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FAF > SEC Filings for FAF > Form 10-Q on 26-Oct-2012All Recent SEC Filings

Show all filings for FIRST AMERICAN FINANCIAL CORP

Form 10-Q for FIRST AMERICAN FINANCIAL CORP


26-Oct-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

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 3-4 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, 2011. There have been no material changes to the Company's critical accounting policies since the filing of its Annual Report on Form 10-K for the year ended December 31, 2011.

Recently Adopted Accounting Pronouncements

In October 2010, the Financial Accounting Standards Board ("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 the interim and annual periods beginning after December 15, 2011. The adoption of the guidance, on a prospective basis, did not 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 U.S. generally accepted accounting principles and International Financial Reporting Standards. 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 updated guidance is effective for interim and annual periods beginning after December 15, 2011. Except for the disclosure requirements, the adoption of the guidance had no impact on the Company's condensed consolidated financial statements.

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 either consecutive presentation of the statement of net income and other comprehensive income or in a single continuous statement of 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. In December 2011, the FASB issued updated guidance deferring the effective date of the change in presentation of reclassification adjustments. The adoption of the guidance that became effective in the first quarter of 2012 had no impact on the Company's condensed consolidated financial statements.


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Pending Accounting Pronouncements

In July 2012, the FASB issued updated guidance that is intended to reduce the cost and complexity of performing an impairment test for indefinite-lived intangible assets, other than goodwill, by simplifying how an entity tests those assets for impairment and to improve consistency in impairment testing guidance among long-lived asset categories. The updated guidance permits entities to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with current guidance. The updated guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. Management did not early adopt this guidance and does not expect this guidance to have a material impact on the Company's condensed consolidated financial statements.

In December 2011, the FASB issued updated guidance requiring entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The updated guidance is effective for interim and annual reporting periods beginning on or after January 1, 2013. 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.

OVERVIEW

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 owned TFAC's financial services businesses and TFAC, which reincorporated and assumed the name CoreLogic, Inc. ("CoreLogic"), continued to own its information solutions businesses.

RESULTS OF OPERATIONS

Summary of Third Quarter

A substantial portion of the revenues for the Company's title insurance and services segment results from the sale, refinancing and foreclosure 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.

A low interest rate environment typically has a favorable impact on many of the Company's businesses. However, in recent years mortgage credit has been generally tight, which together with the uncertainty in general economic conditions, has impacted the demand for most of the Company's products and services. During the third quarter of 2012, primarily due to the historically low interest rate environment and the gradual improvement in both the general economy and availability of mortgage credit, the Company observed a sizable increase in mortgage activity.

According to the Mortgage Bankers Association's September 18, 2012 Mortgage Finance Forecast (the "MBA Forecast"), residential mortgage originations in the United States (based on the total dollar value of the transactions) increased 33.3% in the third quarter of 2012 when compared with the third quarter of 2011. According to the MBA Forecast, the dollar amount of purchase originations decreased 0.9% while refinance originations increased 51.7%.

The Company's direct title operations opened 438,500 title orders during the three months ended September 30, 2012, an increase of 27.3% when compared with 344,500 title orders opened during the same period of the prior year. The increase in title orders opened was driven primarily by the significant increase in refinance activity. While market conditions and order volumes demonstrated improvement during the third quarter of 2012, the Company continues to maintain a tight control on expenses.

During the third quarter of 2012, the Company sold 8.9 million shares of CoreLogic common stock for an aggregate cash price of $207.9 million and recorded a net realized gain of $40.4 million. 6.0 million shares were sold by the Company's holding company and 2.9 million shares were sold by the Company's primary insurance subsidiary, First American Title Insurance Company, resulting in net realized gains to the corporate division and title insurance and services segment of $25.4 million and $15.0 million, respectively. At September 30, 2012, the Company no longer owns any CoreLogic common stock.


