The Company earns revenues principally from insurance premiums, mortality and expense fees, asset administration fees from insurance and investment products, and from net investment income on the investment of general account and other funds. The Company earns premiums primarily from the sale of individual life insurance and annuity products. The Company earns mortality and expense fees, and asset administration fees, primarily from the sale and servicing of universal life insurance and separate account products including variable life insurance and variable annuities. The Company’s operating expenses principally consist of insurance benefits provided and reserves established for anticipated future insurance benefits, general business expenses, reinsurance premiums, commissions and other costs of selling and servicing the various products sold and interest credited on general account liabilities.
We capitalize costs that are directly related to the acquisition or renewal of insurance and annuity contracts. These costs primarily include commissions, as well as costs of policy issuance and underwriting and certain other expenses that are directly related to successfully negotiated contracts. We have also deferred costs associated with sales inducements offered in the past related to our variable and fixed annuity contracts. Sales inducements are amounts that are credited to the policyholders' account balances mainly as an inducement to purchase the contract. For additional information about sales inducements, see Note 6 to the Consolidated Financial Statements. We generally amortize DAC and deferred sales inducements ("DSI") over the expected lives of the contracts, based on our estimates of the level and timing of gross premiums or gross profits, depending on the type of contract. As described in more detail below, in calculating DAC and DSI amortization we are required to make assumptions about investment returns, mortality, persistency and other items that impact our estimates of the level and timing of gross profits or gross premiums. We also periodically evaluate the recoverability of our DAC and DSI. For certain contracts, this evaluation is performed as part of our premium deficiency testing, as discussed further below in “-Policyholder Liabilities”. As of December 31, 2017, DAC for our life products was $1.4 billion. There were no DAC and DSI balances as of December 31, 2017 for our annuity products due to a series of reinsurance transactions that the Company entered into on April 1, 2016 with PALAC and Prudential Insurance. See Note 1, Note 4 and Note 6 to the Consolidated Financial Statements for additional information.
The near-term future equity rate of return assumption used in evaluating DAC and other costs for our domestic variable annuity and variable life insurance products is derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider historical equity returns and adjust projected equity returns over an initial future period of five years (the “near-term”) so that equity returns converge to the long-term expected rate of return. If the near-term projected future rate of return is greater than our near-term maximum future rate of return of 15%, we use our maximum future rate of return. As of December 31, 2017, our variable annuities and variable life insurance businesses assume an 8.0% long-term equity expected rate of return and a 3.3% near-term mean reversion equity expected rate of return.
The weighted average rate of return assumptions consider many factors specific to each business, including asset durations, asset allocations and other factors. We generally update the near-term equity rates of return and our estimate of total gross profits each quarter to reflect the result of the reversion to the mean approach. We generally update the future interest rates used to project fixed income returns annually and in any quarter when interest rates vary significantly from these assumptions. As a result of our 2017 annual reviews and update of assumptions and other refinements, we reduced our long-term expectation of the 10-year U.S. Treasury rate by 25 basis points and now grade to 3.75% over ten years.
The reserves for future policy benefits of our individual life business relate to term life, universal life and variable life products. For term life contracts, the future policy benefit reserves are generally calculated using the net premium valuation methodology, as described above. The primary assumptions used in determining expected future benefits and expenses include mortality, lapse and maintenance expense assumptions. For variable and universal life products, which include universal life contracts that contain no lapse guarantees, reserves are established using current best estimate assumptions similar to the reserving methodology for GMDB and GMIB, as described above.
Includes GMDB/GMIB reserves, embedded derivative liabilities for certain living benefit guaranteed features and URR.
Represents the impact of a parallel shift in the long-term interest rate yield curve.
Total assets increased $16.8 billion, from $155.7 billion at December 31, 2016 to $172.5 billion at December 31, 2017. Significant components were:
Separate account assets increased $13.1 billion from $116.6 billion at December 31, 2016 to $129.7 billion at December 31, 2017, primarily driven by market appreciation partially offset by policy charges.
Reinsurance recoverables increased $3.9 billion from $28.7 billion at December 31, 2016 to $32.6 billion at December 31, 2017. The increase was primarily driven by universal life, term life and variable annuities business growth, the net impact of risks related to the no-lapse guarantees that were previously reinsured to Universal Prudential Arizona Reinsurance Company (“UPARC”) and the subsequent reinsurance of Universal Protector and Universal Life policies to Gibraltar Universal Life Reinsurance Company (“GUL Re”) as well as the impact from Hartford guaranteed universal life business ceded to Prudential Arizona Reinsurance Universal Company (“PAR U”).
Partially offsetting these increases in total assets were the following items:
Total Investments and Cash and cash equivalents decreased $0.5 billion from $8.5 billion at December 31, 2016 to $8.0 billion at December 31, 2017, primarily driven by the recapture and subsequent reinsurance of risks related to the no-lapse guarantees as described above.
Policyholders’ account balances increased $1.1 billion from $18.9 billion at December 31, 2016 to $20.0 billion at December 31, 2017, primarily driven by universal life and variable annuity business growth.
Total equity increased by $0.3 billion from $2.5 billion at December 31, 2016 to $2.8 billion at December 31, 2017, primarily driven by 2017 after-tax net income.
