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FIRST AMERICAN FINANCIAL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) CERTAIN STATEMENTS IN THIS QUARTERLY REPORT ON FORM 10-Q, INCLUDING BUT NOT LIMITED TO THOSE SET FORTH ON PAGE 3 OF THIS QUARTERLY REPORT ARE FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. THESE FORWARD-LOOKING STATEMENTS MAY CONTAIN THE WORDS "BELIEVE," "ANTICIPATE," "EXPECT," "PLAN," "PREDICT," "ESTIMATE," "PROJECT," "WILL BE," "WILL CONTINUE," "WILL LIKELY RESULT," OR OTHER SIMILAR WORDS AND PHRASES. RISKS AND UNCERTAINTIES EXIST THAT MAY CAUSE RESULTS TO DIFFER MATERIALLY FROM THOSE SET FORTH IN THESE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE THE ANTICIPATED RESULTS TO DIFFER FROM THOSE DESCRIBED IN THE FORWARD-LOOKING STATEMENTS INCLUDE THE FACTORS SET FORTH ON PAGES 3 AND 4 OF THIS QUARTERLY REPORT. THE FORWARD-LOOKING STATEMENTS SPEAK ONLY AS OF THE DATE THEY ARE MADE. THE COMPANY DOES NOT UNDERTAKE TO UPDATE FORWARD-LOOKING STATEMENTS TO REFLECT CIRCUMSTANCES OR EVENTS THAT OCCUR AFTER THE DATE THE FORWARD-LOOKING STATEMENTS ARE MADE. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Critical accounting policies are those policies used in the preparation of First American Financial Corporation's (the "Company's") financial statements that require management to make estimates and judgments that affect the reported amounts of certain assets, liabilities, revenues, expenses and related disclosure of contingencies. A summary of these policies can be found in the Management's Discussion and Analysis section of the Company's Annual Report on Form 10-K for the year ended December 31, 2010. Recent Accounting Pronouncements: In January 2010, the Financial Accounting Standards Board ("FASB") issued updated guidance related to fair value measurements and disclosures, which requires a reporting entity to disclose separately, a reconciliation for fair value measurements using significant unobservable inputs (Level 3) information about purchases, sales, issuances and settlements (that is, on a gross basis rather than one net number). The updated guidance is effective for interim or annual financial reporting periods beginning after December 15, 2010 and for interim periods within the fiscal year. Except for the disclosure requirements, the adoption of this guidance had no impact on the Company's condensed consolidated financial statements. In July 2010, the FASB issued updated guidance related to credit risk disclosures for finance receivables and the related allowance for credit losses. The updated guidance requires entities to disclose information at disaggregated levels, specifically defined as "portfolio segments" and "classes". Expanded disclosures include, among other things, roll-forward schedules of the allowance for credit losses and information regarding the credit quality of receivables (including their aging) as of the end of a reporting period. The updated guidance is effective for interim and annual reporting periods ending after December 15, 2010, although the disclosures of reporting period activity are required for interim and annual reporting periods beginning after December 15, 2010. The adoption of this guidance had no impact on the Company's condensed consolidated financial statements. In December 2010, the FASB issued updated guidance related to disclosure of supplementary pro forma information in connection with business combinations. The updated guidance clarifies the acquisition date that should be used for reporting pro forma financial information when comparative financial statements are presented. The updated guidance also expands supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The updated guidance is effective for annual reporting periods beginning on or after December 15, 2010. The adoption of this guidance had no impact on the Company's condensed consolidated financial statements. 38-------------------------------------------------------------------------------- Table of Contents In December 2010, the FASB issued updated guidance related to when goodwill impairment testing should include Step 2 for reporting units with zero or negative carrying amounts. The updated guidance modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts requiring those entities to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating an impairment may exist. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2010. The adoption of this guidance had no impact on the Company's condensed consolidated financial statements. Pending Accounting Pronouncements: In June 2011, the FASB issued updated guidance that is intended to increase the prominence of other comprehensive income in financial statements. The updated guidance eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity, and requires consecutive presentation of the statement of net income and other comprehensive income. In addition, the option to present reclassification adjustments in the notes to financial statements has been eliminated. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2011. Except for the disclosure requirements, management does not expect the adoption of this guidance to have a material impact on the Company's condensed consolidated financial statements. In May 2011, the FASB issued updated guidance that is intended to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with generally accepted accounting principles ("GAAP") and International Financial Reporting Standards ("IFRS"). The amendments are of two types: (i) those that clarify the FASB's intent about the application of existing fair value measurement and disclosure requirements and (ii) those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The update is effective for interim and annual periods beginning after December 15, 2011. Management is currently evaluating the impact of this guidance on the Company's condensed consolidated financial statements. In October 2010, the FASB issued updated guidance related to accounting for costs associated with acquiring or renewing insurance contracts. The updated guidance modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal contracts. Under the updated guidance only costs based on successful efforts (that is, acquiring a new or renewal contract) including direct-response advertising costs are eligible for capitalization. