Industry Fundamentals

The title industry continues to play a critical role in the U.S. economy by insuring the proper transfer of real estate from buyer to seller and by facilitating the growth of the secondary mortgage market. This enables Americans to have one of the highest home ownership rates in the world.

Industry History and Purpose

The title assurance industry is composed of abstractors, attorneys, title insurance agents and title insurance companies. At any real estate closing, the parties involved must be assured that the title of the subject real property is as represented and expected. Members of the land title assurance industry are instrumental in helping to deliver and guarantee this assurance.

The functions of the title search and examination provide the basic information concerning the legal interest affecting the title to the real property. The title search and examination are more than an attempt to confirm the placement on the record of a subject mortgage: they are the underwriting process that distinguishes between significant and insignificant conditions affecting title. The search and examination very often include the curing of defects to the title necessary to complete the transaction. It is acknowledged that few properties have perfect title conditions and, as such, title insurance was developed to guarantee the current status of title, based on search and examination.

Depending on the jurisdiction, the title search and examination can require a search by title insurance personnel of numerous public documents, including tax, court-judgment, deed, encumbrance, federal and state records, as well as the evaluation of real property characteristics such as flood zone, location and construction type.

To assure that real property rights are conveyed as represented, most transactions are covered by title insurance to guarantee the condition of ownership and property rights as represented. A title insurance policy provides indemnification to an insured that has a fee interest, leasehold or mortgage lien for a specified property for any covered loss caused by a defect in title that existed as of the effective date of the policy.

Title insurance involves the acceptance of past transactional events rather than future occurrence events associated with all other property and catastrophe exposures. In addition, title insurance, unlike most other property/casualty exposures, has no termination date and no time limitation on filing claims.

Since title insurance usually involves the acceptance of prior transaction-related risk rather than future risk, the underwriting process in the title insurance industry differs markedly from the typical property/casualty underwriting process. The title underwriting process is designed to limit risk exposure through a thorough search of the recorded documents affecting a particular property. The insurance component of a title product only indemnifies for existing - but unidentified, or specifically underwritten - defects in the condition of a property's title. In other words, title insurance - unlike typical property/casualty insurance - usually does not respond to future occurrences but only to past defects that were in place at the time the property was sold, and not recognized as a problem until after the property was transferred or was insured over.

Property/casualty underwriters are concerned with determining the probability of loss based on the characteristics of the insured risk. Title underwriters, on the other hand, are concerned with reducing the possibility of loss by discovering as much information about the past as possible through extensive searches of public records and stringent examinations of title. Some state title insurance codes provide that no policy or contract of title insurance shall be written unless it is based upon a reasonable examination of title, and unless a determination of insurability of the title has been made in accordance with sound underwriting practices.

The general underwriting examination and search requirements, coupled with the disarray and geographic dispersion of records, have fostered the development of privately owned, indexed databases or title plants. These title plants must be maintained regardless of the level of real estate activity during any given period. The Financial Accounting Standards Board (FASB) has ruled that a title plant is a unique asset that, if properly updated, does not diminish in value over time. The cost to maintain the economic life of a title plant and continuously update the records is extremely high. This is one factor adding to the higher overall fixed-cost percentage for title insurers as compared with property/casualty insurers.

Both property/casualty insurers and title insurers must physically produce policies, but the processes and requirements differ significantly. A typical property/casualty policy might involve filling out a few blanks on a form, while the title policy might require the transcription of a complex legal description unique to the insured property, along with enumeration of often equally complex and unique terms of easements or other special property rights. In property and liability lines, agents' commissions generally are in the range of 10% to 25% of the premium on the policies that agents write. In title insurance, the agent retains a much larger proportion of the amount charged, typically in the range of 60% to 90% of the premium. Commissions for title insurance are more properly described as agent's retention or agent's labor or work charges.

The title insurance activities of search and examination generally are carried out locally, because the public records to be searched are usually only available locally. This activity might be performed by directly owned branch operations of the insurer or by title agents. Payments to a title agent not only reflect an origination commission but incorporate underwriting, loss-prevention and administration costs that title insurers would incur if policies were issued directly. These unique characteristics of the title insurance industry, combined with the necessity of maintaining a title plant or searching public records, contribute to the high fixed costs, the high ratio of salaries to total expenses and the high percentage of total revenues retained by agents.