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During the first quarter of 2012, the Company changed the allocation of certain expenses within its reportable segments and corporate division to reflect the performance of the Company's reportable segments as reported to the chief operating decision maker. The expenses that were impacted as a result of the change in allocation include shared services expenses, benefit plan expense and interest expense. Prior period segment data has been reclassified to conform to the current presentation. For the three and nine months ended September 30, 2011, income before income taxes for the Company's reportable segments were impacted as follows: increases of $3.9 million and $10.6 million, respectively, to the title insurance and services segment, increases of $0.1 million and $0.5 million, respectively, to the specialty insurance segment, and decreases of $4.0 million and $11.1 million, respectively, to the corporate division.

Title Insurance and Services



                                                                      Three Months Ended September 30,                                 Nine Months Ended September 30,
(in thousands, except percentages)                           2012            2011         $ Change        % Change          2012             2011          $ Change        % Change
Revenues
Direct premiums and escrow fees                           $   459,149      $ 355,557      $ 103,592            29.1 %    $ 1,226,934      $   984,907      $ 242,027            24.6 %
Agent premiums                                                443,028        366,028         77,000            21.0        1,220,375        1,114,390        105,985             9.5
Information and other                                         158,803        158,490            313             0.2          481,503          466,211         15,292             3.3
Investment income                                              19,514         20,125           (611 )          (3.0 )         55,024           57,718         (2,694 )          (4.7 )
Net realized investment gains                                  19,821          2,064         17,757             N/M 1         23,235               83         23,152             N/M 1
Net other-than-temporary impairment losses recognized
in earnings                                                        -          (3,942 )        3,942             N/M 1         (3,564 )         (5,216 )        1,652            31.7

                                                            1,100,315        898,322        201,993            22.5        3,003,507        2,618,093        385,414            14.7

Expenses
Personnel costs                                               317,197        274,106         43,091            15.7          894,122          802,912         91,210            11.4
Premiums retained by agents                                   355,191        293,583         61,608            21.0          978,703          893,382         85,321             9.6
Other operating expenses                                      197,030        176,341         20,689            11.7          558,541          533,636         24,905             4.7
Provision for policy losses and other claims                   59,718         69,538         (9,820 )         (14.1 )        166,717          206,180        (39,463 )         (19.1 )
Depreciation and amortization                                  16,538         17,062           (524 )          (3.1 )         49,539           51,187         (1,648 )          (3.2 )
Premium taxes                                                  12,063         14,049         (1,986 )         (14.1 )         32,718           30,796          1,922             6.2
Interest                                                          671            880           (209 )         (23.8 )          1,993            2,179           (186 )          (8.5 )

                                                              958,408        845,559        112,849            13.3        2,682,333        2,520,272        162,061             6.4

Income before income taxes                                $   141,907      $  52,763      $  89,144           169.0 %    $   321,174      $    97,821      $ 223,353           228.3 %

Margins                                                          12.9 %          5.9 %          7.0 %         118.6 %           10.7 %            3.7 %          7.0 %         189.2 %

(1) Not meaningful

Direct premiums and escrow fees were $459.1 million and $1.2 billion for the three and nine months ended September 30, 2012, respectively, increases of $103.6 million, or 29.1%, and $242.0 million, or 24.6%, when compared with the respective periods of the prior year. These increases were due to an increase in the number of title orders closed by the Company's direct operations, which reflected the increase in mortgage originations, partially offset by a decrease in average revenues per


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order closed. The decreases in average revenues per order closed in the three and nine months ended 2012 when compared to the respective periods of the prior year, were primarily attributable to an increase in the mix of direct revenues generated from lower premium refinance transactions. The Company's direct title operations closed 305,600 and 856,200 title orders during the three and nine months ended September 30, 2012, respectively, increases of 34.9% and 28.2% when compared with the same periods of the prior year. The average revenues per order closed were $1,502 and $1,433 for the three and nine months ended September 30, 2012, respectively, decreases of 4.3% and 2.8% when compared with the respective periods of the prior year.

