Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") addresses the consolidated financial condition of Pruco Life Insurance Company as of December 31, 2002, compared with December 31, 2001, and its consolidated results of operations for the years ended December 31, 2002, 2001 and 2000.
Generally, policyholders who purchase the Company's products have the option of investing in the separate accounts, segregated funds for which investment risks are borne by the customer, or the Company's portfolio, referred to as the General Account. The Company earns its profits through policy fees charged to separate account annuity and life policyholders and through the interest spread for the GIC and General Account annuity and life products. Policy charges and
Valuation of investments A large portion of our investments is reflected at fair value in the statements of financial position based on quoted market prices or estimates from independent pricing services. However, when such information is not available, for example, with respect to private placement fixed maturity securities, which comprises 18.6% of our investments at December 31, 2002, fair value is estimated, typically by using a discounted cash flow model, which considers current market credit spreads for publicly traded issues with similar terms by companies of comparable credit quality. Consequently, changes in estimated future cash flows or in our assessment of the issuer's credit quality will result in changes in fair value estimates. For fixed maturities and equity securities classified as available for sale, the impact of such changes is recorded in "Accumulated other comprehensive income (loss)," a separate component of equity. However, the carrying value of these securities is reduced, with a corresponding charge to earnings, when a decline in value is considered to be other than temporary. Factors we consider in determining whether a decline in value is other than temporary include: whether the decline is substantial; the length of time the fair value has been less than cost, generally six months; and the financial condition and near-term prospects of the issuer. This corresponding charge is referred to as an impairment and is reflected in "Realized investment losses, net" in the statements of operations. The level of impairment losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
See "Results of Operations" for discussion of the impact of DAC amortization on our results of our life and annuities products, including increased amortization recorded in 2002 and 2001 reflecting lower estimates of future gross profits.
See "Results of Operations" for a discussion of the proposed AICPA Statement of Position "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts."
Reserves for contingencies A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under GAAP, reserves for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial reserve reflects management 's best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure. In situations in which the Company is to be indemnified by Prudential Insurance, there will be no financial impact on the statement of operations.
Other significant estimates In addition to the items discussed above, the application of GAAP requires management to make other estimates and assumptions. One example is the recognition of deferred tax assets, which depends on management's assumption that future earnings will be sufficient to realize the deferred benefit. This is discussed in Note 7 to the Consolidated Financial Statements.
Other liabilities decreased by $98 million mainly due to the funding of policy credits to the separate account policyholders, which had been accrued in other liabilities at December 31, 2001. This decrease was partially offset by an increase in payables resulting from purchases of securities that had not yet been settled.
During the year, liabilities decreased by $784 million from $21.226 billion to $20.442 billion. Separate account liabilities decreased $1.310 billion as a result of net investment losses of $1.388 billion, expense disbursements and other changes of $244 million offset by net sales of $322 million. Current year net sales of $322 million ($1.540 billion of contributions less $1.218 billion of surrenders and withdrawals) are $918 million lower than the same period prior year sales of $1.240 billion ($2.376 billion of contributions less $1.136 billion of surrenders and withdrawals). The primary reason for the decrease is declines in Discovery Select annuity product ("Discovery Select") exchange sales resulting from the discontinuation of the Exchange Program on May 1, 2000. The Exchange Program had provided the contract holders of older Prudential Insurance or Pruco Life annuity products an opportunity to convert to the Discovery Select product. Annuity product net sales declined $1.118 billion while variable life insurance sales grew $200 million from the prior year.
Total equity declined $181 million from $1.832 billion at December 31, 2000 to $1.651 billion at December 31, 2001. The largest factor in this decrease is the payment of two dividends to Prudential Insurance totaling $153.8 million. One dividend consisted of an extraordinary dividend approved by the Insurance Department of Arizona for $108 million. The other dividend of $45.8 million represented the Company's net investment in its Taiwan branch, which was contributed to a sister company, Prudential Life Insurance Company of Taiwan, and subsequently dividended to Prudential Insurance. Refer to Note 14 for more information on the Taiwan dividend. Equity was also reduced by $128.0 million for policy credits to be made to eligible policyholders. In connection with the Prudential Insurance demutualization, qualified annuity contract holders were given increases to their policy values in the form of policy credits. In addition, equity was increased by net income of $67.6 million, net unrealized investment gains of $30.0 million and net foreign currency translation adjustments of $3.2 million.
