The Company owns an office building and adjacent real estate in Richmond, Virginia that it uses for its corporate headquarters. This property consists of approximately 128,000 square feet of office space and parking facilities. In addition, the Company and its subsidiary, LERETA, own certain properties that, in the aggregate, are not material to the Company’s business taken as a whole. The Company’s subsidiaries conduct their business operations primarily in leased office space. As of December 31, 2003, the Company had numerous leases for its branch offices and subsidiaries throughout the states in which they operate.
The Company’s title plants constitute a principal asset. Title plants consist of copies of public records, maps, documents, previous reports and policies indexed to specific properties in an area. The title plants are generally located at the office which serves a particular locality or in “service centers” serving multiple localities in major metropolitan areas. They enable title personnel to examine title matters relating to a specific parcel of real property as reflected in the title plant, and eliminate or reduce the need for a separate search of the public records. They contain material dating back a number of years and are updated (with the exception of certain title plants) through the addition of copies of documents filed of record which affect real property. The Company maintains title plants covering many of the areas in which it operates, although certain offices utilize title plants jointly owned and maintained with other title insurers. The Company capitalizes only the initial cost of title plants. The cost of maintaining such plants is charged to expense as incurred. The title plants and title examination procedures have been automated and computerized to a large extent in many areas.
In 2002 the Company recorded exit and termination costs net of tax of $8,690 related to its Primis operations.
The net loss reported by the Company for the fiscal year ended December 31, 2000 resulted from a change in the Company’s method for assessing the recoverability of goodwill (not associated with impaired assets) during the fourth quarter of 2000 which resulted in net of tax charges of $110,369.
Premiums and fees are determined both by competition and by state regulation. Revenue from direct title operations is recognized at the time real estate transactions close. There can be a several month delay between the time that a title order is opened and the real estate transaction closes. Operating revenues from independent agents are recognized when the Company receives notification from the agent that a policy has been issued. The delay in notification varies from agent to agent and between regions of the country. During 2003, the Company had an average delay from policy issuance to reporting of 120 days. There can be a significant lag between changes in general real estate activity and their impact on the portion of the Company’s revenues attributable to agents.
Integration of recent and planned future acquisitions, and evaluating new potential acquisitions will also be a significant challenge and opportunity for this segment in 2004.
The Lender Services segment realizes a majority of its income through service revenues associated with tracking and reporting of real estate tax payments and flood zone certificiations related to mortgage loans for lending institutions. The lenders pay for these services at the time they add a loan to their servicing portfolio. The Company defers a significant portion of its revenue received for these services. As a result, revenue reported in the financial statements represents the amortization of both current and prior service fees and is not representative of new contract sales levels. Expenses on the other hand are charged to the income statement as incurred and are not deferred. Thus, an understanding of the levels of deferred revenues in this area is critical to understanding the relative strength of business related to tax services. The amortization rates are reviewed regularly to determine if there have been changes in contract lives and/or changes in the number or timing of prepayments, and adjusted to reflect current
trends. The Company is required in certain instances to reimburse part of the fees should the lender sell the loan to another party.
This segment has a substantial opportunity to leverage the Company’s title insurance business relationships to cross-sell services to other financial institutions. A significant challenge for these businesses will be integration into the Company’s overall structure without jeopardizing their current business relationships.
This group represents business segments that are not significant enough in size to be reported separately. The businesses reported in this group include residential inspection and commercial appraisals and assessments, Orange County Bancorp and its wholly-owned subsidiary, Centennial Bank, a California industrial bank that the Company acquired in November 2003 (“Centennial”) as well as the unallocated portion of the corporate expenses (including unallocated interest expense) related to the Company’s corporate offices in Richmond, Virginia.
This discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The Company considers the following accounting estimates to be critical in preparing and understanding the consolidated financial statements. Actual results could differ from these estimates. Significant accounting policies are disclosed in Note 1 to the accompanying Consolidated Financial Statements.