In addition, with the requirement that each real estate parcel be evaluated and insured based upon the myriad and varying local laws, customs and records, the traditional insurance structure of local marketing and home-office underwriting cannot reasonably and cost-effectively be maintained in the title insurance industry. Since real estate laws, customs and practices vary, at least on a state-by-state and sometimes on a county-by-county basis, it has not been practical for underwriting to be performed on a national basis by a team of underwriters in the home office. Therefore, the economies of scale - made possible by establishing a centralized, skilled technical support staff of actuaries and underwriters to price products and make underwriting decisions - are absent in the title industry.

Rate Regulation

Like the rates for other forms of insurance, rates for title insurance usually are regulated by state governments to ensure that premiums are not excessive, inadequate or unfairly discriminatory to the public. States have different methods of regulating title insurance rates. The types of rate regulation used are:

  • Promulgation — State regulatory body sets the rates.
  • Prior Approval — Insurers propose rates, which must be reviewed formally and approved explicitly or deemed approved by the regulatory body before they can be charged.
  • File and Use — Insurers set rates, but they cannot be charged until the regulator has been notified and has allowed time for review and action, if necessary. In some prior-approval states, almost the same result is achieved through a deemer provision. Under a deemer, rates proposed by insurers are deemed approved if the regulatory body takes no action to disapprove a filing within a specified time, and the filer notifies the state that the rates are being deemed approved.
  • Use and File — Insurers set rates that can be charged immediately, as long as the new rate schedule is filed with the regulatory body.
  • No Direct Rate Regulation — Insurers set rates that can be changed at an insurer's discretion. Even in this apparent unregulated situation, a regulatory body still is charged with overseeing the title insurance industry and can question the propriety of a rate that appears to be unfairly discriminatory or otherwise violates statutory standards.

Title insurance premium rates largely are determined by operating and acquisition cost factors, as compared with property/casualty rates that are based on the actuarial determination of expected losses. The risk of title loss is a function of many factors, which can vary considerably from jurisdiction to jurisdiction and transaction to transaction. Also, the services covered by the title insurance premium vary from state to state. It is difficult to compare a pure title insurance risk premium with an all-inclusive rate that covers not only the risk of loss but also the title search, examination, title opinion and closing.

Rate Adequacy and Stability

Title insurance premium rates are based on five cost considerations, including those related to:

  1. Maintaining current title information on property local to that operation, i.e., title plant.
  2. Searching and examining the title to subject properties.
  3. Resolving or clearing defects to title.
  4. Covering title defects.
  5. Allowing for a reasonable profit.

Loss Characteristics Among Companies

Title insurance loss experience varies considerably among individual companies based on a wide array of factors, including:

  1. Experience and technical competency of agents and title underwriters.
  2. Quality and quantity of title documentation and evidence (both public and private) underlying the search-and-examination process.
  3. Regional differences in title insurance customs and practices, underlying title insurance risks, the mix of residential sale, residential refinance and commercial business, and defalcation risks.
  4. Adequacy and effectiveness of underwriting controls and agency management systems.
  5. Differences in the proportion of agency business versus direct business.
  6. Differences in the proportion of commercial versus residential business.
  7. Differences in claim-administration processes, such as claim recognition, evaluation, timing of settlement and recoupment.

The Title Industry and Real Estate Economics

The title industry is highly dependent on real estate markets, which, in turn, are highly sensitive to mortgage interest rates and the health of the overall economy. Typically, there is an inverse relationship between mortgage rate changes and real estate activity, and therefore, operating revenue for title insurers.

As interest rates fall, real estate transactions generally increase along with the greater demand for title products, and title insurers' operating revenues generally rise. The reverse occurs when interest rates rise. Changes in mortgage interest rates create corresponding fluctuations in title insurers' total operating revenue and pretax operating gains. While this relationship has held to a large degree in previous business cycles, the most recent cycle - characterized by the housing "bubble" in the earlier half of the previous decade (2000-2005) and the subsequent housing market crash beginning in 2006 through 2007 - has exhibited a very different dynamic that has undermined the conventional relationship between interest rates and real estate activity. This is mainly due to the latest business down cycle which was characterized by a collapse of asset prices - particularly housing -and losses taken by banks on mortgage backed securities, which were backed by income produced from loans on these mortgage assets. The subsequent contraction in the availability of credit stemming from these losses has had a significantly negative effect on home sales and prices despite the continued record low interest rate environment. However, one significant countervailing factor in the housing market during the last down cycle has been the federal government's active role in both providing home financing through the FHA, Fannie Mae and Freddie Mac, as well as through certain temporary tax incentives geared towards potential home buyers such as the First Time Homebuyers Tax Credit.

