The information set forth in the following table should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 8, “Financial Statements and Supplementary Data.”
(1) In 2006, we incurred $14.7 million, or $9.5 million after taxes, for the write-off of intangible and other long-lived assets.
(2) 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.
(4) 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.
(5) In 2002, we recorded exit and termination costs of $13.4 million, or $8.7 million after taxes.
Revenue from our Title Operations segment includes title premiums, escrow fees and fees for other ancillary services. Premiums and fees are determined both by competition and by state regulation. In addition, revenue from our Title Operations segment is influenced by our sales and marketing efforts. Revenue from title operations owned by us is recognized at the time the real estate transaction closes. There can be a delay up to several months between the point in time that a title order is opened and the real estate transaction closes. Consequently, expenses may be incurred and recognized related to a direct title order in advance of revenue being recognized. Operating revenue from independent agents is recognized when we receive notification from the agent that a policy has been issued. Agent notification typically occurs later than the closing of the real estate transaction. The delay in notification
Given our relative size and market share, we believe that our business generally trends with the overall real estate industry. The Mortgage Bankers Association (“MBA”) estimated that there were $2.5 trillion residential mortgage originations in 2006, $3.0 trillion in 2005 and $2.8 trillion in 2004. The MBA’s statistics at January 8, 2007 estimate that approximately 44 percent of new mortgage originations in 2006 were refinance transactions as compared with approximately 50 percent in 2005 and 53 percent in 2004. Similar to the real estate industry, we experienced record years in 2004 and 2005 due to a low interest rate environment and strong commercial activity. During 2006, rising mortgage interest rates coupled with several years of strong appreciation in home prices, reduced consumer housing affordability and caused a decline in housing sales and in the volume of refinance activity. In 2006, commercial revenue was 25.7 percent of direct title business and tends to be less sensitive to the interest rate fluctuations. The full year 2006 continued to benefit from strong levels of commercial activity. Consequently, before the impact of the Capital Title merger discussed above, operating revenue in 2006 decreased only 1.1 percent over 2005. The MBA forecast anticipates mortgage interest rates to remain stable in 2007, but expects a decrease in overall mortgage originations of approximately 5 percent to $2.4 trillion in 2007, with refinance transactions accounting for 44 percent of the market. We believe that our results for 2007 will mirror the MBA expectations. In addition, we believe that the commercial real estate cycle reached its peak in 2006 and will level off in 2007.
We may receive additional subpoenas and/or requests for information in the future from state or federal government agencies. We will evaluate, and we intend to cooperate in connection with, all such subpoenas and requests.
Our Lender Services segment provides services to regional and national lending institutions which complement those offered in our title insurance business. We reorganized the management of the Lender Services segment to focus on three lines of business: mortgage origination, loan servicing and loan subservicing. Our mortgage origination business consists primarily of centralized transaction management services, flood zone determinations, appraisal and valuation services, and consumer mortgage credit reporting. Our loan servicing business provides real estate processing services and default management services, and our loan subservicing business provides national loan subservicing though our subsidiary LoanCare Servicing Center, Inc. During the past three years, we have expanded our Lender Services platform through strategic acquisitions. In 2005, 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. In addition we expanded our product offering with the purchase of LoanCare, a mortgage loan subservicer in December 2004. During 2006, our merger with Capital Title further expanded our Lender Services platform with the addition of a centralized management services business and an appraisal and valuation business. We also acquired a business that developed a web-based application that manages the default mortgage process and acquired a flood determination business. In addition, 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 targets servicing relationships and the other targets 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. We expect to continue expanding organically and through small acquisitions or partnerships in this segment and to build on cross-selling opportunities.
The business reported in this segment includes Centennial, a California industrial bank acquisition we made in November 2003. Centennial’s primary business is the origination and bulk purchase of commercial real estate loans in the Southern California market and, to a lesser degree, in Arizona and Nevada; Centennial’s business is dependent on the viability of the commercial real estate market in these markets. Deposits are solicited through the internet for both certificates of deposit and passbook savings accounts. As an industrial bank, Centennial does not accept demand deposits, such as checking accounts, that provide for payment to third parties. Centennial does not offer banking services such as credit cards or automated teller machines. We utilize Centennial to hold a portion of our escrow deposits. At December 31, 2006, the escrow balance was approximately $288.5 million. We will continue to expand the depository services capabilities of Centennial to facilitate escrow transactions.
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 due to occurring changes in underlying economic conditions, these estimates are subject to variability. We review our claims experience quarterly, and in conjunction with our outside actuaries, evaluate the adequacy of our claims reserve. We consider factors such as historical timing of reported claims and claims payments over the period in which policies are effective against actual experience by year of policy issue to determine the amount of claims liability required for each year for which policies are outstanding. We also consider the impact of current trends in marketplace activity, including refinance activity, which may shorten the time period a policy is outstanding, bankruptcies and individual large claims attributable to any particular period in determining the expected liability associated with each year. 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. Our recorded liability for claim losses at December 31, 2006 includes reserves for known claims of $146.0 million and reserves for losses that have been incurred but have not yet been reported of $643.1 million. Reserves for known claims include the estimated amount of the claim and the costs required to settle the claim. A provision for estimated claims that are incurred but not yet reported is established at the time premium revenue is recognized based on reported claims, historical loss experience and other factors, including industry trends.
We completed 11 acquisitions with a total purchase price of $266.5 million in 2006, 9 acquisitions with a total purchase price of $26.1 million in 2005 and 27 acquisitions with a purchase price of $202.1 million in 2004. 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. Depending on the size of an acquisition, we may utilize the services of an outside appraisal company to assist with the allocation of purchase price to acquired assets (including goodwill) and liabilities.
