story office wing, fully occupied, and a newly completed 130,000 square foot, four-story wing, the first floor of which was partially occupied during the fourth quarter of 1998. With the new addition, the Company's headquarters building will be able to accommodate a total of approximately 1,200 employees, which the Company believes to be sufficient for the foreseeable future.
In addition, the Company leases office space for ERNV in London and Rotterdam, and for ERMA's satellite domestic operations in Atlanta, Chicago, Dallas, Houston, Lisle, New York, Pasadena, Phoenix and San Francisco. The domestic branch offices are generally between 2,000 and 3,000 square feet and are intended for only a small number of employees, except for Pasadena, where the leased premises are 15,700 square feet and provide adequate office space for approximately 40 employees. With the discontinuance of the brokerage operations of Sullivan Kelly in the third quarter of 1998, the Company is currently seeking to sublet approximately one-half of the Pasadena office space. The operations of the Company are supported by local area networks of personal computers. The local networks are interconnected via telecommunications and provide services such as electronic mail, desktop faxing, real-time data communications and batch file transfers.
The following discussion should be read in conjunction with the Consolidated Financial Statements of the Company and related notes thereto.
Gross premiums written increased by $84.9 million, or 20%, to $516.3 million in 1998 from $431.4 million in 1997. The increase was due to growth in sales in most of the Company's lines of business, including lawyers
professional liability, miscellaneous professional liability errors and omissions insurance ("E&O") and medical malpractice insurance. These increases were partially offset by a decrease in domestic and international directors and officers liability insurance ("D&O"). The level of D&O gross premiums written has been adversely affected both by continued strong competition in the D&O market and by conservative underwriting of D&O applicants that appear to the Company to present relatively greater exposure to the Year 2000 issue. These factors are likely to affect the level of D&O writings over the next few years.
As a result of the foregoing, net premiums written increased $21.8 million, or 8%, to $283.7 million in 1998 from $261.9 million in 1997. Over the same periods, net premiums earned increased to $254.5 million from $211.2 million.
As a result of the factors described above, net income increased $6.9 million, or 19%, to $43.4 million, or $3.71 per diluted share, in 1998 from $36.5 million, or $3.41 per diluted share, in 1997. The Company's operating earnings, calculated as net income before $5.8 million of one-time expenses associated with the discontinuance of the brokerage operations of Sullivan Kelly and the closing of the Paris office of ERNV and realized capital gains or losses, all net of tax, increased $8.1 million, or 23%, to $42.9 million, or $3.66 per diluted share, in 1998 from $34.8 million, or $3.25 per diluted share, in 1997.
Gross premiums written increased by $99.3 million, or 30%, to $431.4 million in 1997 from $332.1 million in 1996. The increase was due to growth in sales in all of the Company's existing lines of business, including D&O liability insurance and lawyers professional liability and miscellaneous E&O insurance.
Ceded premiums increased $47.8 million, or 39%, to $169.5 million in 1997 from $121.7 million in 1996. The rate of growth in ceded premiums exceeded that of gross premiums written due to increased cessions on E&O and certain D&O products partially offset by a reduction in direct D&O cessions to Travelers Property Casualty Corporation ("Travelers") (formerly known as Travelers/Aetna Property Casualty Company). In connection with the acquisition of The Aetna Casualty & Surety Company ("Aetna") by The Travelers Insurance Group Inc., all reinsurance treaties previously with Aetna were assumed by Travelers. Pursuant to a restructuring of the Company's relationship with Travelers entered into on February 13, 1997 and effective January 1, 1997, Travelers is no longer a 12.5% quota share reinsurer of the Company's direct D&O business.
Net investment income increased by $14.5 million, or 44%, to $47.1 million in 1997 from $32.6 million in 1996. The increase resulted principally from growth in the Company's investment portfolio, measured on an amortized cost basis, from $663.1 million at December 31, 1996 to $1.0 billion at December 31, 1997. The Company's equity investment balances were $61.7 million and $37.7 million at December 31, 1997 and 1996,
respectively, and the cash and short-term investment balances were $88.5 million and $24.7 million, respectively, on the same dates.
As a result of the factors described above, net income increased $8.4 million, or 30%, to $36.5 million, or $3.41 per diluted share, in 1997 from $28.1 million, or $2.67 per diluted share, in 1996. The Company's operating earnings, calculated as net income before $0.3 million of one-time expenses associated with the acquisition of the assets of Sullivan, Kelly & Associates, Inc., Insurance Brokers and realized capital gains or losses, all net of tax, increased $7.4 million, or 27%, to $34.8 million, or $3.25 per diluted share, in 1997 from $27.4 million, or $2.61 per diluted share, in 1996.
Cash flows from operating activities were $157.9 million, $181.0 million, and $169.5 million for 1998, 1997 and 1996, respectively. The decrease in cash flows in 1998 resulted principally from increased loss payments in 1998 partially offset by increased net premiums received and investment income received. Rising loss payments are expected of a maturing professional liability underwriter.
Holders of the Capital Securities are entitled to receive cumulative cash distributions, accumulating from the date of original issuance and payable semi-annually in arrears on February 1 and August 1 of each year at an annual rate of 8.675%. Interest on the Debentures, and hence distributions on the Capital Securities, may be deferred by the Company to the extent set forth in the applicable instrument. The Capital Securities are subject to mandatory redemption on February 1, 2027, upon repayment of the Series B Debentures, at a redemption price equal to the principal amount of, plus accrued but unpaid interest on, the Series B Debentures. The Capital Securities are also subject to mandatory redemption in certain other specified circumstances at a redemption price that may or may not include a make-whole premium. The Company's obligations under the Series B Debentures, the related indenture and trust agreement and the guarantee issued for the benefit of the holders of the Capital Securities, taken together, constitute a full, irrevocable and unconditional guarantee by the Company of the Capital Securities.
On September 12, 1997, the Company completed an underwritten public offering of 1,000,000 shares of its Common Stock at $62.25 per share less underwriting discounts and commissions of $3.05 per share. In connection with this secondary offering, the Company granted to the underwriters an option to purchase an additional 150,000 shares of its Common Stock to cover over-allotments. Such over-allotment option was exercised in full. The Company received $67.8 million in net proceeds which have been used to make surplus contributions to ERII and Executive Risk (Bermuda) Ltd. in order to support existing business lines and to finance entry into new business lines, and for general corporate purposes.
Operating results in 1998 included some expense (less than $1.5 million) directly or indirectly related to Y2K readiness. Based on the progress of the Company's Y2K project to date, it is not currently anticipated that there will be a material impact on operating expense related to Y2K during 1999, nor will the completion of Y2K efforts result in a meaningful reduction in expense levels in 1999 or future years.
Delaware, the state of domicile of ERII, and Connecticut, the state of domicile of ERSIC and Quadrant, impose minimum risk-based capital requirements on all insurance companies that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the insurance company's regulatory total adjusted capital to its authorized control level risk-based capital, both as defined by the NAIC. At December 31, 1998, the total adjusted capital (as defined by the NAIC) of ERII, ERSIC and Quadrant was in excess of the risk-based capital standards.
The following consolidated financial statements of Executive Risk Inc. and its subsidiaries, included on pages et seq. of this Report on Form 10-K:
-- Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996.