Gross Profits. DAC and DSI associated with the variable and universal life policies and the variable and fixed annuity contracts is generally amortized over the expected life of these policies in proportion to total gross profits. Total gross profits include both actual gross profits and estimates of gross profits for future periods. 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 related to our guaranteed minimum death and guaranteed minimum income benefits. For variable annuities, 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 amortization rates and expense amounts. In addition, in calculating gross profits, we include the profits and losses related to contracts 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 12 and Note 14 to the Consolidated 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 DSI, see “-Results of Operations”.
annual review of assumptions, our quarterly adjustments for current period experience and our quarterly adjustments for market performance. Each of these adjustments is further discussed below in “Annual assumptions review and quarterly adjustments”.
As part of a series of reinsurance transactions that the Company entered into on April 1, 2016 with PALAC and Prudential Insurance, the Company unwound its DAC and DSI balances related to its variable annuity contracts. See Note 1, Note 4 and Note 6 to the Consolidated Financial Statements for additional information.
The following table provides a demonstration of the sensitivity of that DAC balance relative to our future mortality assumptions by quantifying the adjustments that would be required, assuming both an increase and decrease in our future mortality rate by 1%. The information below is for illustrative purposes only and considers only the direct effect of changes in our mortality assumptions on the DAC balance with no changes in any other assumptions such as persistency, future rate of return, or expenses included in our evaluation of DAC. Further, this information also does not reflect changes in unearned revenue reserve which would partially offset the adjustments to the DAC balance reflected below.
We present at fair value in the Consolidated 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 Notes 9 and 10 to the Consolidated Financial Statements.
For certain product guarantees, primarily certain optional living benefit features of the variable annuity products, the benefits are accounted for as embedded derivatives, with fair values calculated as the present value of expected future benefit payments to contractholders less the present value of assessed rider fees attributable to the embedded derivative feature. Under U.S. GAAP, the fair values of these benefit features are based on assumptions a market participant would use in valuing these embedded derivatives. Changes in the fair value of the embedded derivatives are recorded quarterly through a benefit or charge to current period earnings.
The reserves for future policy benefits of our individual annuity business relate to reserves for the GMDB and GMIB features of our variable annuities, and for the optional living benefit features that are accounted for as embedded derivatives. As discussed above, in establishing reserves for GMDBs and GMIBs, we utilize current best estimate assumptions. The primary assumptions used in establishing these reserves include annuitization, lapse, withdrawal and mortality assumptions, as well as interest rate and equity market return assumptions. Lapse rates are adjusted at the contract level based on the in-the-moneyness of the living benefit and reflect other factors, such as the applicability of any surrender charges. Lapse rates are reduced when contracts are more in-the-money. Lapse rates are also generally assumed to be lower for the period where surrender charges apply.
For the GMDB and GMIB features of our variable annuities, the reserves for these contracts are significantly influenced by the future rate of return assumptions. As part of a series of reinsurance transactions that the Company entered into on April 1, 2016, the GMDB and GMIB reserves were transferred to PALAC and Prudential Insurance, which currently manage the risks related to these reserves. See Note 1 to the Consolidated Financial Statements for additional information.
An increase or decrease in our effective tax rate by one percent of income (loss) from operations before income taxes would have resulted in a decrease or increase in our consolidated income from operations in 2016 of $3 million.
Separate account assets increased $7.3 billion from $109.3 billion at December 31, 2015 to $116.6 billion at December 31, 2016, primarily driven by favorable fund performance.
Other assets increased $0.2 billion from $0.1 billion at December 31, 2015 to $0.3 billion at December 31, 2016, primarily driven by the deferred loss on reinsurance related to the reinsurance of the Company's variable annuity contracts as part of the Variable Annuities Recapture.
Policyholders’ account balances increased $1.7 billion from $17.2 billion at December 31, 2015 to $18.9 billion at December 31, 2016, primarily driven by universal life and variable annuity business growth.
Debt to affiliates decreased $1.4 billion from $1.4 billion at December 31, 2015 to $0 billion at December 31, 2016, driven by a reassignment of debt to PALAC and Prudential Insurance as a result of the Variable Annuities Recapture.
