities prior to recovering their amortized cost. As such, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2019.
Net gains (realized and unrealized) of $66.7 million and net losses (realized and unrealized) of $38.6 million were recognized for the years ended December 31, 2019 and 2018, respectively, as a result of changes in the fair values of equity securities. Included in net gains during the year ended December 31, 2019 were net unrealized gains of $52.3 million and included in net losses during the year ended December 31, 2018 were net unrealized losses of $37.6 million, related to equity securities still held at December 31, 2019 and 2018, respectively. For the year ended December 31, 2017, sales of equity securities resulted in realized gains of $30.2 million and realized losses of $2.1 million.
The composition of the investment portfolio at December 31, 2019, by credit rating, is as follows:
Debt securities in an unrealized loss position at December 31, 2019, included bank loans totaling $18.1 million, of which $17.5 million were non-investment grade; high yield corporate debt securities totaling $9.3 million, all of which were non-investment grade; and emerging market debt securities totaling $19.9 million, of which $1.2 million were non-investment grade.
Future minimum lease payments under operating and finance leases with noncancelable lease terms, as of December 31, 2019, are summarized as follows:
Future minimum lease payments under operating leases with noncancelable lease terms, as of December 31, 2018, are as follows:
Total rental expense for all operating leases was $89.4 million and $91.0 million for the years ended December 31, 2018 and 2017, respectively.
A summary of the changes in the carrying amount of goodwill, by reportable segment, for the years ended December 31, 2019 and 2018, is as follows:
Amortization expense for finite-lived intangible assets was $28.4 million, $30.4 million and $28.1 million for the years ended December 31, 2019, 2018 and 2017, respectively.
Current year payments, net of recoveries, include $211.4 million, $228.3 million and $225.6 million for the years ended December 31, 2019, 2018 and 2017, respectively, that relate to the Company’s specialty insurance segment. Prior year payments, net of recoveries, include $41.7 million, $56.7 million and $46.1 million for the years ended December 31, 2019, 2018 and 2017, respectively, that relate to the Company’s specialty insurance segment.
“Other” primarily includes foreign currency translation gains and losses and ceded reinsurance claims. Payments and recoveries on reinsured losses for the Company’s title insurance business were immaterial during the years ended December 31, 2019, 2018 and 2017. Payments on reinsured losses for the Company’s property and casualty insurance business totaled $21.1 million, $15.3 million, and $8.9 million, and recoveries totaled $10.3 million, $20.3 million, and $9.6 million for the years ended December 31, 2019, 2018 and 2017, respectively.
The provision for title insurance losses, expressed as a percentage of title insurance premiums and escrow fees, was 4.0% for the years ended December 31, 2019, 2018 and 2017.
The following reflects information as of December 31, 2019 about incurred and paid claims development, net of reinsurance, as well as cumulative claims frequency by claims event, and the total of incurred but not reported claims plus expected development on reported claims included with the net incurred claims amounts.
The information below about incurred and paid claims development for the years ended December 31, 2010 to 2018, is presented as supplementary information.
A reconciliation of the net incurred and paid claims development tables to the liability for claims and claim adjustment expense at December 31, 2019, is as follows:
Supplementary information about average historical claims duration for the Company’s specialty insurance segment as of December 31, 2019, is as follows:
Trust deed note due November 1, 2023, collateralized by land and buildings with net book values of $38,402 and $39,283 at December 31, 2019 and 2018, respectively, fixed interest rate of 5.26%
The weighted-average interest rate for the Company’s notes and contracts payable was 4.22% and 4.42% at December 31, 2019 and 2018, respectively.
In April 2019, the Company entered into a senior unsecured credit agreement with JPMorgan Chase Bank, N.A. in its capacity as administrative agent and the lenders party thereto. The credit agreement, which is comprised of a $700.0 million revolving credit facility, includes an expansion option that permits the Company, subject to satisfaction of certain conditions, to increase the revolving commitments and/or add term loan tranches in an aggregate amount not to exceed $350.0 million. Unless terminated earlier, the credit agreement will terminate on April 30, 2024. The obligations of the Company under the credit agreement are neither secured nor guaranteed. Upon entry into the credit agreement, the Company borrowed $160.0 million and repaid the $160.0 million obligation outstanding under the previous $700.0 million senior unsecured credit agreement, which was terminated at that time. Other proceeds under the credit agreement may be used for general corporate purposes. At December 31, 2019, outstanding borrowings under the facility totaled $160.0 million at an interest rate of 3.30%.
