Rating title firms: a trend that keeps growing

But is a company rated A+ a mover and shaker or just one that won't take the risks some analysts disdain?

While title insurance has existed for more than 120 years, it has only been during the past five years that it has begun to stand out from the long list of other requirements needed in the real estate closing process.

Ratings on the companies that provide title insurance were first offered by Columbus, Ohio-based Demotech Inc. in 1992, according to Joe Petrelli, the company's president. Earlier efforts to rate the industry met with lukewarm response. A 1986 Demotech market study found only "average" interest in a title insurance rating service, but that interest has continued to grow.

Part of the reason for this increased interest was the desire by the Federal National Mortgage Association (Fannie Mae) to have a list of strong, reputable title firms to use on its transactions, according to Barron Putnam, Ph.D., president of LACE Financial Corp., of Frederick, Md. LACE Financial issued its firm's title insurance company rating in 1992.

Also, increased investor interest in commercial real estate has made high-dollar sales more prevalent and brought title insurance to the forefront.

"It was just another fee to be paid as part of the closing costs," says Keith Buckley, a senior vice president with Chicago-based Duff & Phelps Credit Rating Co. "But the growing trend in the securitization of real estate in recent years has placed added emphasis on title insurance as more sophisticated investors want to be certain they are covered in these multiple property transactions."

The ratings measure each firm's financial stability and claims-paying ability, that is, the firm's "ability to meet its current and future policyholder obligations on a timely basis," states Duff & Phelps' Title Insurance Ratings Criteria.

As with other industries, these ratings are used as a marketing tool by title firms. Quality ratings are promoted in company literature and advertising to impress and attract both stock and debt investors, to help build relationships with lenders and ancillary service providers.

Not everyone is in favor of the ratings being used in this way. "The ratings process has gone astray," says Putnam. "The initial idea was to measure the financial soundness of institutions and these companies are either investment grade or non-investment grade. Using the ratings as a marketing tool has placed a tremendous amount of pressure on the firms to get the highest rating possible and on some of the rating agencies to give higher ratings."

Putnam adds that striving for the highest rating possible could be a mistake. Title insurance ratings are based to a large extent on a "risk and reward" basis. He points out that good business requires risk-taking and that a title firm's B+ ratings, as opposed to an A, may simply indicate that the firm is taking the risks necessary to make the company stronger in the long run. An A+ rating could mean a firm is not taking enough risks.

While the ratings may be considered a beauty contest in some circles, "A higher rating is usually tied to a reduced cost of capital from lenders," says Harry Comninellis, an analyst with New York-based Moody's Investor Service Inc.

The ratings firms usually contract with the companies to produce ratings for a fee. LACE Financial is currently the only major ratings firm that does not charge to produce the reports, since Demotech has begun charging a fee.

Title firms usually agree to provide access to the data that analysts use to formulate the ratings. This may cover data not available to the public.

"This can include information such as if the firm is contemplating an acquisition or a divestiture, or issuing equity or debt," says Buckley.

The importance of the rating to the companies is seen in the fact that title firms often review transactions with ratings analysts before going through with them. Buckley says, "They want to know what impact it will have on their rating and what we tell them could make them decide to change their plans."

In general, the size of the title firm doesn't impact its rating directly. For example, Old Republic, the smallest of the top six title companies, has a higher rating than most of its larger counterparts. But size does affect a title firm's ability to increase its market share or capitalize needed investments, which could eventually affect its rating.

Consolidations, particularly among the larger firms, have not tended to have much impact on the new firm's rating. "Consolidations tend to create potential efficiency advantages, but there are a lot of integration challenges that have to be successfully met before any of those efficiencies are realized," says Buckley.

As for further consolidation among the industry's major players, Buckley is not sure a good fit exists. "I wouldn't be shocked to see two of the top firms consolidate," he says. "But it would be surprising to see some of the remaining personalities join forces."

Most analysts observe the same areas when rating title companies, Putnam says. "How we interpret and weight the data is where the difference arises."

The following are some of the more important areas considered by analysts when judging the strength of individual firms.

Quality of capital Analysts are as concerned about the stability of a firm's capital as they are with the actual amount of capital it possesses. Title firms' premium income is strongest during periods of low interest rates, as the low cost of capital inspires more residential and commercial buying. But rises in the interest rate can bring business to a standstill.

As a result, investment income is a strong component in a title firm's capital structure. "The largest part of title companies' investment portfolio, about 75%, are cash or investment-grade bonds," explains Comninellis.

Large positions in high-yield bonds or equity stock positions in other firms can be seen as a weakness for a title firm. "More risk is involved with higher-yield bonds, and analysts are looking for a more liquid and stable financial position for the companies," says Buckley.

Liquidity problems can be overcome if the timing of the investments is considered. "Long-term bonds are not a problem for most firms, from a liquidity standpoint, as long as the maturity schedules are balanced," says Putnam.

But analysts say the stock market is an area in which title firms should not get heavily involved. "Investment in equity holdings have increased capitalization for firms over the last few years," Comninellis says. "But high levels of equity usually detract from a company's strength because of the volatility of the markets."