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2011. Management does not expect the adoption of this guidance to have a material impact on the Company's condensed consolidated financial statements. OVERVIEW Corporate Update The Company became a publicly traded company following its spin-off from its prior parent, The First American Corporation ("TFAC") on June 1, 2010 (the "Separation"). On that date, TFAC distributed all of the Company's outstanding shares to the record date shareholders of TFAC on a one-for-one basis (the "Distribution"). After the Distribution, the Company owns TFAC's financial services businesses and TFAC, which reincorporated and assumed the name CoreLogic, Inc. ("CoreLogic"), continues to own its information solutions businesses. The Company's common stock trades on the New York Stock Exchange under the "FAF" ticker symbol and CoreLogic's common stock trades on the New York Stock Exchange under the ticker symbol "CLGX." To effect the Separation, TFAC and the Company entered into a Separation and Distribution Agreement (the "Separation and Distribution Agreement") that governs the rights and obligations of the Company and CoreLogic regarding the Distribution. It also governs the relationship between the Company and CoreLogic subsequent to the completion of the Separation and provides for the allocation between the Company and CoreLogic of TFAC's assets and liabilities. The Separation and Distribution Agreement identifies assets, liabilities and contracts that were allocated between CoreLogic and the Company as part of the Separation and describes the transfers, assumptions and assignments of these assets, liabilities and contracts. In particular, the Separation and Distribution Agreement provides that, subject to the terms and conditions contained therein: • All of the assets and liabilities primarily related to the Company's business-primarily the business and operations of TFAC's title insurance and services segment and specialty insurancesegment-have been retained by or transferred to the Company; • All of the assets and liabilities primarily related to CoreLogic's business-primarily the business and operations of TFAC's data and analytic solutions, information and outsourcing solutions and risk mitigation and business solutions segments-have been retained by or transferred to CoreLogic; 39 -------------------------------------------------------------------------------- Table of Contents • On the record date for the Distribution, TFAC issued to the Company and its principal title insurance subsidiary, First American Title Insurance Company ("FATICO"), a number of shares of its common stock that resulted in the Company and FATICO collectively owning 12.9 million shares of CoreLogic's common stock immediately following the Separation, some of which have subsequently been sold; and • The Company effectively assumed $200.0 million of the outstanding liability for indebtedness under TFAC's senior secured credit facility through the Company's borrowing and transferring to CoreLogic of $200.0 million under the Company's credit facility inconnection with the Separation. The Separation resulted in a net distribution from the Company to TFAC of $151.0 million. In connection with such distribution, the Company assumed $22.1 million of accumulated other comprehensive loss, net of tax, which was primarily related to the Company's assumption of the unfunded portion of the defined benefit pension obligation associated with participants who were employees of the businesses retained by CoreLogic. Results of Operations Summary of Second Quarter A substantial portion of the revenues for the Company's title insurance and services segment result from the sale, refinancings and foreclosures of residential and commercial real estate. In the specialty insurance segment, revenues associated with the initial year of coverage in both the home warranty and property and casualty operations are impacted by volatility in real estate transactions. Traditionally, the greatest volume of real estate activity, particularly residential resale, has occurred in the spring and summer months. However, changes in interest rates, as well as other economic factors, can cause fluctuations in the traditional pattern of real estate activity. Residential mortgage originations in the United States (based on the total dollar value of the transactions) decreased 21.0% in the second quarter of 2011 when compared with the second quarter of 2010, according to the Mortgage Bankers Association's July 20, 2011 Mortgage Finance Forecast (the "MBA Forecast"). According to the MBA Forecast, the dollar amount of purchase originations decreased 29.3% and refinance originations decreased 15.5% in the second quarter of 2011 when compared with the second quarter of 2010. Despite the low interest rate environment, which has had a favorable effect on many of the Company's businesses, mortgage credit remains generally tight, which together with the uncertainty in general economic conditions, continues to impact the demand for most of the Company's products and services. These conditions have also had an impact on, and continue to impact, the performance and financial condition of some of the Company's customers; should these parties continue to encounter significant issues, those issues may lead to negative impacts on the Company's revenue, claims, earnings and liquidity. Management expects the above mentioned conditions will continue impacting the Company. In addition, the seasonal increase in real estate activity that traditionally occurs during the spring months was not significant in 2011, with second quarter open title orders per day increasing only slightly over first quarter open title orders per day. Given the current order trends and outlook for mortgage and real estate markets, the Company initiated, and substantially completed, an expense reduction program that is expected to yield approximately $40 million in annualized cost savings, which the Company will begin realizing in the third quarter of 2011. The program was primarily directed at shared service functions in the title insurance and services segment and is incremental to the Company's ongoing efforts to manage expenses to order volumes at the division level. Beginning at the end of September 2010, various