Management’s narrative addresses the financial condition of Pruco Life Insurance Company as of December 31, 2009, compared with December 31, 2008, and its results of operations for the years ended December 31, 2009 and 2008.
The Company sells interest-sensitive individual life insurance and variable life insurance, term life insurance and individual fixed and variable annuities. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure as the legal barriers, which have historically segregated the markets of the financial services industry, have been changed through both legislative and judicial processes. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels. The Company also marketed individual life insurance through its branch office in Taiwan. The Taiwan branch was transferred to an affiliated company on January 31, 2001, as described in the Notes to the Financial Statements. Since February 1, 2001, all insurance activity of the Taiwan branch has been ceded to an affiliated company.
The Company earns revenues principally from insurance premiums; mortality, expense, and asset administration fees from insurance and investment products; and investment of general account and other funds. The Company earns premiums primarily from the sale of individual life insurance. The Company earns mortality, expense fees, and asset administration fees on the servicing of separate account products including universal and variable life insurance and variable annuities. The Company’s operating expenses principally consist of insurance benefits provided, general business expenses, commissions and other costs of selling and servicing the various products we sell and interest credited on general account liabilities.
our mortality and morbidity experience on individual life insurance and annuity products which can fluctuate significantly from period to period;
DAC associated with the variable and universal life policies and the variable and fixed annuity contracts is amortized over the expected life of these policies in proportion to gross profits. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and the cost of contract minimum guarantees net of, where applicable, the impact of our own risk of non- performance and certain hedging activities related to these guarantees. We regularly evaluate and adjust the related DAC balance with a corresponding charge or credit to current period earnings for the effects of our actual gross profits and changes in our assumptions regarding estimated future gross profits. Adjustments to the DAC balance include our quarterly adjustments for current period experience and market performance related adjustments, as discussed below, and the impact of the annual reviews of our estimate of total gross profits. We also perform recoverability testing at the end of each reporting period to ensure the DAC balance does not exceed the present value of estimated gross profits.
The quarterly adjustments for current period experience referred to above reflect the impact of differences between actual gross profits for a given period and the previously estimated expected gross profits for that period. Total estimated gross profits include both actual experience and estimates of gross profits for future periods. To the extent each period’s actual experience differs from the previous estimate for that period, the assumed level of total gross profits may change. In these cases, we recognize a cumulative adjustment to all previous periods’ costs, referred to as an adjustment for current period experience.
The near-term future rate of return assumptions used in evaluating DAC for our variable annuity and variable life insurance products are derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider actual returns over a period of time and initially adjust future projected returns over a four year period so that the assets grow at the long-term expected rate of return for the entire period. If the projected future rate of return over the four year period is greater than our maximum future rate of return, we use our maximum future rate of return. In light of 2008 market conditions, we have determined that adjustments to our estimate of total gross profits to reflect actual fund performance and any corresponding changes to the projected future rate of return assumptions for our variable annuity contracts should no longer be dependent on a comparison to a statistically generated range of estimated gross profits. Instead, beginning in the fourth quarter of 2008, the projected future rate of return and our estimate of total gross profits are updated each quarter to reflect the result of the reversion to the mean approach. These market performance related adjustments to our estimate of total gross profits result in cumulative adjustments to prior amortization, reflecting the application of the new required rate of amortization to all prior periods’ gross profits. The new required rate of amortization is also applied prospectively to future gross profits in calculating amortization in future periods. For variable annuities products and variable life policies, as of December 31, 2009, our expected rate of return for the next four years across all asset types is 8.4% and 10.1% per annum, respectively, which are our current maximum future rates of return under the reversion to the mean approach. Included in these composite four year rates are assumptions for returns on various asset classes, including limits on implied returns on equity investments of 13.0%. Our long-term expected rate of return across all asset types for variable annuities products and variable life policies range from 7.7% to 8.0%, depending on the specific block of business, and reflect, among other assumptions, an expected rate of return of 9.5% per annum for equity investments.