Net Income Despite growth in annuity and life insurance sales and the in-force of our life insurance products, consolidated net income declined $54.1 million from $67.6 million in 2001 to $13.5 million in 2002. The primary reason for this decline was the weak equity markets that affected, in particular, the variable annuity products. The unfavorable market conditions caused a decline in the annuity separate account fund values, which resulted in lower policy fee income and higher minimum death benefit guarantees as fund values fell below the guaranteed minimum death benefits. These factors also affected our estimate of expected future gross profits, which is the basis on which DAC is amortized. As a result, DAC amortization was accelerated. DAC amortization, which is included in "General, Administrative and Other Expenses", increased $112.3 million from the prior year, with $75.3 million related specifically to annuity products. This decrease to income was partially offset by higher premiums from term insurance sales and renewals and higher policy charges from life products due to the growth of the in-force business. Most of the policy charges associated with life products such as mortality charges are based on the face amount of the policies and not the fund value and therefore are not as affected by stock market changes as are the annuity products. Tax expense for the current year is lower than the prior year due to reduced income from operations before taxes. Both years include tax benefits from nontaxable investment income. More details regarding the components of revenues and expenses are provided below.
Revenues Consolidated revenues increased by $73.7 million, from $877.1 million to $950.8 million. Policy charges and fee income, consisting primarily of mortality and expense ("M&E"), loading and other insurance charges assessed on general and separate account policyholder fund balances, increased by $39.7 million. The increase was a result of a $56.9 million increase for domestic individual life
In contrast, annuity fees are mainly asset based fees which are dependent on fund balances which are affected by net sales as well as asset depreciation or appreciation on the underlying investment funds in which the customer has the option to invest. Annuity fund balances have declined as a result of unfavorable conditions in the securities market over the past three years, thereby reducing policy fee income.
Other income increased $9.2 million primarily from expense allowance recoveries from a reinsurance agreement associated with the Magnastar contract, a new third party distribution agreement (described in Note 6) and increased modal premiums. Modal premiums, service charges for policyholders who pay other than annual premiums, have grown as term insurance has grown.
Partially offsetting these increases are lower net investment income and higher realized investment losses. Despite the investment portfolio growth due to positive cash inflows, net investment income is lower by $9.1 million due to lower yields available on the reinvestment of fixed maturities and lower interest rates for short-term investments. Realized investment losses are $7.6 million higher mainly due to increased derivative losses of $10.3 million from Treasury futures and swaps as the Company is in a net short position in a declining interest rate environment. Losses on fixed maturities from credit related sales and impairments were $56.0 million in 2002 compared to $60.9 million in 2001. Although the current year experienced less impairments compared to the prior year ($27.8 million in 2002 compared to $53.5 million in 2001), there were higher losses due to credit related sales in 2002 ($28.2 million in 2002 compared to $7.4 million in 2001).
Deferred acquisition costs related to annuity products are evaluated quarterly by comparing our actual profitability to our expectations. Expected profitability considers, among other assumptions, our best estimate of future asset returns to estimate the future fees we expect to earn, the costs associated with minimum death benefit guarantees we expect to incur and other profitability factors. If actual asset returns do not differ significantly from our expectations, they do not result in a change in the rate of amortization of deferred acquisition costs. Where actual asset returns differ more significantly from expectations, future asset return assumptions are evaluated using a reversion to mean approach. Under the reversion to mean approach we consider historical returns over a period of time and project returns for a future four-year period so that the investments underlying the annuities grow at a targeted return for the entire period. We evaluate returns over a historical period beginning January 1, 2000 giving higher weighting to the returns experienced during the most recent two-year period. A calculated rate of return over the four future years, which we refer to as the look-forward period, is determined so that this calculated rate, together with the actual rate of return for the historical period, produces the targeted return for the entire period. If the calculated rate of return is consistent with our range of expectations in light of market conditions, we will use it to project the asset growth for the next four years. If the calculated rate of return is not supported by our current expectations, we adjust our rate of return for purposes of these computations. For contract years after the look-forward period, we project asset growth using our long-term rate, currently an 8% annual blended rate of return, which reflects an assumed rate of return of 8.85% for equity type assets. Beginning in the second quarter and continuing throughout the year, we utilized a rate of return lower than the calculated return, which contributed to additional amortization of deferred acquisition costs during the second and third quarter. The equity rate of return used in the immediate four-year look-forward period varies by product, but is under 15% for all of our variable annuity products for our evaluation of deferred policy acquisition costs as of December 31, 2002. For the average remaining life of our variable annuity contracts in force as of December 31, 2002, our evaluation of deferred policy acquisition costs is based on a 9.25% annual blended rate of return, which reflects an assumed rate of return of 11.5% for equity type assets. Continuation of current market conditions or further deterioration in market conditions may result in increases in the amortization of deferred policy acquisition costs, while a significant improvement in market conditions may result in a decrease in the amortization of deferred policy acquisition costs.
