losses and LAE, including estimates for losses and LAE incurred during the period and changes in estimates from prior periods, less the portion of those insurance losses and LAE that we ceded to reinsurers;
commissions and other underwriting expenses, which consist of commissions we pay to agents and brokers, premium taxes and Company expenses related to the production and underwriting of insurance policies, less ceding commissions that we receive under our reinsurance contracts;
The following table shows the gross and ceded written and earned premium for the twelve months ended December 31, 2006 and 2005.
Bornhuetter-Ferguson paid development methods are a combination of paid development methods and expected loss ratio methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate losses. Expected loss ratio methods are useful for estimating ultimate losses or DCC when little or no paid or incurred loss or DCC information is available. Bornhuetter-Ferguson paid development methods give partial credibility to the actual loss or DCC experience to date. These methods assume that only future losses or DCC will develop at the expected loss ratio level. The percent of paid loss or DCC to ultimate loss or DCC implied from the paid development method is used to determine what percentage of ultimate loss or DCC is yet to be paid. The estimate of losses or DCC yet to be paid is added to current paid losses or DCC to estimate the ultimate loss or DCC for each quarter. The use of the pattern from the paid development method requires consideration of all factors considered for the paid development method. The use of the expected loss ratio method requires analysis of loss ratios from earlier accident quarters or pricing studies and analysis of inflationary trends, frequency trends, rate changes, underwriting changes, and other applicable factors. These methods will react very slowly if actual ultimate loss ratios are different from expectations due to changes not accounted for by the expected loss ratio calculation. We typically apply Bornhuetter-Ferguson paid development methods to estimate paid pure losses, salvage and subrogation recoveries, and paid DCC.
Since loss and LAE reserves are estimates of the remaining amounts that we expect to pay for losses that have occurred and for claim settlement expenses, the establishment of such reserves is an inherently uncertain and complex process. Our goal is to apply actuarial estimation methodologies so that total reserves for losses and LAE reflect our best estimate of our liability for losses and LAE. A key objective of our actuarial staff in developing best estimates of ultimate loss and ultimate LAE, and resulting reserves, is to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them so that they can project future claim activity more reliably. Our actuarial staff regularly refines the detailed mathematical models they use to apply actuarial estimation methodologies so that they incorporate into their analyses changes in underlying assumptions. For purposes of estimating our loss and LAE reserves, we assume that there is consistency or a discernable trend in the following:
Loss and LAE Development Analysis. We determined that our historical loss and LAE reserve development provides the most reasonable indication of the potential variability associated with our reserves. Accordingly, we have included below a sensitivity analysis of our loss and LAE reserve estimates based on our historical reserve development. There can be no assurance that actual future loss and LAE development variability will be consistent with any potential variation indicated by our historical loss and LAE development experience. Management does not currently use such an analysis in establishing loss and LAE reserves.
Associated Risk Factors. As noted above under the heading entitled “Item 1A. - Risk Factors - Our losses and loss adjustment expenses may exceed our loss and loss adjustment expense reserves, which could adversely impact our results of operation, financial condition and cash flows,” our loss and LAE reserves represent our best estimate of the amounts that we will ultimately pay on claims and the related costs of adjusting those claims as of the date of our financial statements. We rely heavily on our historical loss and LAE experience in determining these reserves. The historic development of these reserves may not necessarily reflect future trends in the development of these amounts. In addition, internal and external factors, such as inflation, claims settlement patterns, regulatory activities, legislative activities, and litigation trends, may also affect these reserves. As a result of these and other risks and uncertainties, ultimate losses and LAE may deviate, perhaps substantially, from our estimates included in the loss and LAE reserves in our financial statements. If actual losses and LAE exceed our expectations, our net income and our capital would decrease. Actual paid losses and LAE may be in excess of the reserve estimates reflected in our financial statements.