In accordance with SFAS No. 142, Goodwill and Other Intangibles, we assess the recoverability of goodwill for each of our reporting units. Reporting units are business components of an operating segment, and goodwill is assigned to the reporting unit which benefits from the synergies arising from each business acquisition. We test for the recoverability of goodwill annually or sooner if events or changes in circumstances indicate that the carrying amount of our reporting units, including goodwill, may exceed their fair values. The fair value of the reporting units is determined using cash flow analysis which projects the future cash flows produced by the reporting units and discounts those cash flows to the present value. The projection of future cash flows is necessarily dependent upon assumptions on the future levels of income as well as business trends, prospects and market and economic conditions. In addition, we utilize the services of an outside valuation company to assist with the annual review of goodwill. When the fair value is less than the carrying value for the net assets of the reporting unit, including goodwill, an impairment loss may be charged to operations. Based on our annual analysis, no impairment was identified for the year ending December 31, 2006.
Our intangible assets primarily include capitalized customer relationships and non-competition arrangements which are amortized over their useful lives. Pursuant to SFAS No. 142, tests for impairment must be performed for intangible assets that are amortizable with definite lives if conditions exist that indicate the carrying value may not be recoverable. Such conditions may include a loss of a significant customer or a change in the assessment of future operations. During 2005, LandAmerica Tax & Flood ceased providing future tax services in two states, California and Colorado, for one of its largest tax and flood customers. As a result of the loss of business, we conducted an impairment test of LandAmerica Tax & Flood’s long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, by using estimated future cash flows. We determined that LandAmerica Tax & Flood’s customer relationship intangible was impaired by $37.6 million, which has been reflected in our results of operations for the year ended December 31, 2005. At December 31, 2006, there was approximately $26.8 million of customer relationship intangibles remaining related to the LandAmerica Tax & Flood acquisition. See further details in Note 13 in our financial statements under Part II, Item 8, “Financial Statements and Supplementary Data.”
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, 2006 and 2005 relate primarily to deferred service arrangements, employee benefit plans, goodwill, policy and contract claims, pension liability, tax and flood claims, convertible debt and allowance for doubtful accounts, offset by deferred tax liabilities primarily related to other intangibles, fixed assets, title plants, unrealized gains on our investment portfolio 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 9 in our financial statements under Part II, Item 8, “Financial Statements and Supplementary Data.”
Changing the discount rate would have the following impact on the pension benefit liability:
When we acquire tax processing and home warranty companies, all of their assets and liabilities are adjusted to fair value in accordance with purchase method accounting. In making these adjustments, any balance in the deferred revenue account at the acquisition date, which represents amounts that have been deferred prior to acquisition and would have been amortized over the remaining lives of the contracts are eliminated. The deferred revenue account is replaced with an account called deferred service obligations representing the estimated fair value of the obligation to provide the required services over the remaining life of the subject contracts. This account, established as of the acquisition date, is being amortized over the remaining lives of existing contracts.
As previously noted, real estate tax processing and home warranty service fees received on new contracts entered into since the acquisition dates are deferred and amortized over the estimated lives of the contracts to which they relate. The sum of amortization of the “initial deferred service obligation” and amortization related to fees accrued on new contracts represent the earned fee amount for the period.
The estimated remaining contractual life for real estate tax processing services can vary depending on a number of factors, including but not limited to, type of loan, lender, credit quality of the borrower, interest rates, and portfolio turnover. We evaluate the portfolio of loans under service quarterly to determine the appropriate portfolio life for loans under service. An increase/decrease of six months in the average service life for all loans serviced would result in the following approximate changes to revenue recognized for real estate tax monitoring revenue:
In September 2006, FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (“SFAS No. 158”). This standard requires employers to recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS No. 158 requires employers to measure the funded status of a plan as of the date of its year-end statement of financial position. The new reporting requirement and related new footnote disclosure rules of SFAS No. 158 are effective for fiscal years ending after December 15, 2006 and have been adopted. See Note 12 in our financial statements under Part II, Item 8, “Financial Statements and Supplementary Data.” The new measurement date requirement applies for fiscal years ending after December 15, 2008.
In February 2006, FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140 (“SFAS No. 155”). SFAS No. 155 permits remeasurement for any
hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and amends Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of fiscal years that begin after September 15, 2006. We are evaluating the impact of adopting SFAS No. 155 on our financial statements.
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 changes in interest rates. Periods of increasing interest rates usually have an adverse impact on residential real estate activity and therefore decrease our title insurance premiums and fee revenue. In contrast, periods of declining interest rates usually have a positive impact on residential real estate activity which increase our title insurance premiums and fee revenue.
Commercial real estate volumes are less sensitive to changes in interest rates, but fluctuate based on local supply and demand conditions for space.
The title insurance business tends to be seasonal as well as cyclical. Residential buy/sell activity is 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 of residential refinancing and of commercial real estate transactions. Due to a downturn in the residential real estate environment in 2006, our results did not follow the typical seasonal patterns with third quarter 2006 results below second quarter 2006 results.
Closed orders from direct title operations were approximately 731,000 in 2006 with an average fee per closed order (which includes title insurance premiums and other revenue related to completed transactions by direct operations) of approximately $2,100, compared to 861,000 in 2005 with an average fee per closed order of approximately $1,800. Closed orders from acquired companies were approximately 31,000 in 2006.
Operating revenue from direct title operations increased $188.1 million, or 14.1 percent, in 2005 over 2004. Acquisitions completed during 2005 and 2004 contributed approximately $41.8 million to the increase in operating revenue from direct operations for 2005. During 2005, we continued to experience strong commercial and buy/sell activity. Title insurance revenue from commercial operations was $382.1 million for 2005, an increase of 24.1 percent over 2004. Refinance activity was lower year over year due to moderate increases in the interest rate environment in 2005.
