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| ORI > SEC Filings for ORI > Form 10-Q on 31-Oct-2008 | All Recent SEC Filings |
31-Oct-2008
Quarterly Report
OVERVIEW
This management analysis of financial position and results of operations pertains to the consolidated accounts of Old Republic International Corporation ("Old Republic" or "the Company"). The Company conducts its operations through three major regulatory segments, namely, its General (property and liability), Mortgage Guaranty, and Title insurance segments. A small life and health insurance business, accounting for 2.4% of consolidated operating revenues for the nine months ended September 30, 2008 and 2.0% of consolidated assets as of September 30, 2008, is included within the corporate and other caption of this financial report. The consolidated accounts are presented on the basis of generally accepted accounting principles ("GAAP"). This management analysis should be read in conjunction with the consolidated financial statements and the footnotes appended to them.
The insurance business is distinguished from most others in that the prices (premiums) charged for various insurance coverages are set without certainty of the ultimate benefit and claim costs that will emerge or be incurred, often many years after issuance and expiration of a policy. This basic fact casts Old Republic as a risk-taking enterprise managed for the long run. Management therefore conducts the business with a primary focus on achieving favorable underwriting results over cycles, and on the maintenance of financial soundness in support of the insurance subsidiaries' long-term obligations to insurance beneficiaries. To achieve these objectives, adherence to insurance risk management principles is stressed, and asset diversification and quality are emphasized. In addition to income arising from Old Republic's basic underwriting and related services functions, significant investment income is earned from invested funds generated by those functions and from shareholders' capital. Investment management aims for stability of income from interest and dividends, protection of capital, and sufficient liquidity to meet insurance underwriting and other obligations as they become payable in the future. Securities trading and the realization of capital gains are not objectives. The investment philosophy is therefore best characterized as emphasizing value, credit quality, and relatively long-term holding periods. The Company's ability to hold both fixed maturity and equity securities for long periods of time is in turn enabled by the scheduling of maturities in contemplation of an appropriate matching of assets and liabilities.
In light of the above factors, the Company's affairs are managed without regard to the arbitrary strictures of quarterly or even annual reporting periods that American industry must observe. In Old Republic's view, such short reporting time frames do not comport well with the long-term nature of much of its business. Management believes that the Company's operating results and financial condition can best be evaluated by observing underwriting and overall operating performance trends over succeeding five to ten year intervals. Such extended periods can encompass one or two economic and/or underwriting cycles, and thereby provide appropriate time frames for such cycles to run their course and for reserved claim costs to be quantified with greater finality and effect.
EXECUTIVE SUMMARY
Old Republic's consolidated operating results, which exclude net realized investment gains or losses, continued to decline in this year's third quarter and first nine months. The much reduced performance stemmed from significant weakness in the Company's housing-related mortgage guaranty and title insurance lines in particular. Management currently believes that the substantial dislocations that have enveloped all businesses with housing and mortgage-lending exposures are likely to exert negative pressures on earnings well into 2009. These lowered expectations aside, the Company's strong financial underpinnings and the overall earnings sustainability of its general insurance business should provide reasonable earnings support and capital management flexibility for the anticipated resumption of positive operating earnings trends in 2010 and beyond.
The year-over-year decline in book value per share is mostly due to the shortfall in earnings, to cash outlays for regular dividends to shareholders, and to lower market valuations of fixed maturity and equity investments.
