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FAF > SEC Filings for FAF > Form 10-Q on 26-Apr-2013All Recent SEC Filings

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Form 10-Q for FIRST AMERICAN FINANCIAL CORP


26-Apr-2013

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 PAGE 3 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, 2012. 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, 2012.

Recently Adopted Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board ("FASB") issued updated guidance requiring entities to present either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items affected by the reclassification. If the component is not required to be reclassified to net income in its entirety, entities should instead cross reference to the related footnote for additional information. The updated guidance is effective prospectively for interim and annual reporting periods beginning after December 15, 2012, with early adoption permitted. Except for the disclosure requirements, the adoption of the guidance had no impact on the Company's condensed consolidated financial statements.

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. The adoption of the guidance had no 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. The adoption of the guidance had no 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.


Table of Contents

Results of Operations

Summary of First Quarter

A substantial portion of the revenues for the Company's title insurance and services segment results from the sale and refinancing 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. Over the last several quarters, 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 an increase in mortgage activity.

According to the Mortgage Bankers Association's April 18, 2013 Mortgage Finance Forecast (the "MBA Forecast"), residential mortgage originations in the United States (based on the total dollar value of the transactions) increased 29.2% in the first quarter of 2013 when compared with the first quarter of 2012. According to the MBA Forecast, the dollar amount of purchase originations increased 5.0% and refinance originations increased 40.6%. This increase in residential mortgage origination activity drove an increase in title orders closed by the Company's direct title operations, which contributed to the title insurance and services segment's 19.2% increase in total revenues for the first quarter of 2013 when compared with the first quarter of 2012.

The level of title orders opened per day by the Company's direct title operations during the first quarter of 2013 was essentially flat when compared with the first quarter of 2012. While total open orders per day were flat, the order mix shifted toward residential resale and commercial transactions, which typically generate higher premiums than refinance transactions. Residential resale and commercial open orders per day increased 13.0% and 9.4%, respectively, while refinance open orders per day decreased 6.5%.


Table of Contents

Title Insurance and Services



                                                            Three Months Ended March 31,
(in thousands, except percentages)           2013              2012           $ Change           % Change
Revenues
Direct premiums and escrow fees           $   399,985        $ 343,639        $  56,346               16.4 %
Agent premiums                                484,465          376,986          107,479               28.5
Information and other                         151,749          155,289           (3,540 )             (2.3 )
Investment income                              18,986           17,321            1,665                9.6
Net realized investment gains                   7,396              588            6,808                N/M 1
Net other-than-temporary impairment
losses recognized in earnings                      -            (2,602 )          2,602              100.0

                                            1,062,581          891,221          171,360               19.2

Expenses
Personnel costs                               316,844          277,577           39,267               14.1
Premiums retained by agents                   387,543          302,164           85,379               28.3
Other operating expenses                      188,614          171,752           16,862                9.8
Provision for policy losses and other
claims                                         77,360           52,179           25,181               48.3
Depreciation and amortization                  16,483           16,333              150                0.9
Premium taxes                                  10,904            9,733            1,171               12.0
Interest                                          564              661              (97 )            (14.7 )

                                              998,312          830,399          167,913               20.2

Income before income taxes                $    64,269        $  60,822        $   3,447                5.7 %

Margins                                           6.0 %            6.8 %           (0.8 )%           (11.8 )%

(1) Not meaningful

Direct premiums and escrow fees were $400.0 million for the three months ended March 31, 2013, an increase of $56.3 million, or 16.4%, when compared with the same period of the prior year. This increase was due to an increase in the number of title orders closed by the Company's direct operations and, to a lesser extent, an increase in average revenues per order closed. The Company's direct title operations closed 291,400 title orders during the three months ended March 31, 2013, an increase of 11.5% when compared with 261,300 title orders closed during the same period of the prior year. The increase in closed title orders reflected the increase in residential mortgage originations in the United States in the first quarter of 2013 when compared to the first quarter of 2012. The average revenues per order closed was $1,373 for the three months ended March 31, 2013, an increase of 4.4% when compared with $1,315 for the three months ended March 31, 2012. The increase in average revenues per order closed was primarily attributable to higher real estate values in the first quarter of 2013 when compared with the same period of the prior year.

