Ceded premiums: Premiums ceded as a percentage of gross premiums written was 45.2%, 48.9% and 47.8% in 2006, 2005 and 2004, respectively. The increase in the percentage of premiums ceded in 2005 was largely due to higher reinstatement premiums following our utilization of reinsurance protections on Hurricanes Katrina, Rita and Wilma. The 2006 ratio was also impacted by business mix; a higher percentage of earned premiums were derived from our errors and omissions book which has a low ceding percentage.
The increase in underwriting income in 2006 reflects an absence of major catastrophe losses compared to 2005 and 2004. The book of business underlying our results has grown considerably in the last three years reflecting our geographic and product expansion.
Liquidity is a measure of a Company’s ability to generate sufficient cash flows to meet short-term and long-term cash requirements. Our liquidity requirements have been primarily met by funds generated from operations, routine sales of investments and financing arrangements (see capital resources section below). The cash provided from these sources is primarily used to pay loss and loss expenses and other operating costs. Our diversified portfolio and risk management has demonstrated our ability to withstand extraordinary losses as was the case in 2005. To further ensure the sufficiency of funds we hold a certain amount of invested assets in cash and short term investments and other readily marketable securities. At December 31, 2006 this balance was $8,459.8 million. Although the timing and amount of catastrophe claim payments are inherently unpredictable, we anticipate that our cash flows from the above sources will continue to be sufficient to meet our future liquidity needs, including our contractual obligations, detailed below.
Operating cash flows: Our cash flows from operations generally represent the difference between: (1) premiums collected, reinsurance recoveries and investment income received and (2) losses and loss expenses paid, reinsurance purchased and underwriting and other expenses paid. Cash inflows from operations have been consistent during the last three years despite substantial variations in our levels of net income. We generated net operating cash inflows of $1,613.3 million, $1,582.9 million and $1,600.0 million in 2006, 2005 and 2004 respectively, compared to net income of $963.1 million, $94.4 million and $495.0 million, respectively. The difference between net income and net cash inflow in each of the last three years is primarily due to increases in our net loss reserves, net of paid losses and recoveries.
Loss reserving for catastrophe events in our insurance and reinsurance businesses is an inherently uncertain process. When a catastrophe occurs, we review our exposures to determine which exposures will be impacted by the event. We contact brokers and clients to determine their estimate of involvement and the extent to which their programs are affected. We may also use computer modeling to estimate loss exposures under the actual event scenario. We currently use Risklink version 6.0 licensed by RMS, Classic/2 and CATRADER version 8.5 licensed by AIR and WORLDCAT Enterprise licensed by Eqecat. As part of the underwriting process, we obtain exposure data from our clients, so that when an event occurs we can run our models to produce an estimate of the losses incurred by clients on programs that we insure or reinsure. Typically, we derive our estimate for the losses from a catastrophic event by blending all of the sources of loss information available to us. This estimate is derived by the claims team and, where there are no reported case reserves, is known as “case IBNR”. For catastrophic events, there generally is considerable uncertainty underlying the assumptions and associated estimated reserves for losses and loss expenses. The potential also exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The anticipated effects on us are considered in our catastrophe loss models. The effects of inflation are also considered in pricing and in estimating reserves for unpaid claims and claim expenses. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled. Reserves are reviewed quarterly and as experience develops and additional information is known, the reserves are adjusted as necessary. Adjustments are reflected in the period in which they become known.
The following table illustrates the fair value sensitivity due to changes in life expectancy assumptions:
We have audited the accompanying consolidated balance sheets of AXIS Capital Holdings Limited and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
AXIS Capital Holdings Limited (“AXIS Capital”) is the Bermuda-based holding company for the AXIS group of companies, collectively “the Company”. AXIS Capital was incorporated on December 9, 2002, under the laws of Bermuda. Through its subsidiaries organized in Bermuda, Ireland and the United States, AXIS Capital provides a broad range of insurance and reinsurance products on a worldwide basis under two distinct global underwriting platforms, AXIS Insurance and AXIS Re.
Applying these loss and loss expense ratios to earned premium derives the estimated baseline ultimate costs of the losses from which paid losses and reported case reserves are deducted to generate baseline IBNR. The actuarial methodologies used to derive the baseline estimate can not fully allow for all uncertainties within the Company’s business. To reduce some of these uncertainties, management performs in conjunction with the independent actuaries an analysis of additional factors to be considered when establishing IBNR. These uncertainties may vary over time, but generally contemplate matters such as the timing and emergence of claims or short term market trends that might alter the Company’s otherwise consistent baseline approach. A combination of the baseline estimate of IBNR and the reserves for the additional uncertainties constitutes management’s and the actuaries’ best estimate of IBNR.
The following tables summarize the underwriting results, income before income taxes and ratios for the Company’s reportable operating segments and sub-segments:
During 2006, the Company purchased reinsurance coverage for its U.S. insurance property line of business. The minimum reinsurance premiums are contractually due on a quarterly basis in advance. Accordingly, at December 31, 2006, the Company has an outstanding reinsurance purchase commitment of $47.1 million (2005: nil).
The following is a summary of stock options granted under the LTEC and related activity:
The unaudited statutory capital and surplus, for the principal operating subsidiaries of the Company at December 31, 2006 was as follows. The comparative figures at December 31, 2005 are the combined audited figures submitted to the regulators.
The Company’s U.S. operations required statutory capital and surplus is determined using risk based capital tests, which is the threshold that constitutes the authorized control level. If a company falls below the control level, the commissioner is authorized to take whatever regulatory actions considered necessary to protect policyholders and creditors. The maximum dividends that may be paid by the Company’s U.S. insurance operations are restricted by the regulatory requirements of the domiciliary states. Generally, the maximum dividend that may be paid by each of the Company’s U.S. insurance entities without prior