The Company occupies office space in Shelton, Connecticut, which is leased from an affiliate, Prudential Annuities Information Services and Technology Corporation, formerly known as American Skandia Information Services and Technology Corporation. The Company entered into a lease for office space in Westminster, Colorado, effective January 1, 2001, and established an additional customer service center at that location. Effective December 31, 2004, the Company closed its customer service center in Colorado. The Company believes that its current facilities are satisfactory for its near term needs.
During 2010, each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company within Prudential Financial Inc.’s Prudential Annuities business unit) intends to begin selling a new product line of variable annuity products. In general, the new product line offers the same optional living benefits and optional death benefits as are being offered for new elections under many of the Company’s existing variable annuities. With very limited exceptions, the Company will cease offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of this new product line in 2010. However, subject to applicable contractual provisions and administrative rules, the Company will continue to accept purchase payments on inforce contracts under those existing annuity products. These initiatives are being implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. In addition, by limiting its variable annuity offerings to a single product line sold through one insurer (and its affiliate, for New York sales), Prudential Annuities expects to convey a more focused, cohesive image in the marketplace.
our ability to price our products at a level that enables us to earn a margin over the cost of providing benefits and the expense of acquiring customers and administering those products;
the amount of assets under management and changes in their fair value, which affect the amount of asset administration fees we receive;
We capitalize costs that vary with and are related primarily to the acquisition of new and renewal annuity contracts. These costs primarily include commissions, costs of policy issuance and other variable expenses that are incurred in producing new business. We amortize these deferred policy acquisition costs, or DAC, 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 amortization we are required to make assumptions about investment returns, mortality and other items that impact our estimates of the level and timing of gross profits. As of December 31, 2009 and 2008, DAC was $1,411.6 million and $1,247.1 million, respectively.
DAC is amortized over the expected life of the policy in proportion to estimated 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. The impact of our capital hedging program, which we began in the second quarter of 2009, is not considered in calculating gross profits. 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.
DAC is sensitive to the effects of changes in our estimates of gross profits primarily due to the significant portion of gross profits that is dependent upon the total rate of return on assets held in separate account investment options. This rate of return influences the fees we earn, costs we incur associated with the guaranteed minimum death and optional living benefit features related to our variable annuity contracts, as well as other sources of profit. Returns that are higher than our expectations for a given period produce higher than expected account balances, which increase the fees we earn and decrease the costs we incur associated with the guaranteed minimum death and optional living benefit features related to our variable annuity contracts, resulting in higher expected future gross profits and lower DAC amortization for the period. The opposite occurs when returns are lower than our expectations.
In the fourth quarter of 2008 we 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. As of December 31, 2009, our expected rate of return for the next four years across all asset types is 7.2% per annum. These rates represent a weighted average of our expected rates of return across all contract groups. For most contract groups, our expected rate of return for the next four years equals our current maximum future rates of return, as the near-term projected future rate of return under the reversion to the mean approach is greater than our maximum future rate of return. For certain contract groups relating to variable annuities issued in 2009, the expected rate of return over the next four years is under 7.2% per annum, reflecting the impact of more favorable markets in 2009 and the reversion to the mean approach.
In addition to DAC, we also recognize assets for deferred sales inducements and valuation of business acquired (“VOBA”). The deferred sales inducements 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 6 to the Financial Statements. VOBA represents the present value of future profits embedded in acquired businesses, and is determined by estimating the net present value of future cash flows from the contracts in force at the date of acquisition. VOBA is amortized over the effective life of the acquired contracts. For additional information about VOBA including its bases for amortization, see Note 5 of the financial statements. Deferred sales inducements and VOBA 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.
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 Financial Statements.
The Company’s liability for future policy benefits is primarily comprised of the present value of estimated future payments to or on behalf of policyholders, where the timing and amount of payment depends on policyholder mortality, less the present value of future net premiums. Expected mortality is generally based on the Company’s historical experience or standard industry tables. Interest rate assumptions are based on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are “locked-in” upon the issuance of new insurance or annuity business with fixed and guaranteed terms, significant changes in experience or assumptions may require the Company to provide for expected future losses on a product by establishing premium deficiency reserves. The Company’s liability for future policy benefits is also inclusive of liabilities for guarantee benefits related to certain nontraditional long-duration life and annuity contracts, which are discussed more fully in Note 6. These reserves represent reserves for the guaranteed minimum death and optional living benefit features on our variable annuity products. The optional living benefits are primarily accounted for as embedded derivatives, with fair values calculated as the present value of future expected benefit payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature. For additional information regarding the valuation of these optional living benefit features, see Note 10.
