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STC > SEC Filings for STC > Form 10-K on 28-Feb-2014All Recent SEC Filings




Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations


For the year ended December 31, 2013, net earnings attributable to Stewart of $63.0 million, or $2.60 per diluted share, represents a decrease of $46.2 million from the same period in 2012. The decline in net earnings is attributable to the decrease in earnings in our mortgage services segment and to the impact of a higher reversal of the tax asset valuation allowance in 2012 than in 2013. Pretax earnings for the year ended December 31, 2013 were $101.1 million, an increase of $11.7 million from the same period in 2012. Results for the year ended December 31, 2013 include a non-cash charge of $5.4 million, or $0.22 per diluted share, relating to the early retirement of $37.8 million of our 6% Convertible Senior Notes due October 2014, as well as gains of $2.3 million, or $0.09 per diluted share, on non-title-related insurance policy proceeds (no tax benefit or expense is associated with either item; thus there was no tax-related effect on earnings per share).

Total revenues for 2013 were $1,928.0 million, an increase of $17.6 million, or 0.9%, from $1,910.4 million for the 2012 year.

Our title segment revenues declined 10.5% and 16.2% from the fourth quarter 2012 and third quarter 2013, respectively. Refinancing originations, and therefore title orders, fell significantly from the prior year quarter, and, although existing home sales continue to show improvement on a twelve month moving average basis, existing home sales on an unadjusted basis declined almost 8% over the prior year period. In the fourth quarter 2013, the title segment generated a pretax margin of 11.1%, an improvement of 120 basis points from fourth quarter 2012 and, sequentially, a decrease of 120 basis points from the third quarter 2013. Revenues from direct operations for the fourth quarter 2013 decreased 7.3% compared to the same quarter last year and 9.8% sequentially from the third quarter 2013. U.S. and Canadian commercial revenues increased 11.3% to $42.3 million from the fourth quarter 2012 and increased sequentially by 34.7% from the third quarter 2013. International operating revenues (including foreign-sourced commercial revenues) decreased 0.8% to $27.9 million from the fourth quarter 2012 and sequentially by 18.8% from the third quarter 2013.

Revenues from our mortgage services segment were $25.6 million for the fourth quarter 2013, as compared to $46.7 million in the fourth quarter 2012, largely due to the project-based nature of the contracts in this segment. We are transitioning from this segment's historical service offerings for the management of defaulted and distressed loans to a more sustainable suite of service offerings to support the ongoing loan origination and servicing support needs of lenders in a heightened regulatory environment. Many lending institutions are under pressure to maintain earnings while managing the rising costs of regulatory compliance, which we believe will drive increased demand for the outsourced solutions we offer. We are focused on reducing expenses in the segment; however, we were unable to achieve efficiencies fast enough to offset the decline in revenues. As a result, the segment reported a pretax loss of $1.6 million in the fourth quarter 2013 compared to pretax earnings of $14.2 million and a pretax loss of $1.4 million for the fourth quarter 2012 and third quarter 2013, respectively.

Title policy loss development continued to improve during the fourth quarter 2013, reflecting an ongoing decline in prior policy year loss experience on non-large title losses as well as our continued attention to prudent risk management with emphasis on the quality and profitability of our independent agency network. As a percentage of title revenues, title losses were 6.2% in the fourth quarter 2013, a decrease of 140 basis points from the fourth quarter 2012 and 30 basis points from the third quarter 2013. For the year, title losses as a percentage of title revenues decreased to 5.9% in 2013 from 8.1% in 2012. The decrease in the title loss ratio was due to lower provisioning rates in 2013 compared to 2012, while higher losses in the current year relating to large title losses were offset by non-large loss reserve reductions of a net $2.8 million for the year. Total balance sheet policy loss reserves were $506.9 million at December 31, 2013, and were above the actuarial mid-point of total estimated policy losses.

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Actual results can differ from our accounting estimates. While we do not anticipate significant changes in our estimates, there is a risk that such changes could have a material impact on our consolidated financial condition or results of operations for future periods.

