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Commitments and Contingencies | 6 Months Ended
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Jun. 30, 2011
Commitments and Contingencies |
Commitments and Contingencies |
11. | Commitments and contingencies
Loan origination liabilities The Company's mortgage operation may be responsible for losses associated with mortgage loans originated and sold to investors that may result from certain representations and warranties that the loans sold meet certain requirements, including representations as to underwriting standards, the type of collateral, the existence of primary mortgage insurance, and the validity of certain borrower representations in connection with the loan. If determined to be at fault, the Company either repurchases the loans from the investors or reimburses the investors' losses (a "make-whole" payment). Beginning in 2009, the Company experienced a significant increase in losses as a result of the high level of loan defaults and related losses in the mortgage industry and increasing aggressiveness by investors in presenting such claims to the Company. To date, the significant majority of these losses relate to loans originated in 2006 and 2007 when industry lending standards were less stringent and borrower fraud is believed to have peaked. In 2006 and 2007, the Company originated $37.8 billion of loans, each of which were subject to representations and warranties for which the Company may be liable. This figure includes loans originated by Centex's mortgage operations, but excludes loans originated by Centex's former subprime loan business sold by Centex in 2006. This figure has not been adjusted for subsequent activity, such as borrower repayments of principal, foreclosures, or repurchases or make-whole payments completed to date. Because the Company generally does not retain the servicing rights to the loans it originates, information regarding the current and historical performance, credit quality, and outstanding balances of such loans is limited. Estimating these loan origination liabilities is further complicated by uncertainties surrounding numerous external factors, such as various macroeconomic factors (including unemployment rates and changes in home prices) as well as actions taken by third parties, including the U.S. federal government in its dual capacity as regulator of the U.S. mortgage industry and conservator of the government-sponsored enterprises commonly known as Fannie Mae and Freddie Mac, which own or guarantee the majority of mortgage loans in the U.S. Most requests received to date relate to make-whole payments on loans that have been foreclosed, generally after a portion of the loan principal had been paid down, which reduces the Company's exposure. Requests not immediately refuted undergo extensive analysis to confirm the exposure, attempt to cure the identified defect, and, when necessary, determine the Company's liability. The Company establishes liabilities for such anticipated losses based upon, among other things, the level of current unresolved repurchase requests, the volume of estimated probable future repurchase requests, the ability of the Company to cure the defects identified in the repurchase requests, and the severity of the estimated loss upon repurchase. Determining these estimates and the resulting liability requires a significant level of management judgment. The Company is generally able to cure or refute over 60% of the requests received from investors such that repurchases or make-whole payments are not required. For those requests requiring repurchases or make-whole payments, actual loss severities generally approximate 50% of the outstanding principal balance. During the three and six months ended June 30, 2011 and 2010, the Company recorded additional provisions for losses as a change in estimate primarily to reflect projected claim volumes in excess of previous estimates. The Company's current estimates assume that claim volumes will not decline to pre-2009 levels until after 2012. Given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, it is reasonably possible that future losses may exceed the Company's current estimates. Changes in these liabilities were as follows ($000's omitted):
|  | Three Months Ended June 30, |  |  | Six Months Ended June 30, |
|  | 2011 |  |  | 2010 |  |  | 2011 |  |  | 2010 |
Liabilities, beginning of period |  | $ | 82,460 |  |  | $ | 94,088 |  |  | $ | 93,057 |  |  | $ | 105,914 |
Provision for losses |  |  | 19,347 |  |  |  | 17,210 |  |  |  | 19,347 |  |  |  | 16,856 |
Settlements |  |  | (3,971 | ) |  |  | (8,060 | ) |  |  | (14,568 | ) |  |  | (19,532 | )
Liabilities, end of period |  | $ | 97,836 |  |  | $ | 103,238 |  |  | $ | 97,836 |  |  | $ | 103,238 |
Community development and other special district obligations A community development district or similar development authority ("CDD") is a unit of local government created under various state statutes that utilizes the proceeds from the sale of bonds to finance the construction or acquisition of infrastructure assets of a development. A portion of the liability associated with the bonds, including principal and interest, is assigned to each parcel of land within the development. This debt is typically paid by subsequent special assessments levied by the CDD on the landowners. Generally, the Company is only responsible for paying the special assessments for the period in which it is the landowner of the applicable parcels. However, in certain limited instances the Company records a liability for future assessments that are fixed or determinable for a fixed or determinable period in accordance with ASC 970-470, "Real Estate Debt". At June 30, 2011 and December 31, 2010, the Company had recorded $42.3 million and $73.3 million, respectively, in accrued liabilities for outstanding CDD obligations. During 2011, the Company voluntarily repurchased at a discount prior to their maturity CDD