Lender Services - Operating revenue in the Lender Services segment decreased $15.7 million, or 5.8 percent in 2006 compared to 2005. Acquired companies contributed approximately $18.3 million to operating revenue for 2006. Results for 2005 included accelerated deferred revenue related to our tax and flood business of $33.8 million. The real estate tax processing and flood zone certification business receives cash in advance to provide service over the life of the loan. We are required to defer a significant portion of the revenue received for these services over the anticipated service life of contracts. As a result, revenue reported in the financial statements represents the amortization of both current and prior service fees. In 2006, real estate tax processing and flood certification services revenue was made up of gross receipts of $71.3 million, reduced by deferred recognition of revenue for $54.4 million of these receipts and increased by the recognition into revenue of approximately $49.9 million of our previously deferred service arrangements. The service life of our portfolio has not significantly increased compared to 2005. The expected service life of the portfolio increases with an increasing mortgage interest rate environment because loans tend to be outstanding longer in periods when interest rates increase. This reduces the amount of deferred service arrangements that is amortized into revenue for each period on our life of loan products. If interest rates vary from the current expected trend, the estimated service life is expected to increase or decrease inversely to changes in interest rates.
Corporate and Other - Operating revenue in Corporate and Other increased by approximately $19.6 million, or 19.2 percent, from 2006 over 2005, primarily due to strong commercial business and increased revenue in the home warranty business.
Corporate and Other - Salary and employee benefit expenses for the Corporate and Other segment increased $12.7 million, or 16.1 percent, in 2006 over 2005. In 2006, we incurred higher personnel costs in response to growth in the non-title commercial and home warranty businesses and investments in technology resources. Salaries and benefit expenses increased $12.2 million in 2005, or 18.3 percent, over 2004. Incremental salary and employee benefit expenses from acquisitions completed during 2005 and 2004 were approximately $9.5 million in 2005.
We identified certain title plants in 2006 and in 2004 that will not continue to be used or maintained. As a result, we took charges to earnings of $4.4 million in 2006 and $5.0 million in 2004 to reflect the reduction in value of these plants. We did not have any material charges related to title plants in 2005. We anticipate that as a result of the trend toward automation of property records by municipalities and courts, we will continue to record charges related to the lessening in value of our title plants in future periods.
In the first quarter of 2006, we announced our plan to relocate and consolidate our corporate offices and shared resources operations. As a result, we wrote down the corporate office building and related assets to fair value less cost to sell by $10.3 million. In fourth quarter 2006, we sold the corporate office building and related assets.
See Note 13 in our financial statements under Part II, Item 8, “Financial Statements and Supplementary Data.”
Amortization expense decreased by $2.9 million in 2006 compared to 2005 and increased $4.2 million in 2005 compared to 2004. The decrease from 2005 to 2006 was primarily the result of the write-off of customer relationship intangible assets of $37.6 million in 2005 within our Lender Services segment, offset by increases in intangible assets due to acquisitions. The increase from 2004 to 2005 was the result of acquisitions made by us in
2005 and 2004. Acquired businesses added $16.5 million to amortizable intangible assets in 2006 and $13.5 million in 2005. We are amortizing the intangible assets acquired as part of these businesses over their estimated useful lives.
Interest expense increased by $11.4 million in 2006 over 2005 and by $7.0 million in 2005 over 2004. The increase in interest expense in 2006 was due to increases in interest-bearing deposits and borrowings at Centennial and interest on our senior notes issued in third quarter 2006 and on the revolving credit facility. The increase in interest expense in 2005 was due to increases in interest-bearing deposits and borrowings at Centennial and convertible debt issued in May 2004.
Corporate and Other - General and administrative expenses in the Corporate and Other segment increased by $18.4 million, or 20.9 percent, in 2006 from 2005. The increase in these expenses is primarily related to increased expenses associated with improvement in our commercial assessment business and relocation and related exit costs of our corporate offices. General and administrative expenses in the Corporate and Other segment increased by $22.1 million, or 33.6 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.
Title Operations - The Title Operations segment reported pretax income of $226.5 million in 2006, $326.9 million in 2005, and $331.0 million in 2004. We expect to realize synergies from Capital Title and generate annual cost savings of approximately $16.0 million during 2007 and 2008. Before acquisitions, pretax income in this segment from 2006 compared to 2005 was negatively impacted by lower volumes in the residential real estate market, increased interest expense, an increase in the write-down in the value of certain title plants, and a higher claims provision ratio. Pretax income in this segment from 2005 compared to 2004 was negatively impacted by increases in litigation costs, partially offset by increased operating revenue from higher buy/sell and commercial volumes and from our growth through acquisitions during 2005 and 2004.
Financial Services - The Financial Services segment reported pretax income of $17.7 million in 2006, $13.5 million in 2005 and $9.7 million in 2004. The increase in pretax income from 2005 to 2006 and from 2004 to 2005 was due to growth in the loans receivable and investment portfolios that exceeded the increase in interest-bearing deposits. Pretax income in 2006 was also affected by a modest increase in interest rates that had a positive effect on the investment portfolio.
Our effective income tax rate, which includes a provision for state income and franchise taxes for non-insurance subsidiaries, was 35.8 percent for 2006, 36.6 percent for 2005 and 35.2 percent for 2004. The differences in the effective tax rate were primarily due to changes in the ratio of permanent differences to income before taxes and the mix of state taxes related to our non-insurance subsidiaries.
We reported net income for 2006 of $98.8 million, or $5.61 per share on a diluted basis, compared to $165.6 million, or $9.29 per share on a diluted basis, for 2005 and $171.6 million, or $9.39 per share on a diluted basis, for 2004.
