Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Net income decreased 28.2% to $28.0 million in 2006, compared to net income of $39.0 million in 2005. The net increase in income from higher earned premium net of the corresponding increase in insurance losses and loss adjustment expense was more than offset by higher operating expenses. These higher operating costs were largely associated with our expansions in Texas, Missouri, and Virginia, higher advertising and interest costs, and non-recurring litigation and merger related expenses. Additionally, while ancillary income declined, it was more than offset by an increase in investment income resulting from and the increase in average invested assets and higher yields. There was minimal impact of realized gains and losses on securities and other during 2006 and 2005.
Premiums written refers to the total amount of premiums billed to the policyholder less the amount of premiums returned, generally as a result of cancellations, during a given period. Premiums written become premiums earned as the policy ages. Barring premium rate changes, if an insurance company writes the same mix of business each year, premiums written and premiums earned will be equal, and the unearned premium reserve will remain constant. During periods of growth, the unearned premium reserve will increase, causing premiums earned to be less than premiums written. Conversely, during periods of decline, the unearned premium reserve will decrease, causing premiums earned to be greater than premiums written.
We have historically relied on quota share, excess of loss, and catastrophe reinsurance primarily to manage our regulatory capital requirements and also to limit our exposure to loss. Generally, we ceded a portion of our non-standard automobile insurance premiums to unaffiliated reinsurers in order to maintain a net premiums written to statutory surplus ratio of approximately 3 to 1. Over the past several years, the increasing capitalization of our insurance subsidiaries has enabled us to retain a higher percentage of our business and reduce our use of reinsurance. Our retention has been increasing each year and in 2006, we eliminated our use of quota share reinsurance entirely. We retain 100% of our term life insurance premiums. The following table presents our gross premiums written in our major markets and provides a summary of gross, ceded and net premiums written and earned for the periods indicated.
unrealized gains of $0.4 million and gross unrealized losses of $0.2 million. For the year ended December 31, 2004, “net realized (losses) gains on securities and other” included a net gain of $0.3 million related to the increase in the market value of open contracts.
Reserve Analysis. We perform an actuarial analysis of our loss reserves each quarter, which encompasses an analysis of expected ultimate frequency and severity by accident quarter for all coverages and states in which we operate. Our estimate of ultimate expected losses for the 2006 accident year included decreases in the expected ultimate frequency of claims for all coverages, ranging from a 3.4% improvement in bodily injury to a 6.9% projected improvement in PIP frequency as compared to the 2005 accident year. We believe these projected declines are supported by our growing renewal book of business, an increase in full-coverage business, which may be indicative of a more responsible driver, and, in the case of PIP, a significant reduction in the number of exposures in the Miami, Florida market. Our expected reduction in frequency for the 2006 accident year is also generally consistent with the current trends in the non-standard automobile insurance market. Partially offsetting the projected improved trends for frequency is a projected increase in claims severity. We estimate that average severity for property damage and physical damage claims will increase between 2.0% and 3.5%, while the average severity for bodily injury and PIP claims will increase between 0.5% and 1.5%.
Interest expense increased $3.7 million, due to a higher interest rate environment and the $41.2 million junior subordinated debentures that were issued late in the third quarter of 2005. Reinsurance commissions received by the Company, which are a component of our net SGA costs, decreased $4.7 million in 2006 due to the reduced level of premiums ceded to reinsurers. Non-recurring expenses relating to litigation settlements and accruals amounted to $2.7 million in 2006. Finally, non-recurring expenses related to the pending merger transaction with Elara Holdings, Inc., amounted to $1.8 million in 2006.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Operating expenses increased 24.5% to $141.9 million for the year ended December 31, 2005 from $114.0 million in 2004. The largest component of this increase related to ceded reinsurance commissions. The Company receives reinsurance commissions on the premiums ceded to its reinsurers, which represent the reinsurers reimbursement of underwriting expenses associated with the business they assume. These reinsurance commissions, which are included as a component of our net SGA costs, decreased to $6.9 million in 2005 from $15.4 million in 2004 as we continued to reduce the level of premiums ceded to reinsurers. Gross operating expenses, which exclude the effect of ceded reinsurance commissions, increased $19.4 million or 15.0% during 2005. Approximately $8.7 million of this increase was attributable to our expansion states, including approximately $6.3 million in Texas and approximately $2.4 million of costs related to our sales office development in Missouri and Virginia. The primary drivers of the remaining expense increases included a $2.8 million increase in interest expense, generally caused by the interest on the new junior subordinated debentures and the higher interest rate environment; a $2.2 million increase in advertising costs in our core states; a $1.0 million increase in professional fees, primarily legal fees, and an overall increase in general corporate expenses.
For the year ended December 31, 2005, we received net proceeds of $40.0 million from the issuance of the trust preferred securities. Repurchases of common stock totaled $40.1 million and the Company received $0.6 million from the exercise of employee stock options. During 2005, we had net proceeds under our premium finance revolving credit facility of $14.8 million and net proceeds of $1.4 million of principal associated with other notes and capital lease obligations. Interest paid on outstanding indebtedness totaled $8.5 million and dividends paid on common stock were $3.4 million for the year.
All of the debt securities in our portfolio were rated investment grade by the NAIC and S&P as of December 31, 2006. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or are rated non-investment grade. The quality distribution of our investment portfolio as of December 31, 2006 was as follows:
Also as discussed in Note 1 to the consolidated financial statements, effective January 1, 2006, Direct General Corporation and subsidiaries changed its accounting for stock-based compensation in connection with the adoption of Statement of Financial Standards No. 123R, “Share-Based Payments.”
The Company enters into various other credit agreements from time to time, primarily to finance the purchase of computer equipment and other assets. As of December 31, 2006, the Company has three credit agreements bearing interest at rates ranging from 4.50% to 4.60%. Principal and interest are payable monthly, with principal totaling $1,641,000 and $631,000 due in 2007 and 2008, respectively. Notes in the amount of $1,280,000 are secured by computer equipment.
In early 2007, we engaged in mediation with lead plaintiffs in a pending consolidated federal class action that resulted in a tentative oral settlement agreement. On March 2, 2007 the parties to the consolidated class action entered into a Memorandum of Understanding (“March 2nd MOU”) that sets forth a settlement in principle of this action. The stipulated settlement amount in the March 2nd MOU is $14.94 million, which is apportioned among the defendants, and the plaintiffs have agreed to dismiss with prejudice all claims against all defendants to the action. Neither we nor any other defendant in this action has admitted any liability or fault. The March 2nd MOU is subject to several conditions, including approval by the Federal District Court. In addition, the defendants may withdraw from the settlement, if a to be agreed upon percent of the class members opt out of the settlement. The parties will submit a written Stipulation of Settlement to the Federal District Court seeking preliminary approval of the settlement.