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 term 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 ability to manage risk and exposures, including the degree to which, and the effectiveness of, hedging these risks and exposures.
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, which we validate for reasonability. However, for our investments in private securities such as private placement fixed maturity securities, which comprised 14% of our investments as of December 31, 2008, 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. In determining the fair value of certain securities, the discounted cash flow model may also use unobservable inputs, which reflect our own assumptions about the inputs market participants would use in pricing the asset.
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, over the expected life 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, 2008, DAC in our life business was $260 million and DAC in our annuity business was $66 million.
DAC associated with the variable and universal life policies and the variable and fixed annuity contracts are 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
The DAC balance associated with the variable and universal life policies as of December 31, 2008 was $165 million. 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%. While the information below is for illustrative purposes only and does not reflect our expectations regarding future mortality assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change. This information considers only the effect of changes in our mortality assumptions and not changes in any other assumptions such as persistency, future rate of return, or expenses included in our evaluation of DAC, and does not reflect changes in reserves, such as the unearned revenue reserve, which would partially offset the adjustments to the DAC balance reflected below.
The 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, 2008, our expected rate of return for the next four years across all asset types is 10.5% and 10.9% 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 that range from 12.8% to 15.0%. Our long-term expected rate of return across all asset types for variable annuities products and variable life policies range from 8.0% to 8.2%, 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.
In addition to DAC, we also recognize assets for deferred sales inducements. The deferred sales inducements are recognized and are amortized over the anticipated life of the policy using the same methodology and assumptions used to amortize deferred policy acquisition costs. For additional information about our deferred sales inducements, see Note 4 to the Financial Statements. Deferred sales inducements are also subject to recoverability testing at the end of each reporting period to ensure that the capitalized amounts do not exceed the present value of total anticipated gross profits.
An increase or decrease in our effective tax rate by one percent, would have resulted in a decline or increase in income from continuing operations in 2008 of $0.3 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 and 2003 U.S. Federal tax years is set to expire in 2009. The company does not anticipate any significant changes to it’s unrecognized tax benefit during the next 12 months. U.S. Federal tax years 2004 through 2008 are still open for IRS examination.
On January 26, 2006, the IRS officially closed the audit of our federal income tax returns for the 1997 to 2001 periods. The statute of limitations has closed for these tax years; however, there were tax attributes which were utilized in subsequent tax years for which the statute of limitations remains open.
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under GAAP, reserves for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial reserve reflects management’s best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure.
Total assets decreased by $463 million, from $4.697 billion at December 31, 2007 to $4.234 billion at December 31, 2008. The largest decrease was in separate account assets, which decreased $619 million, from $2.926 billion at December 31, 2007 to $2.307 billion at December 31, 2008, primarily driven by equity market depreciation during the current year. Fixed maturities decreased by $108 million, from $904 million at December 31, 2007 to $796 million at December 31, 2008. This was primarily driven by additional unrealized losses of $70 million driven by market depreciation and reinvestments in commercial loans. The decline was partially offset by transfers from our separate account to our general account due to an automatic rebalancing element in certain of our living benefit features on our annuity products. Also contributing to the increase was continued reinvestment of cash flows from business operations and reinvestment of investment income in our life business primarily due to continued growth of our universal business. These declines are partially offset by the items discussed below.
Reinsurance recoverables from parent and affiliates increased by $114 million from $187 million at December 31, 2007, to $301 million at December 31, 2008. This increase was primarily due to continued growth in term in-force covered by PARCC coinsurance agreement and increased living benefit embedded derivatives resulting from market declines on our annuity products covered under Pruco Re. (see Note 13 to the Financial Statements).