Company and management’s assessment of all other available evidence, management believes that these assets will more likely than not be realized.
Pension. The Company sponsors a defined benefit pension plan which is valued annually by an actuary. The valuation is dependent on significant assumptions. One significant assumption is the expected long-term rate of return on plan assets. The use of expected long-term rates of return may result in recognized returns that are greater or less than actual returns in any given year. Over time the expected returns are used to approximate actual long-term returns which result in a pattern of expense recognition that more closely matches the service lives of typical employees. The Company uses long-term and actual historical returns, current and targeted asset mix and future estimates of long-term investment returns to develop its long-term return for plan assets. The Company’s anticipated rate of return was 8.5% as of the 2003 valuation date.
When the Company acquired LERETA on October 1, 2003, all of LERETA’s assets and liabilities were adjusted to fair value in accordance with SFAS No. 141. In making these adjustments, LERETA’s deferred revenue account, representing amounts which had been deferred and would have been amortized over the remaining lives of the contracts for the provision of real estate tax monitoring and flood certification services existing at the acquisition date, was eliminated. The deferred revenue account was 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.
The amortization period for the purchase date deferred service obligation and for deferred revenue is determined using historical experience and information available from outside sources. Amortization rates are reviewed regularly and adjusted as necessary to reflect changes in contract lives or prepayment rates.
The title insurance business is closely related to the overall level of residential and commercial real estate activity, which is generally affected by the relative strength or weakness of the United States economy. In addition, title insurance volumes fluctuate based on the effect changes in interest rates have on the level of real estate activity. Periods of increasing interest rates, usually have an adverse impact on real estate activity and therefore premium and fee revenues. In contrast, real estate activity usually increases when interest rates fall. In 2002 and 2003 the Company and the title insurance industry benefited from the lowest interest rates in the last 40 years.
Operating Revenues. A summary of the Company’s operating revenues is as follows:
Corporate and Other - Operating revenues in corporate and other increased by $4.5 million in 2003 over 2002 and decreased by $14.1 million in 2002 over 2001. The primary reason for the increase in revenue in 2003 over 2002 is due to increases in the residential inspection and commercial appraisal and assessment businesses of $14.8 million as well as an increase of $3.7 million related to an increase in the equity in unconsolidated subsidiaries, offset by a reduction in revenues of $13.8 million related to the residential appraisal business that the Company exited in 2002. Similarly, the decrease in 2002 over 2001 relates to increases in the residential inspection and commercial appraisal and assessment businesses in 2002 as well as a $2.6 million increase in equity in unconsolidated subsidiaries, offset by a reduction in revenues of $29.1 million related to the residential appraisal business.
Net Realized Investment Gains. Net realized investment gains totaled $8.5 million, $1.3 million and $214,000 in 2003, 2002 and 2001, respectively. The increase of $7.2 million in 2003 compared to 2002 is primarily due to the Company’s sale of a portion of their fixed maturity security portfolio to provide funding for the acquisitions consummated during 2003. The increase of $1.1 million in 2002 as compared to 2001 is due to increases in the sales prices of the
Title Insurance - The Company’s Title Insurance segment accounted for approximately 91.6% of the Company’s total salaries and other personnel costs in 2003. The Title Insurance segment, in particular direct operations, is labor intensive and as a result a significant variable expense component for this segment is salaries and other personnel costs. We manage our personnel expenses to reflect changes in the level of activity in the real estate market. As a result, our employee base expands and contracts over time. In order to manage personnel costs more effectively throughout the real estate cycle, we use temporary or part time employees where appropriate to staff operations so that we can respond promptly to changes in real estate activity. We anticipate that the Title Insurance segment’s portion of total personnel costs will decrease as a percentage of total personnel costs as the Company continues to diversify. As a result of anticipated reductions in refinance activity due to increases in interest rates, the Company has been and will continue to reduce the number of employees in this segment. Depending on the rapidity of the change in real estate activity, the Company may be unable to match increasing or decreasing levels of title orders with staffing levels. In periods of declining activity, personnel costs as a percentage of revenue, may increase.