Ratings analysts also examine whether stock investments are with affiliated firms or nonaffiliates. "Even if the title firm's parent or affilates' stock is doing well, from a diversity standpoint, the investment is more of a risk and that would be factored into our ratings," says Petrelli.

Title firms' need for liquidity can also present a problem for stock investments. "If a title firm has to sell some stock to meet an immediate demand, it could occur at a down cycle in the stock price and result in a catastrophe with regard to the investment," adds Conmimellis.

But there are no absolutes. Moderation seems to be the best solution for title firms on high-yield bonds and stocks. "A limited amount of high-yield bond investment is okay as long as the company has expertise in the area and doesn't push too hard," says Buckley, adding that Duff & Phelps feels comfortable if a title company's stock investment is not above the 25% to 30% range.

Access to capital is also very important to analysts rating title firms. "Capital is the first line of defense for a firm if earnings turn negative," says Buckley. "And it is also related to risk exposure; in general, the more risk a company has, the stronger its capital position needs to be."

"We measure the title firm's average payout per year and compare that with the capital reserves in the company," explains Gary Ketchum, senior title analyst with Oldwick, N.J.-based A.M. Best Co. "Five years of coverage is considered good."

Diversification As mentioned earlier, title insurance is extremely sensitive to interest rate fluctuations. Any rise in the cost of capital can have an immediate impact on sales transactions. "A tick up in the interest rate can bring the title business to a halt," points out Comninellis."

"It is definitely a boom or bust industry," agrees Putnam.

As a result, title insurance companies, particularly the large national firms, have begun to expand their service offerings to provide a hedge against these often volatile swings in the industry.

When the title business is disrupted by rising interest rates, firms offering additional services can make up the revenues by selling their new services. "Some title firms are even selling the services software and other technologies that they have developed" to others in the industry, cites Putnam.

Santa Ana, Calif.-based First American Title Insurance Group was among the first to diversify its service, offering added home warranty, flood certification, credit reporting appraisal and more.

"A lot of title companies are moving into other service products to smooth out the rough edges of any potential downturns," reports Ketchum.

Petrelli adds, "The majority of companies are just getting into service diversification, so they are still dependent on the title business."

But others say the effects of service diversification have not been tested yet. "The title industry has remained very good in the period since firms began adding services," says Fred Loeloff, associate director of insurance ratings at New York-based Standard & Poor's. "We will really have to experience another down cycle before we know how much it actually helps."

Larger title firms are either buying existing service providers or developing their own companies. Smaller title firms are looking at partnering with firms that provide the services.

Most of the title firms are investing in real estate-related businesses, but some analysts disagree as to whether these investments need to be in real estate or if they can be in a totally different industry.

Comninellis says that moves into unrelated businesses could play a part in a firm's having its rating reduced at Moody's. On the other hand, Demotech appears much more willing to let management veer from its traditional business type, but only if management has some amount of experience in the field.

"Our general approach to ratings is that companies should do what is best for them," says Petrelli. "And if we have concerns or questions, we will ask them to explain their actions."

In addition to service expansion, analysts look for geographic diversity as well. "Geographic diversity helps a great deal," says Putnam, noting that if one region suffers an economic setback that curtails business, "The firm can make it up in another area."

Petrelli agrees that geographic diversity is important, but he warns title insurance analysts not to confuse real geographic diversity with licensing.

"We look at a title firms' premium volume concentration," he says. "Even some of the firms that are considered national have a significant dollar volume concentrated in only about five states. So it's not where they are licensed that creates geographic diversity; it is where they are doing business."

But this type of expansion into new areas of the country also raises a red flag to title analysts, who want to make sure the growth isn't accomplished at the expense of quality operations.

"There is always a potential for out-of-control growth when firms are trying to move into new areas too quickly," says Buckley, adding that the problems occur when the title firm does not know the area well and winds up working with disreputable agents.

"The quality of the underwriting is not as good, which increases both the risk for claims' liability and agent defalcations," he says.

Exposure to risk Growing a title firm to increase its profitability can make that firm more vulnerable to financial losses. In creating new relationships with agents, title firms don't always know who they are dealing with. "Often when a title insurer moves into a new area, the reason an agent may be available is that nobody else wants him," says Putnam. The quality of that agent's underwriting could be poor or worse.

"Worse" is defalcation: the embezzlement of policy escrow funds by agents. This practice, which can cost firms millions of dollars, usually occurs in firms that do not have long-term relationships with their agents or procedures in place to prevent or limit the size of defalcations.

Ratings analysts look closely at title firms to see if they have the checks and balances in place to ensure that both independent and in-house agents are operating ethically.

LACE Financial and Demotech check the amount and quality of defalcation insurance that title firms take out as protection. A few years ago, after a rash of large defalcations hit the industry, Demotech asked title firms to provide in writing the procedures the company had in place to prevent or mitigate defalcations. "Not surprisingly, the companies that responded the soonest had the best procedures in place," says Petrelli.