The following table sets forth our condensed consolidated cash flows for the years indicated:
Cash flows from operating activities are affected by the timing of premiums received, fees received, investment income and expenses paid. Principal sources of cash at the operating subsidiary level include sales of our products and services. The decrease in cash flows for the year ended December 31, 2006 from operating activities was primarily the result of lower business volumes and the timing of payments for federal income taxes and other accrued expenses.
The decrease in net cash used in investing activities for the year ended December 31, 2006 compared to December 31, 2005 was primarily the result increased short-term investments partially offset by funds used to purchase businesses.
Total assets were $4.2 billion at December 31, 2006, compared to $3.7 billion at December 31, 2005. The increase in total assets was driven primarily by increased balances of investments and loans receivable from normal business growth and by the merger with Capital Title.
Total liabilities were $2.8 billion at December 31, 2006, compared to $2.4 billion at December 31, 2005. The increase in total liabilities was primarily driven by an increase in notes payable related to our issuance of $100.0 million of Senior Notes, Series E at 6.70 percent due in 2016, $50.0 million of Senior Notes, Series D at 6.66 percent due in 2016 and $100.0 million drawn on our new five-year revolving credit facility; an increase in our provision for claims liability; an increase in passbook savings deposits and increases in deferred revenue; offset partially by repayment of $50.0 million of our Senior Notes, Series A that matured in 2006. See Note 10 under Part II, Item 8, “Financial Statements and Supplementary Data” for additional information about our credit arrangements.
At December 31, 2006, our investment portfolio was designated as available for sale. We review the status of each security quarterly to determine whether an other-than-temporary impairment has occurred. In making our determination, we consider a number of factors including: (1) the significance of the decline, (2) whether the securities were rated below investment grade, (3) how long the securities have been in the unrealized loss position, and (4) our ability and intent to retain the investment for a significant period of time for it to recover. As a change in investment strategy, we are currently exploring options to redesignate approximately 11.6 percent of our fixed maturity investment portfolio from available-for-sale to trading in order to provide us with more flexibility to realize opportunities in the marketplace.
During 2006, we acquired 100 percent of Capital Title’s common stock for approximately $252.6 million, which consisted of $202.9 million of cash, including direct transaction costs of $3.6 million, and $49.7 million of our common stock which represented 775,576 shares. We believe that our merger with Capital Title will strengthen our presence in key western states and add scale to the services we provide to our mortgage lending customers. We funded approximately $100.0 million of the merger through our line of credit and an additional $100.0 million through the issuance of senior notes. The remaining cash consideration was funded through a mixture of cash and short-term investments. We will continue to selectively evaluate additional acquisitions should attractive candidates be identified. See Note 2 in our financial statements under Part II, Item 8, “Financial Statements and Supplementary Data” for further details about the merger.
In July 2006, we entered into a Note Purchase and Master Shelf Agreement (the “Note Purchase Agreement”) with Prudential Investment Management, Inc. (“Prudential”) and the other purchasers thereunder. Under the Note Purchase Agreement, we issued $50.0 million of Senior Notes, Series D (the “Series D Notes”) to
the Series D Note purchasers on August 31, 2006 and we issued $100.0 million of Senior Notes, Series E (the “Series E Notes”) to the Series E Note purchasers on September 7, 2006. In addition, the Note Purchase Agreement contained provisions for an uncommitted shelf facility for which we may issue, on or prior to July 28, 2009, up to $75.0 million of Senior Notes (the “Shelf Notes”) to Prudential, upon mutually acceptable terms and conditions as may be agreed upon at the time of issuance. The Shelf Notes, if issued, will bear interest at a to-be-determined per annum rate and will have maturities of no more than ten years. As of December 31, 2006, there were no borrowings outstanding under the Shelf Notes.
In December 2005, we filed a universal shelf registration statement on Form S-3 with the U.S. Securities and Exchange Commission which permits us to offer and sell, from time to time, various types of securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units, having an aggregate offering price up to $400.0 million. We may from time to time issue debt and equity securities as market conditions permit and our financing needs arise. At December 31, 2006, the universal shelf registration was fully available.
We believe our revolving credit facilities and anticipated cash flows from operations will provide us with sufficient liquidity to meet our operating requirements for the foreseeable future. For further information about our borrowings, see Note 10 in our financial statements under Part II, Item 8, “Financial Statements and Supplementary Data.”
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 $1,702.3 million and $1,111.7 million at December 31, 2006 and 2005, 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 $179.5 million and $409.4 million at December 31, 2006 and 2005, respectively. Due to the structure utilized to facilitate these transactions, like-kind exchanges and reverse exchanges are not considered our assets 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, 2006, we had a policy and contract claims reserve of $789.1 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.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that LandAmerica Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). LandAmerica Financial Group’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of LandAmerica Financial Group, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2006 and our report dated February 27, 2007 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of LandAmerica Financial Group, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of LandAmerica Financial Group Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2007 expressed an unqualified opinion thereon.
When used in these notes, the terms “LandAmerica,” “we,” “us” or “our” means LandAmerica Financial Group, Inc. and all entities included in our consolidated financial statements.
Through our subsidiaries, we are one of the largest title insurance companies in the United States. Our principal title insurance underwriters - Commonwealth Land Title Insurance Company, Lawyers Title Insurance Corporation and Transnation Title Insurance Company - together provide the majority of our insurance products in the United States, Mexico, Canada, Europe, the Caribbean, Latin America and Asia. We also provide escrow and closing services, commercial real estate services and other real estate transaction management services that are included in the Title Operations segment.
Realized gains and losses on sales of investments, as well as declines in value of a security considered to be other than temporary, are recognized in operations on the specific identification basis.
Loans receivable are impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans receivable are generally measured at the present value of expected cash flows discounted at the loan’s effective interest rate. In the case of collateral-dependent loans, impairment is based on the fair value of the collateral.