Agent premiums were $484.5 million for the three months ended March 31, 2013, an increase of $107.5 million, or 28.5%, when compared with the same period 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, first quarter agent premiums typically reflect fourth quarter mortgage origination activity. The increase in agent premiums quarter over quarter was consistent with the 38.1% increase in the Company's direct premiums and escrow fees in the fourth quarter of 2012 as compared with the fourth 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 $151.7 million for the three months ended March 31, 2013, a decrease of $3.5 million, or 2.3%, when compared with the same period of the prior year. This decrease was primarily attributable to lower demand for title related services in Canada due to a decline in mortgage transactions resulting primarily from a recent tightening of lending requirements, partially offset by higher demand for the Company's default and title plant information products as a result of the increase in domestic loss mitigation and mortgage origination activities.


Table of Contents

Investment income totaled $19.0 million for the three months ended March 31, 2013, an increase of $1.7 million, or 9.6%, when compared with the same period of the prior year. The increase was primarily due to increased dividend and interest income from the investment portfolio and higher equity in earnings from investments accounted for using the equity method of accounting. The increase in interest income reflected a higher average investment portfolio balance in the first quarter of 2013 when compared with the same period of the prior year, partially offset by a decline in yields.

Net realized investment gains totaled $7.4 million and $0.6 million for the three months ended March 31, 2013 and 2012, respectively. The gains recognized during the first quarter of 2013 were primarily from the sale of investment securities as well as the sale of an office building.

The title insurance and services segment recognized no other-than-temporary impairment losses for the three months ended March 31, 2013 and $2.6 million for the three months ended March 31, 2012. The other-than-temporary impairment losses recognized in the first quarter of 2012 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 primary 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 $316.8 million for the three months ended March 31, 2013, an increase of $39.3 million, or 14.1%, when compared with the same period of the prior year. The increase was primarily due to higher staffing levels required to support the increased closed order volumes and higher incentive compensation driven by increased revenues when compared to the respective period of the prior year.

Agents retained $387.5 million of title premiums generated by agency operations for the three months ended March 31, 2013, which compares with $302.2 million for the same period of the prior year. The percentage of title premiums retained by agents was 80.0% and 80.2% for the three months ended March 31, 2013 and 2012, respectively.

Other operating expenses for the title insurance and services segment were $188.6 million for the three months ended March 31, 2013, an increase of $16.9 million, or 9.8%, when compared with the same period of the prior year. This increase was primarily due to higher production related expenses and temporary labor costs driven by increased closed order volumes.

The provision for policy losses and other claims, expressed as a percentage of title premiums and escrow fees, was 8.7% and 7.2% for the three months ended March 31, 2013 and 2012, respectively.

The current quarter rate of 8.7% reflected an ultimate loss rate of 5.6% for the current policy year and a $28.6 million net increase in the loss reserve estimates for prior policy years. The increase in loss reserve estimates for prior policy years reflected claims development above expected levels during the first quarter of 2013, primarily from policy years 2006 and 2007, which were adversely impacted by a few large commercial claims and, to a lesser extent, increased claims frequency related to residential lenders policies.

The first quarter of 2012 rate of 7.2% reflected an ultimate loss rate of 6.2% for the 2012 policy year and a net increase in the loss reserve estimates for prior policy years of $7.2 million, primarily associated with the Company's guaranteed valuation product offered in Canada. The reserve strengthening associated with the guaranteed valuation product reflected an increase in claims frequency experienced during the first quarter of 2012, primarily related to policy years 2008 and 2009.

Premium taxes were $10.9 million and $9.7 million for the three months ended March 31, 2013 and 2012, respectively. Premium taxes as a percentage of title insurance premiums and escrow fees were 1.2% and 1.4% for the three months ended March 31, 2013 and 2012, respectively.

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 margin for the three months ended March 31, 2013 and 2012 was 6.0% and 6.8%, respectively.


Table of Contents

Specialty Insurance



                                                                 Three Months Ended March 31,
(in thousands, except percentages)                 2013            2012           $ Change          % Change
Revenues
Direct premiums                                  $ 77,866        $ 70,147        $    7,719              11.0 %
Information and other                                 390             475               (85 )           (17.9 )
Investment income                                   1,678           2,465              (787 )           (31.9 )
Net realized investment gains                       1,575           1,111               464              41.8

                                                   81,509          74,198             7,311               9.9

Expenses
Personnel costs                                    14,331          13,663               668               4.9
Other operating expenses                           10,219          11,042              (823 )            (7.5 )
Provision for policy losses and other claims       38,666          34,499             4,167              12.1
Depreciation and amortization                       1,179           1,055               124              11.8
Premium taxes                                       1,213           1,115                98               8.8

                                                   65,608          61,374             4,234               6.9

Income before income taxes                       $ 15,901        $ 12,824        $    3,077              24.0 %

Margins                                              19.5 %          17.3 %             2.2 %            12.7 %

Direct premiums were $77.9 million for the three months ended March 31, 2013, an increase of $7.7 million, or 11.0%, when compared with the same period of the prior year. The increase was primarily due to an increase in the number of home warranty residential service contracts issued and, to a lesser extent, an increase in property and casualty policies issued. The growth in home warranty residential service contracts issued was primarily associated with renewals and residential purchase transactions.

