I suppose it has something to do with fraud & First American not wanting to be on the hook for  someone who has been previously convicted/ jailed for fraud but that's the risk any company takes when they hire  freelance abstractors.

I expect that in-house people are vetted more closely.  Background checks for bankruptcy, along with criminal records are probably par for the course; but then the company has to cough up a real living wage & social security & possibly even some benefits.  With a freelancer all they have to pay for is the title.   

So they get what they get & I agree - their explanation is pretty lame and no explanation at all.   I'm also with you - I would decline to be involved.  It is too bad, though, that you're going to lose a client over this.  Possibly you could negotiate an exemption given that you've been doing their work for a long time & it would be interesting to know how many good people they will lose over this.