The carrying value of accounts receivable approximates fair value. The allowance for doubtful accounts receivable represents an estimate of amounts considered uncollectible and is determined based on our evaluation of historical collection experience, adverse situations which may affect an individual customer’s ability to repay and prevailing economic conditions.
Property and equipment, including capitalized software costs, is recorded at cost less accumulated depreciation and is depreciated principally on a straight-line basis over the estimated useful lives of the various assets, which range from 3 to 10 years for furniture and equipment, 5 to 40 years for buildings and leasehold improvements, 3 to 5 years for capitalized software, and 15 years for the airplane. Leasehold improvements are depreciated on a straight-line basis over the lesser of the term of the applicable lease or the estimated useful lives of such assets. Capitalized software costs are capitalized from the time that technological feasibility is established until the software is ready for use.
Policy and contract claims represent the estimated ultimate net cost of all reported and unreported losses incurred for policies for which revenue has been recognized through December 31, 2006. We reserve for reported claims based on a review of the estimated amount of the claims and costs required to settle the claim. The reserves for unpaid losses and loss adjustment expenses are estimated using historical loss and loss development analyses.
Deferred income taxes reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Future tax benefits are recognized to the extent that realization of such benefits are more likely than not.
Premiums on title insurance policies issued by our insurance subsidiaries are recognized as revenue when we are legally or contractually entitled to collect the premium. Revenues from title policies issued through independent agents are recognized when the policies are reported by the agent and are recorded on a “gross” basis (before the deduction of agent commissions). Title search and escrow fees are recorded as revenue when the order is closed.
Interest income is recognized by our California industrial bank on the outstanding principal balance using the accrual basis of accounting. Loan origination fees and related direct loan costs are deferred and recognized over the life of the loan. Loans are typically classified as non-accrual if the borrowers miss three or more contractual payments. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, in accordance with the contractual interest and principal payment terms of interest and principal.
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 $1,702.3 million and $1,111.7 million at December 31, 2006 and 2005, 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 $179.5 million and $409.4 million at December 31, 2006 and 2005, 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 obligated for the transfers of property, disbursement of proceeds and the return on the proceeds at the agreed upon rate.
The carrying amounts reported in the balance sheet for cash, federal funds sold, short-term investments, and notes and accounts receivable approximate those assets’ fair values. Fair values for investment securities are based on quoted market prices. The fair value of loans receivable was estimated based on the discounted value of future cash flows using the current rates offered for loans with similar terms to borrowers of similar credit quality. The fair value of the fixed-rate portion of our notes payable are estimated using discounted cash flow analyses, based on our current incremental borrowing rates for similar types of borrowing arrangements. The remaining
portion of our notes payable approximates fair value since the interest rate is variable. The fair value of deposits was estimated based on the discounted value of future cash flows using a discount rate approximating current market for similar liabilities. We have no other material financial instruments. See Notes 3, 4, 7 and 10 for additional information.
Effective January 1, 2006, we adopted the provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”) as revised by SFAS 123(R), Share-Based Payment (“SFAS No. 123-(R)”). We have used the modified prospective adoption method. Under this method, the share-based compensation cost recognized beginning January 1, 2006 includes compensation cost for (i) all share-based payments granted prior to, but not vested as of January 1, 2006, based on the grant date fair value originally estimated in accordance with the provisions of SFAS No. 123 and (ii) all share-based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123-(R). Compensation cost under SFAS No. 123-(R) is recognized ratably using the straight-line attribution method over the expected vesting period or to the retirement eligibility date, if less than the vesting period when vesting is not contingent upon any future performance. As of January 1, 2006, the cumulative effect of adopting SFAS No. 123-(R) was not significant.
Prior to January 1, 2006, we accounted for share-based compensation plans in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123. Accordingly, no compensation expense was recognized for our stock options since all options granted had an exercise price equal to the market value of the underlying stock on the date of grant. No stock options have been granted since 2002.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”), to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that misstatements be quantified based on their impact on each financial statement and related disclosures. SAB 108 was effective as of the end of our 2006 fiscal year, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108. We have determined that SAB 108 has no material impact on our financial statements.
In September 2006, FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (“SFAS No. 158”). This standard requires employers to recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS No. 158 requires employers to measure the funded status of a plan as of the date of its year-end statement of financial position. The new reporting requirement and related new footnote disclosure rules of SFAS No. 158 are effective for fiscal years ending after December 15, 2006 and have been adopted. See Note 12. The new measurement date requirement applies for fiscal years ending after December 15, 2008.
In June 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertain tax positions. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 with earlier adoption permitted. While we are currently evaluating the impact of adopting FIN 48, we do not expect that the adoption of FIN 48 will have a material impact on our financial statements.
In February 2006, FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140 (“SFAS No. 155”). SFAS No. 155 permits remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and amends Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of fiscal years that begin after September 15, 2006. We are evaluating the impact of adopting SFAS No. 155 on our financial statements.
In accordance with SFAS No. 141, the cost of the merger was preliminarily allocated to the tangible and identifiable intangible assets acquired and liabilities assumed based on their fair values as of the close of the merger, with the amounts exceeding the fair value being recorded as goodwill. As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, valuation of separately identifiable intangibles, property, plant and equipment, title plants, deferred taxes, exiting certain contractual arrangements and the expected plans to rationalize the combined workforce. The valuations will be finalized within 12 months of the close of the merger. When the valuations are finalized, any changes to the preliminary valuation of assets acquired or liabilities assumed may result in adjustments to separately identifiable intangibles and goodwill. The results of operations of Capital Title have been included in our consolidated financial statements since the merger date.
The above pro forma results are presented for information purposes only and may not be indicative of the operating results that would have occurred had this merger been consummated as of the beginning of 2004. The above pro forma results include consultant fees of $3.3 million in 2006 related to the merger with Capital Title.
