In 2006, we wrote 73.5% and 19.4% of our direct premiums written in California and Nevada, respectively. We also write business in seven other states (Arizona, Colorado, Montana, Idaho, Illinois, Texas and Utah) and are licensed to write business in eight additional states (Florida, Georgia, Maryland, Massachusetts, New Mexico, New York, Oregon and Pennsylvania). We market and sell our workers’ compensation insurance products through independent local and regional agents and brokers, and through our strategic distribution partners, including our principal strategic distribution partners, ADP and Wellpoint. In 2006, we wrote $114.9 million, or 28.6%, of our gross premiums written through ADP and Wellpoint. We entered Illinois in the fourth quarter of 2006 and we intend to enter Florida and Oregon in the second quarter of 2007.
• the cost of claims that have not yet been reported to us.
Each of the methods listed above requires the selection and application of parameters and assumptions. The key parameters and assumptions are: the pattern with which our aggregate claims data will be paid or will emerge over time; claims cost inflation rates; and trends in the frequency of claims, both overall and by severity of claim. Of these, we believe the most important are the pattern with which our aggregate claims data will be paid or emerge over time and claims cost inflation rates. Each of these key items is discussed in the following paragraphs.
At December 31, 2005, management’s best estimate of unpaid losses and LAE was $1,208.5 million, which was $84.3 million above the consulting actuary’s point estimate. In establishing its best estimate at December 31, 2005, management considered (i) the consulting actuary’s assumptions, point estimate and range, (ii) the inherent uncertainty of workers’ compensation unpaid losses and LAE liabilities, and (iii) the particular uncertainties associated with (a) the potential effects on the cost and payout pattern of claims following workers’ compensation system reforms enacted by the California legislature in late 2003 and the future regulatory implementation of those reforms, the effects of which will become clear over a number of years, but which our initial experience indicated were emerging favorably, (b) the uncertain cost of administering claims (LAE) in the reformed California system, (c) the potential for legislative and/or judicial reversal of the California reforms, (d) the rapid growth in the volume of our business in California, (e) the limited but growing historical experience of ECIC to use as a base for projecting future loss development, (f) the degree of movement observed in EICN’s prior years’ projections of losses and LAE in Nevada following continued premium and market share reductions, (g) recent changes in EICN’s claim department processes, controls and management, (h) the legislative adoption of future cost-of-living increases on permanent total disability payments on injuries occurring January 1, 2004 and after in Nevada, and (i) the degree to which our reinsurance protection will absorb our unanticipated development on years subject to the LPT Agreement and on large claims in excess of our current reinsurance retention. Management did not quantify a specific loss reserve increment for each of these sources of uncertainty, but rather established an overall provision for unpaid losses and LAE that, in management’s opinion, represented a best estimate of unpaid losses and LAE at December 31, 2005 in light of the historical data, the consulting actuary’s assumptions, point estimate and range, current facts and circumstances, and the sources of uncertainty identified by management. Management’s best estimate of unpaid losses and LAE at December 31, 2005 fell within the consulting actuary’s range of estimates. The decrease in management’s best estimate relative to the consulting actuary’s point estimate from December 31, 2004 to December 31, 2005 decreased losses and LAE expense incurred by $5.4 million for the year ended December 31, 2005.
Estimates of incurred losses and LAE attributable to insured events of prior years decreased due to continued favorable development in such prior accident years (actual losses and LAE paid and current projections of unpaid losses and LAE were less than we originally anticipated). The reduction in the liability for unpaid losses and LAE was $37.6 million, $78.1 million and $107.1 million for the years ended December 31, 2004, 2005 and 2006, respectively.
Underwriting and Other Operating Expense Ratio. The underwriting and other operating expense ratio increased by 6.3 percentage points, to 22.3%, for the year ended December 31, 2006 from 16.0% for the year ended December 31, 2005. The underwriting and other operating expense ratio increase was primarily due to an increase in costs discussed above ‘‘-Underwriting and other operating expense’’ and the impact of premium rate declines in California.
Net Premiums Written. Net premiums written increased $21.8 million, or 5.2%, to $439.7 million in 2005 from $417.9 million in 2004. The net premiums written increase was primarily attributable to the increase in gross premiums written. Ceded premiums for the year ended December 31, 2005 totaled $19.0 million, or 4.1%, of gross premiums written as compared to $19.8 million, or 4.5%, of gross premiums written for the year ended December 31, 2004.
Income Taxes. Income taxes increased $19.4 million, or 176.1%, to $30.4 million in 2005 from $11.0 million in 2004. The income taxes increase was primarily to due to an increase in pre-tax net income of $61.4 million for the year ended December 31, 2005.
Net Premiums Written. Net premiums written increased $120.3 million, or 40.4%, to $417.9 million in 2004 from $297.6 million in 2003. The increase was primarily attributable to growth in gross premiums written of $100.6 million. Net premiums written were also affected by a decrease in the amount of premiums ceded under reinsurance agreements. Ceded premiums for the year ended December 31, 2004 totaled $19.8 million, or 4.5% of gross premiums written, as compared to $39.4 million, or 11.7% of gross premiums written, for the year ended December 31, 2003. Ceded premiums in 2003 consisted primarily of the $32.8 million ceded to NICO under the novation agreement entered into with Gerling in accordance with the provisions of the LPT Agreement which require the replacement of Gerling as a reinsurer thereunder because its A.M. Best rating had dropped below ‘‘A−.’’
Consolidated Statements of Income for each of the three years ended December 31, 2006
Deferred Policy Acquisition Costs: Policy acquisition costs, consisting of commissions, premium taxes and certain other underwriting costs that vary with, and are primarily related to, the production of new or renewal business, are deferred and amortized as the related premiums are earned.
Unpaid Losses and Loss Adjustment Expense (LAE) Reserves: Losses and LAE reserves represent management’s best estimate of the ultimate net cost of all reported and unreported losses incurred for the applicable periods. The estimated reserves for losses and LAE include the accumulation of estimates for losses and claims reported prior to the balance sheet date, estimates (based on projections of relevant historical data) of claims incurred but not reported, and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. Amounts reported are necessarily subject to the impact of future changes in economic, regulatory and social conditions. Management believes that, subject to the inherent variability in any such estimate, the reserves are within a reasonable and acceptable range of adequacy. Estimates for losses and claims reported prior to the balance sheet date are continually monitored and reviewed, and as settlements are made or reserves adjusted, the differences are reported in current operations. Salvage and subrogation recoveries are estimated based on a review of the level of historical salvage and subrogation recoveries.
such losses on current operations and the equity of the Company. Reinsurance makes the assuming reinsurer liable to the ceding company to the extent of the reinsurance. It does not, however, discharge the Company from its primary liability to its policyholders in the event the reinsurer is unable to meet its obligations under its reinsurance agreement with the Company.