Net Income Consolidated net income was $35.9 million lower for the year ended December 31, 2001 than for the year ended December 31, 2000. Economic and market downturns resulted in increased realized investment losses for impairments and sales of fixed maturities of $39.8 million. In addition, there was increased amortization of deferred policy acquisition costs ("DAC") of $35.2 million for domestic life and annuity products, resulting from a decline in expected future gross profits. Net asset management fee revenue declined $34.2 million ($63.3 million in revenues less $29.1 million of expenses). The Company ceased receiving fee income or paying asset management fee expenses related to the Prudential Series Fund ("PSF") as of January 1, 2001, as described in the Notes to Consolidated Financial Statements. Policyholder benefits were $8.0 million higher as increases to domestic individual life product reserves, death benefits, and surrender benefits offset decreases in the Taiwan branch's policyholder benefits. Tax expense for the current year is lower than the prior year by $79.7 million due to reduced income from operations before income taxes and a refinement of the estimated benefits from nontaxable investment income.
Net investment income increased by $5.7 million from the prior year as income from fixed maturities rose as a result of a higher average asset base from reinvestment of proceeds from GIC sales, and general account annuity and life deposits. Partially offsetting this increase was a decline in short-term investments and cash equivalent income mainly as a result of lower interest rates. Other income increased $2.5 million due to an increase in the modal premium charges due to the growth in term insurance.
Interest credited to policyholder account balances increased by $25.0 million as policyholder account balances grew by $301.0 million from December 2000 mainly as a result of GIC and general account life and annuity deposits, as mentioned above.
The Company's investment portfolio supports its insurance and annuity liabilities and other obligations to customers for which it assumes investment related risks. The portfolio was comprised of total investments amounting to $6,343.0 million at December 31, 2002, versus $5,207.5 million at December 31, 2001. A diversified portfolio of publicly traded bonds, private placements, commercial mortgages and equity investments is managed under strategies intended to maintain a competitive asset mix consistent with current and anticipated cash flow requirements of the related obligations. The risk tolerance reflects the Company's aggregate capital position, exposure to business risk, liquidity and rating agency considerations.
- ------------ (1) Other long-term investments consist of real estate and non-real estate related investments in joint ventures and partnerships, our interest in separate account investments and other miscellaneous investments.
The asset management strategy for the portfolio is in accordance with an investment policy statement developed and coordinated within the Company by the Asset Liability and Risk Management Group, agreed to by senior management, and approved by the Board of Directors. In managing the investment portfolio, the long-term objective is to generate favorable investment results through asset-liability management, strategic and tactical asset allocation and asset manager selection. Asset management strategies take into account the need to match asset structure to product liabilities, considering the underlying income and return characteristics of investment alternatives and seeking to closely approximate the interest rate sensitivity of the asset portfolio with the estimated interest rate sensitivity of the product liabilities. Asset management strategies also include broad diversification across asset classes, issuers and sectors; effective utilization of capital while maintaining liquidity believed to be adequate to satisfy cash flow requirements; and achievement of competitive performance. The major categories of invested assets, the related quality of the portfolio, and recent activities to manage the portfolio are discussed below.
