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: Copyright © Demotech, Inc. 2014 3 WHAT WE’VE GOT HERE IS A FAILURE TO COMMUNICATE - How Current Financial Reporting Contributes to Misunderstanding of Title Insurance 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