What We've Got Here Is a Failure to Communicate

September 2014

What We’ve Got Here Is a Failure to Communicate

How Current Financial Reporting Contributes to the Misunderstanding of Title Insurance

by Joseph L. Petrelli, ACAS, MAAA, FCA President Demotech, Inc.

Demotech, Inc. 2715 Tuller Parkway Dublin, Ohio 43017-2310 An update of our 2006 White Paper www.demotech.com What We’ve Got Here Is a Failure to Communicate - How Current Financial Reporting Contributes to Misunderstanding of Title Insurance

Introduction

Demotech, Inc. is a financial analysis firm specializing in evaluating the financial stability of regional and specialty insurers, including Title insurance underwriters. Demotech’s philosophy is to review and evaluate insurers based on their area of focus and ability to execute their business model rather than to emphasize financial size. Financial Stability Ratings® (FSRs) assigned by Demotech are a leading indicator of financial stability, providing an objective baseline of the future solvency of insurers. Since 1985, Demotech has assigned accurate, reliable and proven FSRs to Property & Casualty and Title insurers.

Demotech, Inc. was the first company to review the financial stability of the Title insurance industry and publish independent financial opinions. Since that time, Demotech has analyzed the financial stability of the Title insurance industry on a quarterly basis and has assigned Financial Stability Ratings® to virtually all Title underwriters, from largest to smallest. Financial Stability Ratings® of Aʹʹ, Aʹ, A and S are accepted by the major participants in the secondary mortgage marketplace, which in turn facilitates the acceptance of Title underwriters rated S or better by lenders, producers and purchasers of real property.

Acquired by Demotech in 2001, Demotech Performance of Title Insurance Companies (PTIC), has been published annually and updated quarterly for over 20 years. PTIC is the most complete and thorough industry analysis available. PTIC addresses Title underwriter financial stability and the competitive landscape by providing industry-wide analysis and group-level data and benchmarks as well as state by state comparisons of marketshare, loss levels and other pertinent information.

The Problem: A Failure to Communicate

In the 1967 movie, Cool Hand Luke, veteran character actor Strother Martin, as the Captain of Road Prison 36, uttered the famous line, “What we’ve got here is failure to communicate.” Nearly fifty years later, that comment is applicable to the financial reporting requirements imposed on the Title insurance industry. Demotech believes there is a breakdown in communication when the Title industry attempts to explain itself to a constituency that is appreciably more familiar with the underwriting or claims practices and procedures and loss ratios associated with Property & Casualty (P&C) or Life and Health (L&H) insurance.

This white paper focuses on the unique nature of title insurance coverage and the financial reporting practices of its loss adjustment activity. Demotech believes that, in order to be fully aware of the difference of title insurance, a comparison of title companies coverage and loss adjustment activity to P&C and L&H companies is necessary.

Context

Property & Casualty insurance loss and loss adjustment expense (L&LAE) ratios are traditionally at a level of 60% of premium or higher. This implies that 60% or more of the premium charged is ultimately utilized for investigation and settlement of claims. To fulfill its promise to honor meritorious claims, the P&C insurance industry typically expends 25% to 40% of its premium income on operating expenses. The Title insurance industry reports L&LAE ratios in the vicinity of 8%. Concurrently, as Title underwriters expend appreciably higher percentages of premium on underwriting, curative actions, loss

2 Copyright © Demotech, Inc. 2014 What We’ve Got Here Is a Failure to Communicate - How Current Financial Reporting Contributes to Misunderstanding of Title Insurance prevention and mitigation than their P&C counterparts spend on operating expenses. Rote comparisons of the operating expenses of P&C and Title insurers could lead to the inaccurate conclusion that Title underwriters have an excessive expense ratio. These comparisons ignore dissimilar underwriting practices based upon dissimilar coverages and unique business models.

