The fair values of our investment securities are determined by following the guidance and hierarchy in SFAS No. 157. If securities are traded in active markets, quoted prices are used to measure fair value (Level 1). If quoted prices are not available, prices are obtained from various independent pricing vendors based on pricing models that consider a variety of observable inputs (Level 2). Benchmark yields, prices for similar securities in active markets and quoted bid or ask prices are just a few of the observable inputs utilized. Prices determined by the model are then compared with prices provided by other pricing vendors and against prior prices to confirm that deviations are within tolerable limits. If the pricing vendors are unable to provide a current price for a security, a fair value is developed using alternative sources based on a variety of less objective assumptions and inputs (Level 3).
Prior to 2006, a portion of the policyholder premium ceded to the reinsurers under our primary professional liability reinsurance contract was “swing-rated,” or experience rated, on a retrospective basis. These swing-rated contracts were subject to a minimum and maximum premium range to be paid to the reinsurers depending upon the extent of losses ultimately paid by the reinsurers. Under these treaties, we paid a provisional premium during the initial policy year, and recorded a liability that represented our best estimate of the additional premium due under the treaty based on the reinsurers’ expected ultimate experience under the treaty. As this estimated liability for future premium payments relied upon our ceded reserve estimates to project the reinsurers’ anticipated ultimate experience under the treaty, changes in our actuarially estimated ceded loss and loss adjustment expense reserves would also have an impact on the estimated liability for additional premiums. At December 31, 2008, we had a liability of $12.0 million recorded for additional premiums under these swing-rated treaties. This represents the maximum amount of additional premiums that could be due under such treaties.
A determination must be made for deferred tax assets regarding whether it is more likely than not that sufficient taxable income will exist in future periods when deductible temporary differences are expected to reverse to enable the Company to realize the benefit of its deferred tax assets. If it is determined that it is more likely than not that sufficient taxable income will not exist, a valuation allowance must be recorded for the portion of deferred tax assets the Company likely will not realize. At December 31, 2008 and 2007 all deferred tax assets were deemed to be recoverable and no valuation allowance was recorded.
Underwriting Expense Ratio: This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and managing our underwriting operations. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business as more rigorous risk management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn improve our loss ratio, and overall profitability. The determination of which expenses should be classified as underwriting expenses can vary from company to company. Accordingly, comparability of underwriting expense ratios among and between various companies may be limited.
The decrease in incurred loss and loss adjustment expenses from 2006 to 2007 was primarily attributable to $34.2 million of favorable development on prior years’ loss reserves in 2007, compared with $12.9 million in 2006. In addition, the reduced exposure resulting from the decline in net premiums earned accounted for approximately $8.2 million of the overall $31.0 million decrease. The remaining $1.5 million of the decrease in incurred losses was the result of a 1.1% decrease in the current accident year loss ratio, which decreased in spite of the overall 7.8% premium rate decrease due to the adjustment of the historical loss experience for the significant favorable prior year development recognized in 2007.
Investment income decreased $1.7 million, or 3.9% in 2007 compared to 2006. The decrease in investment income in 2007 compared to 2006 was due to the same factors that caused the decrease in 2008 from 2007, principally decreasing short-term interest rates and the reinvestment of the proceeds from the maturity or call of higher-yielding corporate, government-sponsored agency and mortgage-backed securities in lower-yielding tax-exempt municipal bonds. Short-term rates did not start decreasing until late in the third quarter of 2007 and the turnover in our long-term bond portfolio was not as significant in 2007 as in 2008, so the impact of these items on 2007 investment income compared with 2006 was not as significant as the impact in 2008 compared to 2007. However, investment income in 2007 also suffered from a decrease in the undistributed earnings of equity method investees, which decreased from $0.8 million in 2006 to less than $0.1 million in 2007. The decrease in income attributable to equity method investees was the result of the sale of our investment in PIC-Florida in 2007 and the absence of gains from the sale of investment real estate property in our real estate LLC investment. The overall pre-tax yield on our cash and invested asset portfolio for 2007 was 5.00%, a decrease of 30 basis points when compared with a 5.30% yield for 2006. On a net-of-tax basis the overall yield for 2007 decreased only 12 basis points to 3.57% from 3.69% for 2006.
The overall increase in other expenses was the result of moderate increases in investment expenses due to increased software license fees, and interest expense as a result of a minor increase in the variable interest rate on our $30.9 million of outstanding debt obligations. General and administrative expenses increased $112,000, primarily as a result of fees and other expenses incurred in connection with the exploration of select merger and acquisition activities. True “other” expenses, which consist of costs related to exit activities, such as termination benefits for our workers’ compensation employees or changes in estimated cash flows relating to sub-leased office space in Chicago, Illinois, actually produced revenue of $48,000 in 2007. This was primarily the result of a reduction in future estimated variable costs associated with leased office space in Chicago, Illinois.
The decrease in premiums received was the result of the decreases in our direct premiums written primarily due to rate decreases as previously discussed. Loss and loss adjustment expense payments have also been steadily decreasing as our inventory of open claims has decreased over the last several years. Cash from investment income decreased in 2008 compared to 2007 primarily as a result of a decrease in short-term interest rates, as well as an increase in the allocation of our portfolio to tax-exempt securities, which had a lower coupon rate than the investment securities they replaced. Income taxes paid in 2008 were relatively consistent with 2007 as the benefit of minimum tax credits utilized in 2007 was mostly offset by lower taxable income in 2008. Taxes paid in 2006 were less than 2007 or 2008 due partially to lower taxable income and the utilization of our remaining 2003 net operating loss carryforwards. We experienced net positive cash flows related to our reinsurance program in 2007 for the first time in several years. This was primarily due to changes in our reinsurance treaty in 2007 that reduced our premium cessions. The increase in cash from reinsurance of $4.0 million in 2008 compared to 2007 was related to the commutation of our 2005 reinsurance treaty. At December 31, 2008 we had received approximately $4.8 million of the $8.6 million due from reinsurers as a result of the commutation. All other operating cash flow categories have remained relatively consistent and stable over the three year period ended December 31, 2008.
In evaluating our financial condition, three factors are the most critical: first, the availability of adequate statutory capital and surplus to satisfy state regulators and to support our current A.M. Best rating, which currently stands at A- (Excellent); second, the adequacy of our reserves for unpaid loss and loss adjustment expenses; and lastly the quality of assets our investment portfolio.
Level 2: Significant observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means.