Consolidated Results - The major components of Old Republic's consolidated results for the periods reported upon are shown below:
Quarters Ended September 30, Nine Months Ended September 30,
2008 2007 Change 2008 2007 Change
Operating revenues:
General insurance $ 565.7 $ 619.5 -8.7 % $ 1,708.7 $ 1,821.5 -6.2 %
Mortgage guaranty 172.8 157.0 10.1 518.9 443.4 17.0
Title insurance 174.7 226.1 -22.8 521.2 679.9 -23.3
Corporate and other 23.0 23.1 75.6 70.7
Total $ 936.3 $ 1,025.9 -8.7 % $ 2,824.5 $ 3,015.7 -6.3 %
Pretax operating income (loss):
General insurance $ 77.0 $ 112.7 -31.7 % $ 223.2 $ 324.5 -31.2 %
Mortgage guaranty (152.8) (83.0) -84.1 (415.9) 2.1 N/M
Title insurance (9.7) (3.3) -191.9 (27.0) 1.0 N/M
Corporate and other 5.3 4.6 11.4 9.9
Sub-total (80.1) 31.0 -357.8 (208.3) 337.6 -161.7
Realized investment gains (losses):
From sales 18.3 3.9 26.0 20.3
From impairments (11.5) - (448.9) -
Net realized
investment gains (losses) 6.7 3.9 (422.8) 20.3
Consolidated pretax
income (loss) (73.4) 35.0 -309.3 (631.1) 357.9 -276.3
Income taxes (credits) (25.3) 5.8 -537.0 (199.3) 105.7 -288.4
Net income (loss) $ (48.0) $ 29.2 -264.1 % $ (431.8) $ 252.1 -271.2 %
Consolidated underwriting ratio:
Benefits and claims ratio 81.8% 66.4% 80.1% 55.6%
Expense ratio 38.8 40.2 39.0 41.7
Composite ratio 120.6% 106.6% 119.1% 97.3%
Components of diluted
earnings per share:
Net operating income (loss) $ (0.20) $ 0.11 -281.8 % $ (0.50) $ 1.02 -149.0 %
Net realized
investment gains (losses) (0.01) 0.01 (1.37) 0.06
Net income (loss) $ (0.21) $ 0.12 -275.0 % $ (1.87) $ 1.08 -273.1 %
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N/M = not meaningful
The above table shows both operating and net income to highlight the effects of realized investment gain or loss recognition and any non-recurring items on period-to-period comparisons. Operating income, however, does not replace net income computed in accordance with Generally Accepted Accounting Principles ("GAAP") as a measure of total profitability.
The recognition of realized investment gains or losses can be highly discretionary and arbitrary due to such factors as the timing of individual securities sales, recognition of estimated losses from write-downs for impaired securities, tax-planning considerations, and changes in investment management judgments relative to the direction of securities markets or the future prospects of individual investees or industry sectors. Likewise, non-recurring items which may emerge from time to time, can distort the comparability of the Company's results from period to period. Accordingly, management uses net operating income, a non-GAAP financial measure, to evaluate and better explain operating performance, and believes its use enhances an understanding of Old Republic's basic business results.
General Insurance Results - General insurance operating income for the first nine months of 2008 was affected mainly by moderately lower earned premiums and the higher claim ratios shown in the following table:
General Insurance Group
Quarters Ended September 30, Nine Months Ended September 30,
2008 2007 Change 2008 2007 Change
Net premiums earned $ 500.3 $ 549.5 -8.9 % $ 1,507.4 $ 1,611.4 -6.5 %
Net investment income 61.9 65.3 -5.2 189.1 192.8 -1.9
Pretax operating income $ 77.0 $ 112.7 -31.7 % $ 223.2 $ 324.5 -31.2 %
Claims ratio 72.5 % 67.7 % 72.8 % 66.5 %
Expense ratio 23.8 23.0 24.2 24.5
Composite ratio 96.3 % 90.7 % 97.0 % 91.0 %
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Year-to-date earned premiums trended lower as a moderately declining rate environment for most commercial insurance prices in the past three years or so has hindered retention of some business and precluded meaningful additions to Old Republic's premium base. For this year's first nine months, the slightly lower top line was accompanied by the above noted rise in claim ratios; these compare to an average of 66.8% for the five most recent calendar years. This year's higher claim ratio is attributable to the combination of greater loss costs for most insurance coverages and to the cumulative effect of softening premium rates. The higher loss costs were most accentuated for Old Republic's consumer credit indemnity, commercial multi-peril, and general aviation coverages.
Underwriting and other expenses have remained under good overall control; the resulting expense ratios compare favorably year over year and with the average of 24.8% for the five years through 2007.
Mortgage Guaranty Results - Claim costs continued to rise due to higher mortgage loan delinquencies, and claim frequency and severity. These higher costs were offset to some extent by strong premium revenue gains during this year's first half in particular. However, pretax operating results were unprofitable for the fifth consecutive quarter. Key indicators of this cyclical reversal in profitability for Old Republic's second largest business segment are shown below and in the accompanying statistical exhibit.