Dissimilar Underwriting

Before summarizing coverage differences, we summarize the mechanics of underwriting the respective coverages. Each line of insurance implements diligent underwriting procedures with the goal of minimizing L&LAE experience during the policy period. P&C underwriting considers factors such as prior claims history, driving history, region of the country, class of business, etc. as indicators of future claims experience. With that approach, L&LAE ratio expectations are acceptable in the 60% or greater range as it is future events that are being insured. Title insurance underwriting is more intensive as documentation is available prior to policy issuance to review, discover, and address events that already exist. The goal of underwriting is to mitigate the events through curative actions and eliminate, not insure, a future claim. Therefore, title insurance should be expected to have markedly superior loss experience as indicated in the industry L&LAE ratios in the vicinity of 5 - 8% as well as significantly higher expense ratios.

Dissimilar Coverages

Consider that most consumers purchasing automobile insurance are familiar with automobile physical damage claims. A series of well established protocols are associated with the investigation, analysis and settlement of “fender benders.” In such situations, the parties exchange insurance information, file a police report summarizing their respective opinions on the incident and, when applicable, one of the parties may be cited to be at fault. Whenever possible, the respective insurance companies obtain photographs of the damaged vehicles, as well as written estimates of the cost to repair the vehicles. The claimants are then presented with the insurer’s proposed resolution, which is typically a check for covered damage or an introduction to a recommended repair facility.

Most automobile physical damage insurance claims are resolved quickly and efficiently. The process works well and is familiar to consumers, who have likely either experienced an accident themselves or heard of the process by word of mouth.

In stark contrast, a minuscule percentage of consumers have experienced a claim to their title to real property, i.e., the marketability of their title to real property. The extremely limited number of reported Title insurance claims relative to Title insurance policies issued is due solely to the fact that the overwhelming majority of incidents, defects and other problems have been adjusted (cured) prior to the issuance of the Title insurance policy, for a single premium!

Retrospective versus Prospective Coverage

A Title insurance policy involves protection against events that remained undiscovered or existed prior to policy issuance and therefore remain outstanding as of the date of policy issuance. Typically a Title insurance policy states that:

Subject to the exclusions from coverage, the exceptions from coverage contained in Schedule B and the conditions and stipulations, the Title insurance company, insures, as of the Date of Policy shown in Schedule A, against loss or damage . . .

In contrast, the coverage provided by a P&C insurance policy insures against future events that may occur during the policy period. Typical language in a P&C insurance policy states that:

In Consideration of the Provisions and Stipulations herein, this Property and Casualty Insurance Company, for the term of this date at 12:01 a.m. to one year later at 12:01 a.m., does insure . . .

While Title insurance coverage retrospectively is available for the duration of a mortgage or the entire period of homeownership to cover undiscovered or unresolved matters in existence on or prior to the policy effective date for a one-time premium fee, P&C insurance coverage looks forward, utilizing a finite and well-defined policy period, i.e., one year, to define the coverage period, with a renewable premium fee. The time frame of coverage and the need for loss adjustment activity to be consistent with coverage are fundamental differences between Title and P&C insurance. These distinctions in coverage contribute to higher loss ratios in P&C and lower loss ratios in Title. Further, the investigative and curative work that occurs prior to issuing the Title policy are appropriately not reflected as loss adjustment expense, but as operating (underwriting) expense in current financial reporting requirements for Title underwriters.

Types of P&C Loss Adjustment Expenses

To comprehend the miscommunication implicit in current financial reporting requirements, one must understand the two broad categories of loss adjustment expense (LAE):

1. Adjusting and Other (A&O): A&O is a component of loss adjustment expense that includes claims adjusting expenses, whether internal or external to the Company. This component includes fees and salaries of those involved in a claim adjusting function and other related expenses incurred in the determination of coverage. A&O expense is similar to what was once known as unallocated loss adjustment expense (ULAE).

2. Defense and Cost Containment (DCC): DCC includes defense, litigation and medical cost containment, whether internal or external to the Company, associated with the resolution of an incident. These expenses include, but are not limited to, accident investigation, surveillance, litigation management and fees of attorneys and others if working in defense of a claim. DCC expenses are specific to an incident and are incurred to determine if coverage is applicable and the claim should be paid or defended. DCC expense is similar to what was once known as allocated loss adjustment expense (ALAE).