For a discussion of adjustments to the reserves for guaranteed minimum death and income benefits for the years ended December 31, 2009, 2008 and 2007, see “-Results of Operations”.
An increase or decrease in our effective tax rate by one percent of income (loss) from continuing operations before income taxes and equity in earnings of operating joint ventures, would have resulted in an increase or decrease in our loss from continuing operations before equity in earnings of operating joint ventures in 2009 of $0.3 million.
See Note 2 to the Financial Statements for a discussion of adopted and recently issued accounting pronouncements.
Net income increased $63.6 million from $20.0 million for the twelve months ended December 31, 2008 to $83.6 million for the twelve months ended December 31, 2009. This is driven by a $51.4 million increase in income from operations before income taxes, as discussed below, and by a $12.2 million increase in income tax benefit as a result of an increase in the projected amount of nontaxable investment income earned by the Company, as discussed below.
Income from operations for the twelve months ended December 31, 2009 included a $153.4 million of benefits related to adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, compared to $469.3 million of charges included in 2008, resulting in a $622.6 million favorable variance, as shown in the following table:
(3) As discussed below, market performance related adjustments were recognized quarterly beginning in the fourth quarter of 2008. Amounts for 2008 include adjustment recognized as part of our annual reviews in the third quarter of 2008.
These adjustments primarily reflect the market conditions that existed in the respective periods, and the estimated impact of those market conditions on contractholder behavior, and are discussed individually in more detail below. Partially offsetting the net benefit from these adjustments was $76.1 million of mark-to-market losses related to derivative positions associated with our capital hedging program. In the second quarter of 2009, we began a hedging program to include a portion of the market exposure related to the overall capital position of our variable annuity business. These capital hedges primarily consist of equity-based total return swaps, which are designed to partially offset
The overall better than expected market returns in 2009 increased our estimates of total gross profits and decreased our estimate of future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products, by establishing a new, higher starting point for the variable annuity account values used in estimating those items for future periods. The previously expected rates of return for 2009, for most contract groups, was based upon our maximum future rate of return assumption under the reversion to the mean approach, as discussed below. The increase in our estimate of total gross profits and decrease in our estimate of future expected claims costs results in a lower required rate of amortization and lower required reserve provisions, which are applied to all prior periods. The resulting cumulative adjustment to prior amortization and reserve provisions are recognized in the current period. In addition, the lower rate of amortization and reserve provisions will also be applied in calculating amortization and the provision for reserves in future periods. The $282.6 million charge in 2008 is attributable to a similar but opposite impact on gross profits of market value decreases in the underlying assets associated with our variable annuity products, reflecting financial market conditions during the period.
Income from operations for the twelve months ended December 31, 2009 also included $135.8 million of amortization of deferred policy acquisition and other costs from a decrease in the reinsured liability for living benefit embedded derivatives and its impact on actual gross profits resulting from the impact of the change in non-performance risk in the valuation of embedded derivatives. We are required to incorporate our own risk of non-performance in the valuation of the embedded derivatives associated with our living benefit features. In light of recent developments, including rating agency downgrades to our claims-paying ratings beginning in the first quarter of 2009, we incorporated an additional spread over LIBOR into the discount rate used in the valuation of the embedded derivative liabilities to reflect an increase in our market perceived non-performance risk, thereby reducing the value of the embedded derivative liabilities. We amortize deferred policy acquisition and other costs 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 as a result of, for example, reinsurance agreements with those affiliated entities.
Revenues decreased $80.5 million, from $1,216.1 million for the twelve months ended December 31, 2008 to $1,135.6 million for the twelve months ended December 31, 2009. Premiums decreased $7.0 million, from $20.4 million for the twelve months December 31, 2008 to $13.4 million for the twelve months December 31, 2009, reflecting a decrease in funds from customers electing to enter into the payout phase of their annuity contracts.
Net investment income increased $174.6 million from $320.1 million for the twelve months ended December 31, 2008 to $494.7 million for the twelve months ended December 31, 2009 as a result of higher transfers of balances to fixed income investments backed by our general account, as previously discussed,
Policyholders’ benefits decreased $324.9 million, from $329.3 million for the twelve months ended December 31, 2008 to $4.4 million for the twelve months ended December 31, 2009, primarily driven by the impact of the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products.