obligations with an aggregate principal balance of $26.6 million in order to improve the future financial performance of the related communities. The discount of $5.2 million will be recognized as a reduction of cost of revenues over the lives of the applicable communities, which extend for several years. Letters of credit and surety bonds In the normal course of business, the Company posts letters of credit and surety bonds pursuant to certain performance related obligations, as security for certain land option agreements, and under various insurance programs. At June 30, 2011 and December 31, 2010 the Company had outstanding letters of credit and surety bonds totaling $1.6 billion and $1.7 billion, respectively. In addition, the Company was previously subject to $817.4 million of surety bonds related to certain construction obligations of Centex's previous commercial construction business, which was sold by Centex on March 30, 2007. The Company estimated that less than $85.0 million of work remained to be performed on these commercial construction projects as of December 31, 2010. The purchaser of the Centex commercial construction business had previously indemnified the Company against potential losses relating to such surety bond obligations, and the Company had purchased for its benefit a back-up indemnity provided by a financial institution as additional security. During 2011, the Company restructured this arrangement such that the Company is no longer directly subject to the surety bonds and is only contingently liable in the event of non-performance by the purchaser of the Centex commercial construction business and its parent company as well as exhaustion of a letter of credit in excess of the estimated amount of work remaining posted by the purchaser with the surety. Accordingly, the Company terminated the back-up indemnity as it believes the risk of this exposure becoming a cash obligation to the Company is not significant. Litigation The Company is involved in various litigation and legal claims in the normal course of its business operations, including actions brought on behalf of various classes of claimants. The Company is also subject to a variety of local, state, and federal laws and regulations related to land development activities, house construction standards, sales practices, mortgage lending operations, employment practices, and protection of the environment. As a result, the Company is subject to periodic examination or inquiry by various governmental agencies that administer these laws and regulations. The Company establishes a liability for potential legal claims and regulatory matters when such matters are both probable of occurring and any potential loss is reasonably estimable. The Company accrues for such matters based on the facts and circumstances specific to each matter and revises these estimates as the matters evolve. In such cases, there may exist an exposure to loss in excess of any amounts currently accrued. In view of the inherent difficulty of predicting the outcome of these legal and regulatory matters, the Company generally cannot predict the ultimate resolution of the pending matters, the related timing, or the eventual loss. While the outcome of such contingencies cannot be predicted with certainty, management does not believe that the resolution of such matters will have a material adverse impact on the results of operations, financial position, or cash flows of the Company. However, to the extent the liability arising from the ultimate resolution of any matter exceeds the Company's estimates reflected in the recorded reserves relating to such matter, the Company could incur additional charges that could be significant. Allowance for warranties Home purchasers are provided with a limited warranty against certain building defects, including a one-year comprehensive limited warranty as well as coverage for certain other aspects of the home's construction and operating systems for periods of up to ten years. The Company estimates the costs to be incurred under these warranties and records a liability in the amount of such costs at the time product revenue is recognized. Factors that affect the Company's warranty liability include the number of homes sold, historical and anticipated rates of warranty claims, and the cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts such amounts as necessary. Actual warranty costs in the future could differ from the current estimates. Changes to the Company's warranty liabilities were as follows ($000's omitted):
|  | Three Months Ended June 30, |  |  | Six Months Ended June 30, |
|  | 2011 |  |  | 2010 |  |  | 2011 |  |  | 2010 |
Warranty liabilities, beginning of period |  | $ | 74,654 |  |  | $ | 88,767 |  |  | $ | 80,195 |  |  | $ | 96,110 |
Warranty reserves provided |  |  | 10,019 |  |  |  | 15,169 |  |  |  | 19,108 |  |  |  | 25,308 |
Payments |  |  | (14,202 | ) |  |  | (18,666 | ) |  |  | (28,209 | ) |  |  | (36,776 | )
Other adjustments |  |  | 50 |  |  |  | (1,033 | ) |  |  | (573 | ) |  |  | (405 | )
Warranty liabilities, end of period |  | $ | 70,521 |  |  | $ | 84,237 |  |  | $ | 70,521 |  |  | $ | 84,237 |
