Financial Stability Ratings and Financial Reporting Issues Impacting

Financial Stability Ratings® and Financial Reporting Issues Impacting Title Insurance Joseph L. Petrelli, ACAS, MAAA, FCA President, Demotech, Inc.

Corporate Milestones – Title Insurance 1985 Founded by Joseph L. Petrelli and Sharon M. Romano to offer actuarial services. MBA Research Project: An Actuarial Perspective on Title Insurance 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 have Property and 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 and Casualty insurance company rating process formally reviewed and accepted by Freddie Mac. Began offering Property and 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 and Casualty insurers to submit Statements of Actuarial Opinion related to loss and loss adjustment expense reserves concurrent with the 1990 Property and Casualty annual statement.

Corporate Milestones – Title Insurance (cont. ) 1992 First to analyze the financial position for each Title underwriter. 1993 First to have Property and 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 meet traditional rating requirements. Working with the Florida OIR, Demotech developed evaluation procedures for the assignment of FSRs to newly formed Property and Casualty 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.

Corporate Milestones – Title Insurance (cont. ) 1999 Co-authored the 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 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 Introduced Demotech Performance of Title Insurance Companies and Quarterly Updates. Incorporated the Louisiana Title Statistical Services Organization and introduced a closing protection coverage in the State of Louisiana.

Corporate Milestones – Title Insurance (cont. ) 2005 HUD approved Demotech’s rating process for professional liability insurance under Notice H 04 -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. This discussion expounds upon the ramifications of Title underwriters’ required conformance with Property and Casualty financial reporting standards and how industry comparisons fail to recognize fundamental differences between Title and Property and Casualty coverage characteristics. 2007 Designated as the “Official Research Partner” of Insurance Journal, providing research, actuarial and statistical support and collaborating on special joint reports pertaining to insurance industry performance and financial results. 2010 Celebrating 25 th anniversary on September 9, 2010.

Our Philosophy is that Financial Stability Ratings® (FSRs) should be based on a quantitative model and should be independent of size. Small, well-managed underwriters can be more financially stable than larger, highly leveraged competitors. Demotech’s review reflects financial analysis and critical ratios while also considering operational indicators of success, such as business and marketing plans and operational efficiencies. Committed to this unique philosophy, Demotech serves the insurance industry by proactively satisfying the evolving uses and demands for ratings.

Why a Financial Stability Rating® is Important Financial Stability Ratings® are an assessment of an underwriter’s ongoing financial stability. Based on a predominantly quantitative analysis, a Financial Stability Rating® provides an impartial perspective on financial strength. Financial Stability Ratings® streamline the administrative process by addressing concerns related to the financial stability of an underwriter while simultaneously enhancing the image of well-rated underwriters. Since their introduction in 1992, Financial Stability Ratings® have been an integral part of the Title insurance industry. We review and rate more Title underwriters than any other service.

Our Approach … The Financial Stability Analysis Model A Financial Stability Rating® is based on several financial variables. Demotech combines a review of critical balance sheet and income statement items with strategic ratios weighted by using regression and multivariate analysis. These proprietary calculations comprise our Financial Stability Analysis Model. Our Financial Stability Analysis Model was the first risk-based capital or dynamic financial analysis model universally applied to the insurance industry. Its components, as well as selected operational indicators, complete our review and are combined to produce our opinion, summarized as a Financial Stability Rating®.

Financial Stability Rating® Definitions The following Financial Stability Ratings® represent our opinion of financial stability regardless of general economic conditions or the phase of the underwriting cycle. In our opinion, underwriters earning an FSR of A′′ (A Double Prime) have an Unsurpassed ability to maintain liquidity of invested assets, quality reinsurance, acceptable financial leverage and realistic pricing while simultaneously establishing loss and loss adjustment expense reserves at reasonable levels. In our opinion, underwriters earning an FSR of A′′(A Prime) have an Unsurpassed ability to maintain liquidity of invested assets, quality reinsurance, acceptable financial leverage and realistic pricing while simultaneously establishing loss and loss adjustment expense reserves at reasonable levels. The distinction between an underwriter earning an FSR of A′′ and one earning an FSR of A′ may be related to the magnitude of policyholders’ surplus, market share, national presence or other objective factors.

Financial Stability Rating® Definitions (cont. ) The following Financial Stability Ratings® represent our opinion of financial stability regardless of general economic conditions or the phase of the underwriting cycle. In our opinion, underwriters earning an FSR of A have an Exceptional ability to maintain liquidity of invested assets, quality reinsurance, acceptable financial leverage and realistic pricing while simultaneously establishing loss and loss adjustment expense reserves at reasonable levels. In our opinion, underwriters earning an FSR of S have an Substantial ability to maintain liquidity of invested assets, quality reinsurance, acceptable financial leverage and realistic pricing while simultaneously establishing loss and loss adjustment expense reserves at reasonable levels.

Financial Stability Rating® Definitions (cont. ) The following Financial Stability Ratings® represent our opinion of financial stability regardless of general economic conditions or the phase of the underwriting cycle. In our opinion, underwriters earning an FSR of M have an Moderate ability to maintain liquidity of invested assets, quality reinsurance, acceptable financial leverage and realistic pricing while simultaneously establishing loss and loss adjustment expense reserves at reasonable levels. In our opinion, underwriters earning an FSR of L are Licensed by state regulatory authorities. In our opinion, their ability to withstand general economic downturns or deterioration in the underwriting cycle is limited.

