As prescribed by GAAP, we present our fixed maturity investments classified as available for sale, at fair value in the statements of financial position. The fair values for our public fixed maturity securities are based on quoted market prices or estimates from independent pricing services. However, for our investments in private securities such as private placement fixed maturity securities, which comprised 15% of our investments as of December 31, 2005, this information is not available. For these private fixed maturities, fair value is determined typically by using a discounted cash flow model, which relies upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions and takes into account, among other things, the credit quality of the issuer and the reduced liquidity associated with private placements.
Commercial loans, which comprised nearly 4% of our investments as of December 31, 2005, are carried primarily at unpaid principal balances, net of unamortized premiums or discounts and an allowance for losses. This allowance includes a loan specific portion as well as a portfolio reserve for probable incurred but not specifically identified losses. The loan specific portion, is based on management’s judgment as to ultimate collectibility of loan principal. The portfolio reserve is based on a number of factors, such as historical experience and portfolio diversification. Adjustments to the allowance are reflected in “Realized investment gains (losses), net,” in our statements of operations. Similar to impairment losses discussed above, the allowance for losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
We capitalize costs that vary with and are related primarily to the acquisition of new and renewal insurance and annuity contracts. These costs include primarily commissions, costs of policy issuance and underwriting, and variable field office expenses. We amortize these deferred policy acquisition costs, or DAC, over the expected lives of the contracts, based on the level and timing of either gross profits, or gross premiums, depending on the type of contract. As of December 31, 2005, DAC in our life business was $1.172 billion and DAC in our annuity business was $491 million.
DAC associated with the term life policies of our domestic individual life insurance business is amortized in proportion to gross premiums. We evaluate the recoverability of our DAC related to these policies as part of our premium deficiency testing. If a premium deficiency exists, we reduce DAC by the amount of the deficiency or to zero through a charge to current period earnings. If the deficiency is more than the DAC balance, we then increase the reserve for future policy benefits by the excess by means of a charge to current period earnings. Generally, we do not expect significant short-term deterioration in experience, and therefore do not expect significant adjustments to the related DAC.
To demonstrate the sensitivity of our variable annuity DAC balance relative to our future rate of return, increasing or decreasing our future rate of return by 100 basis points would have required us to consider adjustments, subject to the statistical approach described above, to that DAC balance as follows. The information provided in the table below considers only the effect of changes in our future rate of return and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC.
Tax regulations require items to be included in the tax return at different times than the items reflected in the financial statements. As a result, the effective tax rate reflected in the financial statements is different than the actual rate applied on the tax return. Some of these
differences are permanent such as expenses that are not deductible in our tax return, and some differences are temporary, reversing over time, such as valuation of insurance reserves. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet recognized in our financial statements. The application of GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax asset to an amount that is more likely than not to be realized. Realization of certain deferred tax assets is dependent upon generating sufficient taxable income in the appropriate jurisdiction prior to the expiration of the carry-forward periods. Although realization is not assured, management believes it is more likely than not the deferred tax assets, net of valuation allowances, will be realized.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service and other taxing jurisdictions for audits ongoing or not yet commenced. On January 26, 2006, the Internal Revenue Service (“IRS”) officially closed the audit of the parent company’s consolidated federal income tax returns for the 1997 to 2001 periods. As a result of certain favorable resolutions, the Company’s consolidated statement of operations for the year ended December 31, 2005 includes an income tax benefit of $36 million, reflecting a reduction in the Company’s liability for income taxes. The parent company’s consolidated federal income tax returns for the 2002 and 2003 periods are currently under examination.
See Note 2, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements.
Deferred sales inducements are higher by $29 million, driven by increased deferred expenses related to sales inducements for annuity products as the Company sells annuity contracts that contain these features.
Cash and cash equivalents declined by $586 million, from $744 million at December 31, 2004 to $158 million at December 31, 2005, due to the deployment of a portion of the available cash balance.
Consolidated net income of $231 million for 2005 improved $118 million from $113 million earned in 2004. The 2005 results include a net $26 million benefit from a reduction in amortization of DAC and other costs and a decrease in our reserve for the guaranteed minimum death benefit feature of our variable annuity product, due to an increased estimate of total gross profits used as a basis for amortizing DAC and other costs reflecting improved net interest spread from increased investment yields and decreased cost of actual and expected death claims. The 2005 results also include a favorable adjustment of $36 million reflecting the resolution of substantially all issues relating to the Internal Revenue Service examination of Prudential’s consolidated federal income tax returns for the 1997 to 2001 periods. Net income in 2005 also reflects lower general and administrative and other expenses, increased fees and more favorable claims experience, net of reinsurance, compared to the prior year period. In addition, results in 2005 included a higher contribution from investment income, net of interest credited and interest expense, while 2004 results include an after-tax charge to income in 2004 of $9 million for the adoption of SOP 03-1. Further details regarding the components of revenues and expenses are described in the following paragraphs.
Consolidated revenues decreased by $55 million, from $1.090 billion in 2004 to $1.035 billion in 2005.
Premiums of $38 million decreased by $35 million, from $73 million in 2004, due to increased ceded reinsurance premiums resulting from the coinsurance agreement with PARCC, an affiliate, to reinsure 90% of the entire term book of business (see Note 13 to the Consolidated Financial Statements) during the third quarter of 2004.
Net investment income increased by $30 million to $404 million in 2005, from $374 million in 2004, due to positive cash flows from operations, reinvestment of net investment income, and more than $6 million of income resulting from the collection of investment income in 2005 on a previously defaulted bond. The fixed maturities portfolio also increased during 2005 from the deployment of funds accumulated as of December 31, 2004, proceeds from short-term borrowings and positive cash flows. This was partially offset by declining fund balances in the GIC products, particularly in the fourth quarter, which decreased due to contract maturities in 2005.
Interest credited to policyholders’ account balances decreased by $16 million, from $251 million in 2004 to $235 million in 2005. Interest credited in the GIC product business was $18 million lower than in the prior year period due to continued maturities and withdrawals in the current year and no additional sales, partly offset by growth in policyholders’ account balances in the life business which increased due to higher policyholder deposits.
General, administrative, and other expenses decreased by $10 million from $459 million 2004 to $449 million 2005. General, administrative and other expenses, excluding DAC amortization, decreased $33 million from the prior year due to lower net distribution costs in the life business, which include reinsurance expense allowances, net of capitalization. Net reinsurance expense allowances increased as a result of the PARCC coinsurance agreement discussed above and are reflected as a deduction within operating expenses. DAC amortization increased $23 million, from $186 million in 2004 to $209 million in 2005. Net DAC amortization in the life business increased by $6 million from the prior year due to GMDB assumption and unfavorable separate account fund performance, partly offset by favorable persistency. DAC amortization in the annuity business increased $17 million, from $59 million in 2004, due to increased gross profits resulting from higher fee income and lower GMDB costs, partially offset by a benefit from the increased estimate of total gross profits, as discussed above.