Interest credited to policyholders’ account balances increased $129.3 million, from $279.7 million for the twelve months ended December 31, 2008 to $409.0 million for the twelve months ended December 31, 2009, primarily due to an increase in deferred sales inducements (“DSI”) amortization of $110.0 million driven by higher levels of actual gross profits and the impact of the change in non-performance risk in the valuation of embedded derivatives under the authoritative guidance for fair value measurements and disclosures, as previously discussed. Also contributing to the increase was an increase in interest credited to policyholders’ account balances of $72.4 million primarily reflecting higher average annuity account values invested in our general account resulting from transfers relating to an automatic rebalancing element in some of our optional living benefit features. Partially offsetting the above increases was a benefit of $56.6 million from the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing DSI, as previously discussed.
General, administrative and other expenses decreased by $27.3 million, from $370.2 million for the twelve months ended December 31, 2008 to $397.5 million for the twelve months ended December 31, 2009, primarily due to $32.8 million of lower interest expense driven by the repayment of debt. Also contributing to the decrease was $21.3 million impact of the adjustments to our estimate of total gross profits used as a basis for amortizing value of business acquired (“VOBA”). Partially offsetting the above decreases was $30.6 of higher implied trail commission expenses driven by higher sales.
As discussed above, the overall $131.9 million decrease in benefits and expenses included a benefit of $622.6 million related to the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, as previously discussed. Benefits and expenses also included $135.8 million of higher amortization of deferred acquisition cost and other cost related to the impact of the change in non-performance risk in the valuation of embedded derivatives under the authoritative guidance for fair value measurements and disclosures, as previously discussed. Absent the effect of the quarterly adjustments and assumption updates, and the change in non-performance risk in the valuation of embedded derivatives under the authoritative guidance for fair value measurements and disclosures, benefits and expenses for the twelve months ended December 31, 2009 increased $355.0 million from the twelve months ended December 31, 2008.
Shown below is reconciliation between our income tax provision for the years ended December 31, 2008, 2007 and 2006, to the income tax provision that would have resulted from application of the statutory 35% federal income tax rate in each of these periods.
The disruptions in the capital markets that began in the second half of 2007, initially due to concerns over sub-prime mortgage holdings of financial institutions, accelerated to unprecedented levels in the latter half of 2008 and continued into 2009, resulting in failure, consolidation, or U.S. federal government intervention on behalf of several significant financial institutions. These disruptions resulted in significant market volatility and adversely impacted the availability and cost of credit and capital. However, certain markets have shown marked improvement since mid-2009. Equity markets have appreciated, with less volatility, and bond spreads have tightened significantly.
The principal sources of the Company’s liquidity are annuity considerations, investment and fee income, and investment maturities and sales, as well as 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, and payments in connection with financing activities.
Liquid assets include cash, cash equivalents, short-term investments, most fixed maturities that are not designated as held to maturity and public equity securities. As of December 31, 2009 and December 31, 2008, the Company had liquid assets of $7.3 billion and $10.2 billion, respectively, which includes a portion financed with asset-based financing. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $0.8 billion and $0.3 billion as of December 31, 2009 and December 31, 2008, respectively. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures in order to evaluate the adequacy of our operations’ liquidity under a variety of stress scenarios. We believe that the liquidity profile of our assets is sufficient to satisfy current liquidity requirements, including under foreseeable stress scenarios.
Our liquidity is managed through access to substantial investment portfolios as well as a variety of instruments available for funding and/or managing cash flow mismatches, including from time to time those arising from claim levels in excess of projections. To the extent we need to pay claims in excess of projections, we may borrow temporarily or sell investments sooner than anticipated to pay these claims, which may result in increased borrowing costs or realized investment gains or losses affecting results of operations.
The implementation of VACARVM, a new statutory reserve methodology for variable annuities with guaranteed benefits, effective December 31, 2009 had an impact of approximately $61 million benefit on the statutory surplus of the Company. As discussed above, market conditions during 2008 negatively impacted the level of our capital. In order to address these impacts on our capital, Prudential Financial made capital contributions to certain domestic insurance subsidiaries, including the Company, which was subsequently used to repay portions of our outstanding loans with Prudential Financial.