Significant developments and events in 2004 reflect our continued efforts to redeploy capital effectively to seek enhanced returns. These developments included:
Realized investment gains (losses), net, and related charges and adjustments for the Financial Services Businesses in 2004 included impairments and credit-related losses of $143 million, down from $404 million in 2003.
The future policy benefit reserves for the traditional participating life insurance products of our Closed Block Business, which as of December 31, 2004, represented 48% of our total future policy benefit reserves, are determined using the net level premium method as prescribed by GAAP. In applying this method, we use mortality assumptions to determine our expected future benefits and expected future premiums, and apply an interest rate to determine the present value of both the expected future benefit payments and the expected future premiums. The mortality assumptions we used were based on data from the standard industry experience studies that were used to determine the cash surrender value of the policies and the interest rates used are the contractually guaranteed interest rates used to calculate the cash surrender value of the policy. Gains or losses in our results of operations for each period resulting from deviations in actual experience compared to the experience assumed in establishing our reserves for this business are included in the determination of our annual dividends to these policyholders. Given our current level of policy dividends, we do not anticipate significant volatility in our results of operations in future periods as a result of these deviations.
For a discussion of DAC adjustments related to our individual annuities business for the years ended December 31, 2004, 2003 and 2002, see “-Results of Operations for Financial Services Businesses by Segment-Insurance Division-Individual Life and Annuities.”
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service and other taxing jurisdictions for audits ongoing or not yet commenced. We anticipate that the Internal Revenue Service will complete its examination of 1997 through 2001 during the first half of 2005. Although the results of these audits are not final, based on currently available information, we believe that the outcome will not have an adverse effect on our financial position, cash flows or results of operations.
2003 to 2002 Annual Comparison. The Financial Advisory segment reported a loss, on an adjusted operating income basis, of $111 million in 2003, as discussed above.
Adjusted operating income from the segment’s original defined contribution business increased $53 million, from a loss of $1 million in 2003 to income of $52 million in 2004, primarily reflecting lower crediting rates on general account liabilities and higher asset management and service fees from a larger base of customer account values. Adjusted operating income from the segment’s original guaranteed products business decreased $39 million, from $193 million in 2003 to $154 million in 2004, primarily due to the benefit in the prior year from investment market value changes.
Benefits and expenses exclude related charges that represent the element of “Dividends to policyholders” that is based on a portion of certain realized investment gains required to be paid to policyholders. For a discussion of these items see “-Realized Investment Gains and General Account Investments-Realized Investment Gains.”
2003 to 2002 Annual Comparison. Gibraltar Life’s adjusted operating income decreased $8 million, from $378 million in 2002 to $370 million in 2003, including a $22 million negative impact of currency fluctuations. Excluding the impact of currency fluctuations, adjusted operating income of Gibraltar Life increased $14 million in 2003 from 2002. This increase reflected improved investment results in 2003 and the negative impact in 2002 of refinements in estimates, primarily related to amounts due to policyholders. This increase was partially offset by a reduction in the amount of Gibraltar Life’s business in force as expected during the period following its restructuring and a less favorable level of policy benefits and expenses in 2003 than the prior year.
2004 to 2003 Annual Comparison. On a constant exchange rate basis, new annualized premiums declined $17 million from $962 million in 2003 to $945 million in 2004. On the same basis, new annualized premiums from our Japanese insurance operation other than Gibraltar Life increased $28 million, reflecting an increase in the number of Life Planners. Sales in all other countries, also on a constant exchange rate basis, declined $2 million, primarily reflecting a decline in sales in Korea resulting from the appointment of Life Planners to sales management positions in newly opened agencies as well as weakness in economic conditions in that country. New annualized premiums from our Gibraltar Life operation declined $43 million, on a constant exchange rate basis, from 2003 to 2004 as sales results in the prior year benefited $97 million from the sales of single premium insurance contracts for which the current year benefited $41 million. Sales of our single premium insurance contracts declined due to a reduction in guaranteed rates in the latter half of 2003. Sales other than single premium insurance contracts increased 6%.
2003 to 2002 Annual Comparison. The segment reported a loss, on an adjusted operating income basis, of $10 million in 2003 compared to a break-even result in 2002, as 2003 results included a charge of $34 million to write off a receivable related to an investment in Korea. This charge was partially offset by the benefit from recently acquired units and higher earnings from our existing businesses.
Adjusted operating income of our real estate and relocation services increased by $17 million, from $46 million in 2002 to $63 million in 2003, which benefited from decreased expenses in the 2003 period.