lenders' foreclosure processes came under the review and scrutiny of a number of regulators such as the state Attorneys General, the Federal Reserve and other agencies. Additionally, a growing number of court rulings have called into question some foreclosure practices and regulators have conducted and continue to conduct investigations into such practices. Many of the country's largest lenders and other key parties also have entered into consent decrees which require them, among other things, to alter their foreclosure processes. Though the ultimate effect of the court rulings, regulatory investigations, consent decrees and related matters pertaining to foreclosure processing are currently unknown, the Company believes that, as a result of these matters, its revenues tied to foreclosures have declined, and may continue to decline, especially in the short term, and the Company may incur costs associated with its duty to defend its insureds' title to foreclosed properties they have purchased. As of the current date, these matters have not had a material adverse effect on the Company. Though the Company will continue to monitor foreclosure developments, at this time, the Company does not believe these matters will have a material adverse effect on the Company in the future. 40 -------------------------------------------------------------------------------- Table of Contents Title Insurance and Services Three Months Ended June 30, Six Months Ended June 30, (in thousands, except percentages) 2011 2010 $ Change % Change 2011 2010 $ Change % Change Revenues Direct premiums and escrow fees $ 333,837 $ 363,271 $ (29,434 ) (8.1 )% $ 630,855 $ 660,274 $ (29,419 ) (4.5 )% Agent premiums 348,441 362,640 (14,199 ) (3.9 ) 748,362 736,632 11,730 1.6 Information and other 157,376 153,450 3,926 2.6 306,216 298,118 8,098 2.7 Investment income 19,499 18,695 804 4.3 36,581 37,964 (1,383 ) (3.6 ) Net realized investment (losses) gains (855 ) 7,305 (8,160 ) (111.7 ) (1,981 ) 11,363 (13,344 ) (117.4 ) Net other-than-temporary impairment losses recognized in earnings (977 ) (3,739 ) 2,762 73.9 (1,274 ) (5,109 ) 3,835 75.1 857,321 901,622 (44,301 ) (4.9 ) 1,718,759 1,739,242 (20,483 ) (1.2 ) Expenses Personnel costs 274,745 285,103 (10,358 ) (3.6 ) 538,308 546,178 (7,870 ) (1.4 ) Premiums retained by agents 279,812 292,298 (12,486 ) (4.3 ) 599,799 593,866 5,933 1.0 Other operating expenses 179,424 184,969 (5,545 ) (3.0 ) 351,983 365,273 (13,290 ) (3.6 ) Provision for policy losses and other claims 40,267 49,276 (9,009 ) (18.3 ) 136,642 88,649 47,993 54.1 Depreciation and amortization 16,952 18,264 (1,312 ) (7.2 ) 34,119 36,167 (2,048 ) (5.7 ) Premium taxes 8,707 8,149 558 6.8 16,747 16,447 300 1.8 Interest 536 2,644 (2,108 ) (79.7 ) 2,847 4,503 (1,656 ) (36.8 ) 800,443 840,703 (40,260 ) (4.8 ) 1,680,445 1,651,083 29,362 1.8 Income before income taxes $ 56,878 $ 60,919 $ (4,041 ) (6.6 )% $ 38,314 $ 88,159 $ (49,845 ) (56.5 )% Margins 6.6 % 6.8 % (0.2 )% (2.9 )% 2.2 % 5.1 % (2.9 )% (56.9 )% Direct premiums and escrow fees were $333.8 million and $630.9 million for the three and six months ended June 30, 2011, respectively, decreases of $29.4 million, or 8.1%, and $29.4 million, or 4.5%, when compared with the respective periods of the prior year. These decreases were due to a decline in the number of title orders closed by the Company's direct operations, partially offset by an increase in the average revenues per order closed. The decrease in direct title orders closed reflected the decline in mortgage originations for the three and six months ended June 30, 2011 when compared with the respective periods of the prior year. The increase in the average revenues per order closed was primarily due to an increase in the mix of direct revenues generated from higher premium commercial transactions for the three and six months ended June 30, 2011 when compared with the respective periods of the prior year. The Company's direct title operations closed 215,600 and 441,200 title orders during the three and six months ended June 30, 2011, respectively, decreases of 18.1% and 12.9% when compared with same periods of the prior year. The average revenues per order closed were $1,548 and $1,430 for the three and six months ended June 30, 2011, respectively, increases of 12.2% and 9.7% when compared with the respective periods of the prior year. Agent premiums were $348.4 million and $748.4 million for the three and six months ended June 30, 2011, respectively, a decrease of $14.2 million, or 3.9%, when compared with the three months ended June 30, 2010, and an increase of $11.7 million, or 1.6%, when compared with the six months ended June 30, 2010. Agent premiums are recorded when notice of issuance is received from the agent, which is generally when cash payment is received by the Company. As a result, there is generally a delay between the agent's issuance of a title policy and the Company's recognition of agent premiums. Therefore, second quarter agent premiums primarily reflect first quarter mortgage origination activity. The decrease in agent premiums quarter over quarter was consistent with the decrease in the Company's direct title orders closed in the first quarter of 2011 as compared with the first quarter of 2010. The Company continually analyzes the terms and profitability of its title agency relationships, seeking amendments when warranted. Amendments include, among others, changing the percentage of premiums retained by the agent and the deductible paid by the agent on claims; if changes to the agreements cannot be made, the Company may elect to terminate certain agreements. Information and other revenues, which primarily consists of revenues generated from fees associated with title search and related reports, title and other real property records and images, and other non-insured settlement services, were $157.4 million and $306.2 million for the three and six months ended June 30, 2011, respectively, increases of $3.9 million, or 2.6%, and $8.1 million, or 2.7%, when compared with the same periods of the prior year. These increases were primarily attributable to higher demand for the Company's title plant information and other non-insured title products. 