Self-insured risks The Company maintains, and requires the majority of its subcontractors to maintain, general liability insurance coverage, including coverage for certain construction defects. The Company also maintains builders' risk, property, errors and omissions, workers compensation, and other business insurance coverage. These insurance policies protect the Company against a portion of the risk of loss from claims. However, the Company retains a significant portion of the overall risk for such claims either through policies issued by the Company's captive insurance subsidiaries or through its own self-insured per occurrence and aggregate retentions, deductibles, and claims in excess of available insurance policy limits. The availability of general liability insurance for the homebuilding industry and its subcontractors has become increasingly limited, and the insurance policies available require companies to maintain higher per occurrence and aggregate retention levels. In certain instances, the Company may offer its subcontractors the opportunity to purchase insurance through one of the Company's captive insurance subsidiaries or to participate in a project specific insurance program provided by the Company. Policies issued by the captive insurance subsidiaries represent self-insurance of these risks by the Company. This self-insured exposure is limited by reinsurance policies purchased by the Company. General liability coverage for the homebuilding industry is complex, and the Company's coverage varies from policy year to policy year. The Company is self-insured for a per occurrence deductible which is capped at an overall aggregate retention level. Beginning with the first dollar, amounts paid on insured claims satisfy the Company's per occurrence and aggregate retention obligations. Any amounts incurred in excess of the occurrence or aggregate retention levels are covered by reinsurance up to the Company's purchased coverage levels. The Company's insurance policies, including the captive insurance subsidiaries' reinsurance policies, are maintained with highly-rated underwriters for whom the Company believes counterparty default risk is not significant. At any point in time, the Company is managing over 1,000 individual claims related to general liability, property, errors and omission, workers compensation, and other business insurance coverage. The Company generally reserves for costs associated with such claims (including expected claims management expenses relating to legal fees, expert fees, and claims handling expenses) based on actuarial analyses of the Company's historical claims. The actuarial analyses calculate an estimate of the ultimate net cost of all reported and unreported losses incurred but unpaid. These estimates make up a significant portion of the Company's liability and are subject to a high degree of uncertainty due to a variety of factors, including changes in claims reporting and resolution patterns, third party recoveries, insurance industry practices, the regulatory environment, and legal precedent. State regulations vary, but construction defect claims are reported and resolved over an extended period often exceeding ten years. In certain instances, the Company has the ability to recover a portion of its costs under various insurance policies or from its subcontractors or other third parties. Estimates of such amounts are recorded when recovery is considered probable. The Company's recorded reserves for all such claims totaled $790.6 million at June 30, 2011, substantially all of which relates to general liability claims. The recorded reserves include loss estimates related to both (i) existing claims and their related claim expenses and (ii) incurred but not reported claims and their related claim expenses. Liabilities related to incurred but not reported claims and their related claim expenses represented approximately 77% of the total general liability reserve at June 30, 2011. The actuarial analyses that determine the incurred but not reported portion of reserves consider a variety of factors, including the frequency and severity of losses, which are based on the Company's historical claims experience supplemented by industry data. The actuarial analyses of the reserves also consider historical third party recovery rates and claims management expenses. As a result of the inherent uncertainty related to each of these factors, actual costs could differ significantly from estimated costs. Adjustments to estimated reserves are recorded in the period in which the change in estimate occurs. Because the majority of the Company's recorded reserves relates to incurred but not reported claims, adjustments to reserve amounts for individual existing claims generally do not impact the recorded reserves materially. However, changes in the frequency and timing of reported claims and the estimates of specific claim values can impact the underlying inputs and trends utilized in the actuarial analyses, which could have a material impact on the recorded reserves. Changes in these liabilities were as follows ($000's omitted):
|  | Three Months Ended June 30, |  |  | Six Months Ended June 30, |
|  | 2011 |  |  | 2010 |  |  | 2011 |  |  | 2010 |
Balance, beginning of period |  | $ | 804,066 |  |  | $ | 569,666 |  |  | $ | 813,841 |  |  | $ | 566,693 |
Reserves provided |  |  | 17,083 |  |  |  | 19,318 |  |  |  | 32,007 |  |  |  | 35,631 |
Liabilities assumed with Centex merger |  |  | — |  |  |  | 2,514 |  |  |  | — |  |  |  | 2,514 |
Payments |  |  | (30,552 | ) |  |  | (13,807 | ) |  |  | (55,251 | ) |  |  | (27,147 | )
Balance, end of period |  | $ | 790,597 |  |  | $ | 577,691 |  |  | $ | 790,597 |  |  | $ | 577,691 |
The Company's insurance-related expenses as reflected in the above table are reflected within selling, general, and administrative expenses. The Company has experienced a high level of insurance-related expenses in recent years, primarily due to the adverse development of general liability claims, the frequency and severity of which have increased significantly over historical levels. As a result of these trends, the actuarial analyses used to estimate the Company's liabilities assume that the long-term future frequency, severity, and development of claims will most closely resemble the claims activity experienced in recent years. The higher reserve balance at June 30, 2011 compared with June 30, 2010 resulted from recording additional expense to insurance reserves in the third quarter of 2010 when the Company experienced a greater than anticipated frequency of newly reported claims and a significant increase in specific case reserves related to certain known claims for homes closed in prior periods.

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