Management's Discussion and Analysis of Financial Position and Results ---------------------------------------------------------------------- of Operations. -------------- Pruco Life Insurance Company of New Jersey meets the conditions set forth in General Instruction I(1)(a) and (b) on Form 10-K and is filing this form with reduced disclosure.
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 General Account annuity and life products. Policy charges and fee income consist mainly of three types, sales charges or loading fees on new sales, mortality and expense charges ("M&E") assessed on fund balances, and mortality and related charges based on total life insurance in-force business. Policyholder fund values are affected by net sales (sales less withdrawals), changes in interest rates and investment returns. The interest spread represents the difference between the investment income earned by the Company on its investment portfolio and the amount of interest credited to the policyholders' accounts. Products that generate spread income primarily include the general account life insurance products, fixed annuities and the fixed-rate option of variable annuities.
o the returns on invested assets, net of the amounts we credit to policyholders' accounts;
o the ability to generate favorable investment results through asset-liability management and strategic and tactical asset allocation.
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 16.6% of our investments at December 31, 2003, 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.
Policyholder liabilities The liability for "Future policy benefits and other policyholder liabilities" represents 5.4% of total liabilities as of December 31, 2003. Changes in this liability are generally reflected in the "Policyholders' benefits" caption in our statements of operations. This liability is primarily comprised of the present value of estimated future payments to holders of life insurance and annuity products where the timing and amount of payment depends on policyholder mortality or surrender experience. For life insurance and annuity products, expected mortality is generally based on the Company's historical experience or standard industry tables. Interest rate assumptions are based on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are "locked-in" upon the issuance of new insurance or annuity business with fixed and guaranteed terms, significant changes in experience or assumptions may require us to provide for expected future losses on a product by establishing loss recognition reserves.
Deferred policy acquisition costs For most life insurance and annuity products that we sell, we defer costs that vary with and are related primarily to the production of new business to the extent these costs are deemed recoverable from future profits, and we record these costs as an asset known as deferred policy acquisition costs or "DAC" which is 5.5% of total assets as of December 31, 2003. We amortize this DAC asset over the expected lives of the contracts, based on the level and timing of either estimated profits or premiums, depending on the type of contract. For products with amortization based on future premiums, the amortization rate is locked-in when the product is sold. For products with amortization based on estimated profits, the amortization rate is periodically updated to reflect current period experience or changes in assumptions that affect future profitability, such as lapse rates, investment returns, mortality experience, expense margins and surrender charges.
The Company's Changes in Financial Position and Results of Operations are described below.
by $25 million as a result of growth in the term insurance business. Income taxes payable, which is a net number comprised of payables and receivables, increased by $18 million mainly as a result of tax expense and a tax refund received from Prudential Financial. In accordance with the tax sharing agreement with Prudential Financial, the Company was reimbursed for operating losses utilized in the consolidated federal tax return Other liabilities increased by $11 million due to an increase in payables resulting from purchases of securities that had not settled at the balance sheet date.
Stockholder's equity increased by $64 million from December 31, 2002. The largest factor in this increase was a capital contribution of $40 million received from the Parent Company. Retained earnings increased from net income of approximately $21 million and other accumulated comprehensive income increased by approximately $3 million due to unrealized appreciation on fixed maturities.
Net Income Net income of $20.6 million for 2003 was $5.2 million more than the $15.4 million earned for 2002. The largest contributing factor to this increase was a decrease in realized investment losses of $13.4 million as a result of an improving credit environment in 2003. Continued growth in the in-force business of life and annuity products caused increases in premiums and benefit expenses. However, policy charges were flat as the prior year had a large fee of $12 million on the sale of an affiliated COLI policy. The total income effect of this transaction in 2002 was $7.1 million after adjusting for reserves and DAC. The increase in taxes for the year of $14.1 million is primarily related to the increase in income from operations before taxes, and a decrease in the dividends received deduction. Further details regarding the components of revenues and expenses are described in the following paragraphs.
Revenues Revenues increased by $25.9 million from the prior year. Realized investment losses decreased $13.4 million as a result of lower losses on fixed maturities of $11.6 million and higher derivative gains of $1.8 million. The prior year had fixed maturity losses of $12.7 million consisting of $9.0 million of impairments and $3.7 million of credit related losses on sales. The current year has fixed maturity losses of $1.1 million consisting of $2.0 million of impairments and $.9 million of gains on sales.
Asset management fees increased by $2.8 million in 2003 as the Company did not begin receiving these fees in the prior year until October 2002.
Benefits and Expenses Policyholder benefits increased by $5.4 million from increased reserve provisions for life insurance reserves and higher death claims. The change in reserves for life and annuity products increased by $4.0 million from the prior year primarily as a result of higher reserves for term insurance due to increased premiums, partially offset by lower reserves for extended term insurance. There were also increased death claims of $1.3 million primarily from term insurance policies as a result of the increasing in-force business. Included in this change, is a decrease of $.4 million for annuity guaranteed minimum death benefits from $1.7 million in 2002 to $1.3 million in 2003 due to favorable market performance during 2003.
The guaranteed minimum death benefit (GMDB) feature provides annuity contract holders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically, the greatest of these values, depending on features offered in various contracts and elected by the contract holders. Previously, accounting literature did not prescribe the recognition of a liability for the expected future net costs associated with GMDB provisions. Accordingly, a reserve was not previously established for the annuity business. However, effective January 1, 2004, we will adopt SOP 03-01 which requires us to record such a liability based on application of an expected loss ratio to "cumulative assessments" through the balance sheet date, and then subtracting "cumulative excess payments" through that date. We currently estimate this liability to be approximately $1.6 million. However, in our periodic evaluation of unamortized deferred policy acquisition costs associated with our variable annuity business, we considered the expected net costs associated with the guaranteed minimum death benefits in our calculation of expected gross profits from this business. Accordingly, the effect of establishing the guaranteed minimum death benefit reserve related to this business will be partially offset by an estimated increase of approximately $.4 million in unamortized deferred policy acquisition costs, resulting in higher future amortization.