One positive result of the decline in housing prices combined with low interest rates has been that housing usually becomes more affordable. The Housing Affordability Index measures housing affordability as represented by a household earning the median income to qualify for a mortgage loan with a 20% down payment on a median-priced home. An index of 100 means a typical family has just enough income to afford a median-priced house. Thus, a higher index score means that housing is more affordable. This figure has continued to show steady improvement since 2006 when the housing boom effectively ended, and is now at its highest level in several decades. However, the ability to buy is not the same as the facility to buy, as many borrowers are unable to qualify for mortgages due to tighter credit market conditions.

Another measure of improvement or deterioration in the housing market is the supply of existing houses available for sale and the number of months it would take to clear this inventory at the current sales pace. A "balanced" market (i.e. a market evenly matched between buyers and sellers) is thought to be approximately a supply of six months. During real estate down cycles, typically there is a steadily increasing inventory of unsold houses well above that level, putting downward pressure on prices and thus steadily shifting the market to the buyers' favor. This real estate situation causes many homeowners to pull their houses off the market due to inadequate demand and/or mismatches in bid and ask prices, which creates a "phantom" inventory of houses.

Title Insurance and the Real Economy

The demand for title insurance products is largely dependent on the demand for real estate transactions, which are, in turn, critically dependent on the financial factors described above, as well as on a healthy labor market characterized by low or decreasing unemployment rates and generally increasing wages. In addition, a stable inflation environment helps to ensure market stability and consumer purchasing power.

Following favorable labor market conditions in the first half of the previous decade, unemployment rates increased significantly, while wage growth had been relatively muted. This rapid increase in unemployment posed a more traditional threat to the housing market and to the title insurance industry as it hinged directly upon the ability of buyers to purchase homes, and their subsequent need to obtain title insurance.

Core inflation (excluding the prices of food and energy) was relatively tame, as the sharp economic downturn of 2008-2009 and the subsequent sluggish recovery of 2010-2011 unfolded. However, prices of food and energy remained volatile. In particular, the price of gasoline, while fluctuating from quarter to quarter, witnessed an overall upward trend. Food prices have also shown a generally upward trend. Together, they have the effect of reducing household purchasing power, which can have an indirect dampening effect on the decision to purchase high-value, long-term assets such as real estate.

Growth in real (inflation adjusted) per capita income is also a critical determinant in the long-term prospects of the housing market, and by derivation, the demand for title insurance. While this measure rose in years before the downturn of 2008-2009, the sharp contraction in GDP during this period, and the subsequent sluggish growth rates, meant that economic growth did not keep up with population growth, causing per capita income to decline. This decline in per capita income helped contribute to a lack luster demand for housing during this period. Thus, a long-term rate of stable economic growth is a prerequisite for a healthy housing market.

How Title Insurance Differs From Other Lines of Insurance

Since title insurance is an evidence-producing/loss-prevention line of insurance, its loss expense is less than - and its operating expense is greater than - that of other property/casualty lines of business. Insurance expenses are loss-prevention,, underwriting-related and loss-related.

A typical loss-prevention insurance line - such as title, boiler and machinery or surety - usually has higher operating costs and lower losses than other insurance lines. It should be noted that according to the statutory accounting rules for title insurance, only reported claims are reflected in the loss expense. In other lines, both reported and unreported -, known as incurred but not reported (IBNR) - claims are included in the loss expense. As a result, timing differences occur in the reporting of losses and loss-adjustment expenses for title insurance when compared to other lines. In addition to known claims, title insurers - unlike insurers in other lines - carry a statutory liability known as the statutory premium reserve that provides ultimate loss protection for policyholders. However, it is not counted as a loss statistic.