The following table summarizes the estimated fair value of the assets and liabilities acquired in the merger with Capital Title on the merger date. The allocation of the excess of merger costs over the fair value of net assets is preliminary and subject to final adjustment, primarily because we are finalizing the opening balance sheet related to this merger. We will complete the allocation of the excess merger costs within one year of the merger date.
These acquisitions have been accounted for using the purchase method of accounting and each of the acquisitions’ results has been included in the consolidated financial statements since the acquisition date. These businesses were not considered significant individually or in the aggregate for 2006, 2005 and 2004. Substantially all of these acquisitions in 2006, 2005 and 2004 have escrow agreements where a portion of the consideration has
been placed in escrow until predetermined criteria have been met. Additionally, in certain instances, we have entered into purchase agreements which contain provisions for additional payments should the acquired company meet certain operating results. Neither the escrow agreements nor the contingent consideration are material to our financial statements or operations.
The following table summarizes intangible assets acquired during 2006, exclusive of any contingent payments and purchase accounting adjustments:
Approximately $30.5 million of the acquired goodwill is expected to be tax deductible.
The amortized cost and estimated fair value of investments in fixed maturities available-for-sale at December 31, 2006 and 2005 were as follows:
At December 31, 2006, we held 805 securities which were in an unrealized loss position with a total estimated fair value of $581.0 million and gross unrealized losses of $9.4 million. Of the 805 securities, 408 had been in a continuous unrealized loss position for greater than one year and had a total estimated fair value of $332.6 million and gross unrealized losses of $6.8 million. The 408 securities with unrealized losses in excess of twelve months were investment grade long-term bonds and equity securities and we have the intent and the ability to hold those securities to recovery.
We review the status of each security quarterly to determine whether an other-than-temporary impairment has occurred. In making our determination, we consider a number of factors including: (1) the significance of the decline, (2) whether the securities were rated below investment grade, (3) how long the securities have been in the unrealized loss position, and (4) our ability and intent to retain the investment for a significant period of time for it to recover. During 2006, we recognized a loss of $2.9 million as we no longer had the intent to hold certain fixed income securities to recovery. We have concluded that none of the other available-for-sale securities with unrealized losses at December 31, 2006 has experienced an other-than-temporary impairment.
At December 31, 2006, no industry group comprised more than 10 percent of our investment portfolio. This portfolio is widely diversified among various geographic regions in the United States, and is not dependent on the economic stability of one particular region.
Earnings on investments and net realized gains for the three years ended December 31 follow:
Loans receivable at December 31, 2006 and December 31, 2005 are summarized as follows:
The activity in the allowance for loan losses for the years ended December 31, 2006 and December 31, 2005 is as follows:
There were no investments in loans for which an impairment has been recognized. There were no loans in non-accrual status at December 31, 2006 and December 31, 2005.
Passbook and investment certificate accounts at December 31, 2006 and December 31, 2005 are summarized as follows:
Current year incurred losses include escrow and small claims payments. Incurred losses include $18.6 million in 2006, $16.8 million in 2005, and $6.9 million in 2004 that relate to our non-title segment operations.
We file a consolidated federal income tax return. Significant components of our deferred tax assets and liabilities at December 31, 2006 and 2005 were as follows:
The breakout of our income tax expense between current and deferred is as follows:
The provision for income tax differs from the amount of income tax determined by applying the U.S. statutory income tax rate (35 percent) to pre-tax income as a result of the following:
Taxes paid were $97.4 million in 2006, $54.2 million in 2005 and $103.5 million in 2004.
On July 28, 2006, we entered into a five-year credit agreement with SunTrust Bank, as administrative agent for a syndicate of other banks, issuing bank and swingline lender. The credit agreement replaced our previous five-year revolving credit arrangement entered into as of November 6, 2003 (which had no borrowings as of December 31, 2005). The credit agreement established a credit facility with the aggregate principal amount of up to $200.0 million. Interest accrues on the outstanding principal balance of the credit facility, at our option, based on (1) LIBO (reserve adjusted) for 30, 60, 90 or 180 days with respect to any Eurodollar Borrowing plus a margin determined by our leverage ratio or (2) SunTrust’s Base Rate as defined in the credit agreement. The credit agreement contains certain restrictive covenants, including a minimum debt to capital ratio, an interest coverage ratio and maintenance of consolidated net worth requirement. We were in compliance with all debt covenants at December 31, 2006. At December 31, 2006, there was $100.0 million of outstanding borrowings under the credit agreement which was used to fund a portion of the Capital Title merger consideration.
In November, 2003, we issued $115.0 million of our 3.125 percent Convertible Senior Debentures due 2033 through a private placement. The debentures are convertible into our common shares at $66.18 per share (see additional information in Note 11). We may redeem some or all of the senior convertible debentures at any time on or after November 15, 2010. The holders may also require us to repurchase the debentures for cash at five designated repurchase dates as defined in the indenture. Additionally, we may be required to pay contingent interest during interest periods beginning in 2010, depending on the trading price of the debentures, as defined in the indenture.
In May 2004, we issued $125.0 million principal amount of our 3.25 percent Convertible Senior Debentures due 2034 through a private placement. The 2004 debentures are convertible into our common shares at an equivalent price of $53.72 per share. See additional information in Note 11. We may redeem some or all of the senior convertible debentures at any time on or after May 2014. The holders may also require us to repurchase the debentures for cash at four designated repurchase dates as defined in the indenture.
Our banking subsidiary has a line of credit with the Federal Home Loan Bank of San Francisco (“FHLB”) in the amount of $252.2 million, with an outstanding balance of $64.6 million at December 31, 2006. All advances under this line of credit were collateralized with loans receivable and FHLB stock of $4.8 million in 2006 and $3.8 million in 2005. These borrowings, which included fixed term, fixed and variable rate advances maturing 2007 through 2012, bear or carry interest rates ranging from 2.5 percent to 5.4 percent.