2004 to 2003 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $249 million, from $7.982 billion in 2003 to $8.231 billion in 2004. Net realized investment gains increased $289 million, from $426 million in 2003 to $715 million in 2004. Premiums decreased $84 million, from $3.860 billion in 2003 to $3.776 billion in 2004. We expect the decline in premiums for this business to continue as the policies in force mature or terminate in the Closed Block.
As part of the acquisition of CIGNA’s retirement business, we entered into reinsurance agreements with CIGNA, including a modified-coinsurance-with-assumption arrangement that applies to the defined-benefit guaranteed-cost contracts acquired. The net results of these contracts are recorded in “Commissions and other income,” as a result of the reinsurance arrangement, and such net results include realized investment gains and losses. Adjustments to “Realized investment gains (losses), net” include the adjustment necessary to exclude these realized investment gains and losses from adjusted operating income.
During 2003, we recorded total other than temporary impairments of $382 million attributable to the Financial Services Businesses, compared to total other than temporary impairments of $585 million attributable
The gross unrealized losses related to our fixed maturity portfolio attributable to the Closed Block Business were $0.1 billion as of December 31, 2004, compared to $0.1 billion as of December 31, 2003. The gross unrealized losses as of December 31, were concentrated primarily in the manufacturing, finance and utilities sectors, while gross unrealized losses as of December 31, 2003 were concentrated primarily in the manufacturing, U.S. Government and utilities sectors.
Includes $38 million of gross unrealized gains and $21 gross unrealized losses as of December 31, 2004, compared to $41 million of gross unrealized gains and $25 million of gross unrealized losses as of December 31, 2003 on securities classified as held to maturity that are not reflected in other comprehensive income.
Includes $1 gross unrealized gains and zero gross unrealized losses as of December 31, 2004, compared to $1 million of gross unrealized gains and $1 million of gross unrealized losses as of December 31, 2003 on securities classified as held to maturity that are not reflected in other comprehensive income.
Certain products included in the retirement business we acquired from CIGNA, as well as certain products included in the International Insurance segment, are experience-rated, meaning that the investment results associated with these products will ultimately inure to contractholders. The investments supporting these experience-rated products are classified as trading. These trading investments are reflected on the balance sheet as “Trading account assets supporting insurance liabilities, at fair value.” All investment results, which include realized and unrealized gains and losses, as well as net investment income, for these investments are reported in “Commissions and other income.” Investment results on these assets will ultimately inure to contractholders. The following table sets forth the composition of our “trading account assets supporting insurance liabilities” portfolio as of the dates indicated.
In the years 2005 and 2009, a special dividend to certain Gibraltar Life policyholders will be payable based on 67% of net realized investment gains, if any, over the value of real estate and loans, net of transaction costs and taxes, included in the Reorganization Plan. As of December 31, 2004, a liability of $975 million is included in “Policyholders’ dividends” to cover the special dividend. The special dividend will take the form of either additional policy values or cash. We expect that the 2005 installment will be approximately $670 million, based upon realized investment gains as of December 31, 2004, and will be mostly in the form of additional policy values. Gibraltar’s investment portfolio is structured to provide adequate liquidity for the special dividend.
To enhance financial flexibility, Prudential Financial filed a $5 billion shelf registration statement, effective April 25, 2003, with the Securities and Exchange Commission, which permits the issuance of public debt, equity and hybrid securities. The total principal amount of debt outstanding under this shelf program as of December 31, 2004 was $4.2 billion.
The total principal amount of debt outstanding under Prudential Financial’s domestic medium-term note and senior note programs as of December 31, 2004 and December 31, 2003 was $3.7 billion and $1.5 billion, respectively. The weighted average interest rates on Prudential Financial’s long-term debt, including the effect of interest rate hedging activity, were 4.20% and 3.76% for the years ended December 31, 2004 and 2003, respectively.
On December 18, 2001 (the “date of demutualization”), the Prudential Insurance Company of America (“Prudential Insurance”) converted from a mutual life insurance company to a stock life insurance company and became an indirect, wholly owned subsidiary of Prudential Financial. At the time of demutualization Prudential Financial issued two classes of common stock both of which remain outstanding. The Common Stock, which is publicly traded, reflects the performance of the Financial Services Businesses and the Class B Stock, which was issued through a private placement, reflects the performance of the Closed Block Business.
Cash and cash equivalents include cash on hand, amounts due from banks, money market instruments and other debt instruments with maturities of three months or less when purchased.
