The Company has sold a wide array of annuities, including deferred and immediate variable annuities with (1) fixed interest rate allocation options, subject to a market value adjustment, that are registered with the United States Securities and Exchange Commission (the “SEC”), and (2) fixed-rate allocation options not subject to a market value adjustment and not registered with the SEC. In addition, the Company has a relatively small in force block of variable life insurance policies. The Company stopped actively selling such products between March 2010 and December 2017.
In March 2010, the Company ceased offering its variable and fixed annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product line by each of Pruco Life Insurance Company ("Pruco Life") and Pruco Life Insurance Company of New Jersey ("PLNJ") (which are affiliates of the Company). These initiatives were implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. During 2012, the Company suspended additional customer deposits for variable annuities with certain living benefit guarantees. However, the Company continues to accept additional customer deposits on certain in force contracts, subject to applicable contract provisions and administrative rules. The Company launched a new fixed indexed annuity in January 2018 and will launch a new deferred income annuity during 2018.
As disclosed in Note 1 to the Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2015, the Company surrendered its New York license effective as of December 31, 2015, and reinsured the majority of its New York business to an affiliate, The Prudential Insurance Company of America (“Prudential Insurance”). The license surrender relieves the Company of the requirement to hold New York statutory reserves on its business in excess of the statutory reserves required by its domiciliary regulator, the AZDOI. For the small portion of New York business retained by the Company, a custodial account has been established to hold collateral assets in an amount equal to a percentage of the reserves associated with such business, as calculated in accordance with PALAC's New York Regulation 109 Plan approved by the New York Department of Financial Services.
The Company earns revenues principally from contract charges, 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’s operating expenses principally consist of guaranteed benefits provided and reserves established for anticipated future guaranteed benefits and costs of managing risk related to these products, interest credited to contractholders' account balances, general business expenses, reinsurance premiums, commissions and other costs of selling and servicing the various products it sold.
insurance reserve levels, amortization of deferred policy acquisition costs ("DAC")/value of business acquired (“VOBA”)
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews estimates and assumptions used in the preparation of financial statements. If management determines that modifications in assumptions and estimates are appropriate given current facts and circumstances, the Company’s results of operations and financial position as reported in the Financial Statements could change significantly.
We capitalize costs that are directly related to the acquisition of 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 7 to the Financial Statements. We generally amortize DAC and DSI over the expected lives of the contracts, based on our estimates of the level and timing of gross profits. 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. 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 and DSI were $4,597 million and $1,021 million, respectively.
We generally amortize DAC and other costs over the expected life of the contracts in proportion to total gross profits. Total gross profits include both actual gross profits and estimates of gross profits for future periods. Gross profits are defined as i) amounts assessed for mortality, contract administration, surrender charges, and other assessments plus amounts earned from investment of policyholder balances less ii) benefit claims in excess of policyholder balances, costs incurred for contract administration, interest credited to policyholder balances and other credits. If significant negative gross profits are expected in any period, the amount of insurance in force is generally substituted as the base for computing amortization. For variable annuities, U.S. GAAP, gross profits and amortization rates also include the impacts of the embedded derivatives associated with certain of the optional living benefit features of our variable annuity contracts and related hedging activities. In calculating amortization expense, we estimate the amounts of gross profits that will be included in our U.S. GAAP results, and utilize these estimates to calculate distinct amortization rates and expense amounts. In addition, in calculating gross profits, we include the profits and losses related to contracts previously issued by the Company that are reported in affiliated legal entities other than the Company as a result of, for example, reinsurance agreements with those affiliated entities. The Company is an indirect subsidiary of Prudential Financial (an SEC registrant) and has extensive transactions and relationships with other subsidiaries of Prudential Financial, including reinsurance agreements, as discussed in Note 13 to the Financial Statements. Incorporating all product-related profits and losses in gross profits, including those that are reported in affiliated legal entities, produces a DAC amortization pattern representative of the total economics of the products. For a further discussion of the amortization of DAC and other costs, see “-Results of Operations”.
We present at fair value in the statements of financial position our investments classified as available-for-sale (including fixed maturity and equity securities), investments classified as trading, derivatives, and embedded derivatives. For additional information regarding the key estimates and assumptions surrounding the determination of fair value of fixed maturity and equity securities, as well as derivative instruments, embedded derivatives and other investments, see Note 10 to the Financial Statements.
For our investments classified as available-for-sale, the impact of changes in fair value is recorded as an unrealized gain or loss in “Accumulated other comprehensive income” (“AOCI”), a separate component of equity. For our investments classified as trading, the impact of changes in fair value is recorded within “Asset administration fees and other income”. In addition, investments classified as available-for-sale are subject to impairment reviews to identify when a decline in value is other-than-temporary. For a discussion of our policies regarding other-than-temporary declines in investment value and the related methodology for recording OTTI of fixed maturity and equity securities, see Note 2 to the Financial Statements.
There are no new critical accounting estimates resulting from new accounting pronouncements adopted during 2017. See Note 2 to the Financial Statements for a complete discussion of newly adopted accounting pronouncements and accounting pronouncements issued but not yet adopted.