Total liabilities decreased by $450 million from $4.270 billion at December 31, 2007, to $3.820 billion at December 31, 2008, primarily due to a decline in separate account liabilities of $619 million due to market depreciation during the current year. Future policy benefits and other policyholder liabilities increased by $145 million, from $313 million at December 31, 2007 to $458 million at December 31, 2008, primarily due to an increase in the liability for living benefit embedded derivatives resulting from equity market declines. Also contributing was the increases to life reserves as a result of sales and renewals of term products. Policyholder account balances increased by $104 million from $806 million at December 31, 2007 to $910 million at December 31, 2008, primarily due to transfers to our general account due to an automatic rebalancing element in certain of our living benefit annuity features and continued universal life products sales. The Company’s short-term borrowings from an affiliate used to provide short-term working capital decreased by $55.8 million from $55.9 million at December 31, 2007 to $.1 million at December 31, 2008 due to payments. Total securities lending position at December 31, 2008 decreased by $2 million from December 31, 2007. The relative amounts of cash collateral for loaned securities and securities sold under agreements to repurchase decreased $10 million and increased $8 million, respectively.
Net realized investment losses increased by $25 million, from realized losses of $2 million in 2007 to realized losses of $27 million in 2008, mainly due to losses of $10 million due to mark-to-market accounting on embedded derivatives associated with a dollar denominated foreign investment and realized losses of $9 million from impairments of fixed maturities. Also contributing was $3 million of realized losses on derivative values resulting from lower interest rates and mark-to-market losses on embedded derivatives associated with certain externally managed investments in the European markets.
Policy charges and fee income, consisting primarily of mortality and expense charges, loading and other insurance charges assessed on general and separate account policyholders’ fund balances, decreased by $1 million, from $77 million in 2007, to $76 million in 2008. Results for 2008 included a $3 million charge related to the amortization of unearned revenue reserves based on the annual reviews in the third quarter. Results for the third quarter 2007 include a $3 million benefit from the annual review. Absent this item policy charges and fee income increased $5 million due to growth in our universal life insurance in-force.
Policyholders’ benefit and expenses, including related changes in reserves, increased by $13 million, from $17 million in 2007, to $30 million in 2008. The increase was mainly driven by the annual review in both periods, discussed above, due to increased reserves for guaranteed minimum death benefits and income benefits of $2 million in third quarter 2008. The prior year benefited $1 million from the annual review conducted in the third quarter due to lower reserves. Also contributing in 2008 was $4 million of charges relating to reserve increases for the guaranteed minimum death and income benefit of our variable annuity contracts in the fourth quarter, as discussed above. Absent the impacts of the annual reviews conducted in both periods and additional market performance adjustments policyholders’ benefit and expenses, including related changes in reserves, increased $5 million primarily due to reserve growth in the term life business due to continued sales.
General, administrative, and other expenses decreased by $4 million from $61 million in 2007 to $57 million in 2008. The current year benefited $3 million due to the result of annual reviews in the third quarter, discussed above. The prior year increased $3 million from the annual review conducted in the third quarter of 2007. Fourth quarter 2008 expenses included an $5 million increase in amortization of deferred policy acquisition costs due to market and reversion to the mean assumptions on our variable annuity and life business. Absent the impacts of the annual reviews conducted in both periods and reversion to the mean assumptions, general, administrative, and other expenses decreased $3 million in 2008, primarily driven by driven by lower bonus costs and higher net reinsurance expense allowances resulting from growth in the term business. This decrease was partially offset by higher amortization of deferred acquisition costs due to unfavorable separate account fund performance.
The decline in income tax expense primarily reflects the decline in income from continuing operations before income taxes for the year ended December 31, 2008. 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 market dislocation has adversely impacted our liquidity and capital plans, results of operations, and financial position. The market conditions also negatively impacted the level of capital, as a result of asset value declines and the need to strengthen reserves, particularly in our annuity businesses.
Liquidity is measured against internally developed benchmarks that take into account the characteristics of both the asset portfolio and the liabilities that they support. The results are affected substantially by the overall asset type and quality of our investments.
The principal sources of the Company’s liquidity are premiums and annuity considerations, investment and fee income, and investment maturities and sales associated with our insurance and annuity operations, as well as internal borrowings. The principal uses of that liquidity include benefits, claims, dividends paid to policyholders, and payments to policyholders and