41-------------------------------------------------------------------------------- Table of Contents Investment income totaled $19.5 million and $36.6 million for the three and six months ended June 30, 2011, respectively, an increase of $0.8 million, or 4.3%, when compared with the three months ended June 30, 2010, and a decrease of $1.4 million, or 3.6%, when compared with the six months ended June 30, 2010. The increase for the three months ended June 30, 2011 when compared to the three months ended June 30, 2010 was primarily due to a slight increase in equity in earnings recognized on investments accounted for under the equity method. The decrease for the six months ended June 30, 2011, when compared to the six months ended June 30, 2010 was primarily due to a reduction in interest income from intercompany notes receivable due to a reduction in principal balance. Net realized investment losses totaled $0.9 million and $2.0 million for the three and six months ended June 30, 2011, respectively. Net realized investment gains totaled $7.3 million and $11.4 million for the same respective periods of the prior year. These totals primarily reflected the net realized gains from the sales of investment securities and fixed assets, partially offset by impairments recorded on certain non-marketable investments and notes receivable. Net other-than-temporary impairment losses recognized in earnings totaled $1.0 million and $1.3 million for the three and six months ended June 30, 2011, respectively. Net other-than-temporary impairment losses recognized in earnings totaled $3.7 million and $5.1 million for the three and six months ended June 30, 2010, respectively. The decrease reflected a reduction in impairment losses on debt and equity securities in the current periods when compared to the prior year periods. The title insurance and services segment (primarily direct operations) is labor intensive; accordingly, a major expense component is personnel costs. This expense component is affected by two competing factors: the need to monitor personnel changes to match the level of corresponding or anticipated new orders and the need to provide quality service. Personnel costs were $274.7 million and $538.3 million for the three and six months ended June 30, 2011, respectively, decreases of $10.4 million, or 3.6%, and $7.9 million, or 1.4%, when compared with the same periods of the prior year. These decreases were primarily due to a decrease in domestic headcount, reduced incentive compensation and a reduction in healthcare related expenses. Partially offsetting these reductions was an increase in severance costs due to the Company's on-going cost management efforts in the field and the expense reduction program implemented in the current quarter primarily directed at shared service functions. Total severance costs were $6.3 million and $8.8 million for the three and six months ended June 30, 2011, respectively, compared with $1.5 million and $3.5 million for the three and six months ended June 30, 2010, respectively. Agents retained $279.8 million and $599.8 million of title premiums generated by agency operations for the three and six months ended June 30, 2011, respectively, which compared with $292.3 million and $593.9 million for the same periods of the prior year. The percentage of title premiums retained by agents was 80.3% and 80.1% for the three and six months ended June 30, 2011, respectively, and 80.6% for the three and six months ended June 30, 2010. The improvement in the agent retention percentage for the three months ended June 30, 2011 when compared to the three months ended June 30, 2010 was primarily due to the geographic mix of agency revenues, since the agency share or split varies from region to region, and an improvement in the agency splits, on both existing and new agency relationships. The improvement in the agent retention percentage for the six months ended June 30, 2011 when compared to the six months ended June 30, 2010 was primarily due to a large commercial deal that closed during the first quarter of 2011 with a favorable agent split. The Company continues to focus on improving its agent retention by negotiating better splits as new agents are signed or as contracts come up for renewal. Other operating expenses for the title insurance and services segment were $179.4 million and $352.0 million for the three and six months ended June 30, 2011, respectively, decreases of $5.5 million, or 3.0%, and $13.3 million, or 3.6%, when compared with the same periods of the prior year. These decreases were primarily due to lower office related expenses resulting from the Company's consolidation and closure of certain title offices and a reduction in consulting expenses, partially offset by an increase in production related expenses in the Company's commercial and default businesses, and by higher legal expenses. The provision for policy losses and other claims as a percentage of title insurance premiums and escrow fees was 5.9% and 9.9% for the three and six months ended June 30, 2011, respectively, compared with 6.8% and 6.3% for the respective three and six month periods of the prior year. The current quarter rate of 5.9% reflects an ultimate loss rate of 6.0% for the current policy year, and minor net favorable development for prior policy years. The current six month period rate of 9.9% reflects a $45.3 million reserve strengthening adjustment recorded in the first quarter of 2011 related to a guaranteed valuation product offered in Canada that experienced a meaningful increase in claims activity during the first quarter of 2011. The Company also recorded a charge of $14.6 million in the first quarter of 2011, which reflected adverse development for certain prior policy years, primarily policy year 2007. Premium taxes were $16.7 million and $16.4 million for the six months ended June 30, 2011 and 2010, respectively. Premium taxes as a percentage of title insurance premiums and escrow fees were 1.2% for both the current six month period and for the same period of the prior year. 42-------------------------------------------------------------------------------- Table of Contents In general, the title insurance business is a lower profit margin business when compared to the Company's specialty insurance segment. The lower profit margins reflect the high cost of performing the essential services required before insuring title, whereas the corresponding revenues