Mortgage Guaranty Group
Quarters Ended September 30, Nine Months Ended September 30,
2008 2007 Change 2008 2007 Change
Net premiums earned $ 148.4 $ 133.9 10.8 % $ 445.2 $ 377.0 18.1 %
Net investment income 22.0 19.9 10.2 65.0 57.9 12.1
Pretax operating income $ (152.8) $ (83.0) -84.1 % $ (415.9) $ 2.1 N/M
(loss)
Claims ratio 203.1 % 161.9 % 192.3 % 96.4 %
Expense ratio 14.8 15.0 15.8 18.4
Composite ratio 217.9 % 176.9 % 208.1 % 114.8 %
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Mortgage guaranty premium growth in this year's first nine months was mostly due to a 20.0% increase in traditional primary risk in force since September 2007. This increase stems from rising new insurance writings during the second half of 2007 and first half of 2008 as a result of greater market acceptance of traditional primary coverage and from higher business persistency (81.4% on an annualized basis as of September 2008 versus 76.6% through the same month end of 2007.)
The unprecedented cyclical downturn in housing and related mortgage finance industries contributed to the above noted offsetting impact of higher claim costs. Such costs reflect the combination of unfavorable loan default trends, greater claim severity caused by the larger insured loan values of recent years, and lessened opportunities to mitigate reported claims. Inflated inventories of unsold homes, weakening home values, and a more restrictive credit environment are main causes for the reduced mitigation opportunities, though greater numbers of submitted claims are being rescinded due to detected frauds and material deviations from required underwriting standards.
The disparity between paid and incurred loss ratios shown in the above table stems from much greater claim reserve provisions which accounted for 118.4 loss ratio points in this year's third quarter, compared to 117.8 loss ratio points in the same quarter of 2007. For the first nine months, claim reserve provisions produced increases of 125.7 and 57.4 loss ratio points in 2008 and 2007, respectively. For all of 2007 reserve increases accounted for 76.3 points of that year's loss ratio of 118.8%. As of September 30, 2008, net claim reserves of $1.20 billion were approximately 158.5% higher than they were twelve months earlier, and 86.7% greater than the amount posted at year end 2007.
The lower production and operating expense ratios for this year's third quarter and first nine months continued to be a bright spot in operating trends as greater premium volume has not been accompanied by a corresponding increase in fixed operating costs. The beneficial effect of the relatively lower expense ratio, however, was fully offset by the more severe impact of the higher claim ratio.
In combination, the above-cited factors produced a continuing uptrend in the composite underwriting ratios. Underlining the extreme severity of the current cyclical downturn in the housing and mortgage lending fields, this year's nine month composite ratio of 208.1% compares with an average of 74.0% registered during the five years ended December 31, 2007.
Underwriting results notwithstanding, Old Republic's Mortgage Guaranty segment continued to post strong operating cash flows. These have been additive to a high quality and liquid invested asset base which reached $1.95 billion as of September 30, 2008, up 14.4% from the level registered one year earlier. The greater invested asset base was mainly responsible for the investment income growth posted in the periods reported upon.
Title Insurance Results - Old Republic's title insurance business registered an operating loss for each of this year's quarters. Key operating performance indicators are shown in the following table:
Title Insurance Group
Quarters Ended September 30, Nine Months Ended September 30,
2008 2007 Change 2008 2007 Change
Net premiums and fees $ 168.4 $ 219.1 -23.1 % $ 502.1 $ 658.7 -23.8 %
earned
Net investment income 6.2 6.7 -6.9 19.1 20.2 -5.8
Pretax operating income $ (9.7) $ (3.3) -191.9 % $ (27.0) $ 1.0 N/M
(loss)
Claims ratio 7.0 % 6.8 % 7.0 % 6.4 %
Expense ratio 102.2 97.5 102.0 96.3
Composite ratio 109.2 % 104.3 % 109.0 % 102.7 %
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The ongoing cyclical downturn in the housing and related mortgage lending sectors of the U.S. economy also led to year-over-year reductions of premium and fee revenues for the Company's Title segment. Direct production facilities in the Western United States continued to sustain the most significant bottom line adverse effects of this downturn. Claim ratios in 2008 have trended up slightly as they did for all of 2007. While overall 2008 production and operating expenses have dropped significantly, the decline continues to be insufficient to counter the much larger reduction in title premium and fees revenues.