Title loss reserves

Our most critical accounting estimate is providing for title loss reserves.

                                           2013          2012          2011
                                                    ($ in millions)
            Provisions - Known Claims:
            Current year                     24.0          19.0          24.4
            Prior policy years               83.2         107.8         100.8

                                            107.2         126.8         125.2
            Provisions - IBNR
            Current year                     68.0          81.4          69.7
            Prior policy years               14.3          39.6          48.0

                                             81.3         121.0         117.7
            Transferred to Known Claims     (83.2 )      (107.8 )      (100.8 )

            Total provisions                106.3         140.0         142.1

Provisions for known claims arise primarily from prior policy years as claims are not typically reported until several years after policies are issued. Provisions - IBNR are estimates of claims expected to be incurred over the next 20 years; therefore, it is not unusual or unexpected to experience adjustments to the provisions in both current and prior policy years as new loss development of policy years occurs. This loss development experience may result in changes to our estimate of total ultimate losses expected (IBNR). As claims become known, provisions are reclassified from IBNR to known claims. Adjustments relating to large losses may impact provisions for either known claims or IBNR.

Known claims provisions decreased for the year ended December 31, 2013 to $107.2 million from $126.8 million in 2012, primarily as a result of adjustments to existing claims filed on policies issued in previous years. Current year provisions - IBNR are recorded on policies issued in the current year as a percentage of premiums realized (provisioning rate). For the year ended December 31, 2013, current year provisions - IBNR decreased $13.4 million to $68.0 million compared to 2012 as a result of a reduction in our provisioning rate which was partially offset by a 3.8% increase in title revenues for the year ended December 31, 2013 compared to 2012. As a percentage of title operating revenues, provisions - IBNR for the current policy year decreased from 4.7% in 2012 to 3.8% in 2013 due to the lowering of the provisioning rate effective for policies issued in the second quarter 2013 resulting from a decrease in incurred losses. Provisions - IBNR relating to prior policy years decreased from $39.6 million in 2012 to $13.3 million in 2013 due to declining adverse development on large title losses relating to policies issued in prior years. This trend is indicative of lower incurred losses as the claims environment continues to improve and as claims have been closed in policy years with higher than normal claims.

In addition to title policy claims, we incur losses in our direct operations from escrow, closing and disbursement functions. These escrow losses typically relate to errors or other miscalculations of amounts to be paid at closing, including timing or amount of mortgage payoff, payment of property or other taxes and payment of homeowners' association fees. Escrow losses are typically paid less than 12 months after the loss is discovered and have been immaterial for each of the three years ended December 31, 2013.

We consider our actual claims payment and incurred loss experience, including consideration of the frequency and severity of claims, compared to our actuarial estimates of claims payments and incurred losses in determining whether our overall loss experience has improved or worsened compared to prior period. We also consider the impact of economic or market factors on particular policy years to determine whether the results of those policy years are indicative of future expectations. In addition, we evaluate the frequency and severity of large losses in determining whether our experience has improved or worsened. The loss provision rate is applied to current premium revenues resulting in the title loss expense for the period. This loss provision rate is set to provide for losses on current year premiums and is determined using moving average ratios of recent actual policy loss payment experience (net of recoveries) to premium revenues.

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Provisions for title losses, as a percentage of title operating revenues, were 5.9%, 8.1% and 9.4% for the years ended December 31, 2013, 2012 and 2011, respectively. Actual loss payment experience, including the impact of large losses, is the primary reason for increases or decreases in our loss provision. A change of 100 basis points in this percentage, a reasonably likely scenario based on our historical loss experience, would have increased or decreased our provision for title losses and pretax operating results approximately $18.0 million for the year ended December 31, 2013.

Our method for recording the reserves for title losses on both an interim and annual basis begins with the calculation of our current loss provision rate, which is applied to our current premium revenues resulting in a title loss expense for the period.