Investment income totaled $1.7 million for the three months ended March 31, 2013, a decrease of $0.8 million, or 31.9%, when compared with the same period of the prior year. The decrease was primarily due to a decrease in interest income earned from the investment portfolio reflecting a decline in yields.

Net realized investment gains were $1.6 million and $1.1 million for the three months ended March 31, 2013 and 2012, respectively. The net realized gains were due to gains from the sale of investment securities.

Personnel costs and other operating expenses were $24.5 million for the three months ended March 31, 2013, a decrease of $0.2 million, or 0.6%, when compared with the same period of the prior year. This slight decrease was primarily related to decreased amortization of deferred acquisition costs, partially offset by increased salary expense associated with higher employee headcount and increased commissions associated with increased volume in the home warranty and property and casualty businesses.

The provision for home warranty claims expressed as a percentage of home warranty premiums was 48.1% for the current three month period, which was essentially unchanged when compared with 47.9% for the same period of the prior year. For the property and casualty business, the provision for property and casualty claims expressed as a percentage of property and casualty insurance premiums was 52.5% for the current three month period, an increase when compared with 51.3% for the same period of the prior year. This increase was primarily attributable to higher weather-related claims across the U.S. in the first quarter of 2013 when compared to the same quarter of 2012.

Premium taxes were $1.2 million and $1.1 million for the three months ended March 31, 2013 and 2012, respectively. Premium taxes as a percentage of specialty insurance segment premiums were 1.6% for the three months ended March 31, 2013 and 2012.

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 month period were 19.5%, up from 17.3% for the comparable period of the prior year.


Table of Contents

Corporate



                                                   Three Months Ended March 31,
(in thousands, except percentages)     2013           2012          $ Change        % Change
Revenues
Investment income                    $   3,145      $   2,248      $      897            39.9 %
Net realized investment gains              285             -              285              -

                                         3,430          2,248           1,182            52.6

Expenses
Personnel costs                         13,325         14,039            (714 )          (5.1 )
Other operating expenses                 6,519          6,360             159             2.5
Depreciation and amortization              733            671              62             9.2
Interest                                 3,431          3,274             157             4.8

                                        24,008         24,344            (336 )          (1.4 )

Loss before income taxes             $ (20,578 )    $ (22,096 )    $    1,518             6.9 %

Investment income totaled $3.1 million and $2.2 million for the three months ended March 31, 2013 and 2012, respectively. The increase in investment income was primarily attributable to the impairment of a non-marketable investment recorded in the first quarter of 2012 with no impairment recorded in the first quarter of 2013. This increase was partially offset by a decrease in earnings on investments associated with the Company's deferred compensation plan.

Corporate personnel costs and other operating expenses were $19.8 million and $20.4 million for the three months ended March 31, 2013 and 2012, respectively. The decrease in personnel costs and other operating expenses was primarily due to decreased costs associated with the Company's deferred compensation plan.

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 months ended March 31, 2013 and 2012.

INCOME TAXES

The Company's effective income tax rate (income tax expense as a percentage of income before income taxes) was 39.2% and 39.7% for the three months ended March 31, 2013 and 2012, respectively. The difference in the effective tax rates was primarily due to changes in the ratio of permanent differences to income before income taxes, changes in state and foreign income taxes resulting from fluctuations in the Company's noninsurance and foreign subsidiaries' contribution to pretax profits, and changes in the liability related to tax positions reported on the Company's tax returns. The effective tax rate for 2012 included the release of valuation allowances recorded against capital losses.

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.

NET INCOME AND NET INCOME ATTRIBUTABLE TO THE COMPANY

Net income for the three months ended March 31, 2013 and 2012 was $36.2 million and $31.1 million, respectively. Net income attributable to the Company for the three months ended March 31, 2013 and 2012 was $36.2 million and $31.3 million, or $0.33 and $0.29 per diluted share, respectively.


Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

Cash Requirements. The Company generates cash primarily from the sale of its products and services and investment income. The Company's current cash requirements include operating expenses, taxes, payments of principal and interest on its debt, capital expenditures, potential business acquisitions and dividends on its common stock. Management forecasts the cash needs of the . . .

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