The following table provides a demonstration of the sensitivity of that DAC balance relative to our future rate of return assumptions by quantifying the adjustments to the DAC balance that we would be required assuming both an increase and decrease in our future rate of return by 100 basis points. The sensitivity includes an increase and decrease of 100 basis points to both the near-term future rate of return assumptions used over the next four years, and the long-term expected rate of return used thereafter. While the information below is for illustrative purposes only and does not reflect our expectations regarding future rate of return assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change. This information considers only the direct effect of changes in our future rate of return on the DAC balance and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC. Further, this information does not reflect changes in reserves, such as the reserves for the guaranteed minimum death and optional living benefit features of our variable annuity products, or the impact that changes in such reserves may have on the DAC balance.
Our investment portfolio consists of public and private fixed maturity securities, commercial mortgage and other loans, equity securities, derivative financial instruments, and other long-term investments. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or the values of securities. Derivative financial instruments we generally use include swaps, options, and futures may be exchange-traded or contracted in the over-the-counter market. We are also party to financial instruments that contain derivative instruments that are “embedded” in the financial instruments. Management believes the following accounting policies related to investments, including derivatives, are most dependent on the application of estimates and assumptions. Each of these policies is discussed further within other relevant disclosures related to the investments and derivatives, as referenced below.
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 (loss), net,” 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 other-than-temporary impairments of fixed maturity and equity securities, see Note 2 to the Consolidated Financial Statements.
Commercial mortgage and other loans are carried primarily at unpaid principal balances, net of unamortized premiums or discounts and a valuation allowance for losses. For a discussion of our policies regarding the valuation allowance for commercial mortgage and other loans see Note 2 to the Consolidated Financial Statements.
An increase or decrease in our effective tax rate by one percent, would have resulted in a increase or decline in consolidated income from continuing operations in 2009 of $2.1 million.
Our liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the IRS or other taxing authorities. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards, or tax attributes, the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to our liability for income taxes. The statute of limitations for the 2002 tax year expired on April 30, 2009. The statute of limitations for the 2003 tax year expired on July 31, 2009. The statute of limitations for the 2004 and 2005 tax years is set to expire in June 2010, unless extended. Tax years 2006 through 2008 are still open for IRS examination. See Note 9 to the Consolidated Financial Statements for a discussion of the impact in 2009 of changes to our total unrecognized tax benefits related to tax years for which the statute of limitations has expired. We do not anticipate any significant changes within the next 12 months to our total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.
See Note 2 to the Consolidated Financial Statements for a discussion of recently adopted accounting pronouncements, including the adoption of revised authoritative guidance for disclosing fair value of financial instruments, the recognition and presentation of other-than-temporary impairments and fair value measurements and disclosures.
Fixed maturities increased by $1.310 billion from $4.544 billion at December 31, 2008 to $5.854 billion at December 31, 2009. This increase was primarily driven by investment of cash flows from business operations, the investment of a capital contribution of $360 million received in late December 2008, reinvestment of investment income, and unrealized gains on fixed maturities in the current year resulting from a narrowing of credit spreads that increased the market value of these securities. Partially offsetting this increase were transfers of account balances to the separate account variable investment options from the fixed investment options backed by our general account due to an automatic rebalancing element on certain variable annuity contracts.
Reinsurance recoverables decreased by $648 million from $3.044 billion at December 31, 2008 to $2.396 billion at December 31, 2009 driven by the impact of an increase in LIBOR swap rates and the change in non-performance risk (NPR) in the valuation of embedded derivatives that are classified as reinsurance recoverables. We are required to incorporate the risk of non-performance of our Company and its affiliates in the valuation of the embedded derivatives associated with the living benefit features of variable annuity contracts and no lapse features in our universal life policies. In light of first quarter 2009 developments, including rating agency downgrades to claims-paying ratings of the Company and its affiliates, we updated the discount rate used in these valuations to reflect the market-perceived increase in non-performance risk of the Company and its affiliates. As of December 31, 2009, we used a higher discount rate in the embedded derivative valuations as a result of the market perceived increase in our non-performance risk, thereby reducing the value of the embedded derivative assets. This was partially offset by increased reinsurance recoverable due to continued growth in the term life in force covered under the Prudential Arizona Reinsurance Captive Company, or “PARCC”, and Prudential Arizona Reinsurance III Company, or “PAR III”, agreements.