At each quarter end, our recorded reserve for title losses begins with the prior period's reserve balance for claim losses, adds the current period provision to that balance and subtracts actual paid claims, resulting in an amount that our management compares to its actuarially-based calculation of the ending reserve balance necessary to provide for future title losses. The actuarially-based calculation is a paid loss development calculation where loss development factors are selected based on company data and input from our third-party actuaries. We also obtain input from third-party actuaries in the form of a reserve analysis utilizing generally accepted actuarial methods. While we are responsible for determining our loss reserves, we utilize this actuarial input to assess the overall reasonableness of our reserve estimation. If our recorded reserve amount is within a reasonable range (+/- 4.0%) of our actuarially-based reserve calculation and the actuary's point estimate, but not at the point estimate, our management assesses the major factors contributing to the different reserve estimates in order to determine the overall reasonableness of our recorded reserve, as well as the position of the recorded reserves relative to the point estimate and the estimated range of reserves. The major factors considered can change from period to period and include items such as current trends in the real estate industry (which management can assess although there is a time lag in the development of this data for use by the actuary), the size and types of claims reported and changes in our claims management process. If the recorded amount is not within a reasonable range of our third-party actuary's point estimate, we will adjust the recorded reserves in the current period and reassess the provision rate on a prospective basis. Once our reserve for title losses is recorded, it is reduced in future periods as a result of claims payments and may be increased or reduced by revisions to our estimate of the overall level of required reserves.

Large claims (those exceeding $1.0 million on a single claim), including large title losses due to independent agency defalcations, are analyzed and reserved for separately due to the higher dollar amount of loss, lower volume of claims reported and sporadic reporting of such claims. Large title losses due to independent agency defalcations typically occur when the independent agency misappropriates funds from escrow accounts under its control. Such losses are usually discovered when the independent agency fails to pay off an outstanding mortgage loan at closing (or immediately thereafter) from the proceeds of the new loan. Once the previous lender determines that its loan has not been paid off timely, it will file a claim against the title insurer. It is at this point that the title insurance underwriter is alerted to the potential theft and begins its investigation. As is industry practice, these claims are considered a claim on the newly issued title insurance policy since such policy insures the holder (in this case, the new lender) that all previous liens on the property have been satisfied. Accordingly, these claim payments are charged to policy loss expense. These incurred losses are typically more severe in terms of dollar value compared with traditional title policy claims since the independent agency is often able, over time, to conceal misappropriation of escrow funds relating to more than one transaction through the constant volume of funds moving through its escrow accounts. As long as new funds continue to flow into escrow accounts, an independent agency can mask one or more defalcations. In declining real estate markets, lower transaction volumes result in a lower incoming volume of funds, making it more difficult to cover up the misappropriation with incoming funds. Thus, when the defalcation is discovered, it often relates to several transactions. In addition, the overall decline in an independent agency's revenues, profits and cash flows increases the agency's incentive to improperly utilize the escrow funds from real estate transactions.

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Internal controls relating to independent agencies include, but are not limited to, pre-signing and periodic audits, site visits and reconciliations of policy inventories and premiums. The audits and site visits cover examination of the escrow account bank reconciliations and an examination of a sample of closed transactions. In some instances, the scope of our review is limited by attorney agencies that cite client confidentiality. Certain states have mandated annual reviews of all agencies by their underwriter. We also determine whether our independent agencies have appropriate internal controls as defined by the American Land Title Association and us. However, even with adequate internal controls in place, their effectiveness can be circumvented by collusion or improper override of the controls by management at the independent agencies. To aid in the selection of independent agencies to review, we have developed an agency risk model that aggregates data from different areas to identify possible problems. This is not a guarantee that all independent agencies with deficiencies will be identified. In addition, we are typically not the only underwriter for which an independent agency issues policies, and independent agencies may not always provide complete financial records for our review.

Due to the inherent uncertainty in predicting future title policy losses, significant judgment is required by both our management and our third party actuaries in estimating reserves. As a consequence, our ultimate liability may be materially greater or less than current reserves and/or our third party actuary's calculated estimate.