Because of the large service and underwriting component of title insurance, its closest property/casualty counterparts are service, underwriting and loss-control-intensive sectors. Lines of insurance containing these features include surety, and boiler and machinery.

Operating expenses are the largest component of a title company's costs. A title company's ability to expand its infrastructure and maximize operating profits in good market conditions, and to contract and control costs in poor market conditions, is critical to its long-term financial success and solvency. This isn't necessarily the case with property/casualty companies, where the control of loss costs is more critical to success and solvency.

Because of title insurers' dependency on the health of the real estate market and favorable interest rates - as well as their being required by law in most states to be monoline writers - title industry revenues and profitability are susceptible to volatility. To dampen this volatility, title insurers have:

  • Improved their technology and work-flow processes.
  • Diversified their operating revenue by introducing new title products and expanding nationally and internationally.

Investment Income Characteristics

Important differences exist between title insurers and traditional property/casualty companies in their abilities to generate investment income. Property/casualty insurers collect premiums in advance and hold them until they must indemnify claimants for losses. These premiums constitute a large cash flow that companies generally invest in intermediate and long-term, investment-grade assets. The investment income generated is reinvested, and a company's asset base grows at a compounded rate until losses on policies materialize and are paid. Claims for the long-tail casualty business lines might take decades to appear and the accruing premiums can add significantly to a company's assets. As a property/casualty company's ratio of written premiums to surplus (equity) increases, the fraction of total assets that are financed by advanced premiums from policyholders also increases. In other words, writing property/casualty insurance can create financial leverage.

These property/casualty reserves are debt, in that if a policy is canceled, the reserves are owed to the former policyholder, yet they bear no rate of interest. Hence, this kind of financial leverage does not burden the property/casualty insurer with additional fixed charges and, as long as rates are adequate, it provides all the conventional benefits of leverage without much of the downside risk.

Title companies collect premiums after the largest component of their costs - operating expenses - has been incurred. Title companies' expense ratio typically averages more than 90, while the property/casualty industry's expense ratio is less than 30. The title industry's higher expense ratio results in a significant reduction in available cash flow for companies to invest. Although the remainder of the title premium is available for investment, the relative percentage of premium collected and invested is significantly less than that of the property/casualty industry. As such, the title industry's financial leverage is relatively low.

Title insurers use much of the premiums collected to cover the underwriting costs associated with the issuance of a title insurance policy. In contrast to property/casualty insurers, title insurers expend premium dollars before collection, and therefore do not retain most of the premium dollars before they are expended in the ordinary course of business.

On the other hand, the loss tail for title insurers is much longer than that of most other lines of insurance, and it constitutes a form of leverage where some percentage of premiums is set aside and held for future claims. The loss-tail leverage constitutes only a small percentage of the premiums, however.

Title Insurance Profitability

The financial strength and surplus of title companies, however, might be more critical than that of property/casualty underwriters. The title industry's premium volume and profitability is highly dependent on real estate sales and mortgage-refinancing activity. Since large infrastructures of personnel and title plants must be maintained to provide title services, a title company's profitability is highly sensitive to real estate market activity. A significant portion of a title company's cost structure is fixed, and the variable component largely is related to personnel. It is as difficult for a company to reduce its costs of doing business in the face of a downturn in real estate activity as it is to reacquire trained staff when activity rebounds.

Surplus plays a critical role by providing a cushion that permits a title insurer to ride out poor real estate markets, since not all of its costs are variable and able to be reduced. Property/casualty companies have a built-in level of demand. Many property/casualty coverages are required by law or business judgment and have to be purchased annually.

As with every industry, the title industry has certain inherent risks that must be understood to properly evaluate an individual company's operational strengths and weaknesses, balance-sheet vulnerabilities and volatility of earnings. The major business risks a title insurer faces are:

  • Volatility of revenue;
  • Expense control;
  • Mix of business;
  • Distribution mix (agency or direct);
  • Defalcations;
  • Rate adequacy and stability; and
  • Legislative reform.

The title industry's revenue is more volatile than that of the property/casualty industry. Cyclicality in a line of insurance creates challenges but isn't always a negative quality, since it creates opportunities for well-managed companies. In such businesses, management must make sure the company's operating structure is flexible and responsive to both increases and decreases in revenue over a relatively short period. A well-managed company must be able to access trained staff to service business adequately when demand for title insurance is rising.