These LAE categories, and their predecessors, ULAE and ALAE, are well established in P&C insurance industry financial reporting and were created to address P&C policy characteristics, such as claims and cost containment expenses arising and manifesting after policy issuance, during a coverage period.

In direct contrast, Title insurance coverage is designed to respond to undiscovered or unresolved incidents that existed prior to policy issuance. Therefore, the majority of the Title industry’s cost containment expense activities must be expended prior to policy issuance and are associated with discovery and preemptive clarification and adjustment of matters that could impact the marketability of title to real property. With LAE categories and financial reporting protocols designed for the P&C industry, the Title industry does not report investigative, curative costs or other adjustment activities as loss adjustment expense. This issue contributes to the failure to communicate and must be addressed.

Impact on Operating Expenses

The failure to communicate manifests itself again in the comparison of P&C and Title insurer operating expenses. The Title industry’s LAE relative to P&C LAE is significantly lower because of the curative and preventative work performed during the underwriting process to cure the risk before the policy is issued. Thus, the Title operating expenses reflect the curative procedures in higher labor costs (Direct Operations) or premiums retained by title agents (Non-Affiliated and Affiliated Agency Operations) on the Part 3 of the Operations and Investment Exhibit. Further, the majority of premiums retained by title agents covers the costs born of the curative and preventative work performed by the title agent. As such, title agents retain more of the premiums to compensate for the significant underwriting expense compared to a P&C agency which typically keep less of the premium as the P&C agency focuses more of their efforts on marketing.

Because the financial reporting requirements applied to Title underwriters were developed for P&C insurance companies, the significant cost of underwriting of Title policies is appropriately reported as operating expense. P&C coverage is prospective and thus when the claim is processed, the cost containment activity is appropriately A&O or DCC expense. The inherent differences in coverage produce the respective loss ratio differences, as title has lower loss ratios as future losses are eliminated through preventative procedures and result in higher operating expenses. Conversely, P&C coverage is prospective and cost containment bears the burden through LAE and lower operating expenses.

The Inequity in the Current Reporting Method

The current financial reports and LAE categories presume cost containment activities are based on P&C insurance coverage characteristics, i.e., cost containment activities and loss adjustment occur after policy issuance. However, in the case of Title insurance coverage, claims only exist prior to the date of policy. As such, the effort and expenses to address and adjust these situations must also occur prior to policy issuance.

Example

Assume that a P&C insurer expended time, effort and expense to evaluate a covered incident on behalf of a policyholder. Assume that after doing so, the P&C insurer determined that no liability existed. Current P&C financial reporting would not allocate this time, effort and expense to the P&C insurer’s operating expenses, even though no claim payment was made. This activity would be categorized as

Copyright © Demotech, Inc. 2014 5 What We’ve Got Here Is a Failure to Communicate - How Current Financial Reporting Contributes to Misunderstanding of Title Insurance loss adjustment expense. However, comparable activities by a Title underwriter, working on behalf of a policyholder to preemptively resolve potential exposure issues (i.e., close a claim without payment), continue to be allocated to operating expenses even though the effort is focused on resolving matters that must be addressed. The difference between the coverage time frame and ensuing loss adjustment activities of Title insurance (retrospective) and P&C insurance (prospective) must be considered in a comparison of P&C and Title L&LAE ratios or operating expense ratios to be fair to either industry.

Title Insurance Agent as Underwriter, Investigator and Examiner

In our 2008 study entitled Title Insurance Agent as Claim Investigator and Claim Examiner, Demotech reviewed a random sample of 114 Title insurance policies issued in the State of Louisiana. The source data was a random sample of HUD-1 commitments selected by Melvin L. Maxwell, Esquire, (then) President and Owner of Insured Title Company, Ltd in Lafayette, Louisiana. (Information provided to Demotech was redacted.) Demotech analyzed and quantified the cost and scope of Title insurance loss adjustment expense expended to identify and cure title related matters in the sample.