Agency revenues

We recognize revenues on title insurance policies written by independent agencies (agencies) when the policies are reported to us. In addition, where reasonable estimates can be made, we accrue for revenues on policies issued but not reported until after period end. We believe that reasonable estimates can be made when recent and consistent policy issuance information is available. Our estimates are based on historical reporting patterns and other information about our agencies. We also consider current trends in our direct operations and in the title industry. In this accrual, we are not estimating future transactions; we are estimating revenues on policies that have already been issued by agencies but not yet reported to or received by us. We have consistently followed the same basic method of estimating unreported policy revenues for more than 10 years.

Our accruals for revenues on unreported policies from agencies were not material to our consolidated assets or stockholders' equity as of December 31, 2013 and 2012. The differences between the amounts our agencies have subsequently reported to us compared to our estimated accruals are substantially offset by any differences arising from prior years' accruals and have been immaterial to consolidated assets and stockholders' equity during each of the three prior years. We believe our process provides the most reliable estimate of the unreported revenues on policies and appropriately reflects the trends in agency policy activity.

Goodwill and other long-lived assets

Our evaluation of goodwill is normally completed annually in the third quarter using June 30 balances, but an evaluation may also be made whenever events may indicate impairment. This evaluation is based on a combination of a discounted cash flow analysis (DCF) and market approaches that incorporate market multiples of comparable companies and our own market capitalization. The DCF model utilizes historical and projected operating results and cash flows, initially driven by estimates of changes in future revenue levels, and risk-adjusted discount rates. Our projected operating results are primarily driven by anticipated mortgage originations, which we obtain from projections by industry experts. Fluctuations in revenues, followed by our ability to appropriately adjust our employee count and other operating expenses, or large and unanticipated adjustments to title loss reserves, are the primary reasons for increases or decreases in our projected operating results. Our market-based valuation methodologies utilize (i) market multiples of earnings and/or other operating metrics of comparable companies and (ii) our market capitalization and a control premium based on market data and factors specific to our ownership and corporate governance structure (such as our Class B Common Stock). To the extent that our future operating results are below our projections, or in the event of adverse market conditions, an interim review for impairment may be required, which may result in an impairment of goodwill.

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We evaluate goodwill based on five reporting units (direct operations, agency operations, international operations, mortgage services and corporate). Goodwill is assigned to these reporting units at the time the goodwill is initially recorded. Once assigned to a reporting unit, the goodwill is pooled and no longer attributable to a specific acquisition. All activities within a reporting unit are available to support the carrying value of the goodwill.

We also evaluate the carrying values of title plants and other long-lived assets when events occur that may indicate impairment. The process of determining impairment for our goodwill and other long-lived assets relies on projections of future cash flows, operating results, discount rates and overall market conditions, including our market capitalization. Uncertainties exist in these projections and they are subject to changes relating to factors such as interest rates and overall real estate and financial market conditions, our market capitalization and overall stock market performance. Actual market conditions and operating results may vary materially from our projections.

Based on these evaluations, we estimate and expense to current operations any loss in value of these assets. As part of our process, we have an option to assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount. If we decide not to use a qualitative assessment or if we fail the qualitative assessment, then we obtain input from third-party appraisers regarding the fair value of our reporting units. While we are responsible for assessing whether an impairment of goodwill exists, we utilize the input from third-party appraisers to assess the overall reasonableness of our conclusions. We utilized a qualitative assessment for our annual goodwill impairment test and, based on our analysis, determined it was not more-likely-than-not that the fair value of our reporting units were less than their carrying amounts as of June 30, 2013. There were no impairment charges for goodwill or material impairment charges for other long-lived assets during the three years ended December 31, 2013.

Operations. Our business has three operating segments: title insurance and related services, mortgage services and corporate.

Our primary business is title insurance and settlement-related services. We close transactions and issue title policies on homes, commercial and other real properties located in all 50 states, the District of Columbia and international markets through policy-issuing offices and agencies. We also provide loan origination and servicing support; loan review services; loss mitigation; REO asset management; home and personal insurance services; loan due diligence; compliance solutions; service performance management and technology to streamline the real estate process.

