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STC > SEC Filings for STC > Form 10-Q on 1-Aug-2014All Recent SEC Filings

Show all filings for STEWART INFORMATION SERVICES CORP

Form 10-Q for STEWART INFORMATION SERVICES CORP


1-Aug-2014

Quarterly Report


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

MANAGEMENT'S OVERVIEW

In the second quarter 2014, the industry continued to experience lower than prior year levels of mortgage originations with existing home sales falling 4.5% year over year and refinancing mortgage loans falling 65.3%. The decline can be attributed to harsh winter weather conditions in the first quarter 2014 that limited new contracts as well as rising interest rates that negatively impacted affordability and the ability to refinance existing mortgages. Following the usual seasonal pattern home sales increased 5.8% sequentially from the first quarter 2014, although this increase was less than that anticipated by industry forecasts. Median home prices rose 4.6% from a year ago and 11.2% from the first quarter of this year.

We reported net earnings attributable to Stewart of $6.3 million, or $0.27 per diluted share, for the second quarter 2014, compared to earnings of $26.9 million, or $1.09 per diluted share, for the second quarter 2013. Second quarter 2014 results included a charge of $10.5 million recorded in the title segment relating to a previously announced litigation settlement as well as approximately $3.2 million of aggregate costs recorded in the corporate segment which were primarily acquisition-related costs. Pretax earnings for the second quarter 2014 were $11.5 million, a decrease of 76.4% over $48.9 million for the second quarter 2013. The decline is attributable to decreases in earnings from our title and mortgage services segments of $28.2 million and $6.5 million, respectively.

Total revenues for the second quarter 2014 were $446.8 million, a decrease of $70.4 million, or 13.6%, from $517.2 million for the second quarter 2013. Operating revenues decreased 13.7% to $442.6 million in the second quarter 2014 compared to $512.8 million in the second quarter 2013. Compared to the second quarter 2013, title revenues decreased 14.3% in the second quarter 2014, while mortgage services revenues decreased 3.6%.

Revenues from our title segment decreased 15.3% and increased sequentially 11.6% from the second quarter 2013 and first quarter 2014, respectively. In the second quarter 2014, the title segment generated a pretax margin of 11.2%, a decrease of 420 basis points from second quarter 2013 and, sequentially, an increase of 630 basis points from the first quarter 2014. Revenues from direct operations for the second quarter 2014 decreased 4.3% compared to the same quarter last year but increased 35.5% sequentially from the first quarter 2014. (Direct operations revenues were favorably influenced by the acquired DataQuick Lending Solutions title offices.) Our direct operations include local closing offices, commercial and international operations. We generate commercial revenues both domestically and internationally. U.S. and Canadian commercial revenues decreased 8.3% to $34.2 million from the second quarter 2013. International operating revenues (including foreign-sourced commercial revenues of $3.4 million) increased 7.3% to $32.8 million from the second quarter 2013 and increased sequentially by 49.2% from the first quarter 2014, due largely to increased overseas commercial transactions.

Revenues from our mortgage services segment were $39.4 million for the second quarter 2014, increasing 5.5% from $37.3 million in the second quarter 2013 and increasing 37.1% sequentially from the first quarter 2014. The segment reported a pretax loss of $1.4 million in the second quarter 2014 compared to pretax earnings of $5.2 million and a pretax loss of $1.6 million for the second quarter 2013 and first quarter 2014, respectively. During the second quarter, we completed the previously announced acquisitions of Wetzel Trott, Inc. (closed April 2nd), the title business of DataQuick Lending Solutions (closed April 2nd; the closing of the collateral valuation business of DataQuick is scheduled for August 1st) and LandSafe Title (closed May 31st). In accordance with segment accounting rules, the revenues associated with the acquired centralized title businesses are reported in the mortgage services segment, and the title office operations are reported in the title segment.

During the second quarter 2014, we acquired approximately 96,000 shares of our common stock for an aggregate purchase price of approximately $2.9 million pursuant to the previously announced stock repurchase program.

CRITICAL ACCOUNTING ESTIMATES

The preparation of the Company's Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of certain assets, liabilities, revenues, expenses and related disclosures surrounding contingencies and commitments.

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.


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During the six months ended June 30, 2014, the Company made no material changes to its critical accounting estimates as previously disclosed in Management's Discussion and Analysis in the Company's Annual Report on Form 10-K for the year ended December 31, 2013.

