Management’s Discussion and Analysis of Financial Condition and Result of Operations, or “MD&A”, is omitted pursuant to General Instruction I(2)(a) of Form 10-K. The management narrative for Prudential Annuities Life Assurance Corporation that follows should be read in conjunction with the Forward-Looking Statements included below the Table of Contents, “Risk Factors”, and the Financial Statements and related notes included in this Annual Report on Form 10-K.
Our ability to manufacture and distribute products and services and to introduce new products gaining market acceptance on a timely basis;
Our returns on invested assets, including the impact of credit impairments, net of the amounts we credit to policyholders’ accounts;
Our amount of assets under management and changes in their fair value, which affect the amount of asset administration fees we receive;
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews estimates and assumptions used in the preparation of financial statements. If management determines that modifications in assumptions and estimates are appropriate given current facts and circumstances, results of operations and financial position as reported in the Financial Statements could change significantly.
Commercial loans, which comprised nearly 4% of our investments as of December 31, 2008, 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 annuity contracts. These costs primarily include commissions, costs of policy issuance and other variable expenses. We amortize these deferred policy acquisition costs, or DAC, over the expected lives of the contracts, based on the level and timing of gross profits. As of December 31, 2008 and 2007, DAC was $1,247.1 million and $1,042.8 million, respectively.
The quarterly adjustments for current period experience referred to above reflect the cumulative 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.
DAC is sensitive to the effects of changes in our estimates of gross profits due primarily to the significant portion of gross profits that is dependent upon the total rate of return on assets held in separate account investment options, and the shorter average life of the contracts. This rate of return influences the fees we earn, costs we incur associated with minimum death benefit and other contractual guarantees specific to our variable annuity contracts, as well as other sources of profit.
The future rate of return assumptions used in evaluating DAC is 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 a 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, we 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. Our expected rate of return for the next four years across all asset types is 10.5% per annum our maximum future rate of return under the reversion to the mean approach, which reflects, among other assumptions, a rate of return of 12.8% per annum for equity type assets. Our long-term expected rate of return across all asset types is 8.2% per annum, respectively, which reflects, among other assumptions, an expected rate of return of 9.5% per annum for equity type assets.
To demonstrate the sensitivity of our 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 range of estimated gross profits determined by the statistically generated rate of returns described above, to that DAC balance as follows. 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. The information provided in the table below 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.
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.
On January 1, 2007, we adopted FIN No. 48, “Accounting for Uncertainty in Income Taxes,” an Interpretation of FASB Statement No. 109. This interpretation prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that a company has taken or expects to take on a tax return. FIN No. 48 is a two-step process, the first step being recognition. We determine whether it is more likely than not, based on the technical merits, that the tax position will be sustained upon examination. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. We measure the tax position as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate resolution with a taxing authority that has full knowledge of all relevant information. This measurement considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement using the facts, circumstances, and information available at the reporting date.
Assets decreased by $5.7 billion, from $45.3 billion at December 31, 2007 to $39.6 billion at December 31, 2008. Separate account assets decreased by $17.3 billion, primarily driven by market depreciation during the current year and transfers to our general account due to an automatic rebalancing element in certain of our living benefit features which resulted in increases in fixed maturities of $8.5 billion and commercial loans of $333 million. Reinsurance recoverables increased $2.0 billion from $104.0 million at December 31, 2007 to $2.1 billion at December 31, 2008 driven by an increase in the reinsured liability for living benefit embedded derivatives resulting from market volatility. Additionally, deferred policy acquisition costs (“DAC”) and deferred sales inducements (“DSI”) also increased by $204.3 million and $167.5 million from December 31, 2007 to December 31, 2008, respectively, due to sales driving higher capitalized costs.