Corporate and Other Operations - The Company's small life and health insurance business and the net costs associated with the parent holding company and internal services subsidiaries produced net operating gains in this year's first nine months. Period-to-period earnings variations for these relatively minor elements of Old Republic's operations usually stem from the volatility inherent to the small scale of its life and health business, fluctuations in the costs of external debt, and net interest on intra-system financing arrangements.
Cash, Invested Assets, and Shareholders' Equity - The following table reflects Old Republic's consolidated cash and invested assets as well as shareholders' equity at the dates shown:
% Change
September December September Sept '08/ Sept '08/
2008 2007 2007 Dec '07 Sept '07
Cash and invested assets - at $ 8,733.7 $ 8,924.0 $ 8,762.4 -2.1 % -0.3 %
fair value
Cash and invested assets - at $ 9,143.3 $ 8,802.5 $ 8,604.4 3.9 % 6.3 %
original cost
Shareholders' equity:
Total $ 3,914.3 $ 4,541.6 $ 4,563.9 -13.8 % -14.2 %
Per common share $ 16.96 $ 19.71 $ 19.81 -14.0 % -14.4 %
Composition of shareholders'
equity per share:
Equity before items below $ 16.96 $ 19.31 $ 19.37 -12.2 % -12.4 %
Unrealized investment gains or
losses and other accumulated
comprehensive income - 0.40 0.44
Total $ 16.96 $ 19.71 $ 19.81 -14.0 % -14.4 %
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Consolidated cash flow from operating activities amounted to $467.6 for the first nine months of 2008 versus $642.7 for the same period in 2007.
The investment portfolio reflects a current allocation of approximately 85% to fixed-maturity securities and 6% to equities. As has been the case for many years, Old Republic's invested assets are managed in consideration of enterprise-wide risk management objectives intended to assure solid funding of its subsidiaries' long-term obligations to insurance policyholders and other beneficiaries, as well as evaluations of their long-term effect on stability of capital accounts. The portfolio contains little or no insurance risk-correlated asset exposures to real estate, mortgage-backed securities, collateralized debt obligations ("CDO's"), derivatives, junk bonds, or illiquid private equity investments. In a similar vein, the Company does not engage in hedging transactions or securities lending operations, nor does it invest in securities whose values are predicated on non-regulated financial instruments exhibiting amorphous counter-party risk attributes.
Substantially all changes in the shareholders' equity account reflect the Company's net income or loss, dividend payments to shareholders, and changes in market valuations of invested assets for the periods reported upon. A summary of all changes in book value per share follows:
Shareholders' Equity Per Share
Quarter Nine Months Fiscal Twelve
Ended Ended Months Ended
September 30, September 30, September 30,
2008 2008 2008
Beginning book value per share $ 17.59 $ 19.71 $ 19.81
Changes in shareholders' equity for the
periods:
Net operating income (loss) (0.20) (0.50) (0.55)
Net realized investment gains (losses):
From sales 0.05 0.07 0.21
From impairments (0.06) (1.44) (1.44)
Subtotal (0.01) (1.37) (1.23)
Net unrealized investment gains (losses) (0.25) (0.37) (0.48)
Total realized and unrealized investment (0.26) (1.74) (1.71)
gains (losses)
Cash dividends (0.17) (0.50) (0.66)
Stock issuance, foreign exchange, and - (0.01) 0.07
other transactions
Net change (0.63) (2.75) (2.85)
Ending book value per share $ 16.96 $ 16.96 $ 16.96
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As indicated in the table below, Old Republic's significant investments in the stocks of two leading publicly held mortgage guaranty businesses (MGIC Investment Corp. and The PMI Group) and that of a national title insurer (LandAmerica Financial Group) account for a substantial portion of the investment losses reflected in the preceding summary. Unrealized losses, including such losses as are categorized as other-than-temporarily impaired ("OTTI") represent the net difference between the most recently established cost and the quarter-end market values of the investments. These three significant investments account for approximately 85% of the total net investment losses from impairments sustained by the Company in 2008. The aggregate cost, market value, and latest underlying equity values reported by the three investees, are shown below.