Title loss reserves

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

Provisions for title losses, as a percentage of title operating revenues, were 4.4%, 5.0% and 6.3% for the quarters ended June 30, 2014, June 30, 2013 and March 31, 2014, respectively. Title policy loss experience continued to improve, including both incurred losses and claims payments, during the second quarter 2014, and due to this ongoing improvement, we recorded a policy loss reserve reduction of $6.5 million relating to prior policy years. During the second quarter 2013, we lowered our policy loss reserves by $6.6 million. 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 $7.8 million for the six months ended June 30, 2014.

                                    For the Three Months           For the Six Months
                                       Ended June 30,                Ended June 30,
                                     2014            2013          2014           2013
                                                     ($ in millions)
    Provisions - Known Claims:
    Current year                         3.4            5.9            8.0           7.7
    Prior policy years                  19.7           20.1           33.6          33.2

                                        23.1           26.0           41.6          40.9
    Provisions - IBNR
    Current year                        21.2           24.8           39.2          46.3
    Prior policy years                  (6.4 )         (6.5 )         (6.3 )        (6.3 )

                                        14.8           18.3           32.9          40.0
    Transferred to Known Claims        (19.7 )        (20.1 )        (33.6 )       (33.2 )

    Total provisions                    18.2           24.2           40.9          47.7

Provisions for known claims arise primarily from prior policy years as claims are not typically reported until several years after policies are issued. Provisions - Incurred But Not Reported (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 experience of policy years occurs. This loss experience may result in changes to our estimate of total ultimate losses expected (i.e., the IBNR policy loss reserve). As claims become known, provisions are reclassified from IBNR to known claims. Adjustments relating to large losses may impact provisions either for known claims or for IBNR.

Known claims provisions increased for the period ended June 30, 2014 to $41.6 million from $40.9 million, primarily as a result of adjustments to existing claims relating to 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 three months ended June 30, 2014, current year provisions - IBNR decreased $3.6 million to $21.2 million compared to 2013. As a percentage of title operating revenues, provisions - IBNR for the current policy year decreased from 5.3% in 2013 to 5.1% in 2014 due to a decrease in the provisioning rate as a consequence of favorable loss experience relative to actuarial expectations of losses. Provisions - IBNR relating to prior policy years were a net credit due to the aforementioned reserve releases.

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 a mortgage payoff, payment of property or other taxes and payment of homeowners' association fees. Escrow losses also arise in cases of mortgage fraud, and in those cases the title insurer incurs the loss under its obligation to ensure that an unencumbered title is conveyed. Escrow losses are recognized as expense when discovered and are typically paid less than 12 months after the loss is discovered. During the six months ended June 30, 2014 and 2013, we accrued approximately $3.9 million and $2.9 million, respectively, for policy loss reserves relating to legacy escrow losses arising from mortgage fraud.


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We consider our actual claims payments 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 periods. 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. 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 experience calculation where loss experience 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.

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


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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.

Operations. Our business has three main 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, agencies and centralized title services centers. We also provide loan origination and servicing support; loan review services; real estate valuation 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;

• opening of new offices and acquisitions;

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

• government or regulatory initiatives, including tax incentives;

• number of REO and foreclosed properties and related debt;

• acquisitions or divestitures of businesses; and

• seasonality and/or weather.

Premiums are determined in part by the insured values of the transactions we handle. To the extent inflation or market conditions cause increases in the prices of homes and other real estate, premium revenues are also increased. Conversely, falling home prices cause premium revenues to decline. These factors may override the seasonal nature of the title insurance business. Historically, our first quarter is the least active in terms of title insurance revenues as home buying is generally depressed during winter months. Our third and fourth quarters are the most active as the summer is the traditional home buying season, while commercial transaction closings are skewed to the end of the year.

On a 12-month moving average seasonally adjusted basis, median home prices increased 9.6% from the second quarter 2013 and sequentially 1.4% from the first quarter 2014. A 5% increase in home prices results in an approximately 3.6% increase in title premiums.


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RESULTS OF OPERATIONS

Comparisons of our results of operations for the three and six months ended June 30, 2014 with the three and six months ended June 30, 2013 follow. Factors contributing to fluctuations in the 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 the discussions and, when relevant, are discussed separately.

Our statements on home sales 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. We also use information from our direct operations.

Operating environment. Existing home sales in the second quarter of 2014 fell 4.5% from the second quarter 2013, partially due to harsh winter weather in first quarter 2014 that limited new contracts as well as rising interest rates that negatively impacted affordability. Following the usual seasonal pattern home sales increased 5.8 percent sequentially from the first quarter 2014, although this increase was less than that anticipated by industry forecasts. According to Fannie Mae, one-to-four family residential lending decreased from an estimated $572 billion in the second quarter 2013 to $317 billion in the second quarter 2014, primarily driven by an estimated $243 billion decrease in refinance originations from the second quarter 2013 to the second quarter 2014. Sequentially, residential lending for home purchase volumes increased from $123 billion in the first quarter of 2014 to $188 billion in the second quarter of 2014. Residential refinance lending volumes increased from $114 billion in the first quarter 2014 to $129 billion in the second quarter 2014. On average, refinance premium rates are 60% of the title premium revenue of a similarly priced sale transaction.