In December 2005, we filed a universal shelf registration statement with the U.S. Securities and Exchange Commission which permits us to offer and sell, from time to time, various types of securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units, having an aggregate offering price up to $400 million. At December 31, 2006, the universal shelf registration was fully available.
The aggregate annual maturities for notes payable in each of the five years after December 31, 2006, are as follows:
At December 31, 2006, we had three stock compensation plans which have been approved by the shareholders: the 1991 and 1992 stock plans and the 2000 Stock Incentive Plan, as amended (the “2000 Plan”). No further awards may be granted under the 1991 and 1992 stock plans. All future grants of stock compensation will be granted through the 2000 Plan. Under the 2000 Plan, we may grant/award common stock, restricted stock, stock options, stock appreciation rights and phantom stock to officers, directors, employees, agents, consultants and advisors of us and our subsidiaries, as determined in the discretion of the Executive Compensation Committee of the Board of Directors. Shares of phantom stock are designated as cash units and payable solely in cash. The maximum number of shares of common stock authorized for issuance under the 2000 Plan is 3,600,000 subject to adjustment as described in the 2000 Plan. At December 31, 2006, there were 2,150,672 shares available for future grant under the 2000 Plan.
Restricted stock and related cash units may be granted pursuant to the 2000 Plan and vest over three to four years. The fair value of non-vested shares is determined based on the closing trading price of our shares on the grant date. We recognize compensation expense on a straight-line basis over the requisite service period for the entire award. Recipients of restricted stock are entitled to vote and receive dividends on the shares. The shares are subject to certain transfer restrictions and may be forfeited if a participant leaves our company for reasons other than retirement, disability or death.
The weighted average grant-date fair value of awards granted was $67 in 2006, $55 in 2005, and $39 in 2004. Cash settlement of vested cash units was $3.5 million in 2006, $1.2 million in 2005, and $1.4 million in 2004.
The Employee Stock Purchase Plan (“ESPP”), available to virtually all employees, allows participants to purchase our common stock at a 15 percent discount from the fair market value on the purchase date. Common stock purchases are paid for through periodic payroll deductions and a company match. Compensation expense for the employee match was $0.8 million in 2006 and $0.4 million in 2005.
Under our Executive Voluntary Deferral Plan, executives can defer eligible compensation into deferred stock units or a cash account bearing interest at a fixed rate of return. Under the Outside Directors Deferral Plan, directors can defer eligible compensation into deferred stock units bearing interest at a fixed rate of return. Under the terms of the original plans, deferred stock units were settled by a cash payment to the plan participant. Effective April 24, 2002, we amended the deferral plans to provide for the settlement of deferred stock units in our common stock. Effective January 1, 2004, the Executive Voluntary Deferral Plan and the Outside Directors Deferral Plan were amended to provide a maximum of 800,000 and 100,000, respectively, of common stock that can be issued under the plans. A trust has been established to hold the shares of common stock to be used to fund payments to executives and directors. We provide the trustee of the Plans with the funds to purchase shares of common stock on the open market to match the number of deferred stock units credited to participants’ accounts under the deferral plans. The aggregate number of shares purchased by the trustee of the plans in 2006 was 66,371 at a cost of $4.4 million. At December 31, 2006, there were 585,494 shares available for future grant under our Executive Voluntary Deferral Plan and Outside Directors Deferral Plan.
The cost of the bond hedge transaction was partially offset by our sale to a counterparty of warrants to acquire up to 2,301,894 shares of our common stock. The warrants are initially exercisable at a price of approximately $63.98 per share, subject to adjustment. The warrants may be settled through a net share settlement based on the amount by which the then current market price of our common stock exceeds the exercise price.
In February 2007, the Board of Directors approved a repurchase program expiring in October 2008 that authorized us to repurchase 1.5 million shares.
On December 31, 2006, we adopted the recognition and disclosure provisions of SFAS No. 158 which requires us to recognize the funded status of our postretirement benefit plans in the December 31, 2006 balance sheet with the offset recorded as an adjustment to accumulated other comprehensive income (AOCI), net of tax. The funded status of the pension plan had been recorded in our balance sheet since the plan was frozen in 2004, through a minimum pension liability adjustment in AOCI required under pension accounting rules prior to SFAS No. 158. The funded status of other postretirement benefits was not previously required to be recorded on the balance sheet. The adjustment to AOCI represents the net unrecognized actuarial losses, unrecognized prior service costs, and unrecognized transition obligation for pension and other postretirement benefits. These amounts will be amortized, consistent with prior policy, as a portion of net periodic benefit cost.
Weighted-average assumptions used to determine net cost for years ended December 31:
Our pension plan asset allocation at September 30, 2006 and 2005 and target allocation for 2006 by asset category are as follows:
We anticipate that our weighted average long-term rate of return will be 8.25 percent. This was developed based on our analysis of the anticipated returns for the assets based on our targeted asset allocation. Our investment strategy is to provide average market returns through the strategic use of equity and fixed-income and alternative investments to ensure both liquidity and stability of the portfolio. It is anticipated that the current mix of investments will enable the plan to meet our expected rate of return while maintaining principal throughout a variety of market conditions. Plan assets were not invested in LandAmerica securities during 2006 and 2005. No plan assets are expected to be returned to us during 2007.
The expected benefit payments for our other postretirement benefit plans do not reflect any estimated federal subsidies expected to be received under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Federal subsidies are estimated at approximately $0.4 million annually from 2007 to 2011 and at approximately $2.2 million for the period 2012 through 2016.