Likewise, when the demand for title insurance is sharply reduced, a company must be able to downsize its infrastructure and personnel in an efficient and orderly manner so that servicing of its current orders is not interrupted. Property/casualty insurers, in general, are larger and therefore have a more difficult time fluidly adjusting expenses around macroeconomic cycles; whereas the title industry's margins have historically been more controlled.

Temporary personnel do not provide a total solution to this problem. Unskilled and part-time personnel can satisfy the need for an increase in title messengers or clerks, but they typically cannot fill the roles of more highly skilled positions, such as title searchers and underwriters.

Title plans also are a significant component of fixed costs. They are important because they are the raw material of the underwriting process and require both an initial investment and constant updating of various records. Even in slow markets, title plants must be current, with each day's recordings entered into the plant's database. If a title plant becomes outdated, it will become a source of errors and lead to title insurance losses.

The acquisition and maintenance of title plants gradually is becoming more cost effective as the business becomes computerized. Modern title insurance companies feature the computerization of order taking, title search and examinations, and policy issuance. These advances have permitted companies to increase premium volume capacity dramatically with only a modest increase in personnel. This capability not only enhances the profitability of a title company but also makes it easier to manage expense levels during slow real estate markets.

Title insurance provides coverage for the following basic types of real estate transactions listed in ascending order of underwriting complexity:

  • Residential mortgage refinancing or equity lines.
  • Residential resale or new construction.
  • Commercial resale or new construction.

Each successive product requires a significantly increased effort to market, underwrite and administer claims. The production costs necessary to generate each of these products also vary significantly.

First, residential mortgage refinancing is a classic, high-volume, commodity business, that tends to come in waves based on the relative level and trend of mortgage interest rates. During typical economic cycles when rates go down quickly, the volume of new title orders usually increases. During such times, title industry companies must hire large numbers of workers to service orders to maintain market share. However, the level of title orders can contract as quickly as it surges, and well-managed companies must adjust their personnel (cost) levels accordingly.

In underwriting refinance transactions, the title insurer, or its agent, performs a more limited title search than is necessary for a resale transaction. This less-comprehensive title search occurs because only the position of the lender of the refinanced mortgage has to be determined to assure the lender of its priority. No owner's coverage arises from these transactions, since the original owner's title policy, whenever purchased, continues to protect the basic title in the name of the property owner.

In addition to the challenges of managing the surges and contractions of title orders, companies also face difficulties managing the claims process. Some companies believe the best practice to minimize claim losses is to settle claims early to minimize legal fees, which are a large component of most claims. Other companies litigate claims when possible - which incurs more up-front expense - to establish and maintain a deterrent against fraud and future nuisance claims.

This tactic can be particularly effective in those regions where a small number of law firms specialize in representing title claimants. Whether a company's approach is successful or not can be determined only when the results of that approach are compared with industry averages.

Companies must recognize when it is prudent to settle small-dollar claims quickly and when to litigate certain claims in order to establish a reputation within the legal community. What's more, claims approaches are dependent on the region of the country and the local legal and claims environment.

Secondly, more profitable and complex than refinance orders is the residential purchase business. And lastly, underwriting commercial transactions represent the highest profit margin for title insurers. In a typical sale/development of an office building, both buyers and sellers generally are knowledgeable and sophisticated and retain lawyers to represent their competing interests. Generally, both title insurers and lenders assign senior underwriters to manage and underwrite commercial transactions. This more intensive underwriting process - undertaken by both the buyer and the seller - results in fewer mistakes and title defects and, consequently, reduces the risk of loss. Since title premiums are linked to property values, large-value commercial title business generally generates the highest underwriting profit.

Loss Experience in the Title Industry

The average loss experience for the title industry improved over the past twenty years due to better up-front underwriting as well as more stringent monitoring of agents to help avoid defalcations. However, once the housing boom (from 2000 through 2006) ended, there was a subsequent rapid increase in defaults and foreclosures that led to a significantly greater incidence of title claims arising out of those calendar years.

Title insurance policies have no set termination date and no limitation on filing claims. However, the only fees collected are the one-time charges when the policy is issued. Thus, losses reported in any one year will affect that year's profitability for statutory accounting purposes but are not, in the main, generated by that year's business activity. By the nature of the business, most title losses are reported and paid within the first five to seven years after policy issuance. However, the tail for title policy claims is at least 20 years.