Values of Three Significant Investments
As of
September 30, June 30, December 31,
2008 2008 2007
Total value of the three Original cost $ 512.9 $ 509.8 $ 435.7
investments:
Impaired cost 132.0 128.9 N/A
Market value 159.0 128.9 383.6
Underlying equity(*) $ 668.6 $ 680.7 $ 699.6
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(*) Underlying equity based on latest reports (usually lagging by one quarter) issued by investees.
When making investment decisions, management considers the Company's ability to retain its holdings for a period sufficient to recover their cost and to obtain a competitive long-term total return. It also considers such factors as balance sheet effects of potential changes in market valuations, asset-liability matching objectives, long term ability to hold securities, tax planning considerations, and the investees' reported book values and ability to continue as going concerns. The three above-noted holdings were acquired as passive long-term investment additions to two core segments of Old Republic's business. In management's judgment, the currently negative market valuations of companies operating in the housing and mortgage-lending sectors of the American economy have been impacted significantly by the cyclical macroeconomic conditions affecting these sectors and by the recently dysfunctional banking and mortgage lending industries.
For external GAAP reporting purposes, however, Old Republic uses a simplistic mark to market valuation process and relatively short time frames in making periodic OTTI adjustments in its income statement. In this context, absent issuer-specific circumstances that would result in a contrary conclusion, all unrealized investment losses pertaining to any equity security reflecting a 20% or greater decline for a six month period are included in the determination of net income. Unrealized losses that are deemed temporary and all unrealized gains are recorded directly as a separate component of the shareholders' equity account and in the consolidated statement of comprehensive income. As a result of accounting idiosyncrasies, however, OTTI losses recorded in the income statement of one period can not be offset in the income statement of a subsequent period by market value gains on the previously impaired securities unless the gains are realized through actual sales. Such unrealized market value gains can only be recognized through direct credits in the shareholders' equity account and the consolidated statement of comprehensive income.
DETAILED MANAGEMENT ANALYSIS
FINANCIAL ACCOUNTING AND REPORTING POLICIES
The Company's annual and interim financial statements incorporate a large number and types of estimates relative to matters which are highly uncertain at the time the estimates are made. The estimation process required of an insurance enterprise is by its very nature highly dynamic inasmuch as it necessitates a continuous evaluation, analysis, and quantification of factual data as it becomes known to the Company. As a result, actual experienced outcomes can differ from the estimates made at any point in time, and thus affect future periods' reported revenues, expenses, net income, and financial condition.
Old Republic believes that its most critical accounting estimates relate to: a) the determination of other-than-temporary impairments in the value of fixed maturity and equity investments; b) the establishment of deferred acquisition costs which vary directly with the production of insurance premiums; c) the recoverability of reinsured paid and/or outstanding losses; and d) the establishment of reserves for losses and loss adjustment expenses. The major assumptions and methods used in setting these estimates are discussed in the Company's 2007 Annual Report on Form 10K.
In July 2006, the Financial Accounting Standards Board ("FASB") issued its Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), which became effective for the Company in the first quarter of 2007. FIN 48 provides recognition criteria and a related measurement model for uncertain tax positions taken or expected to be taken in income tax returns. FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. The Company's unrecognized tax benefits, including interest and penalty accruals, are not considered material to the consolidated financial statements and did not change significantly upon the adoption of FIN 48. There are no tax uncertainties that are expected to result in significant increases or decreases to unrecognized tax benefits within the next twelve month period. As indicated in Note 1 of the Notes to Consolidated Financial Statements, the Company believes that the major uncertainties relating to its tax position pertain to timing differences in the recognition of taxable income. Accordingly, the annual effective tax rate, other than possible interest and penalties, would be largely unaffected as an increase in currently due income taxes would likely be offset by a corresponding deferred income tax adjustment.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 Fair Value Measurements ("FAS 157"), which establishes a framework for . . .
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