During 2004, we announced a facility consolidation and rationalization plan to reduce expenses as a result of a change in the business environment. As a result, we closed 61 facilities. In connection with these programs, we incurred $6.5 million of exit costs primarily attributable to the Title Operations segment. These costs were comprised of $4.9 million related to lease termination, $1.2 million of severance and $0.4 million of other miscellaneous exit costs and were substantially paid as of December 31, 2005.
Following is a schedule of future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2006.
Our banking subsidiary loan portfolio is collateralized primarily by commercial and residential real estate properties throughout Southern California, and to a lesser extent in Arizona and Nevada. As a result, the loan portfolio consists of similar property types in the same region. Although we have a diversified portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economies of Southern California, Arizona, and Nevada.
The top five customers in our Lender Services segment account for approximately 29.9 percent of the operating revenue.
On January 14, 2005, First California Title Company, New Century Title Company and United Title Company (collectively, “Plaintiffs”) filed a Complaint in the Superior Court of the State of California, County of Los Angeles, against Financial Title Company, Mercury Companies, Inc., Stacy Neves, Stephanie Howard, George Willard and Tony Becker (Case No. BC 327332) (collectively, “Defendants”). On September 8, 2006, we completed the merger with Plaintiffs. The lawsuit claims substantial monetary and punitive damages for unfair competitive business practices in conjunction with Plaintiffs’ loss of approximately 80 employees in California to Defendants over an approximately eight month period. The complaint was later amended to include Alliance Title Company and Christine De’Martini as named Defendants. A jury trial began on October 17, 2006. On December 28, 2006, the jury returned its verdict for Plaintiffs in the approximate amount of $2 million. The punitive damages phase of the bifurcated trial was held on January 2, 2007 and resulted in a punitive damages award for Plaintiffs in the approximate amount of $14.6 million. Judgment has not been entered pending resolution of post-trial motions and could be appealed. The parties have agreed to engage in voluntary mediation on April 4, 2007 in an effort to resolve their claims.
The Government Accountability Office and various states are studying the title insurance product, market, pricing, business practices, and potential regulatory and legislative changes. Multiple states, including California, Florida, Nevada, New Mexico, New York, Texas, and Washington, are examining pricing levels and/or title insurance regulations. If it is determined that prices are not justified, rate changes may be implemented, including potential reductions. Some of the examinations, like those conducted in Texas and New Mexico, are conducted annually or biannually and usually result in adjustments to the prices we can charge. Subsequent to a hearing of the Texas title rate case in August 2006, the Texas Commissioner of Insurance ordered a rate reduction of 3.2 percent effective February 1, 2007. The California Department of Insurance (“CA DOI”) submitted to the Office of Administrative Law (“OAL”) proposed regulations governing the rating of title insurance and related services that could impose future rate reductions and filing of mandated statistical plans that impose substantially higher costs on title insurance operations in California. On February 21, 2007, the OAL disapproved the regulatory action for failure to comply with certain standards and requirements. The OAL will issue a written decision detailing the reasons for disapproval by February 28, 2007 and the CA DOI will then have 120 days to resubmit the regulatory action.
In June 2005, we established reserves of $19.0 million to cover anticipated exposure to regulatory matters nationwide, an amount which includes settlements with the California, Arizona, Nevada, Virginia, Colorado, and North Carolina departments of insurance. Based on these settlements and the status of inquiries, we released $6.7 million of this reserve back into earnings in fiscal year 2005 and $0.8 million in fiscal year 2006. The remaining reserve at December 31, 2006 was approximately $4.9 million.
We enter into joint ventures and partnerships related to our title operations and title plants in the ordinary course of our business. These entities are immaterial to our financial position and results of operations individually and in the aggregate. At December 31, 2006, we had no material exposure to loss associated with variable interest entities to which we are a party.
twenty year release period under NAIC SAP than is allowed by state statute. Additionally, there are differences between NAIC SAP and state statute for allowable assets in the areas of deferred taxes, goodwill and electronic data processing (“EDP”) equipment.
In a number of states, our insurance subsidiaries are subject to regulations which require minimum amounts of statutory equity and which require that the payment of any extraordinary dividends receive prior approval of the Insurance Commissioners of these states. An extraordinary dividend is generally defined by various statutes in the state of domicile of the subsidiary insurer. Under such statutory regulations, net assets of our three principal insurance subsidiaries aggregating $237.0 million of 2006 net assets is available for dividends, loans or advances to us during the year 2007 without prior approval.
At December 31, 2006 our insurance and industrial bank subsidiaries had $41.6 million on deposit with various state and federal regulatory agencies that are shown primarily as investments on the consolidated balance sheet.
We cede and assume title policy risks to and from other insurance companies in order to limit and diversify our risk. We cede insurance on risks in excess of certain underwriting limits, which provides for recovery of a portion of losses. We remain contingently liable to the extent that reinsuring companies cannot meet their obligations under reinsurance agreements. The companies that we cede insurance to have financial ratings from external rating agencies of A or better, which indicates an excellent or superior ability to meet their obligations.
We cede to and assume significantly all of our title reinsurance from four other insurance companies. The amount of paid and recovered reinsured losses during the three years ended December 31, 2006 was immaterial to our operations. The total amount of premiums for assumed and ceded risks was less than one percent of title premiums in each of the last three years.
We are engaged in the business of providing title insurance as well as a broad array of real estate transaction related services through our subsidiaries. We have three reporting segments that fall within three primary business segments, Title Operations, Lender Services and Financial Services. The remaining immaterial reportable segments have been combined into a group called Corporate and Other.
Corporate and Other includes Buyers Home Warranty Company, a residential home warranty company acquired in August 2004, a residential property inspection business, and a commercial property valuation and assessment business, as well as the unallocated portion of the corporate expenses related to our corporate offices in Richmond, Virginia and unallocated interest expense.
Basis of presentation - The accompanying parent company financial statements should be read in conjunction with our Consolidated Financial Statements.