Cash and cash equivalents decreased by $452 million, from $595 million at December 31, 2008 to $143 million at December 31, 2009. A capital contribution of $360 million was made in late December 2008 to the Company from Prudential Insurance. These funds were used to purchase fixed maturities securities during 2009.
Deferred policy acquisition costs decreased by $119 million from $2.602 billion at December 31, 2008, to $2.483 billion at December 31, 2009, primarily due to an increase of $370 million related to unrealized investment gains. Also contributing to the decline in the asset was $294 million of additional amortization related to non-performance risk on our embedded derivative liabilities as discussed above. We amortize deferred policy acquisition and other costs associated with variable and universal life policies and the variable and fixed annuity contracts over the expected lives of the contracts based on the level and timing of gross profits on the underlying product. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and include profits and losses related to these contracts that are reported in affiliated legal entities other than the Company, for example, reinsurance agreements with those affiliated entities. This amortization was partially offset by $545 million of capitalization of acquisition costs from the continued growth of sales in life and annuity products.
Net income decreased $420 million from income of $323 million in 2008 to a loss of $97 million in 2009. This decline was driven by a $677 million decrease in income from operations before income taxes, primarily due to a loss of $370 million in 2009 compared to a gain of $340 million in 2008 related to the change in the value of the embedded derivative related to the no-lapse guarantee on our universal life products with UPARC, as discussed below. This decline was partially offset by improved earnings on variable products which benefited from lower amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, driven by the impact of more favorable equity markets in 2009 on separate account fund performance. Separate account fund performance above expected levels results in an increase in total expected gross profits on which the amortization of deferred policy acquisition costs net of the amortization of unearned revenue reserves is based, and accordingly, lower amortization in the current period. The prior year period contained higher amortization of deferred policy acquisition costs, net of higher amortization of unearned revenue reserves in comparison to the current year, due to separate account fund performance that was below expected levels. Net Income also benefited from higher earnings in 2009 associated with growth in term and universal life insurance in force, as well as a $258 million income tax benefit driven by the decline in pre-tax income. Net income for 2009 also includes a net benefit of $1 million resulting from an annual review of the assumptions used in our estimate of total gross profits as discussed below. Results for 2008 include a net benefit of $21 million from the annual assumption review.
Revenues decreased $683 million from $1.055 billion in 2008 to $372 million in 2009.
Benefits and expenses decreased $7 million from $593 million in 2008 to $586 million in 2009, driven by lower amortization of deferred policy acquisition costs (“DAC”) that decreased $62 million, from $221 million in 2008 to $159 million in 2009. Absent the net impact of the annual reviews that resulted in higher amortization of $24 million as discussed below, amortization of deferred policy acquisition costs decreased $86 million, from $267 million in 2008 to $181 million in 2009. The $86 million of lower amortization of deferred policy acquisition costs in 2009, relative to the prior year, was primarily due to the impact of more favorable equity markets in the last three quarters of 2009 on variable product separate account fund performance. Weak equity markets in 2008 drove unfavorable separate account fund performance that resulted in higher DAC amortization in 2008. Included in the $86 million of lower amortization of DAC is a partial offset due to an increase in amortization of DAC caused by lower variable product policy persistency reflecting the impact of unfavorable equity markets in late 2008 and early 2009.
Policyholders’ benefits and expenses increased $41 million, from $133 million in 2008 to $174 million in 2009, primarily due to term life and universal life reserve growth attributable to continued sales and in force growth.
Interest credited to policyholders’ account balances increased $21 million, from $125 million in 2008 to $146 million in 2009, primarily driven by continued growth in the universal life in force and associated policyholder fund balances.
Net investment income increased $30 million, from $136 million in 2008 to $166 million in 2009, reflecting higher average annuity account values backed by our general account due to market driven transfers into our general account in the first part of 2009 from the automatic rebalancing element in some of our optional living benefit features.