Benefits and expenses decreased $0.4 billion from $0.9 billion in 2016 to $0.5 billion in 2017, primarily driven by a favorable variance of $0.7 billion in amortization of deferred policy acquisition costs and interest credited to policyholders’ account balances, primarily driven by higher amortization due to NPR gains in the first quarter of 2016 as a result of declining rates. This was partially offset by an unfavorable variance of $0.2 billion in policyholders’ benefits due to ceded GMDB and GMIB reserves as a result of the Variable Annuities Recapture partially offset by the impact of the cost of reinsurance on the universal block of business (see “-Accounting Policies & Pronouncements-Application of Critical Accounting Estimates-Accounting for Certain Reinsurance Contracts in our Individual Life business” above).
The primary risk exposures of our variable annuity contracts relate to actual deviations from, or changes to, the assumptions used in the original pricing of these products, including capital market assumptions such as equity market returns, interest rates, and market volatility, along with actuarial assumptions such as contractholder mortality, the timing and amount of annuitization and withdrawals, and contract lapses. For these risk exposures, achievement of our expected returns is subject to the risk that actual experience will differ from the assumptions used in the original pricing of these products. We currently manage our exposure to certain risks driven by capital markets fluctuations primarily through a combination of four strategies described below including Product Design Features, External Reinsurance, an Asset Liability Management ("ALM") Strategy and a capital hedge program.
During the third quarter of 2016, PALAC and Prudential Insurance implemented a new ALM strategy that utilizes a combination of both traditional fixed income instruments and derivatives to help defray potential claims associated with the variable annuity living benefit guarantees. Under the revised strategy, expected living benefit claims under less severe market conditions are managed through the accumulation of fixed income instruments and potential living benefit claims resulting from more severe market conditions are hedged using derivative instruments. PALAC and Prudential Insurance expect the revised strategy to result in more efficient management of its capital and liquidity associated with these products while continuing to mitigate fluctuations in net income due to capital market movements. Since the ALM strategy is conducted in PALAC and Prudential Insurance, the results of the strategy do not directly impact the Company's results of operations or financial condition.
During 2017, we commenced a capital hedge program within PALAC to further hedge equity market impacts. The program is intended to protect a portion of the overall capital position of the variable annuities business against its exposure to the equity markets. The capital hedge program is conducted using equity derivatives which include equity call and put options, total return swaps and futures contracts. Since the capital hedge program is conducted in PALAC, the results of the strategy do not directly impact the Company's results of operations or financial condition.
The effective tax rate is the ratio of “Total income tax expense (benefit)” divided by “Income before income taxes and equity in earnings of operating joint ventures." Our effective tax rate for fiscal years 2017, 2016 and 2015 was (90.8)%, (22.9)% and (2.1)%, respectively. For a detailed description of the nature of each significant reconciling item, see Note 8 to the Consolidated Financial Statements. The decrease in the effective tax rate from (2.1)% in 2015 to (22.9)% in 2016 was primarily driven by a decrease in pre-tax net income. The decrease in the effective tax rate from (22.9)% in 2016 to (90.8)% in 2017 was primarily driven by a decrease in pre-tax net income and the impacts of the Tax Act of 2017 on the date of enactment.
Prudential Financial is a Designated Financial Company under Dodd-Frank. As a Designated Financial Company, Prudential Financial is subject to supervision and examination by the Federal Reserve Bank of Boston and to stricter prudential regulatory standards, which include or will include requirements and limitations (many of which are the subject of ongoing rule-making) relating to capital, leverage, liquidity, stress-testing, overall risk management, resolution and recovery plans, credit exposure reporting, early remediation, management interlocks and credit concentration. They may also include additional standards regarding enhanced public disclosure, short-term debt limits and other related subjects. In addition, the Financial Stability Board has identified Prudential Financial as a global systemically important insurer ("G-SII"). For information on these regulatory initiatives and their potential impact on us, see "Regulatory Developments" above and "Business-Regulation” and “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2017.
Our capital management framework is primarily based on statutory RBC measures. The RBC ratio is a primary measure of the capital adequacy of the Company. RBC is calculated based on statutory financial statements and risk formulas consistent with the practices of the National Association of Insurance Commissioners (“NAIC”). RBC considers, among other things, risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products and liabilities, interest rate risks and general business risks. RBC ratio calculations are intended to assist insurance regulators in measuring an insurer’s solvency and ability to pay future claims. The reporting of RBC measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities, but is available to the public. We expect that the Tax Act of 2017 will adversely affect the statutory capital position of Prudential Financial's domestic insurance companies as of December 31, 2017, due to the reduction in the corporate tax rate from 35% to 21% and the resulting reduction in the value of statutory deferred tax assets and increase in certain statutory reserves. Nevertheless, we expect the Company’s RBC ratios to exceed the minimum level required by applicable insurance regulations, even after giving effect to impacts from the Tax Act of 2017.
Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of the Company. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact of Prudential Funding, LLC’s ("Prudential Funding") financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company.
Liquid assets include cash and cash equivalents, short-term investments, U.S. Treasury fixed maturities, fixed maturities that are not designated as held-to-maturity and public equity securities. As of December 31, 2017 and 2016 the Company had liquid assets of $5,517 million and $5,802 million, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $214 million and $133 million as of December 31, 2017 and 2016, respectively. As of December 31, 2017, $4,784 million, or 92%, of the fixed maturity investments in Company general account portfolios were rated high or highest quality based on NAIC or equivalent rating.