As of December 31, 2002, our investment portfolio consisted primarily of $5,158.1 million of fixed maturity securities versus $4,024.9 in 2001 (81% of the total portfolio in 2002 versus 77% in 2001), $7.0 million of commercial loans versus $8.2 million in 2001, $0.2 million of equity securities versus $0.4 million in 2001 and $1,177.7 million of other investments (19% of the total portfolio in 2002 versus 23% in 2001). The commercial loan portfolio consists of loans secured mainly by commercial buildings, which are concentrated in the United States. The equity securities portfolio in 2002 consists of $0.2 million of publicly traded equity securities. The equity securities portfolio in 2001 consists of $0.2 million of publicly traded equity securities and $0.2 million of privately traded equity securities. The remaining $1,177.7 million of other investments were comprised of other long-term investments, policy loans and short-term investments as compared to $1,174.0 million in 2001.
Continuation of the low interest rate environment will result in our reinvestment of maturing securities at lower rates and would reduce the yield we are able to earn on our investments, which support our obligations for certain products, including fixed annuities, and guaranteed investment contracts. This reduction in yield would also have a corresponding impact on the "spread," the difference between the yield on our investments and the amounts that we are required to pay our customers related to these products, which would have a negative impact on our future profitability.
- ------------ (1) Yields are based on quarterly average carrying values except for fixed maturities, equity securities and securities lending activity. Yields for fixed maturities are based on amortized cost. Yields for equity securities are based on cost. Yields for securities lending activity are calculated net of corresponding liabilities and rebate expenses. Yields for prior year are presented on a basis consistent with our current reporting practices.
Investment Mix We manage our public portfolio to a risk profile directed by the Asset Liability and Risk Management Group. We seek to employ relative value analysis both in credit selection and in purchasing and selling securities. To the extent that we actively purchase and sell securities as part of portfolio selection and portfolio rebalancing, the total return that we earn on the portfolio will be reflected both as investment income and also as realized gains or losses on investments.
The Company has classified all private placements and publicly traded securities as available for sale. "Available for sale" securities are carried in the Consolidated Statement of Financial Position at fair value, with unrealized gains and losses (after certain related adjustments) recognized by credits and charges to equity capital. At December 31, 2002 the fixed maturities portfolio totaled $5,158.1 million, an increase of $1,133.2 million compared to December 31, 2001. This increase in fixed maturities reflected growth in the overall portfolio due to positive cash flow from insurance operations during 2002, appreciation arising from a lower interest rate environment, as well as reinvestment of net investment income.
Our fixed maturity securities portfolio consists principally of public and private fixed maturities across an array of industry categories. As of December 31, 2002, we held approximately 81% of assets in fixed maturity securities (versus 77% as of December 31, 2001) with a total amortized cost of $4,921.7 million and an estimated fair value of $5,158.1 million, compared to an amortized cost of $3,935.5 million and estimated fair value of $4,024.9 million as of December 31, 2001. Our investments in public fixed maturities as of December 31, 2002 were $3,793.0 million at amortized cost and $3,977.4 million at estimated fair value compared to $2,638.9 million at amortized cost and $2,695.1 million at estimated fair value as of December 31, 2001. Our investments in private fixed maturities as of December 31, 2002 were $1,128.7 million at amortized cost and $1,180.7 million at estimated fair value compared to $1,296.6 million at amortized cost and $1,329.8 million at estimated fair value as of December 31, 2001.
- ------------ (1) Investment data for 2002 has been classified based on industry accepted Lehman categorizations for public holdings and similar classifications by industry for all other holdings. Prior year data has been reclassified to conform to current year presentation. This table includes redeemable preferred stock.
As a percentage of amortized cost, fixed maturity investments as of December 31, 2002 consist primarily of 21% manufacturing sector, 14% finance sector, 13% asset-backed securities, 12% U.S. Government, and 11% services sector compared to 19% manufacturing sector, 17% finance sector, 15% asset-backed securities, 8%
The gross unrealized losses related to our fixed maturity portfolio were $17.2 million as of December 31, 2002 compared to $31.2 million as of December 31, 2001. The gross unrealized losses in 2002 were concentrated primarily in the utilities, manufacturing and services sectors while gross unrealized losses in 2001 were concentrated in the services, utilities, transportation and manufacturing sectors. Non-investment grade securities represented 65% of the gross unrealized losses in 2002 versus 40% of gross unrealized losses in 2001.