are subject to regulatory and competitive pricing restraints. Due to this relatively high proportion of fixed costs, title insurance profit margins generally improve as closed order volumes increase. Title insurance profit margins are affected by the composition (residential or commercial) and type (resale, refinancing or new construction) of real estate activity. In addition, profit margins from refinance transactions vary depending on whether they are centrally processed or locally processed. Profit margins from resale, new construction and centrally processed refinance transactions are generally higher than from locally processed refinance transactions because in many states there are premium discounts on, and cancellation rates are higher for, refinance transactions. Title insurance profit margins are also affected by the percentage of title insurance premiums generated by agency operations. Profit margins from direct operations are generally higher than from agency operations due primarily to the large portion of the premium that is retained by the agent. The pre-tax margins for the three and six months ended June 30, 2011 were 6.6% and 2.2%, respectively, compared with pre-tax margins of 6.8% and 5.1% for the three and six months ended June 30, 2010, respectively. Specialty Insurance Three Months Ended June 30, Six Months Ended June 30, (in thousands, except percentages) 2011 2010 $ Change % Change 2011 2010 $ Change % Change Revenues Direct premiums $ 68,474 $ 68,303 $ 171 0.3 % $ 134,466 $ 133,941 $ 525 0.4 % Investment income 2,567 3,037 (470 ) (15.5 ) 5,075 6,181 (1,106 ) (17.9 ) Net realized investment gains (losses) 605 (324 ) 929 286.7 936 (303 ) 1,239 408.9 Net other-than-temporary impairment losses recognized in earnings - (84 ) 84 N/M 1 - (111 ) 111 N/M 1 71,646 70,932 714 1.0 140,477 139,708 769 0.6 Expenses Personnel costs 12,787 13,920 (1,133 ) (8.1 ) 24,390 27,453 (3,063 ) (11.2 ) Other operating expenses 9,377 10,114 (737 ) (7.3 ) 19,217 21,546 (2,329 ) (10.8 ) Provision for policy losses and other claims 36,970 33,728 3,242 9.6 70,107 65,337 4,770 7.3 Depreciation and amortization 1,077 1,442 (365 ) (25.3 ) 2,093 3,145 (1,052 ) (33.4 ) Premium taxes 1,206 1,109 97 8.7 2,209 2,075 134 6.5 Interest 5 5 - - 9 11 (2 ) (18.2 ) 61,422 60,318 1,104 1.8 118,025 119,567 (1,542 ) (1.3 ) Income before income taxes $ 10,224 $ 10,614 $ (390 ) (3.7 ) $ 22,452 $ 20,141 $ 2,311 11.5 % Margins 14.3 % 15.0 % (0.7 )% (4.7 )% 16.0 % 14.4 % 1.6 % 11.1 % (1) Not meaningful Direct premiums were $68.5 million and $134.5 million for the three and six months ended June 30, 2011, respectively, increases of $0.2 million, or 0.3%, and $0.5 million, or 0.4%, when compared with the same periods of the prior year. The slight increases were due to an increase in premiums from the home warranty division, while premiums from the property and casualty division were essentially flat. Investment income for the segment totaled $2.6 million and $5.1 million for the three and six months ended June 30, 2011, respectively, decreases of $0.5 million, or 15.5%, and $1.1 million, or 17.9%, when compared with the same periods of the prior year. These decreases primarily reflect a decrease in interest income earned from the investment portfolio reflecting a decline in yields and average balances. Net realized investment gains totaled $0.6 million and $0.9 million for the three and six months ended June 30, 2011, respectively, compared with net realized investment losses of $0.3 million for the same periods of the prior year. The net realized investment gains and losses for all periods reflected the net gains and losses on sales of investment securities. Personnel costs and other operating expenses were $22.2 million and $43.6 million for the three and six months ended June 30, 2011, respectively, decreases of $1.9 million, or 7.8%, and $5.4 million, or 11.0%, when compared with the same periods of the prior year. These decreases primarily relate to lower commission expense in the property and casualty division. 43 -------------------------------------------------------------------------------- Table of Contents For the home warranty business, the provision for home warranty claims expressed as a percentage of home warranty premiums was 52.2% for the current six month period and 47.9% for the same period of the prior year. This increase in rate was due to an increase in severity of claims and a greater number of claims incidents. For the property and casualty business, the provision for property and casualty claims expressed as a percentage of property and casualty insurance premiums was 52.6% for the current six month period, an increase when compared with 50.6% for the same period of the prior year. This increase was primarily due to higher routine or non-event core losses, which were partially offset by lower winter storm losses. Premium taxes were $2.2 million and $2.1 million for the six months ended June 30, 2011 and 2010, respectively. Premium taxes as a percentage of specialty insurance segment premiums were 1.6% and 1.5% for the current six month period and for the same period of the prior year, respectively. A large part of the revenues for the specialty insurance businesses are generated by renewals and are not dependent on the level of real estate activity. With the exception of loss expense, the majority of the expenses for this segment are variable in nature and therefore generally fluctuate consistent with revenue fluctuations. Accordingly, profit margins for this segment (before loss expense) are relatively constant, although as a result of some fixed expenses, profit margins (before loss expense) should nominally improve as revenues increase. Pre-tax margins for the current three and six month periods were 14.3% and 16.0%, respectively, compared with pre-tax margins of 15.0% and 14.4% for the three and six months ended June 30, 2010, respectively. Corporate Three Months Ended June 30, Six Months Ended June 30, (in thousands, except percentages) 2011 2010 $ Change % Change 2011 2010 $ Change % Change Revenues Investment income (losses) $ 1,112 $ (2,276 ) $ 3,388 148.9 % $ 3,314 $ 187 $ 3,127 N/M 1 Net realized investment (losses) gains (1,653 ) 6 (1,659 ) N/M 1 (1,790 ) (428 ) (1,362 ) (318.2 ) (541 ) (2,270 ) 1,729 76.2 1,524 (241 ) 1,765 732.4 Expenses Personnel