At the Company’s election, borrowings of revolving loans under the credit agreement bear interest at (a) the Alternate Base Rate plus the applicable spread or (b) the Adjusted LIBOR rate plus the applicable spread (in each case as defined in the credit agreement). The Company may select interest periods of one, two, three or six months or (if agreed to by all lenders) such other number of months for Eurodollar borrowings of loans. The applicable spread varies depending upon the debt rating assigned by Moody’s Investor Service, Inc., Standard & Poor’s Rating Services and/or Fitch Ratings Inc. The minimum applicable spread for Alternate Base Rate borrowings is 0.25% and the maximum is 1.00%. The minimum applicable spread for Adjusted LIBOR rate borrowings is 1.25% and the maximum is 2.00%. The rate of interest on any term loans incurred in connection with the expansion option will be established at or about the time such loans are made and may differ from the rate of interest on revolving loans.
The aggregate annual maturities for notes and contracts payable for the next five years and thereafter, are summarized as follows:
For the years ended December 31, 2019, 2018 and 2017, domestic and foreign pretax income from continuing operations, before noncontrolling interests, were $857.2 million and $47.8 million, $571.9 million and $37.6 million, and $391.4 million and $53.9 million, respectively.
The exercise of stock options and vesting of RSUs represent a tax benefit that has been reflected as a reduction of income taxes payable and a reduction of income tax expense for the years ended December 31, 2019, 2018 and 2017. The benefits recorded were $3.2 million, $5.2 million and $3.4 million for the years ended December 31, 2019, 2018 and 2017, respectively.
At December 31, 2019, the Company had available net operating loss carryforwards for income tax purposes totaling $80.2 million, consisting of federal, state and foreign losses of $0.2 million, $35.9 million and $44.1 million, respectively. Of the aggregate net operating losses, $31.7 million has an indefinite expiration and the remaining $48.5 million expires at various times beginning in 2020.
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, 2019 and 2018, the Company carried a valuation allowance of $9.8 million and $10.6 million, respectively, against its deferred tax assets. Of this amount, $8.8 million and $8.9 million, respectively, related to net operating losses; the remaining $1.0 million and $1.7 million, respectively, related to other deferred tax assets. The decrease in the overall valuation allowance during 2019 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.
As of December 31, 2019, 2018 and 2017, the liability for income taxes associated with uncertain tax positions was $1.5 million, $13.3 million and $12.8 million, respectively. The net decrease in the liability during 2019 was primarily the result of the resolution of state tax matters from prior years and the net increase in the liability during 2018 was attributable to new uncertain tax positions. The net decrease in the liability during 2017 was primarily attributable to activity related to examinations conducted by various taxing authorities. The liabilities could be reduced by $0.4 million as of December 31, 2019 and $3.7 million as of December 31, 2018 and 2017 due to offsetting tax benefits associated with the correlative effects of potential adjustments, including timing adjustments and state income taxes. The net liability, if recognized, would favorably affect the Company’s effective income tax rate.
The Company maintains a deferred compensation plan for certain employees that allows participants to defer up to 100% of their salary, commissions and certain bonuses. Participants can allocate their deferrals among a variety of investment crediting options (known as “deemed investments”). The term deemed investments means that the participant has no ownership interest in the funds they select; the funds are only used to measure the gains or losses that will be attributed to each participant’s deferral account over time. Participants can elect to have their deferral balance paid out while they are still employed or after their employment ends. The deferred compensation plan is exempt from most provisions of the Employee Retirement Income Security Act (“ERISA”) because it is only available to a select group of management and highly compensated employees and is not a qualified employee benefit plan. To preserve the tax-deferred savings advantages of a nonqualified deferred compensation plan, federal law requires that it be unfunded or informally funded. Participant deferrals, and any earnings on those deferrals, are general unsecured obligations of the Company. The Company informally funds the deferred compensation plan through a tax-advantaged investment known as variable universal life insurance. Deferred compensation plan assets are held as an asset of the Company within a special trust, known as a “Rabbi Trust.” At December 31, 2019 and 2018, the value of the assets held in the Rabbi Trust of $103.5 million and $86.5 million, respectively, and the unfunded liabilities of $115.1 million and $94.3 million, respectively, were included in the consolidated balance sheets in other assets and pension costs and other retirement plans, respectively.
Certain of the Company’s subsidiaries have separate savings and employee benefit plans. Expenses related to these plans and the Company’s deferred compensation plan are included in the table below under “other plans, net”.