Investigation Must Occur Prior to Issuance of Title Policy

As noted throughout this paper, the role of the Title insurance agent, or a title underwriter employee, as an investigator and examiner, is misunderstood in large part because underwriting of Title insurance is reflected as an operating expense. The Title insurance L&LAE ratios, collected using a P&C insurance reporting process, do not reflect the time, effort and expense that must be expended due tothe retroactive coverage provisions of Title insurance coverage.

In the context of Title Insurance, a Title insurance agent or Title underwriter employee serves as an investigator and adjuster as well as a producer of business. These concurrent responsibilities are required to perfect the interest in real property prior to the issuance of a policy. In the resolution of a P&C claim, a claims adjuster relies upon a variety of loss adjustment protocols and practices. These may include a police report, photographs, investigation and interviews with the claimant. In the resolution of Title insurance matters, the Title insurance agent or title underwriter employee, in his or her role as an investigator and examiner, must review and analyze a variety of sources in an effort to uncover and cure defects that could adversely impact the marketability of the title to real property. The investigation and examination resolves each matter that is discovered and attempts to ensure that no other situations exist. Our review of these 114 Title policies concluded that the Title agent’s discovery, review and analysis process uncovered 583 matters that needed to be addressed or cured prior to transferring a marketable title to the prospective owner.

These 583 matters needed to be underwritten or cured (i.e., adjusted) prior to the issuance of the Title insurance policy to avoid being considered claims subsequent to policy issuance. Many of the 583 matters were discovered through the acquisition of an abstract and the subsequent analysis of the abstract. Some of the underwriting expenses were specifically expended and allocated to address a specific title matter or defect discovered by the Title agent in the role of investigator. Other underwriting expenses were expended for the purpose of discovering whether defects existed and were, therefore, equivalent to P&C unallocated loss adjustment expense.

Title matters identified and cured prior to policy issuance

Instrument filing matters 113 Grantor-Mortgagor matters 113 Tax reconciliations 113 Materialmen matters 111 Multiple indebtedness mortgage matters 26 Tax or lien matters 2 Cancellation of collateral mortgage 16 Release of judgment 3 Release of second judgment 1 Cancellation of mortgages 63 Chain of title matters 14 Release of mortgage, UCC filing or judgment 4 Donation 1 Other 3 Total 583

To estimate the expenses that were considered loss adjustment expenses, we apportioned the costs associated with Section 1100 of the HUD-1, Title insurance expenses, according to the following allocation process:

Allocation Loss Adjustment Service Expense Cost Settlement or closing fee 100% Abstract or title search 100% Title examination 100% Title insurance binder 100% Document preparation 100% Notary fees 100% Attorney’s fees 100% Title insurance premium 80% Title insurance endorsements 80% Mortgage certificates 100% Closing protection coverage 100% Courier fees 100% Bank wire fees 100%

Based upon this sample, 70% of the Title insurance cost on the HUD-1s would have met the Property & Casualty definition of allocated or unallocated loss adjustment expense, i.e., A&O or DCC. The remainder of the Title insurance cost on the HUD-1s was related to closing, escrow and other service costs and would be recorded as an operating expense under P&C reporting standards.

The estimated loss adjustment expense ratio of 70% does NOT include the losses or loss adjustment expenses expected to be paid by the Title underwriter for claims made after issuance of the policy. At the time of the study, the Title insurance loss ratio in Louisiana represented an additional 8% of Title insurance premium. This study would imply a loss and LAE ratio of 78%, comprised of 70% of additional LAE plus the 8% L&LAE reported.

Implications

A head-to-head comparison of Title versus Property & Casualty L&LAE ratios is part of the failure to communicate because the current reporting protocol for Title insurance understates L&LAE ratios and overstates operating expense ratios, which thereby hinders analysis of the appropriateness of Title insurance rates. A Title L&LAE ratio of 8% does not provide an accurate reflection of the loss adjustment expenses associated with coverage, investigation, litigation management and cost containment yet a P&C L&LAE ratio reflects all such considerations. Continuing to rely on loss ratios compiled under the current financial reporting standards impedes the dialogue between the industry and its regulators because the reported results make it impossible to compare Title and P&C L&LAE ratios. This leads to a failure to communicate.