In addition, Petrelli says that every two years his firm asks state insurance departments for a list of agents who have been disciplined in the past year. If any of these agents are working with a title company, Demotech asks the firm why.

"The executives of firms that continually have disciplined agents working for them have their credibility damaged because it raises the question of how well they are managing the firm," explains Petrelli.

Residential has traditionally been the bread and butter of the title industry, but commercial business is a rapidly growing segment, particularly since each policy is for a much larger dollar amount than the average new home.

To help mitigate the risk involved in underwriting these larger policies, title firms purchase reinsurance. Reinsurance involves a title firm getting insurance on a portion of a large policy. Often several portions may be reinsured with other title firms, reinsurance firms or even Lloyd's of London.

The object is to keep the title firm's liability below what its capital position can handle. These statutory maximums are set by some states, by ratings agencies and by the title firms themselves. "Most firms keep their self-imposed underwriting limits below the limits set by the various ratings agencies," says Petrelli. "This looks better to analysts."

Competitive positioning Although a title firm may have a strong capital position currently, analysts have to ask the question, "Is the firm prepared to meet the new challenges of the industry as well as its competitors?"

Says Buckley, "We recognize that some title companies can look very good today but not be positioned well for the future." He cites a hypothetical regional firm that has not made the needed investment in the future and is behind in both the use of technology and in the types of services that they offer.

"This firm, although it may have a strong capital position, is very susceptible to another firm entering its market and taking away a large portion of its market share by offering clients more servicesand a greater use of technology," says Buckley.

While financial strength is important to the ratings analysts produce, it must not be gained at the expense of property business investments. "We look at the title companies' expense ratios every quarter," says Petrelli. "If there are major changes in the amount of money being spent, we want to know why."

If the expense ratio is up, Petrelli says, "It triggers a series of questions on our part to find out what the money was spent on, and if it was spent on items that improve the company we will probably be satisfied with the answers."

On the other hand, if the expense ratio goes down, analysts want to know where the spending cuts were made. Perhaps the company closed an unprofitable branch or is doing more direct operations business, therefore saving on commissions. But the analysts also want to know if the cuts were made in technology or other service areas that could potentially hurt the firm down the road.

Indeed, as with other industries, technology and the efficiency it produces are viewed as the keys to future success. "This is a very technology-driven industry," says Putnam. "It makes transactions more simple and efficient and it is necessary to compete."

Buckley says technology allows agents to do thorough title searches in less time.

"Many firms are trying to tie all of their services together, so the entire closing can be done at a personal computer," says Comninellis.

Analysts also look at the quality of a firm's independent agents to be sure they are affiliated with strong players in at least some of its markets. "Title is a very localized business and firms need agents in at least some of their markets that are entrenched in their communities," Buckley says.

Management "While they are important, you can't just base your ratings off the numbers," says Loeloff.

The strategy and philosophy behind the numbers is just as critical to a title firm's future success. What is management's track record? Does management have strategic vision? These are questions that are important to analysts.

"Management is heavily weighted in the ratings process because ultimately it is their decisions that will lead the company into the future," says Buckley. "We meet at least once a year with the management of the major title firms we rate. We want to know the individuals and hear their business strategy for the coming year."

One of the most important areas to be analyzed is expense management. Analysts must weigh the timing of good and bad periods of business and ascertain who originates the majority of the company's title policies.

In periods of low interest rates and strong title business, title firms prefer direct operations. These company-owned offices are more profitable than business from independent agents, who make anywhere from 60% to 90% commissions on premiums.

But when interest rates move up and the title business dwindles, independent agents are preferred since they present no overhead costs for the title firm. "It is really a question of whether management is willing to act quickly to cut overhead when they see a down cycle coming," says Buckley.

Many firms keep this division close to an equal split and then adjust according to the strength of the market. "The 50-50 mix makes sense," says Ketchum.

But each firm develops its own ratio of agents that works best for it. "Some title firms are 100% one way or the other," says Petrelli. "The companies that are constantly shifting the deck are usually the ones with problems they are trying to correct. So, we like consistency."

The strength of the parent company is another important focus of ratings analysts. Putnam says, "We grade the title firm as a stand-alone company, but we do take the influence of the parent company into consideration."

This influence can be good or bad. If the parent firm is strong, it can be a source of capital to help the title firm grow. But if the parent firm is in trouble, the title firm could be a source of capital for the parent firm, which would weaken it in the estimation of analysts.

"Ideally, the parent firm will have the ability to be indifferent to the title firm," says Petrelli. "If the title underwriter is not under any pressure to perform at a certain level, that usually means the parent firm does not need its capital for its own operations."

Examples of data agencies use when rating title insurance companies:

* financial statements of parent and subsidiary companies

* five years of annual reports

* debt, liquidity and loss history

* independent audit reports and opinions

* biographical data on principal officers

* management and investment strategy

* relationship with holding company

* reinsurance arrangements

* annual operating plans

* investments and assets

* accounting practices

* actuarial reports

- A.M. Best Co.

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