Lender Services - Lender Services compensation expenses increased in both 2003 and 2002. The Company acquired LERETA and INFO1 in October and August 2003, respectively. Personnel costs in the Lender Services segment tend to increase during periods of increased sales volume and decrease when sales volume is lower. This is the case because a significant amount
of work is required to set up new accounts. Once accounts are established, monitoring and maintenance activities are less labor intensive.
Provision for Policy and Contract Claims. The loss ratio (the provision for policy and contract claims as a percentage of operating revenues for the Title Insurance segment) was 5.8%, 4.2% and 4.0% in 2003, 2002, and 2001, respectively. Claims paid as a percentage of title insurance operating revenues were 3.2%, 3.7% and 3.8% in 2003, 2002 and 2001, respectively. The adverse development on prior year loss reserves during 2003 was attributable to the emergence of a few large claims for policy years 2001 and 2002. Reserves for policy years 1999 and prior developed favorably in 2003. The favorable development on prior year loss reserves during 2002 and 2001 was attributable to lower than expected payment levels on recent issue years which included a high proportion of refinance business. The Company believes that the loss ratio will generally decrease over the next year.
Additionally, on June 1, 2002, the Company entered into a joint venture agreement with The First American Corporation to combine its residential real estate valuation operations. Under the terms of the agreement, the Company contributed its former Primis residential appraisal production division to First American’s eAppraiseIT subsidiary. In connection with the transaction, the Company exited the residential appraisal production business which had been unprofitable and recorded a charge of $13.4 million for exit, termination and other costs during 2002.
Amortization. Amortization expense increased substantially in 2003 over 2002 and decreased in 2002 from 2001. The increase in 2003 is related to the acquisition of approximately $363.0 million in businesses during 2003 and the related amortizable intangible assets acquired as a result of these acquisitions. The decrease in 2002 from 2001 is the result of the implementation of SFAS No. 142 on January 1, 2002, which eliminated the amortization of goodwill and long-lived intangible assets.
Interest Expense. Interest expense increased slightly in 2003 over 2002 and decreased by $.4 million in 2002 as compared to 2001. The increase for 2003 was related to the Company’s convertible debt offering in November 2003 as well as additional debt acquired as the result of its acquisitions of Centennial Bank and other businesses. These increases were offset by lower levels of borrowings on the Company’s other credit facilities. The decrease in 2002 from 2001 was the result of lower levels of borrowings outstanding.
Premium Taxes. Insurers are generally not subject to state income or franchise taxes. However, they are subject to a “premium tax” on certain operating revenues, depending on the state. Tax rates and their application to operating revenues to vary from state to state. Premium taxes as a percentage of total title insurance revenues remained relatively constant during the last three years. This percentage was 1.3% in 2003, 1.4% in 2002 and 1.3% in 2001.
Title Insurance - Title Insurance general and administrative expenses increased by $68.3 million, or 20.6% in 2003 over 2002 and increased by $16.6 million, or 5.3% in 2002 over 2001. The increase in 2003 over 2002 is primarily related to incremental costs associated with servicing increases in total order volume, particularly in the area of outsourced services, as well as costs associated with new acquisitions. The increase in 2002 over 2001 was primarily related to higher servicing costs in 2002 due to increased order volumes. The Company is continuing to identify ways to streamline the process of producing title insurance policies and believes that these efforts could result in lower total costs to provide this insurance in future periods.
Lender Services - Lender Services general and administrative expenses increased in 2003 over 2002 and in 2002 over 2001 due to the acquisitions of LERETA and INFO1 in 2003 and the new services provided in the default services area in 2002.