The following table sets forth the amortized cost and gross unrealized losses of fixed maturity securities where the estimated fair value had declined and remained below amortized cost by 20% or more for the following timeframes:
Our private fixed maturity asset managers conduct specific servicing tests on each investment on an ongoing basis to determine whether the investment is in compliance or should be placed on the watch list or assigned an early warning classification. We assign early warning classifications to those issuers that have failed a servicing test or experienced a minor covenant default, and we continue to monitor them for improvement or deterioration. In certain situations, the Company benefits from negotiated rate increases or fees resulting from a covenant breach. We assign closely monitored status to those investments that have been recently restructured or for which restructuring is a possibility due to substantial credit deterioration or material covenant defaults. We classify as not in good standing securities of issuers that are in more severe conditions, for example, bankruptcy or payment default.
We classify our fixed maturity securities as available for sale. As a result, we record unrealized gains and losses to the extent that amortized cost is different from estimated fair value. All available for sale securities with unrealized losses are subject to our review to identify other-than-temporary impairments in value. In evaluating whether a decline in value is other-than-temporary, we consider several factors including, but not limited to, the following:
1. whether the decline is substantial; 2. the duration (generally greater than six months); 3. the reasons for the decline in value (credit event or interest rate related); 4. our ability and intent to hold our investment for a period of time to allow for a recovery of value; and 5. the financial condition of and near-term prospects of the issuer.
Cash outflow requirements principally relate to benefits, claims, and payments to contract holders as well as amounts paid to policyholders and contract holders in connection with surrenders, withdrawals, and net policy loan activity. Uses of cash also include commissions, general and administrative expenses, and purchase of investments. We regularly monitor our liquidity requirements associated with our policyholder and contract holder obligations so that we manage cash inflows to match anticipated cash outflow requirements. We utilize a cash flow projection system and regularly perform asset/liability duration matching in the management of our asset and liability portfolios.
We sell variable life insurance products that contain both general and separate account components, with the bulk of account balances in separate accounts. The principal product of this type, Variable Appreciable Life, also imposes surrender charges for the first ten years after issuance. In addition to the right to surrender, policyholders may transfer account balances between the general account and the separate account components, subject to limitations on the amount transferred and only within a 30-day period following each anniversary of the policy. As of December 31, 2002 and 2001, general account balances for variable life insurance products were $1.677 billion and $1.539 billion, respectively, while separate account balances were $5.620 billion and $6.080 billion, respectively.
Our financing principally consists of an affiliated revolving line of credit with Prudential Funding LLC, a wholly owned subsidiary of Prudential Insurance, and asset-based or secured forms of financing. Our total capacity to borrow is $700 million, which includes both the asset-based financing and borrowings from Prudential Funding LLC. There was no outstanding debt relating to the Prudential Funding LLC credit facility as of December 31, 2002 or December 31, 2001. The secured financing arrangements include transactions such as securities lending and repurchase agreements, which we generally use to finance portfolios of liquid securities and earn additional spread income.
We capitalize costs that vary with and are related primarily to the production of new insurance and annuity business. These costs include commissions, costs to issue and underwrite the policies and certain variable field office expenses. The capitalized amounts are known as deferred policy acquisition costs, or DAC. Our total DAC, including the impact of unrealized investment gains and losses, amounted to $1.153 billion and $1.160 billion as of December 31, 2002 and 2001, respectively.
If we were to experience a significant increase in lapse or surrender rates on policies for which we amortize DAC based on estimated gross margins or gross profits, such as variable life insurance and variable annuities, we would expect acceleration of the write-off of DAC for the affected blocks of policies. Additionally, for all policies on which we have outstanding DAC, we would be required to evaluate whether this experience called into question our ability to recover all or a portion of the DAC, and we would be required to write off some or all of the DAC if we concluded that we could not recover it. While an accelerated write-off of DAC would not affect our cash flow or liquidity, it would negatively affect our reported earnings and level of capital under generally accepted accounting principles.