Based upon Demotech’s analysis of the sample, we restated historical countrywide title insurance loss and loss adjustment expense ratios to reflect additional loss adjustment expense equal to 70% of direct earned premium. The graph below presents the historical loss and LAE ratios for Title insurance, P&C and L&H insurance as currently reported.

Reported Loss and Loss Adjustment Expense Ratios – Current Reporting Requirements

In contrast, the graph below reproduces the historical P&C and L&H loss and loss adjustment expenses ratios and presents a Title insurance loss ratio that more properly allocates loss adjustment activity to the Title insurance loss and LAE ratios.

Pro Forma Loss & Loss Adjustment Expense Ratios – Based on Demotech’s Study

The Adjustment Will Not Change the Combined Ratio

Utilizing current financial reporting guidelines, a P&C insurance company with a 60% L&LAE ratio and a 35% operating expense ratio would report a 95% combined ratio. A Title underwriter might report a 5% L&LAE ratio with a 90% operating expense ratio, for an identical 95% combined ratio. If revised, financial reporting procedures broaden the P&C definitions of A&O and DCC to reflect Title insurance characteristics, a Title underwriter would report a higher L&LAE ratio, a lower operating expense ratio, and the same combined ratio. Under this scenario, comparisons to P&C results would be more accurate than they are under the current reporting guidelines.

Conclusion

Demotech, Inc. respectfully submits that the fundamental differences between Title and P&C coverage characteristics result in the misunderstanding of reported financial results. Current financial reporting requirements have A&O and DCC expense definitions designed for P&C coverage characteristics imposed on Title insurance, despite the fundamentally different timeframe and loss containment considerations.

If Title and P&C L&LAE ratios are to be directly compared, the Title insurance industry and regulators should work to develop financial reporting protocols that compare similarly categorized costs and activities. This could be accomplished without impacting P&C financial reporting by appropriately broadening the definition of A&O and DCC expenses to consider Title insurance characteristics and industry activities. Since Title insurance is monoline, the reporting changes necessary to accomplish this effort would impact Title underwriters only. Clearly, care should be taken in such an initiative.

Demotech believes that representative financial results can be obtained by expanding the A&O and DCC definitions to include loss adjustment considerations unique to Title underwriters and Title insurance coverage. By identifying Title industry activities currently being reported as operating expense that are more appropriately loss adjustment expense (A&O or DCC), head-to-head comparisons of Title versus P&C L&LAE ratios can be meaningful and thereby enhance the dialogue between the industry and its regulators.

Until the coverage timeframes and cost containment activities for the respective insurance contracts are appropriately reflected in financial reporting requirements or supplemental analyses, industry-to- industry comparisons of loss and loss adjustment expense ratios and operating expenses will continue to perpetuate misperceptions and misunderstanding.

About Demotech, Inc.

Demotech, Inc. has been providing financial analysis to regional and specialty insurers since 1985. Our initial mission statement — to become the leading provider of innovative solutions to financial analysis issues by focusing our resources on niches presenting opportunity for corporate growth — still serves us well. Financial Stability Ratings® have been effectively identifying financially stable insurers for nearly thirty years. Our capability to discern financially stable carriers has been documented through comparisons to industry icons and independent analysis. Our outstanding record of success is based on several factors; however, we believe our philosophical tenets distinguish Demotech from its competition:

We believe in innovative solutions to financial analysis issues. We focus on function and fundamentals.