Agent premiums were $443.0 million and $1.2 billion for the three and nine months ended September 30, 2012, respectively, increases of $77.0 million, or 21.0%, and $106.0 million, or 9.5%, when compared with the respective periods of the prior year. 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, third quarter agent premiums primarily reflected second quarter mortgage origination activity. The increase in agent premiums quarter over quarter was consistent with the 27.0% increase in the Company's direct premiums and escrow fees in the second quarter of 2012 as compared with the second quarter of 2011. The Company continuously analyzes the terms and profitability of its title agency relationships and, where it deems it necessary, amends agent agreements to the extent possible.

Information and other revenues primarily consist 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. These revenues generally trend with direct premiums and escrow fees but are typically less volatile since a portion of the revenues are subscription based and do not fluctuate with transaction volumes.

Information and other revenues were $158.8 million and $481.5 million for the three and nine months ended September 30, 2012, respectively, increases of $0.3 million, or 0.2%, and $15.3 million, or 3.3%, when compared with the same periods of the prior year. These increases primarily reflected higher demand for the Company's title information products as a result of the increase in mortgage origination activity, offset by lower revenues in the Company's Canadian operations in the current quarter due to a decline in mortgage transactions resulting primarily from a recent tightening of lending requirements.

Net realized investment gains totaled $19.8 million and $23.2 million for the three and nine months ended September 30, 2012, respectively, and $2.1 million and $0.1 million for the three and nine months ended September 30, 2011. These totals primarily reflected the net realized gains from the sales of investment securities, partially offset by impairments recorded on certain non-marketable investments and notes receivable. The 2012 net realized investment gains included $15.0 million in gains resulting from the sale of CoreLogic common stock during the three months ended September 30, 2012.

The title insurance and services segment recognized no other-than-temporary impairment losses for the three months ended September 30, 2012, and $3.6 million of other-than-temporary impairment losses for the nine months ended September 30, 2012, compared to $3.9 million and $5.2 million in the respective periods of the prior year. The other-than-temporary impairment losses recognized related to the Company's non-agency mortgage-backed securities portfolio.

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 $317.2 million and $894.1 million for the three and nine months ended September 30, 2012, respectively, increases of $43.1 million, or 15.7%, and $91.2 million, or 11.4%, when compared with the respective periods of the prior year. The increases were primarily due to higher incentive compensation driven by improved revenues and profitability and higher staffing levels required to support the increased order volume when compared to the respective periods of the prior year.

Agents retained $355.2 million and $978.7 million of title premiums generated by agency operations for the three and nine months ended September 30, 2012, respectively, which compares with $293.6 million and $893.4 million for the respective periods of the prior year. The percentage of title premiums retained by agents was 80.2% for the three and nine months ended September 30, 2012 and 2011.

Other operating expenses for the title insurance and services segment were $197.0 million and $558.5 million for the three and nine months ended September 30, 2012, respectively, increases of $20.7 million, or 11.7%, and $24.9 million, or 4.7%, when compared with the respective periods of the prior year. These increases were primarily due to increased production related expenses and higher temporary labor driven by the increase in order volumes, partially offset by a decline in legal expenses.


