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How Title Insurance Differs From Other Lines of Insurance

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July/August 2000 - Volume 79, Number 4

Since title insurance is an evidence-producing/loss-prevention line of insurance, its loss expense is less and its operating expense is greater than other property and casualty lines of business. Insurance expenses can be divided into two kinds: loss prevention/underwriting expenses and loss-related expenses. A typical loss prevention insurance line, such as title, boiler and machinery, or surety insurance, 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 loss expense, while in other lines both reported and unreported (IBNR) claims are included in loss expense. This different methodology causes timing differences in the reporting of losses and loss adjustment expenses for title as compared to the other lines.

Because of the large service and underwriting component of title insurance, its closest counterparts in the property/casualty sector are service, underwriting and loss control-intensive lines of business. Lines of insurance that contain these features are surety, and boiler and machinery. Table 1 compares the average loss and expense ratios between these lines vs. the general property and casualty industry. Title insurance is dramatically different from the general property/casualty industry, with a 70+ point difference in the loss and Loss Adjustment Expense ratio over the past 30 years.

Operating expenses are the single 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 contract and control costs in poor market conditions, is a critical factor 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 a more critical factor to success and solvency.

Table 2 shows the percentage of the operating dollar expended for operating expenses. As can be seen in the title industry, at least three times as much of the operating dollar goes toward expenses as in traditional property/casualty lines. Title insurance even requires close to 50% more than some rather traditional loss-prevention lines (such as boiler and machinery). Again, these two tables point out the significant operating difference between title insurance and other lines of insurance.

Table 3 shows the combined ratio for the title industry and the other lines of insurance. Here we see that although the components of the combined ratio are markedly different between the various insurance lines, the total combined ratios are very similar.

Investment Income Characteristics

Important differences exist in title insurers’ and traditional property and casualty companies’ ability to generate investment income. Property and casualty insurers collect premiums in advance and hold them until they must be paid out to 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 becomes reinvested and a company’s asset base grows at a compound rate until losses on policies materialize and are paid. For longer-tail casualty lines of business, these claims may take decades to appear and may result in large accumulations of assets. As a property and casualty company increases its ratio of written premiums to surplus (equity), it
automatically increases the fraction of its total assets that are financed by advanced premiums from its policyholders. In other words, writing property and casualty insurance can create financial leverage.

These property and casualty reserves are debt, in that in the event the policy is canceled, they are owed to the former policyholder, yet they bear no rate of interest. Hence, this kind of financial leverage does not burden the property and casualty insurer with additional fixed charges and, as long as rates are adequate, 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) have been incurred. As shown in Table 8, title companies average expense ratio is 90.0+%, while the property and casualty industry has an expense ratio under 30.0%. This results in a significant reduction in available cash flow for title companies to invest. Although the remainder of the title premium collected is available for investment, the relative percentage of premium collected and invested is significantly less. The title industry’s financial leverage is low.

Title insurers sell protection against losses caused by problems with legal title to real property arising out of events that occurred before the effective date of the policy. Because most uncertainty about the past can be reduced by careful research, a title insurer can exert a great deal of control over the risks it underwrites. For example, a title insurer can almost eliminate the possibility that a real estate title will become encumbered by a lien for past unpaid real estate taxes by looking up the property tax records of past years. However, hidden defects in a real estate title, such as errors in public records, will always cause losses. Because of the great importance of real estate titles, title insurers establish their underwriting criteria at a high level of stringency, eliminating all risks they possibly can through careful examination of title before issuing insurance. Consequently, title insurers operate by collecting premiums, much of which are used to cover the underwriting costs associated with the issuance of a title insurance policy. Therefore, in contrast to property and casualty insurers, title insurers expend premium dollars before collection and therefore do not retain most of the premium dollar before it is expended in the ordinary course of business. On the other hand, the loss tail for title insurers is much longer than that for most other lines of insurance and constitutes a form of leverage in that some percentage of premiums is set aside and held for future claims. The loss tail leverage constitutes only a small percentage of the premium, however.

Table 4 shows the ratio of net investment income earned to premiums for title insurers and property/casualty insurers for the years 1974-1998. The property/casualty ratio is significantly larger than for title insurers.

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