Demotech, Inc. Milestones

1985 Founded by Joseph L. Petrelli and Sharon M. Romano Petrelli to serve the financial analysis and actuarial service needs of regional and specialty insurers. 1986 First to issue Financial Stability Ratings® (FSRs) for health maintenance organizations (HMOs). 1987 First to issue FSRs for public entity liability self-insured pools through the development of our Management Audit Process. 1989 First to review and rate independent regional and specialty insurance companies. First to have Property & Casualty insurance company rating process formally reviewed and accepted by Fannie Mae. An FSR of A or better eliminates the need for property insurance cut-through endorsements. 1990 First to have Property & Casualty insurance company rating process formally reviewed and accepted by Freddie Mac. Began offering Property & Casualty insurance companies and Title underwriters loss cost analysis and rate, rule and form filing assistance. Responded to the National Association of Insurance Commissioners (NAIC) requirements for Property & Casualty insurers to submit Statements of Actuarial Opinion related to loss and loss adjustment expense reserves concurrent with the 1990 Property & Casualty annual statement. 1992 First to analyze the financial position of each Title underwriter. 1993 First to have Property & Casualty insurance company rating process formally reviewed and accepted by HUD. 1994 Fannie Mae issued Title underwriting guidelines, naming Demotech as an approved Title underwriter rating service. 1995 First to promulgate Commercial Real Estate Recommendations (CRERs) to provide additional financial due diligence of Title underwriters involved in larger real estate transactions. 1996 Contacted by the Florida Office of Insurance Regulation (OIR) when the property insurance market encountered newly established insurers that did not have the representative historical operating experience to meet traditional rating requirements. Demotech developed evaluation procedures for the assignment of FSRs to newly formed companies. Coordinated the first seminar regarding the implementation of Statements of Actuarial Opinion for Title insurance companies on behalf of the Conference of Consulting Actuaries. 1999 Co-authored Commerce Clearing House publication describing the evolution of the Canadian Title insurance industry. 2001 Completed the initial loss and loss adjustment expense review of the Iowa Finance Authority – Title Guaranty Division. 2002 Revitalized the Ohio Title Insurance Rating Bureau (OTIRB). 2003 Auto-Owners Insurance Group made umbrella insurance available to insurers earning an FSR of A or better. Assisted the North Carolina Title Insurance Rating Bureau with the development and filing of Closing Services insurance product. Assisted the OTIRB with its first rate revision since 1980. 2004 Published Serious about Solvency – Financial Stability Rating® Survival Rates 1989 through 2004. Introduced Demotech Performance of Title Insurance Companies and Quarterly Updates, presenting consolidated statutory financial information for the Title insurance industry. 2005 Celebrated 20th anniversary. HUD approved Demotech’s rating process for professional liability insurance under Notice H04-15, Professional Liability Insurance for Section 232 and 223(f) Programs. 2006 Joseph L. Petrelli, ACAS, MAAA, FCA, authored What We’ve Got Here Is a Failure to Communicate – How Traditional Financial Reporting Contributes to Misunderstanding of Title Insurance Loss Activity. 2007 Demotech introduced its Company Classification System. Designated as the “Official Research Partner” of Insurance Journal. Expanded operations into a larger facility reflecting our increased capacity to serve our clients.

2008 Introduced Insurance Agents’ Errors and Omissions Insolvency Gap Legal Defense Coverage. 2009 Expanded the Insolvency Gap Coverage to include indemnity as well as legal defense. 2010 Celebrated 25th Anniversary. Participated in a comprehensive examination of insurer financial strength authored by Florida State University and The University of North Texas. 2011 Achieved the milestone of more than 350 insurance entities being actively reviewed, rated and followed. Florida State University publishes “A Comprehensive Analysis of Insurer Financial Strength Ratings” comparing and contrasting Demotech to Moody’s, Standard & Poor’s, A. M. Best and Fitch. 2012 Financial Stability Ratings® added to SNL Financial website, www.snl.com. 2013 A leading insurance agent’s errors and omissions insurance carrier retains Demotech to perform a financial due diligence on the carriers that will receive an extension of insolvency coverage. Introduced Stakeholder Team Accomplishment Recognition™ award to identify Property and Casualty insurers that were able to successfully address the diverse needs of all corporate stakeholders. Achieved the milestone of more than 400 insurance entities being actively reviewed, rated and followed. 2014 Fannie Mae MultiFamily accepts captive insurers and risk retention groups rated A or better by Demotech as regards professional and general liability insurance coverage for senior care facilities.