Commercial Real Estate Recommendations Highly Recommended In our opinion, Title underwriters receiving a Commercial Real Estate Recommendation of Highly Recommended for Commercial Real Estate Transactions have substantial financial resources as well as significant in-house capacity and expertise. Strongly Recommended In our opinion, Title underwriters receiving a Commercial Real Estate Recommendation of Strongly Recommended for Commercial Real Estate Transactions have adequate financial resources of their own and significant in-house capacity and expertise, or they have access to the necessary resources because of their placement of reinsurance coverage. Recommended In our opinion, Title underwriters receiving a Commercial Real Estate Recommendation of Recommended for Commercial Real Estate Transactions have sufficient financial resources of their own and sufficient in-house capacity and expertise, or they have access to the necessary resources because of their placement of reinsurance coverage.

Summary FSRs are based, in part, upon the quality and liquidity of the invested assets of a Title underwriter, the adequacy of its loss and loss adjustment expenses reserves, quality and quantity of its reinsurance, leverage – as measured by total liabilities to surplus as regards policyholders, operating profit or loss, and, in some situations, it’s ability to access additional capital.

What We’ve Got Here is a Failure to Communicate While Title insurance coverage looks backward from a certain date, P&C insurance coverage looks forward, utilizing a finite future period, to evaluate liability. The timeframe of coverage and cost containment activities are a fundamental difference between Title and P&C coverages. This distinction for Title underwriters has not been properly reflected in financial reporting requirements nor statistical reporting requirements.

Typical Language in a Title Insurance Policy States: Subject to the exclusions from coverage, the exceptions from coverage contained in Schedule B and the conditions and stipulations, the Title insurance company, as of the Date of Policy shown in Schedule A, against loss or damage… Coverage is Retrospective.

Typical Language in a P&C Insurance Policy States: In Consideration of the Provisions and Stipulations herein, the 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. at the location of the property involved, does insure… Coverage is Prospective.

P & C is Prospective Date of Policy Incident must have occurred prior to policy date to be considered covered Date of Policy Title is Retrospective Incident must occur within policy period to be considered covered

Loss and Loss Adjustment Expense Ratio Loss adjustment expenses include allocated loss adjustment expenses and unallocated loss adjustment expenses. Allocated loss adjustment expenses are those expenses, such as attorneys’ fees and other legal costs, that are incurred in connection with and assigned to specific claims. Unallocated loss adjustment expenses are all other claim adjustment expenses and include salaries, utilities and rent apportioned to support the claim adjustment function although not readily assignable to any specific claim.

Allocated Loss Adjustment Expense An expense directly allocated to a particular claim or incident. Addressing specific defects and everything in Schedule B?

Unallocated Loss Adjustment Expense An expense pertaining to handling claims that cannot be specifically attributable to a specific claim. Your entire preliminary investigation? Looking for situations that need to be cured!

Unallocated Loss Adjustment Activity Order Entry ◦ Verify property address ◦ Verify owner(s) ◦ Legal Description Run the Chain ◦ Run names and nicknames ◦ Determining encumbrances or possible encumbrances ◦ Back ground – determining and indication of legal incompetence – conservator, bankruptcy, etc. ◦ Impairments in chain of Title ◦ Determine adverse claims ◦ Interest which affects tenancy ◦ Property tax

Unallocated Loss Adjustment Activity Examination ◦ ◦ ◦ Legal Description Conveyances Execution Notarization Evidence of fraud, forgery, competence, etc.

Unallocated Loss Adjustment Activity Matters Affecting ◦ ◦ ◦ ◦ Covenants and restrictions Easements Rights of first refusal Judgment of lien Market requirement to cure Indemnities Review prior transaction Application of statute of limitations

Unallocated Loss Adjustment Activity Matters Affecting (cont. ) ◦ ◦ ◦ ◦ ◦ Update for last minute items Fallout Review tax certificate Reconcile difference with tax discrepancies Check for outstanding tax sales Review survey for adverse matters Verify legal access Mineral reservations Geographic posting

Unallocated Loss Adjustment Activity File Work Up ◦ Verify sellers names on contract match vesting ◦ In a refinance, verify borrowers names match vesting ◦ Ensure all Title requirements are addressed on the settlement statement ◦ Comply with terms of real estate contract ◦ Comply with requirements in lender’s closing instructions ◦ Verify borrowers names on loan document match contract

Unallocated Loss Adjustment Activity Closing ◦ ◦ Ensure all documents are executed properly Correctly notarize all appropriate documents Comply with lender’s funding requirements Ensure no disbursements are made without all funds being received Post-closing ◦ Disburse all funds per HUD-1 ◦ Return lender’s package ◦ Record documents in correct order

Allocated Loss Adjustment Expenses Once you found a situation that needed to be resolved, no matter how simple or routine, the time and effort on that specific situation would be allocated loss adjustment expense.

WAC 284 -24 D-020 (Excerpts) Property and Casualty Insurance Code “Allocated loss adjustment expense” or “ALAE” means expenses paid to defend and litigate a claim. These expenses may be internal or external, and include: ◦ ◦ ◦ ◦ ◦ Attorney’s fees paid to defend claims; The cost of engaging experts; Litigation management expenses; Fees or salaries for private investigators, hearing representatives or fraud investigators; Surveillance expenses; and Court costs; Stenographic expenses; Fees associated with witnesses and summonses; and The costs to obtain copies of documents.

Example of Inequity – P&C vs. Title § Missed lien by a Title professional. § Truck driver in an accident.

Incidents Per Policy State Policies in Sample Incidents Discovered and Resolved Colorado 83 888 Florida 43 248 Louisiana 114 585 North Carolina 270 3, 323 All Samples 510 5, 044

Conclusion Given the retrospective nature of a Title insurance policy, appreciable loss adjustment expense – unallocated and allocated – is expended PRIOR to policy issuance. This effort resolves claims that would otherwise occur. Unfortunately, current financial reporting requirements are based upon the prospective nature of P&C policies, thereby overstating the Title expense ratio and understating the Title loss adjustment expense ratio.