Total equity decreased by $2.0 billion from $4.5 billion at December 31, 2015 to $2.5 billion at December 31, 2016, primarily reflecting the impact of the Variable Annuities Recapture.
Income from operations before income taxes decreased $0.2 billion from $0.5 billion in 2015 to $0.3 billion in 2016. This was primarily driven by an unfavorable variance of $1.3 billion from a decline in net fee income driven by ceded policy charges and fee income to PALAC and Prudential Insurance reflecting the impact of the Variable Annuities Recapture. This was partially offset
Revenues decreased $1.7 billion from $2.9 billion in 2015 to $1.2 billion in 2016, primarily driven by a decline in policy charges and fee income, and asset administration fees of $1.7 billion primarily due to the Variable Annuities Recapture. Premiums decreased $0.9 billion due to consideration for the Variable Annuities Recapture, partially offset by an increase in realized investment gains (losses) of $1.0 billion as described above.
Benefits and expenses decreased $1.5 billion from $2.4 billion in 2015 to $0.9 billion in 2016, primarily driven by a favorable variance in general, administrative and other expenses of $0.8 billion primarily driven by the commission and expense allowance, ceded trail commissions and the deferral of the loss on reinsurance. Policyholders' benefits decreased $0.6 billion due to ceded GMDB and GMIB reserves as a result of the Variable Annuities Recapture.
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 three strategies described below including Product Design Features, External Reinsurance and an Asset Liability Management ("ALM") Strategy.
For our GMDBs, we provide a benefit payable in the event of death. Our base GMDB is generally equal to a return of cumulative deposits adjusted for any partial withdrawals. Certain products include an optional enhanced GMDB based on the greater of a minimum return on the contract value or an enhanced value. We have retained the risk that the total amount of death benefit payable may be greater than the contractholder account value. However, a substantial portion of the account values associated with GMDBs are subject to an asset transfer feature because the contractholder also selected a living benefit guarantee which includes an asset transfer feature. All of the variable annuity account values with living benefit guarantees also contain GMDBs. The living and death benefit features for these contracts cover the same insured life and, consequently, we have insured both the longevity and mortality risk on these contracts.
Our income tax provision amounted to an income tax benefit of $74 million and $11 million in 2016 and 2015, respectively. The increase in income tax benefit primarily reflects the decrease in pre-tax income from operations for the year ended December 31, 2016.
Prudential Financial and the Company use captive reinsurance companies to more effectively manage our reserves and capital on an economic basis and to enable the aggregation and transfer of risks. The captive reinsurance companies assume business from affiliates only. To support the risks they assume, the captives are capitalized to a level we believe is consistent with the “AA” financial strength rating targets of Prudential Financial’s insurance subsidiaries. All of the captive reinsurance companies are wholly-owned subsidiaries of Prudential Financial and are located domestically, typically in the state of domicile of the direct writing insurance subsidiary that cedes the majority of business to the captive. In addition to state insurance regulation, the captives are subject to internal policies governing their activities. In the normal course of business, Prudential Financial contributes capital to the captives to support business growth and other needs. Prudential Financial has also entered into support agreements with the captives in connection with financing arrangements.
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, 2016 and 2015 the Company had liquid assets of $5,802 million and $7,383 million, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $133 million and $425 million as of December 31, 2016 and 2015, respectively. As of December 31, 2016, $5,205 million, or 93%, of the fixed maturity investments in Company general account portfolios were rated high or highest quality based on NAIC or equivalent rating. The remaining $412 million, or 7%, of these fixed maturity investments were rated other than high or highest quality.
and the amount necessary to maintain solvency for moderately adverse experience is considered to be the non-economic portion of the statutory reserve.
As discussed under “Business-Regulation,” in June 2016, the NAIC adopted a recommendation that will activate a principles-based reserving approach for life insurance products. At the Company's discretion, it may be applied to new individual life business beginning as early as January 1, 2017, and must be applied for all new individual life business issued January 1, 2020 and later. During 2017, the Company expects to adopt principles-based reserving for its guaranteed universal life products and to introduce updated versions of these products. The updated products are expected to support the principles-based statutory reserve level without the need for captive reserve financing or additional assets under AG 48. The Company is continuing to assess the impact of this new reserving approach on projected statutory reserve levels and product pricing for its remaining portfolio of individual life product offerings.