The following table presents an allocation of the purchase price to assets acquired and liabilities assumed:
On July 1, 2003, the Company completed the combination of its retail securities brokerage and clearing operations with those of Wachovia Corporation (“Wachovia”) to form a joint venture, Wachovia Securities. The Company has a 38% ownership interest in the joint venture, while Wachovia owns the remaining 62%. The transaction included certain assets and liabilities of the Company’s securities brokerage operations but did not include its equity sales, trading and research operations. As part of the transaction, the Company retained certain assets and liabilities related to the contributed businesses, including liabilities for certain litigation and regulatory matters. The Company and Wachovia have each agreed to indemnify the other for certain losses, including losses resulting from litigation and regulatory matters relating to certain events arising from the operations of their respective contributed businesses prior to March 31, 2004. The Company accounts for its 38% ownership of the joint venture under the equity method of accounting; periods prior to July 1, 2003, continue to reflect the results of the Company’s previously wholly owned securities brokerage operations on a fully consolidated basis.
Non-performing commercial loans with no allowance for losses are loans in which the fair value of the collateral or the net present value of the loans’ expected future cash flows equals or exceeds the recorded
At December 31, 2004, gross unrealized losses on equity securities were $82 million, compared to $89 million at December 31, 2003. At December 31, 2004, $18 million of the gross unrealized losses represented declines of greater than 20%, substantially all of which had been in that position for less than six months. At December 31, 2003, $8 million of the gross unrealized losses represented declines of greater than 20%, substantially all of which had been in that position for less than six months. In accordance with its policy described in Note 2, the Company concluded that an adjustment for other than temporary impairments for these securities was not warranted at December 31, 2004 or 2003.
6. VALUATION OF BUSINESS ACQUIRED AND GOODWILL AND OTHER INTANGIBLES (continued)
adoption of SOP 03-1, primarily due to the change in the liability for the MVA feature associated with the American Skandia business, since the expected cash flows on this business in force at the time of acquisition that corresponded to obligations covered by SOP 03-1 were considered in establishing the initial VOBA.
Assets under set-off arrangements represent a reduction in the amount of fixed rate notes included in long-term debt, relating to an arrangement where valid rights of set-off exist and it is the intent of both parties to settle on a net basis under legally enforceable arrangements.
On January 12, 2004, the FASB issued FSP 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003.” As permitted by FSP 106-1, the Company elected to defer the accounting for the effects of the Act in 2003.
On May 19, 2004, the FASB issued FSP 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003.” In accordance with FSP 106-2, the Company remeasured its plan assets and Accumulated Postretirement Benefit Obligation (“APBO”) as of January 1, 2004 to account for the subsidy and other effects of the Act. This remeasurement resulted in a $39 million reduction in postretirement benefit costs in 2004. The $39 million reduction in postretirement benefit costs reflects $33 million as a result of the subsidy and is comprised of a $18 million reduction in the amortization of actuarial loss, a $15 million reduction in interest costs, and a $0 million reduction in service cost. The reduction in the APBO for the subsidy related to past service was $337 million.
The increase in the minimum liability included in “Accumulated other comprehensive income” as of September 30, 2004 and September 30, 2003 is as follows:
The assumptions as of September 30, used by the Company to calculate the domestic benefit obligations as of that date and to determine the benefit cost in the year are as follows:
On October 22, 2004, the American Jobs Creation Act (“the AJCA”) was signed into law. The AJCA includes a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The Company may elect to apply this provision to qualifying earning repatriations during 2005. The Company has started an evaluation of the effects of the repatriation provision; however, the Company does not expect to be able to substantially complete any aspect of this evaluation earlier than the second quarter of 2005 and the evaluation of the effects of the repatriation provision will likely be assessed throughout 2005. The maximum allowable amount to be considered for repatriation under the laws applicable to the Company is $2.24 billion (which is the amount of unrepatriated earnings as disclosed in the Company’s 2002 financial statements); however, the Company is unable to reasonably estimate what portion, if any, of this amount the Company may repatriate. Similarly, the Company is unable to reasonably estimate the related potential range of income tax benefit or expense.
The excluded items are important to an understanding of overall results of operations. Adjusted operating income is not a substitute for net income determined in accordance with GAAP, and the Company’s definition of adjusted operating income may differ from that used by other companies. However, the Company believes that the presentation of adjusted operating income as measured for management purposes enhances the understanding of results of operations by highlighting the results from ongoing operations and the underlying profitability factors of the Financial Services Businesses.