Faf Title Insurance
Image source: First American Financial.

With its focus on the title and specialty insurance industry, First American Financial (NYSE:FAF) gives investors a direct barometer on the health of the U.S. housing industry. Most homebuyers need title insurance in order to finance their mortgages, and so the fortunes of First American Financial and rivals like Stewart Information Services (NYSE:STC) tend to stay in line with the health of the housing market.

Coming into Thursday morning's third-quarter financial report, First American Financial shareholders had expected to see the recent health of housing continue to show up in the title insurer's results, but natural disasters in northern California held back the contribution that First American Financial's specialty insurance business makes to the overall company and pulled down earnings growth for the quarter.

Let's look more closely at how First American Financial did this quarter and what's ahead for the company in the future.

Earnings growth goes up in smoke
First American Financial's third-quarter results were generally mixed. The top line showed the continued strength in housing that investors were expecting to see, as total revenue of $1.38 billion was up 10% from year-ago levels and did even better than the consensus forecast for a 7% growth rate in sales. Net income fell 6.5% to $75.5 million, and even after allowing for realized investment losses during the quarter, adjusted earnings of $0.71 per share fell short of the $0.74 per share that most of those following the stock had wanted from First American Financial.

The title insurance and services division continues to produce the lion's share of First American Financial's business, making up more than 90% of its overall sales. Revenue for the segment rose 10%, as a 3% rise in the number of title orders closed during the quarter combined with a 10% rise in the average revenue per order to push premiums and escrow fees up 11% from the year-ago quarter. Rising real estate values in the residential market helped drive premium growth, and First American Financial saw increases both in the number of big commercial real estate transactions it closed and the average size of those commercial transactions. Agent premiums rose 16% from last year's third quarter.

As we've seen in past quarters, though, First American Financial continues to struggle with its information services business. Revenue from the sub-segment rose just 1%, and when you take out the positive impact of a recent acquisition, the lack of demand for default information products sent organic revenue down 2%. Still, investment income climbed 15% to $25.4 million, and increases in expenses were largely confined to compensation for incentive payments that were tied to revenue gains.

In general, First American Financial's specialty Insurance segment doesn't get a huge amount of attention, given its relatively small size. Yet this quarter, losses of $3.5 million related to California wildfires made a substantial impact on the overall company's results. Higher losses in the home warranty business segment also weighed on the unit's performance, and even though revenue climbed, pre-tax income for the segment plunged by more than 80% from the year-ago quarter.

Will First American Financial keep moving upward?
CEO Dennis Gilmore seemed pleased with the quarter. "Third-quarter results in the title segment were strong," Gilmore said, "driven by higher closing activity in the residential purchase market and continued growth in our commercial business." He noted that negative impact of claim losses in the specialty insurance unit but pointed out that much of the loss was in line with past claim rates.

Still, First American Financial did see an uptick in its provisions for policy losses and other claims, reversing the favorable trend from the previous quarter. The insurance specialist boosted its reserves by $6.7 million to $71.8 million, which works out to expectations for an ultimate loss rate for the current policy year of 6%.

One area where Gilmore sees potential disruptions is in the implementation of new mortgage rules from the Consumer Financial Protection Bureau. "While it is still too early to evaluate the ultimate impact," Gilmore said, "we continue to expect temporary delays in closings as the industry adapts to the changes required." Nevertheless, First American Financial still has a positive view on what the market environment is likely to look like next year. Moreover, Stewart Information Services and other title insurance rivals are going to have to go through the same regulatory challenges, so First American Financial should be able to seize the opportunity to try to demonstrate its competitive advantage in managing the title process.

First American Financial shareholders didn't particularly like the company's results, with shares quickly falling 3% shortly after the stock opened for the regular market session following the announcement. Despite short-term hits like the California wildfire situation, the housing market will continue to be the prime determinant for First American Financial's results. As long as housing performs well, First American Financial should be able to ride the wave of business toward further growth.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends First American Financial. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.