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The provision for policy losses and other claims was $59.7 million and $166.7 million, or 6.6% and 6.8% of title premiums and escrow fees, for the three and nine months ended September 30, 2012, respectively. For the three and nine months ended September 30, 2011, the provision for policy losses and other claims was $69.5 million and $206.2 million, or 9.6% and 9.8% of title premiums and escrow fees, respectively. The current quarter rate of 6.6% reflected an ultimate loss rate of 5.6% for the current policy year and a net increase in the loss reserve estimates for prior policy years. The three and nine months ended September 30, 2012 included approximately $8.0 million and $12.6 million, respectively, of net unfavorable development related to the Company's guaranteed valuation product offered in Canada. There is substantial uncertainty as to the ultimate loss emergence for this product due to the following factors, among others, (i) claims associated with this product are generally made only after a foreclosure on the related property and foreclosure rates in Canada are difficult to predict and (ii) limited historical loss data exists as a result of the relatively recent introduction of this product in 2003. While the Company believes its claims reserve attributable to this product is adequate, this uncertainty increases the potential for adverse loss development relative to this product. The rate of 9.6% for the three months ended September 30, 2011 reflected an ultimate loss rate of 5.8% for the 2011 policy year and included $14.7 million in unfavorable development for prior policy years and a $13.0 million charge in connection with Bank of America's lawsuit against the Company, which was settled during the fourth quarter of 2011. The rate of 9.8% for the nine months ended September 30, 2011 reflected a $45.3 million reserve strengthening adjustment recorded in the first quarter of 2011 related to the guaranteed valuation product offered in Canada.

Premium taxes were $12.1 million and $32.7 million for the three and nine months ended September 30, 2012, respectively, compared to $14.0 million and $30.8 million for the respective periods of the prior year. Premium taxes as a percentage of title insurance premiums and escrow fees were 1.3% for the three and nine months ended September 30, 2012, compared to 1.9% and 1.5% in the respective periods of the prior year. Premium taxes as a percentage of title insurance premiums and escrow fees were higher in the prior year periods primarily due to incremental premium taxes paid in 2011 related to a state audit and a non-cash amount recorded in the third quarter of 2011 to adjust the accrued premium tax liability.

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 nine months ended September 30, 2012 were 12.9% and 10.7%, respectively, compared with 5.9% and 3.7% in the respective periods of the prior year.


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Specialty Insurance



                                                                       Three Months Ended September 30,                             Nine Months Ended September 30,
(in thousands, except percentages)                            2012          2011         $ Change        % Change         2012           2011         $ Change        % Change
Revenues
Direct premiums                                             $ 76,697      $ 70,976      $    5,721             8.1 %    $ 219,986      $ 204,698      $  15,288             7.5 %
Information and other                                            303           477            (174 )         (36.5 )        1,196          1,221            (25 )          (2.0 )
Investment income                                              2,368         2,635            (267 )         (10.1 )        7,065          7,710           (645 )          (8.4 )
Net realized investment gains                                  2,063           195           1,868             N/M 1        6,971          1,131          5,840             N/M 1

                                                              81,431        74,283           7,148             9.6        235,218        214,760         20,458             9.5

Expenses
Personnel costs                                               14,298        13,427             871             6.5         41,678         37,569          4,109            10.9
Other operating expenses                                       9,950         8,976             974            10.9         30,586         28,074          2,512             8.9
Provision for policy losses and other claims                  46,491        42,639           3,852             9.0        121,559        112,746          8,813             7.8
Depreciation and amortization                                  1,179         1,046             133            12.7          3,351          3,139            212             6.8
Premium taxes                                                  1,407         1,354              53             3.9          3,828          3,563            265             7.4

                                                              73,325        67,442           5,883             8.7        201,002        185,091         15,911             8.6

Income before income taxes                                  $  8,106      $  6,841      $    1,265            18.5 %    $  34,216      $  29,669      $   4,547            15.3 %

Margins                                                         10.0 %         9.2 %           0.8 %           8.7 %         14.5 %         13.8 %          0.7 %           5.1 %

(1) Not meaningful

Direct premiums were $76.7 million and $220.0 million for the three and nine months ended September 30, 2012, respectively, increases of $5.7 million, or 8.1%, and $15.3 million, or 7.5%, when compared with the same periods of the prior year. These increases were due to an increase in premiums from both the home warranty and property and casualty divisions.

Net realized investment gains totaled $2.1 million and $7.0 million for the three and nine months ended September 30, 2012, respectively, and $0.2 million and $1.1 million for the three and nine months ended September 30, 2011, . . .

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