In June 2002, FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which is effective for periods after December 31, 2002. The statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at its fair value in the period in which the liability is incurred. Previously, these liabilities were required to be accrued at the time management committed to an activity. Costs required to be accrued included but are not limited to termination benefits provided to current employees that are involuntarily terminated, costs to terminate a contract that is not a capital lease, and costs to consolidate facilities or relocate employees. The Company adopted this statement in 2003 without a material impact to operating results.
In January 2003, the Financial Accounting Standards Board issued Interpretation (“FIN”) No.46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. The interpretation requires the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Prior to this Interpretation, entities were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority voting interest in the entity. The Company adopted the provisions of this interpretation in the fourth quarter of 2003 related to its ownership interests in entities entered into prior to February 1, 2003 and in the second quarter of 2003 for entities entered into subsequent to February 1, 2003. There was no material impact to the Company’s financial condition or results of operations resulting from implementation of this Interpretation. See additional disclosures regarding this Interpretation in Note 17 to the Consolidated Financial Statements.
In December 2003, FASB issued SFAS No. 132 (Revised 2003), Disclosures Regarding Pension and Other Postretirement Benefit Plans. This statement amends the disclosure requirements about the investment strategy of the Company with regards to its benefit plan assets as well as information surrounding the Company’s contributions to the plan and the plan’s anticipated payment stream to participants. This statement was effective on December 15, 2003, with the exception of anticipated benefit payment streams whose effective date is periods ending after June 15, 2004.
Cash provided by operating activities for the years ended December 31, 2003, 2002, and 2001 was $305.1 million, $228.3 million and $137.6 million, respectively. The principal non-operating uses of cash and cash-equivalents for the three year period ending December 31, 2003 were for acquisitions, capital expenditures, additions to the investment portfolio and the
repayment of debt. The most significant non-operating sources of cash and invested cash were the proceeds from the issuance in 2003 of the Company’s $115.0 million 3.125% Convertible Senior Debentures due 2033, and the issuance in 2001 of $150.0 million of Senior Notes through a private placement which was used to repay outstanding debt on the Company’s revolving credit facility and the proceeds from the sales and maturities of certain investments. The net of all activities was to increase cash and invested cash by $4.8 million, $57.1 million and $45.4 million for 2003, 2002 and 2001, respectively. As of December 31, 2003, the Company held cash and invested cash of $230.6 million and fixed-maturity securities of $1,043.8 million.
On November 6, 2003, the Company entered into a new five-year credit arrangement with SunTrust Bank, individually and as administrative agent for a syndicate of selected other banks, pursuant to which a credit facility, in the aggregate principal amount of up to $200.0 million, was established. This line of credit replaced the Company’s prior six-year credit facility with Bank of America that expired on November 6, 2003. The Company has $200.0 million available under the facility as of December 31, 2003. The facility contains certain restrictive covenants, including a minimum debt to capital ratio, an interest coverage ratio and maintenance of statutory surplus. The Company was in compliance with all such covenants at December 31, 2003.
The Company administers escrow and trust deposits as a service to its customers. These deposits totaled $2.0 billion and $1.7 billion at December 31, 2003 and 2002, respectively. Escrow and trust deposits are not considered assets of the Company and are not included in the accompanying balance sheets. However, the Company remains contingently liable for the disposition of these deposits.
Additionally, the Company facilitates tax-deferred property exchanges for customers pursuant to Section 1031 of the Internal Revenue Code. As a facilitator and intermediary, the Company holds the proceeds from sales transactions until a qualified acquisition occurs. These deposits totaled $524.3 million and $299.4 million at December 31, 2003 and 2002, respectively. Similarly, the Company also facilitates tax-deferred reverse exchanges pursuant to Revenue Procedure 2000-37. These exchanges require the Company, 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 $183.7 million and $90.2 million at December 31, 2003 and 2002, respectively. Due to the structure utilized to facilitate these transactions, like-kind exchanges and reverse exchanges are not considered assets of the Company and are not included in the accompanying consolidated balance sheets. However, the Company remains contingently liable for the transfers of property, disbursement of proceeds and the return on the proceeds at the agreed upon rate.