Net realized investment losses decreased $14 million from a loss of $76 million in 2008 to a loss of $62 million in 2009. The decline was driven by an increase in embedded derivative breakage of $48 million driven by increasing interest rates in 2009. Also contributing to the decrease was lower general account losses of $38 million driven by the impact of changing interest rates on futures used for asset/liability duration management. This was partially offset by mark-to-market losses of $76 million related to derivative positions associated with our capital hedging program see below.
Policy charges and fee income, consisting primarily of mortality and expense and other insurance charges assessed on general and separate account policyholders’ fund balances, decreased $17 million from $248 million in 2008 to $231 million in 2009. The decrease was primarily driven by lower fee income due to a decrease in average variable annuity asset balances invested in separate accounts. The decrease in separate account balances was driven by market depreciation and transfers of balances to fixed income investments backed by our general account related to the automatic rebalancing element on certain variable annuity contracts.
Benefits and expenses decreased $122 million from $479 million in 2008 to $357 million for in 2009.
Policyholders’ benefits decreased $220 million, from $206 million in 2008 to $(14) million in 2009 primarily due to favorable adjustments to reserves for the guaranteed minimum death and income benefit features of our variable annuity products due to the quarterly market performance adjustment as discussed below.
Amortization of deferred policy acquisition costs (“DAC”) increased by $47 million, from $88 million in 2008 to $135 million in 2009 primarily due to higher gross profits used to amortize DAC including the impact of non-performance risk in the valuation of embedded derivatives, partially offset by a favorable adjustment due to the quarterly market performance adjustment as discussed below.
Interest credited to policyholders’ account balances increased $37 million, from $88 million in 2008 to $125 million in 2009, primarily driven by increased deferred sales inducement (“DSI”) amortization due to higher gross profits used to amortize DSI including the impact of the change in non-performance risk in the valuation of embedded derivatives and higher interest credited on fixed investment options backed by the general account as discussed above.
Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the guaranteed minimum death and income benefit, or GMDB / GMIB, features of both our variable life and annuity products.
As discussed below, market performance related adjustments were recognized quarterly beginning in the fourth quarter of 2008. Amounts for the third quarter of 2008 were recognized as part of our annual reviews.
As shown in the table above, results for both periods include quarterly updates for the impact of fund performance on our DAC amortization net of unearned revenue reserves and GMDB/GMIB reserves for our variable life and variable annuity products. 2009 included $114 million of lower net DAC amortization and other costs associated with these quarterly updates due to favorable market performance. 2008 updates resulted in a charge of $196 million due to unfavorable market performance.
The dividends received deduction, or DRD, reduces the amount of dividend income subject to tax and is the primary component of the non-taxable investment income shown in the table above, and, as such, is a significant component of the difference between our actual tax expense and the expected amount determined using the federal statutory tax rate of 35%. The DRD for the current period was estimated using information available from current year results, information from 2007 calculations, and estimates to take into account the current year’s equity market performance. The actual current year DRD can vary from the estimate based on factors such as, but not limited to, changes in the amount of dividends received that are eligible for the DRD, changes in the amount of distributions received from mutual fund investments, changes in the account balances of variable life and annuity contracts, and our taxable income before the DRD.
This recent negative market conditions unfavorably impacted our liquidity and capital plans, results of operations, and financial position. The adverse market conditions also negatively impacted our level of capital, as a result of asset value declines and the need to strengthen reserves, particularly in our annuity products.
Gross account withdrawals amounted to approximately $1.3 billion and $1.6 billion for the years ended December 31, 2009 and 2008, respectively. Because these withdrawals were consistent with our assumptions in asset/liability management, the associated cash outflows did not have a material adverse impact on our overall liquidity.
Prudential Funding, LLC, or Prudential Funding, a wholly owned subsidiary of Prudential Insurance, serves as an additional source of financing to meet our working capital needs. Prudential Funding operates under a support agreement with Prudential Insurance whereby Prudential Insurance has agreed to maintain Prudential Funding positive tangible net worth at all times. Prudential Financial has also issued a subordinated guarantee covering Prudential Funding domestic commercial paper program. Prudential Funding borrows funds primarily through the direct issuance of commercial paper.