All insurance companies require adequate loss reserves to cover all known and future losses, as well as adequate surplus levels to provide a cushion for reserve shortfalls, contingencies and unexpected losses from underwriting and investment activities. For title companies, the potential adverse loss-reserve development is not as problematic as it is for casualty lines of business, since losses are a relatively small percentage of the total.

Although large title claims are infrequent, they do occur. They can arise in the context of the transfer of upscale, single-family residential properties; single family or multifamily real estate developments; or office buildings, shopping centers or other commercial developments. Overlapping tasks and regulatory hurdles involved with these complex transactions complicate these claims. For instance, often there are entitlement issues, easement, ingress/egress issues and mechanic-lien risks associated with construction.

The term of a title policy generally ends upon the sale, transfer or refinancing of the underlying property, which means that title insurers are unable to determine which and how many of its policies still are in force. This situation arises because the title insurer is not advised of the new policy, unless that insurer is fortunate enough to have written both the new and the old coverage. This feature provides for significant differences in the nature of claims and the reporting of financial information between the property/casualty business and that of the title insurer.

Title losses vary by a wide array of factors, including the:

  • Local patterns and practices of land holding.
  • Local record-keeping system.
  • Value of the actual property.
  • Length of time the property has been owned or encumbered by mortgages or liens.

However, without the ability to pinpoint the exposure from in-force policies, companies are unable to translate this loss/claims information into definitive reserving data. Instead, they use assumptions and extrapolation methods that are detailed in Reserving Characteristics.

Title claims experience has an emergence pattern similar to that of a property/casualty product line with a moderate-length tail, such as personal automobile. Like personal auto, title insurance experiences a high frequency of low-dollar claims, occasionally generating a severe claim. Title underwriters have the ability to cure modest defects that occur frequently at a nominal cost. In many cases, the defect can be solved and the title loss averted simply by recording a document to correct, or confirm, the true property interests of the parties. However, a severe title defect or agent defalcation can result in a costly claim that might take years to settle.

The typical property/casualty company operates with a loss and loss-adjustment expense ratio between 70% and 80%, depending on its lines of business. This compares with a typical title company's loss and loss-adjustment expense ratio of 5% to 10%. This difference appears dramatic and leads most property/casualty-oriented analysts to assume that the business must be extremely profitable. However, the low loss and loss-adjustment expense (LAE) ratio is the result of the large expense component associated with underwriting and servicing a title product. This brings the overall profitability of title insurance, as measured by the combined ratio, more in line with property/casualty products.

Much of the stability in the title industry's loss ratio stems from the relatively low risk inherent in title insurance. The bulk of title insurance claims occurs shortly after closing and represents low-dollar costs. In these instances, the title company or its agent amends or corrects the title documentation and makes any required re-filings and notifications. The policyholder might not be made aware of these technical corrections and does not receive any cash payment. Typically, the title company uses a staff underwriter or counsel to correct the problem, and the loss cost is relatively small.

Some of the most severe and difficult claims involve agent defalcations. Defalcation is the act of diverting fiduciary escrow funds without authority and without applying those funds to satisfy or pay off the existing mortgages, liens and encumbrances on the property that is the subject of the escrow. Defalcation losses are similar to catastrophe losses experienced by property/casualty insurers. Agent defalcation claims are the only shock-loss type of claim that has a concentrated geographic effect, depending upon the region controlled by the defrauding agent.

Because the title industry's loss reserves are more stable, have less-adverse development and represent lower exposure to the industry's surplus, it follows that less surplus is required to protect against unexpected or catastrophic underwriting events. This differs significantly from the experience of property/casualty companies, which require a relatively larger surplus cushion to protect property underwriters from catastrophes or casualty underwriters from adverse loss-reserve development.