The Company, in the ordinary course of business, enters into business arrangements that fall within the scope of FIN No. 45, Guarantors Accounting and Disclosure Requirements Including Guarantees of Indebtedness of Others, and FIN No. 46, Variable Interest Entities, both of which the Company adopted in 2003. There were no arrangements in these categories that are reasonably likely to have a material impact on the Company’s current or future operations, financial condition or results of operations. Required disclosures are in Notes 13 and 17 to the Consolidated Financial Statements.
The Company also has long-term debt of $327.4 million bearing interest at an average rate of 5.14% at December 31, 2003. A 0.25% change in the interest rate would affect income before income taxes by approximately $.8 million annually.
The Company’s results of operations and financial condition are susceptible to changes in mortgage interest rates and general economic conditions.
Our operating revenues for the year ended December 31, 2003 increased by 32.0% over the same period last year, primarily due to a favorable residential mortgage interest rate environment and a large volume of mortgage refinancing transactions. However, the Company began to experience a decline in refinancing transactions during the third quarter of 2003 that continued during the fourth quarter of the year. For fiscal year 2004, we expect that the level of refinancing transactions will be substantially below that experienced in recent years. This decline in the volume of refinancing transactions is the result of an extended period of declining mortgage interest rates followed by recent increases in those rates. The Company has been reducing our staffing levels in response to the reduction in refinance transactions. The Company expects to realize the full effect of expense savings from these staffing level reductions in 2004. As a result, operating results for the years ended 2002 and 2003 should not be viewed as indicative of results for any future period.
An element of the Company’s business strategy is to expand the services it provides through acquisitions of complementary businesses. During 2003, the Company acquired several businesses outside of its traditional business operations, including LERETA, INFO1 and Centennial, previously described in Item 7 above. The businesses of LERETA, INFO1 and Centennial are different from each other and from the business of providing title insurance and related services. The Company also may in the future acquire other businesses outside of its traditional business operations, although no assurances can be given that the Company will do so or that it will continue to acquire such companies at the levels experienced during 2003. Such acquisitions involve a number of special risks, including the Company’s inexperience in managing businesses that provide products and services beyond its traditional business, new regulatory requirements, diversion of management’s attention, failure to retain key acquired personnel, failure to effectively integrate operations, company cultures and services, increased costs to improve managerial, operational, financial and administrative systems, legal liabilities, and amortization of acquired intangible assets. In addition, there can be no assurance that acquired businesses will achieve anticipated levels of revenues, earnings or performance. The failure of the Company to manage its acquisitions successfully could materially and adversely affect the Company’s business, operating results and financial condition.
The business of providing real estate transaction products and services is very competitive. Competition for residential title insurance business is based primarily on price and quality of service. With respect to national and regional mortgage lenders, service quality includes a large distribution network and the ability to deliver a broad array of real estate services quickly, efficiently and through a single point of contact. Competition for commercial title business is based primarily on price, service, expertise in complex transactions and the size and financial strength of the insurer. Title insurance underwriters also compete for agents on the basis of service and commission levels. Although the Company is one of the largest providers of real estate transaction products and services in the United States, four other companies-Fidelity National Financial, Inc., The First American Corporation, Old Republic International Corporation and Stewart Information Services, Inc. have the size, capital base and agency networks to compete effectively with the Company’s products and services. In addition, some of the Company’s competitors may have, or will have in the future, greater capital and other resources than the Company. Competition among the major providers of real estate transaction products and services and any new entrants could adversely affect the Company’s revenues and profitability.
profitable products and services may have a material adverse effect on the Company’s business, operating results or financial condition.
The Company may not succeed in implementing its strategy of becoming a major provider of real estate transaction management services.
• standards of solvency and minimum amounts of capital surplus that must be maintained
• filing of annual and other reports with respect to financial condition and other matters