costs 7,936 1,748 6,188 354.0 17,933 10,327 7,606 73.7 Other operating expenses 5,956 8,554 (2,598 ) (30.4 ) 12,080 13,127 (1,047 ) (8.0 ) Depreciation and amortization 838 414 424 102.4 1,754 1,061 693 65.3 Interest 2,616 1,552 1,064 68.6 5,142 2,009 3,133 155.9 17,346 12,268 5,078 41.4 36,909 26,524 10,385 39.2 Loss before income taxes $ (17,887 ) $ (14,538 ) $ (3,349 ) (23.0 )% $ (35,385 ) $ (26,765 ) $ (8,620 ) (32.2 )% (1) Not meaningful Investment income totaled $1.1 million and $3.3 million for the three and six months ended June 30, 2011, respectively, compared with investment losses of $2.3 million for the three months ended June 30, 2010 and investment income of $0.2 million for the six months ended June 30, 2010. The increases in the current periods were primarily due to an increase in yields earned on investments associated with the Company's deferred compensation plan. For the three and six months ended June 30, 2010, the Company recorded a loss on investments associated with its deferred compensation plan. Net realized investment losses totaled $1.7 million and $1.8 million for the three and six months ended June 30, 2011, respectively, which was primarily related to the impairment of a corporate fixed asset. Corporate personnel costs totaled $7.9 million and $17.9 million for the three and six months ended June 30, 2011, respectively, increases of $6.2 million and $7.6 million when compared with the respective periods of the prior year. These increases were primarily due to a higher level of corporate personnel costs following the Separation when compared to the amounts allocated from TFAC prior to the Separation. Following the Separation, the Company is a separate publicly traded company, which resulted in a higher level of corporate costs. The increases were also due to an increase in costs associated with the Company's deferred compensation plan. The increase in costs associated with the Company's deferred compensation plan was offset by the increase in income earned on investments associated with the deferred compensation plan, as discussed above. Other operating expenses were $6.0 million and $12.1 million for the three and six months ended June 30, 2011, respectively, decreases of $2.6 million and $1.0 million when compared with the same periods of the prior year. The decreases in the current periods were primarily attributable to a decline in professional services costs. A higher level of professional services costs were incurred prior to the Separation. 44 -------------------------------------------------------------------------------- Table of Contents Interest expense totaled $2.6 million and $5.1 million for the three and six months ended June 30, 2011, increases of $1.1 million and $3.1 million when compared with the same periods of the prior year. Interest expense prior to the Separation related to draws made in 2008 used for the Company's operations in the amount of $140.0 million under TFAC's credit agreement that was allocated to the Company. In connection with the Separation, the Company borrowed $200.0 million under its credit facility and paid off the allocated portion of TFAC's debt. Interest expense increased in the current year because the Company's credit facility bears interest at a higher rate than the allocated portion of TFAC's debt. Additionally, approximately $1.1 million and $2.1 million of interest expense related to intercompany notes payable to the title insurance and specialty segments was included for the three and six months ended June 30, 2011, respectively, compared to $0.4 million of interest expense for both the three and six months ended June 30, 2010. Eliminations Eliminations primarily represent interest income and related interest expense associated with intercompany notes between the Company's segments, which are eliminated in the condensed consolidated financial statements. The Company's inter-segment eliminations were not material for the three and six months ended June 30, 2011 and 2010. INCOME TAXES The effective income tax rate (income tax expense as a percentage of income before income taxes) was 34.7% and 34.4% for the three and six months ended June 30, 2011, and 40.1% and 41.3% for the same periods of the prior year. The differences between the U.S. federal statutory rate of 35% and the effective rates were primarily attributable to losses in foreign jurisdictions for which no tax benefit was provided, the change from income before income taxes in 2010 to a loss before income taxes in the first quarter of 2011, the release of the valuation allowance on Australian net operating loss carryforwards in the second quarter of 2011, and the mix of taxable and non taxable income for state tax purposes. The Company evaluates the realizability of its deferred tax assets by assessing its valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization are the Company's forecast of future taxable income and available tax planning strategies that could be implemented to realize the deferred tax assets. Failure to achieve forecasted taxable income in the applicable taxing jurisdictions could affect the ultimate realization of deferred tax assets and could result in an increase in the Company's effective tax rate on future earnings. The Company continues to monitor the realizability of recognized losses, impairment losses, and unrecognized losses recorded through June 30, 2011. The Company believes it is more likely than not that the tax benefits associated with those losses will be realized. However, this determination is a judgment and could be impacted by further market fluctuations, among other factors. During the current quarter, the Company reviewed its valuation allowance with respect to certain Australian net operating loss carryforwards and determined that, based upon an evaluation of new evidence in the quarter, the release of that valuation allowance was appropriate. The impact of releasing that valuation allowance was a $4.2 million reduction in the Company's income tax expense for the current quarter. NET INCOME AND NET INCOME ATTRIBUTABLE TO THE COMPANY Net income was $32.1 million and $16.9 million for the three and six months ended June 30, 2011, respectively, and $34.1 million and $47.9 million for the three and six months ended June 30, 2010, respectively. Net income attributable