Total assets increased by $0.2 billion from $59.8 billion at December 31, 2016 to $60.0 billion at December 31, 2017. Significant components were:
Total investments and cash and cash equivalents increased $0.3 billion due primarily to cash from insurance operations and unrealized gains on investments due to a decline in rates, partially offset by a return of capital to PAI and a decline in affiliated derivative assets due to favorable equity markets.
DAC and DSI increased $0.3 billion primarily driven by positive unlocks and capitalization of new business, partially offset by base amortization.
Separate account assets increased $0.6 billion primarily driven by market appreciation, partially offset by net outflows from continued surrenders on runoff block and contract charges.
Total liabilities increased by $1.0 billion, from $52.7 billion at December 31, 2016 to $53.7 billion at December 31, 2017. Significant components were:
Separate account liabilities increased $0.6 billion, offsetting the increase in separate account assets discussed above.
and the related amortization of DAC and other costs, for the year ended December 31, 2017 and 2016:
Excludes $(389) million for the twelve months ended December 31, 2016, representing the impact of managing interest rate risk through capital management strategies other than hedging of particular exposures.
For the twelve months ended December 31, 2017, the net impact from changes in the U.S. GAAP embedded derivative and hedge positions, after the impacts of NPR, DAC and other costs, was a charge of $671 million. The net impact from changes in the U.S. GAAP embedded derivative and hedge positions resulted in a net charge of $745 million, predominantly as a result of tightening credit spreads used in measuring our living benefit contracts.
For the twelve months ended December 31, 2016, the net impact from changes in the U.S. GAAP embedded derivative and hedge positions was a charge of $2.9 billion. This was primarily driven by a $2.9 billion loss resulting from the recapture of the living benefit guarantees from Pruco Re and subsequent reinsurance of the variable annuity business from Pruco Life, as described above within the Variable Annuities Recapture. Also contributing to the loss was a $4.0 billion loss relating to the change in the NPR adjustment, primarily driven by tightening of credit spreads. Partially offsetting these losses was a benefit for the changes in the portions of the U.S. GAAP liability before NPR that are excluded from our hedge target, as well as a benefit from our annual review and update of actuarial assumptions, driven by modifications to both actuarial assumptions, including updates to expected withdrawal rates, and economic assumptions.
Revenues increased $2.5 billion from a loss of $0.2 billion for the twelve months ended December 31, 2016 to income of $2.3 billion for the twelve months ended December 31, 2017, primarily driven by an increase of $2.6 billion in realized investment gains / (losses), as well as an increase of $0.5 billion in policy charges and fee income and asset administration fees and other income, due to the Variable Annuities Recapture. Partially offsetting these increases was a decline of $0.8 billion in premiums mainly due to the consideration received for the Variable Annuities Recapture in 2016.
Benefits and expenses decreased $0.4 billion from $1.6 billion for the twelve months ended December 31, 2016 to $1.2 billion for the twelve months ended December 31, 2017, primarily driven by a Policyholders' benefits decrease of $0.5 billion primarily due to the Variable Annuities Recapture offset in premiums discussed above, as well as a $0.1 billion decline in the amortization of deferred policy acquisition costs net of favorable variance related to the annual review and update of assumptions and other refinements.
• Different accounting treatment between liabilities and assets supporting those liabilities- Under U.S. GAAP, changes in value of the embedded derivative liability and derivative instruments used to hedge a portion of the economic liability are immediately reflected in net income. In contrast, changes in fair value of fixed income instruments that support a portion of the economic liability are designated as available for sale and are not recorded in net income but rather are recorded as unrealized gains (losses) in other comprehensive income.
For additional information on income tax related items, see “Business-Regulation” and Note 9 to the Financial Statements.
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 be greater than 400% as of December 31, 2017, even after giving effect to impacts from the Tax Act of 2017.
In addition, the NAIC is expected to revise the RBC requirements for future periods to reflect the Tax Act of 2017, which may further adversely affect the statutory capital position of the Company in future periods. While the impact of the NAIC rules will not be fully known until the final updated RBC requirements are formally issued and adopted, the updated requirements may cause the regulatory capital levels of the Company to be below our “AA” ratings targets, in which case we would expect to fund any additional capital necessary to get back to our target levels using available capital and/or funding obtained through the capital markets.
The principal sources of the Company’s liquidity are certain annuity considerations, investment and fee income, investment maturities and internal borrowings. The principal uses of that liquidity include benefits, claims, and payments to policyholders and contractholders in connection with surrenders, withdrawals and net policy loan activity. Other uses of liquidity include commissions, general and administrative expenses, purchases of investments, the payment of dividends and return of capital to the parent company, hedging activity and payments in connection with financing activities. In March 2010, the Company ceased offering its existing variable annuity products to new investors upon the launch of a new product line by certain affiliates, but has launched a new fixed indexed annuity in January 2018 and will launch a new deferred income annuity during 2018.
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 $12.6 billion and $12.3 billion, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $2.4 billion and $2.8 billion as of December 31, 2017 and 2016, respectively. As of December 31, 2017, $9.6 billion, or 95%, of the fixed maturity investments in company general account portfolios were rated high or highest quality based on NAIC or equivalent rating.
These liquidity needs can vary materially due to, among other items, changes in interest rates, equity markets, mortality and policyholder behavior.