Net actuarial loss and prior service credit for the unfunded supplemental benefit plans expected to be amortized from accumulated other comprehensive loss into net periodic cost over the next fiscal year include an expense of $5.3 million and a credit of $3.1 million, respectively.
The Company expects to make cash contributions of $15.5 million to its unfunded supplemental benefit plans during 2020.
The valuation techniques and inputs used by the Company to estimate the fair value of assets measured on a recurring basis are summarized as follows:
There were no transfers between Levels 1, 2 and 3 during the years ended December 31, 2019 and 2018. Transfers into or out of the Level 3 category occur when unobservable inputs become more or less significant to the fair value measurement. The Company’s policy is to recognize transfers between levels in the fair value hierarchy at the end of the reporting period.
The carrying amount for cash and cash equivalents approximates fair value due to the short-term maturity of these investments.
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 391,000, 363,000 and 390,000 shares issued in connection with this plan for the years ended December 31, 2019, 2018 and 2017, respectively. At December 31, 2019, there were 1.6 million shares reserved for future issuances.
As of December 31, 2019, there was $26.9 million of total unrecognized compensation cost related to unvested RSUs that is expected to be recognized over a weighted-average period of 2.2 years. The fair value of RSUs is generally based on the market value of the Company’s shares on the date of grant. The weighted-average grant-date fair value of RSUs was $51.46, $54.80 and $39.56 for the years ended December 31, 2019, 2018 and 2017, respectively. The total fair value of shares distributed for the years ended December 31, 2019, 2018 and 2017 was $50.5 million, $54.5 million and $34.6 million, respectively. At December 31, 2019, 0.9 million shares were vested but not distributed.
During the year ended December 31, 2019, all remaining stock options outstanding were exercised at a weighted-average exercise price of $27.66 with cash proceeds of $0.8 million.
The following table presents a summary of the changes in each component of AOCI for the years ended December 31, 2019, 2018 and 2017:
The following table presents the other comprehensive income (loss) reclassification adjustments for the years ended December 31, 2019, 2018 and 2017:
These components of AOCI are components of net periodic cost. See Note 14 Employee Benefit Plans for additional details.
For those non-ordinary course lawsuits where the Company has determined that a loss is both probable and reasonably estimable, a liability representing the best estimate of the Company’s financial exposure based on known facts has been recorded. Actual losses may materially differ from the amounts recorded.
Anatao 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,
The Company and/or its subsidiaries are also parties to numerous class action lawsuits as a result of the information security incident that occurred during the second quarter of 2019. All of these lawsuits are putative class actions for which a class has not been certified. For the reasons described above, the Company has not yet been able to assess the probability of loss or estimate the possible loss or the range of loss.
The Company’s title insurance, property and casualty insurance, home warranty, banking, thrift, trust and wealth management businesses are regulated by various federal, state and local governmental agencies. Many of the Company’s other businesses operate within statutory guidelines. Consequently, the Company may from time to time be subject to examination or investigation by such governmental agencies. Currently, governmental agencies are examining or investigating certain of the Company’s operations. These include numerous regulatory inquiries and/or investigations as a result of the information security incident that occurred during the second quarter of 2019, including inquiries and/or investigations of the Nebraska Department of Insurance and other state insurance regulators, the Federal Trade Commission and the Securities and Exchange Commission. These also include an inquiry by the New York Attorney General and the Massachusetts Attorney General into competitive practices in the title insurance industry. With respect to matters where the Company has determined that a loss is both probable and reasonably estimable, the Company records a liability representing its best estimate of the financial exposure based on known facts. While the ultimate disposition of each such exam or investigation is not yet determinable, the Company does not believe that individually or in the aggregate they will have a material adverse effect on the Company’s financial condition, results of operations or cash flows. These exams or investigations could, however, result in changes to the Company’s business practices which could ultimately have a material adverse impact on the Company’s financial condition, results of operations or cash flows.
Selected financial information about the Company’s operations, by segment, for the years ended December 31, 2019, 2018 and 2017, is as follows:
Long-lived assets allocated between domestic and foreign operations, by segment, as of December 31, 2019, 2018 and 2017, are as follows:
On February 13, 2020, the Company announced the signing of a definitive agreement to acquire a company that provides document, eClose and fulfillment technology for the mortgage industry for a purchase price of $350 million. The transaction is expected to close by March 31, 2020, subject to certain customary closing conditions, including certain regulatory reviews. The Company expects to fund the acquisition with operating cash.