to the Company for the three and six months ended June 30, 2011 was $32.3 million, or $0.30 per diluted share, and $17.0 million, or $0.16 per diluted share, respectively. Net income attributable to the Company for the three and six months ended June 30, 2010 was $33.8 million, or $0.32 per diluted share, and $47.6 million, or $0.45 per diluted share, respectively. Net loss attributable to noncontrolling interests was $194 thousand and $100 thousand for the three and six months ended June 30, 2011, respectively. Net income attributable to noncontrolling interests was $307 thousand and $267 thousand for the three and six months ended June 30, 2010, respectively. LIQUIDITY AND CAPITAL RESOURCES Cash Requirements. The Company's current cash requirements include operating expenses, taxes, payments of interest and principal on its debt, capital expenditures, potential business acquisitions, payments in connection with employee benefit plans and dividends on its common stock. The Company continually assesses its capital allocation strategy, including decisions relating to dividends, share repurchases, capital expenditures, acquisitions and investments. Management expects that the Company will continue to pay quarterly cash dividends at or above the historical levels paid since the Separation. The timing, declaration and payment of future dividends, however, falls within the discretion of the Company's board of directors and will depend upon many factors, including the Company's financial condition and earnings, the capital requirements of its businesses, industry practice, restrictions imposed by applicable law and any other factors the board of 45-------------------------------------------------------------------------------- Table of Contents directors deems relevant from time to time. The Company believes that all anticipated cash requirements for current operations will be met from internally generated funds, including those generated by the Company's investment portfolio, and borrowings on its revolving credit facility, as needed. The Company's short-term and long-term liquidity requirements are monitored regularly to ensure that it can meet its cash requirements. Due to the Company's liquid-asset position and its ability to generate cash flows from operations, management believes that its resources are sufficient to satisfy its anticipated operational cash requirements and obligations for at least the next twelve months. Pursuant to insurance and other regulations under which the Company's insurance subsidiaries operate, the amount of dividends, loans and advances available to the Company is limited, principally for the protection of policyholders. As of June 30, 2011, under such regulations, the maximum amount of dividends, loans and advances available to the Company from its insurance subsidiaries for the remainder of 2011 was $144.7 million. Such restrictions have not had, nor are they expected to have, an impact on the Company's ability to meet its cash obligations. Cash used for operating activities amounted to $27.0 million and $40.1 million for the six months ended June 30, 2011 and 2010, respectively, after net claim payments of $233.2 million and $222.8 million, respectively. The principal nonoperating uses of cash and cash equivalents for the six months ended June 30, 2011 were additions to the investment portfolio, repayment of debt, capital expenditures and dividends to common stockholders. The most significant nonoperating sources of cash and cash equivalents for the six months ended June 30, 2011 were increases in the deposit balances at the Company's banking operations and proceeds from the sales and maturities of debt and equity securities. The principal nonoperating uses of cash and cash equivalents for the six months ended June 30, 2010 were additions to the investment portfolio, capital expenditures, repayment of debt (to TFAC and third parties), and the cash distribution to TFAC upon the Separation. The most significant nonoperating sources of cash and cash equivalents were proceeds from issuance of debt (to TFAC and third parties), net increase in deposits and proceeds from the sales and maturities of debt and equity securities. The net effect of all activities on total cash and cash equivalents was a decrease of $128.1 million for the six months ended June 30, 2011, and a decrease of $4.1 million for the six months ended June 30, 2010. In March 2011, the Company's board of directors approved a stock repurchase plan which authorizes the repurchase of up to $150.0 million of the Company's common stock. Purchases may be made from time to time by the Company in the open market at prevailing market prices or in privately negotiated transactions. As of June 30, 2011, no common stock had been repurchased by the Company under the plan. Financing. On April 12, 2010, the Company entered into a credit agreement with JPMorgan Chase Bank, N.A. in its capacity as administrative agent and a syndicate of lenders. The credit agreement is comprised of a $400.0 million revolving credit facility. The revolving loan commitments terminate on the third anniversary of the date of closing, or June 1, 2013. On June 1, 2010, the Company borrowed $200.0 million under the facility and transferred such funds to CoreLogic, as previously contemplated in connection with the Separation. Proceeds may also be used for general corporate purposes. At June 30, 2011, the interest rate associated with the $200.0 million borrowed under the facility is 3.00%. At June 30, 2011, the Company is in compliance with the debt covenants under the credit agreement. Notes and contracts payable as a percentage of total capitalization was 12.4 % and 12.8% at June 30, 2011 and December 31, 2010, respectively. Investment Portfolio. As of June 30, 2011, the Company's debt and equity investment securities portfolio consists of approximately 91% of fixed income securities. As of that date, over 74% of the Company's fixed income investments are held in securities that are United States government-backed or rated AAA, and approximately 97% of the fixed income portfolio is rated or classified as investment grade. Percentages are based on the amortized cost basis of the securities. Credit ratings are based on Standard & Poor's Ratings Group ("S&P") and Moody's Investors Service, Inc. ("Moody's") published ratings. If a security was rated differently by both rating agencies, the lower of the two ratings was selected. 