Reserving Characteristics

Title insurance companies file annual financial statements (National Association of Insurance Commissioners Form 9) with their respective state insurance regulators in accordance with statutory accounting principles. Statutory accounting principles are more conservative than generally accepted accounting principles (GAAP) because assets and liabilities are valued on a liquidation basis versus a GAAP going-concern basis. As a result, all statutory balance-sheet items are valued as though the company intended to discontinue its business and discharge all liabilities immediately, including claims, before a final distribution of remaining assets to its shareholders. As such, only assets that consist of cash - or those that can be converted into cash in a relatively short period - generally are allowed to be admitted to a company's financial statement under statutory accounting principles. Assets that are contingent in nature, whose values are uncertain or whose collectability is questionable, are not assigned value and are classified as nonadmitted assets.

By statute, title insurers are required to carry two liability reserves: known claims and statutory premium. The known claims reserve is the aggregate estimated amount required to settle all claims submitted to the company and unpaid as of the balance sheet date. The known claims reserve is similar to the property/casualty industry's case reserve. Over the decades, most title insurers have established reasonable baseline case reserves by tracking and analyzing historical claims data. Based on these data, individual known claims reserves are estimated by a company and are modified for special circumstances. These estimates must be reviewed at least annually and adjusted as necessary.

The statutory premium reserve is a liquidation reserve, the amount of which is determined by state-mandated formulas that establish a liability reserve and a charge to income based on the amount of business written. Defined by a formula, the initial reserve is reduced gradually, with an offsetting gain to income over a stated period, generally 10 to 20 years, depending on the rules of the domiciliary state.

Since title policies have no termination date, the statutory premium reserve is required and is reduced gradually to reflect the long-tail nature of the company's liability. The statutory premium reserve is equivalent to the property/casualty industry's IBNR reserve, which also is established and held for many years for long-tail liabilities. The major difference is the statutory premium reserve is determined and reduced by prescribed state formulas, whereas a property/casualty company has more discretion in establishing and reducing its IBNR reserves.

The statutory premium reserve is considered a liquidation reserve, since state statutes also require a company to segregate investment-grade assets in an amount equal to its statutory premium reserve. If a title insurer becomes insolvent, such segregated assets can be used only to pay future claims or to purchase reinsurance to settle future claims. These segregated assets may not be used to pay current claims, operating expenses or distributions to shareholders. This feature is unique to the title industry. In contrast, the assets of a property/casualty company are not segregated and are available to pay any claims.

The required segregation of assets to support reserves assures policyholders that the company will not utilize these funds to pay losses or other expenses in the ordinary course of business or make distributions to shareholders. This provision and its protections are part of the title insurance industry's regulatory framework, and much of the industry's financial structure is built around these statutory reserves.

Statutory premium reserve formulas vary significantly from state to state and reflect a state's underlying title framework and customs, but not necessarily its loss experience.

Under GAAP, the statutory premium reserve is not recognized as an expense and isn't included as part of a title insurer's liability. It does, however, exist as restricted equity. Title insurers that are required to file GAAP financial reports, or are part of a consolidated group of companies that are required to file under Securities and Exchange Commission (SEC) rules, normally develop an IBNR component like any other insurance line and include it as part of their GAAP liabilities.

For the property/casualty industry, IBNR is derived from actuarial predictions of future occurrences based on current loss data, and it is an unsecured liability. The title industry's statutory premium reserves are set by statute at a rate that is somewhat arbitrary. Few states, if any, currently can support the establishment or change of their statutory premium reserving levels based upon their title industries' actual loss experience. This situation has created inconsistent statutory premium reserves among companies across the country.

Additionally, since the statutory premium reserve is a charge to income, variances for individual title insurers' operating results (operating gain or loss) often reflect different statutory premium reserve requirements rather than actual differences in operations.

In addition to the statutory premium reserve and the known claims reserve, the title insurers' statutory financial statements provide for a supplemental reserve. Title insurers are required to have an actuarial certification of the adequacy of their reserves. If the actuary indicates that the statutory premium reserve plus the known-claims reserve is less than the estimated dollar value of known-plus-expected future claims - plus expected loss-adjustment expenses - the title company would have to fund the shortfall in the supplemental reserve. Since the supplemental reserve is not tax deductible, it is in the best interest of title insurers to have the statutory premium reserve as close as possible to actuarial estimates, if not actually more than the estimates.

In regions that experience significant real estate appreciation, turnover of homes is higher as owners sell their homes and use their realized gains to buy more expensive homes. Depressed regions of the country generally experience slower real estate activity as homeowners wait for the turnaround and try to avoid losing the equity in their homes.

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