Title revenues. Revenues from direct title operations decreased $9.1 million, or 4.3%, and $19.0 million, or 5.1%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013. Revenues in the second quarter and first six months of 2014 decreased primarily as a result of declining refinance transaction volume, partially offset by increases in revenue per transaction resulting from home price appreciation. Revenues in the second quarter 2014 were also favorably influenced by the acquisitions closed during the quarter. International revenues (including foreign-sourced commercial revenues of $3.4 million) increased $2.2 million, or 7.3%, and $4.3 million, or 8.5%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013. Revenues from U.S. and Canadian commercial and other large transactions decreased $3.1 million, or 8.3%, and increased $3.1 million, or 4.9%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013. Direct operating revenues, excluding commercial and other large transactions, decreased 4.2% and 7.5%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013.

Direct orders closed decreased 20.0% and 24.0%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013 due to significantly fewer refinancing orders. The average revenue per file closed (including commercial and other large transactions) increased 18.8% and 24.7%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013 due to a shift in mix to more resale and commercial orders combined with the decline in refinancing orders. Excluding commercial and other large transactions, the average revenue per closing increased 19.8% and 21.8%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013 due to fewer refinancing transactions, home price appreciation, and to a lesser extent, a rate increase in Texas that went into effect May 1, 2013.

Total opened orders decreased 16.7% and 18.4%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013 driven principally by the decline in refinancing transactions, but increased 15.6% sequentially from the first quarter 2014, following the usual seasonal pattern. Refinancing transactions fell from 30.2% of total opened orders in the second quarter 2013 to 18.1% of the total in the second quarter 2014. Opened orders per workday increased 17.4% sequentially from the first quarter 2014.

Revenues from independent agencies decreased $60.0 million, or 22.2%, and $74.0 million, or 14.9%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013. Revenues from independent agencies fluctuate generally based on the same factors that influence revenues from direct title operations. However, revenues from independent agencies can be significantly influenced by the geographic mix of agency business in states that are experiencing more significant changes in transaction volume. We believe the decline in independent agency revenue relative to direct revenue is largely due to the geographic distribution of our agents compared to our direct offices. Many of the states with the highest agency revenues experienced year over


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year declines in existing home sales in addition to the sharp decline in refinancing transactions. While we also experienced such declines in several states with a direct operations presence, our significant direct operations presence in Texas helped offset those declines. Further, revenues from both independent agencies and our direct operations benefit from improving commercial business. We continue to emphasize quality of the independent agency network while partnering with them to prepare for changes in the industry brought about by CFPB regulations as well as implementing ALTA Best Practices.

Mortgage services revenues. Mortgage services operating revenues decreased $1.1 million, or 3.6%, and $11.0 million, or 16.4%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013, as demand for default and distressed property-related services continued to fall due to the improved housing market. However, revenues increased sequentially 14.0% from the first quarter 2014 due to the acquisitions completed in the second quarter as well as new contracts generating incremental revenue. Mortgage services segment revenues increased 5.5% for the second quarter 2014 compared to the same quarter in 2013 and declined 13.3% for the six months ended June 30, 2014 compared to the same period in the prior year. Revenues from the acquisitions pertaining to centralized title operations are included in the mortgage services segment revenues in accordance with applicable accounting rules.

We continue to see opportunity through the mortgage value chain and took advantage of the shifting market to make attractive acquisitions to expand our offerings to mortgage lenders. During the second quarter 2014, we completed the previously announced acquisitions of Wetzel Trott, Inc. (closed April 2nd), the title business of DataQuick Lending Solutions (closed April 2nd; the closing of the collateral valuation business of DataQuick is scheduled for August 1st) and LandSafe Title (closed May 31st). These acquisitions will take several quarters to become fully integrated into our operations.

Our objective for this segment is to expand from its historical service offerings for the management of defaulted and distressed loans to service offerings that support the ongoing loan origination and servicing support needs of lenders in a more demanding regulatory environment. The acquisitions discussed previously, in combination with existing offerings, will allow us to deliver a comprehensive solution set and position us as a leading provider of outsourcing solutions to the mortgage lending market.

Investment income. Investment income increased $0.6 million, or 13.4%, and $0.8 million, or 10.0%, respectively, in the second quarter and first six months of 2014 compared to the same periods in 2013. Investment income increased primarily . . .

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