46 -------------------------------------------------------------------------------- Table of Contents The table below outlines the composition of the investment portfolio currently in an unrealized loss position by credit rating (percentages are based on the amortized cost basis of the investments). Credit ratings are based on S&P and Moody's published ratings and are exclusive of insurance effects. If a security was rated differently by both rating agencies, the lower of the two ratings was selected: Non- A-Ratings BBB+ Investment or to BBB- Grade/Not June 30, 2011 Higher Ratings Rated Municipal bonds 100.0 % 0.0 % 0.0 % Foreign bonds 99.0 % 1.0 % 0.0 % Governmental agency bonds 100.0 % 0.0 % 0.0 % Governmental agency mortgage-backed securities 100.0 % 0.0 % 0.0 % Non-agency mortgage-backed securities 0.4 % 0.0 % 99.6 % Corporate debt securities 95.0 % 5.0 % 0.0 % 90.6 % 0.4 % 9.0 % Substantially all securities in the Company's non-agency mortgage-backed portfolio are senior tranches and were investment grade at the time of purchase, however many have been downgraded below investment grade since purchase. The table below summarizes the composition of the Company's non-agency mortgage-backed securities by collateral type, year of issuance and current credit ratings. Percentages are based on the amortized cost basis of the securities and credit ratings are based on S&P's and Moody's published ratings. If a security was rated differently by both rating agencies, the lower of the two ratings was selected. All amounts and ratings are as of June 30, 2011. Non- Number Estimated A-Ratings BBB+ Investment of Amortized Fair or to BBB- Grade/Not(in thousands, except percentages and number of securities) Securities Cost Value Higher Ratings Rated Non-agency mortgage-backed securities: Prime single family residential: 2007 1 $ 6,369 $ 4,935 0.0 % 0.0 % 100.0 % 2006 7 27,128 18,801 0.0 % 0.0 % 100.0 % 2005 2 4,795 4,465 0.0 % 0.0 % 100.0 % 2003 1 246 234 100.0 % 0.0 % 0.0 % Alt-A single family residential: 2007 2 17,824 15,480 0.0 % 0.0 % 100.0 % 13 $ 56,362 $ 43,915 0.4 % 0.0 % 99.6 % As of June 30, 2011, none of the non-agency mortgage-backed securities were on negative credit watch by S&P or Moody's. The Company assessed its non-agency mortgage-backed securities portfolio to determine what portion of the portfolio, if any, is other-than-temporarily impaired at June 30, 2011. Management's analysis of the portfolio included its expectations of the future performance of the underlying collateral, including, but not limited to, prepayments, defaults and loss severity assumptions. In developing these expectations, the Company utilized publicly available information related to individual assets, analysts' expectations on the expected performance of similar underlying collateral and certain of CoreLogic's securities, loans and property data and market analytic tools. As a result of the Company's security-level review, it recognized other-than-temporary impairments considered to be credit related on its non-agency mortgage-backed securities of $1.0 million and $1.3 million in earnings for the three and six months ended June 30, 2011. In addition to its debt and equity investment securities portfolio, the Company maintains certain money-market and other short-term investments. Off-balance sheet arrangements. The Company administers escrow deposits and trust assets as a service to its customers. Escrow deposits totaled $4.09 billion and $3.03 billion at June 30, 2011 and December 31, 2010, respectively, of which $1.0 billion and $0.9 billion, respectively, were held at the Company's federal savings bank subsidiary, First American Trust, FSB. The escrow deposits held at First American Trust, FSB, are included in the accompanying condensed consolidated balance sheets, in cash and cash equivalents and debt and equity securities, with offsetting liabilities included in deposits. The remaining escrow deposits were held at third-party financial institutions. Trust assets totaled $3.0 billion and $2.9 billion at June 30, 2011 and December 31, 2010, respectively, and were held or managed by First American Trust, FSB. Escrow deposits held at third-party financial institutions and trust assets are not the Company's assets under generally accepted accounting principles and, therefore, are not included in the accompanying condensed consolidated balance sheets. However, the Company could be held contingently liable for the disposition of these assets. 47-------------------------------------------------------------------------------- Table of Contents In conducting its operations, the Company often holds customers' assets in escrow, pending completion of real estate transactions. As a result of holding these customers' assets in escrow, the Company has ongoing programs for realizing economic benefits, including investment programs, borrowing agreements, and vendor services arrangements with various financial institutions. The effects of these programs are included in the condensed consolidated financial statements as income or a reduction in expense, as appropriate, based on the nature of the arrangement and benefit earned. Like-kind exchange funds held by the Company totaled $848.0 million and $609.9 million at June 30, 2011 and December 31, 2010, respectively, of which $352.1 million and $408.8 million, respectively, were held at the Company's subsidiary, First Security Business Bank ("FSBB"). The like-kind exchange deposits held at FSBB are included in the accompanying condensed consolidated balance sheets in cash and cash equivalents with offsetting liabilities included in deposits. The remaining exchange deposits were held at third-party financial institutions and, due to the structure utilized to facilitate these transactions, the proceeds and property are not considered assets of the Company under generally accepted accounting principles and, therefore, are not included in the accompanying condensed consolidated balance sheets. All such amounts are placed in bank deposits with FDIC insured institutions. The Company could be held contingently liable to the customer for the transfers of property, disbursements of proceeds and the return on the proceeds. |