Factors affecting revenues. The principal factors that contribute to changes in operating revenues for our title and mortgage services segments include:

• mortgage interest rates;

• availability of mortgage loans;

• ability of potential purchasers to qualify for loans;

• inventory of existing homes available for sale;

• ratio of purchase transactions compared with refinance transactions;

• ratio of closed orders to open orders;

• home prices;

• volume of distressed property transactions;

• consumer confidence, including employment trends;

• demand by buyers;

• number of households;

• premium rates;

• market share;

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• opening of new offices and acquisitions;

• number of commercial transactions, which typically yield higher premiums;

• government or regulatory initiatives, including tax incentives; and

• number of REO and foreclosed properties and related debt.

To the extent inflation causes increases in the prices of homes and other real estate, premium revenues are also increased. Conversely, falling home prices cause premium revenues to decline. Premiums are determined in part by the insured values of the transactions we handle. These factors may override the seasonal nature of the title insurance business. Historically, our first quarter is the least active and our third and fourth quarters are the most active in terms of title insurance revenues.

Industry data. Published mortgage interest rates and other selected residential data for the years ended December 31, 2013, 2012 and 2011 follow (amounts shown for 2013 are preliminary and subject to revision). The amounts below may not relate directly to or provide accurate data for forecasting our operating revenues or order counts.

Our statements on home sales, mortgage interest rates and loan activity are based on published industry data from sources including Fannie Mae, the National Association of Realtorsฎ, the Mortgage Bankers Association and Freddie Mac.

                                                           2013        2012        2011
Mortgage interest rates (30-year, fixed-rate) - %
Averages for the year                                        3.98        3.66        4.46
First quarter                                                3.50        3.92        4.85
Second quarter                                               3.69        3.80        4.66
Third quarter                                                4.44        3.55        4.31
Fourth quarter                                               4.30        3.36        4.01
Mortgage originations - $ billions                          1,817       2,153       1,496
Refinancings - % of originations                             62.1        71.5        65.7
New home sales - in millions                                 0.43        0.37        0.30
Existing home sales - in millions                            4.48        4.13        3.79

Existing home sales - median sales price in $ thousands 197.4 177.2 166.2

The real estate market experienced increasing home prices in 2013 and is expected to provide an increasing contribution to GDP in 2014 principally due to new homebuilding activity. Although mortgage rates have risen since the spring 2013, multiple housing indicators posted large increases at the end of 2013. Housing recovery in 2014 should continue to progress based on the strengthening of consumer confidence.

Trends and order counts. For the three years ended December 31, 2013, mortgage interest rates (30-year, fixed-rate) have fluctuated from a monthly high of 4.95% in February 2011 to a monthly low of 3.4% in November 2012. In 2013, total mortgage originations and refinancing mortgage originations decreased 15.6% and 26.7%, respectively. During 2013, sales of new homes and existing homes increased 16.3% and 8.6%, respectively. In 2012, sales of new homes and existing homes increased 19.9% and 9.2%, respectively.

Our direct order levels decreased from 2012 to 2013 and increased from 2011 to 2012. The decline in orders was primarily a result of fewer refinance orders in the second half of 2013.

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The number of direct title orders opened follows:

                                         2013      2012      2011
                                              (in thousands)
                        First quarter      105       103        84
                        Second quarter     116       111        91
                        Third quarter       95       112       101
                        Fourth quarter      76       104        90

                                           392       430       366

The number of direct title orders closed follows:

                                         2013      2012      2011
                                              (in thousands)
                        First quarter       73        71        62
                        Second quarter      85        79        67
                        Third quarter       76        81        69
                        Fourth quarter      62        85        73

                                           296       316       271


A comparison of our results of operations for 2013 to 2012 and 2012 to 2011 follows. Factors contributing to fluctuations in results of operations are presented in the order of their monetary significance, and we have quantified, when necessary, significant changes. Results from our mortgage services and corporate segments are included in year-to-year discussions and, when relevant, are discussed separately.

Title revenues. Revenues from direct title operations increased $26.5 million, . . .

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