During the period, total liabilities decreased by $6.3 billion, from $44.2 billion at December 31, 2007 to $37.9 billion at December 31, 2008. Separate account liabilities decreased by $17.3 billion driven by market depreciation during the current year and transfers to our general account due to an automatic rebalancing element in certain of our living benefit features. Partially offsetting the separate account decrease were increases in policyholders’ account balances of $9.1 billion primarily due to the aforementioned general account transfers. Additionally, future policy benefits and other policyholder liabilities increased $2.3 billion from $228.2 million at December 31, 2007 to $2.5 billion at December 31, 2008 driven by an increase in liability for living benefit embedded derivatives resulting from market volatility.
Realized investment losses, net, decreased by $87.0 million from losses of $41.0 million for the year ended December 31, 2007 to gains of $46.0 million for the year ended December 31, 2008 driven by increased investment gains on our general account and MVA portfolio due to decrease in interest rates.
Asset administration fees decreased $26.8 million, from $223.8 million for the year ended December 31, 2007 to $197.0 million for the year ended December 31, 2008 as a result of lower variable annuity asset balances invested in separate accounts due to market depreciation. Asset administration fees are asset based fees, which are dependent on the value of assets under management.
Benefits and expenses increased $546.7 million, from $688.7 million for the year ended December 31, 2007 to $1,235.4 million for the year ended December 31, 2008. Results for both periods include the impact of the annual reviews discussed above. Benefits and expenses for the first year of 2008 included a $363.8 million charge from the annual review, including $217.5 million relating to reserve increases for the guaranteed minimum death and income benefit features of our variable annuity products and $146.3 million relating to increased amortization of deferred policy acquisition and other costs. Benefits and expenses for the first year of 2007 included a $40.6 million benefit from the annual review including $24.8 million relating to reserve decreases for the guaranteed minimum death and income benefit features of our variable annuity products and $15.8 million relating to decreased amortization of deferred policy acquisition and other costs. Absent the impact of these annual reviews, benefits and expenses for the year ended December 31, 2008 increased $142.4 million from the year ended December 31, 2007.
Policyholders’ benefits increased $261.9 million, from $67.4 million for the year ended December 31, 2007 to $329.3 million for the year ended December 31, 2008, driven by $242.3 million from the impact of an annual review relating to reserve increases for the guaranteed minimum death and income benefit features of our variable annuity products, as discussed above.
Interest credited to policyholders’ account balances increased $187.7 million, from $92.0 million for the year ended December 31, 2007 to $279.7 million for the year ended December 31, 2008, primarily driven by higher average annuity account values invested in our general account resulting from transfers relating to an automatic rebalancing element in some of our living benefit features, as discussed above. Also contributing to the increase was the impact of an annual review of our estimate of total gross profits used as a basis for amortizing deferred sales inducements, as discussed above.
Shown below is our income tax provision for the years ended December 31, 2008, 2007 and 2006, separately reflecting the impact of certain significant items. Also presented below is the income tax provision that would have resulted from application of the statutory 35% federal income tax rate in each of these periods.
In August 2007, the Internal Revenue Service, or IRS, issued Revenue Ruling 2007-54, which included, among other items, guidance on the methodology to be followed in calculating the DRD related to variable life insurance and annuity contracts. In September 2007, the IRS released Revenue Ruling 2007-61. Revenue Ruling 2007-61 suspends Revenue Ruling 2007-54 and informs taxpayers that the U.S. Treasury Department and the IRS intend to address through new regulations the issues considered in Revenue Ruling 2007-54, including the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulations or legislation, could increase our actual tax expense and reduce our net income. These activities had no impact on our 2007 or 2008 results.
Extraordinary Market Conditions and their Impact on our Liquidity and Capital Resources
Beginning in the latter half of 2007 and continuing into 2009, severe dislocations in the credit and capital markets, initially driven by broad market concerns over the impact of sub-prime mortgage holdings of financial institutions, generally resulted in reduced availability and increased cost of credit for financial institutions in the marketplace, including the Company. These dislocations accelerated following the failure, consolidation, or U.S. federal government intervention on behalf of several significant financial institutions.
This market dislocation has adversely impacted our liquidity and capital plans, results of operations, and financial position. The market conditions also negatively impacted our capital levels, as a result of asset value declines and the need to strengthen reserves.
The Company continues to operate with significant cash on the balance sheet and has access to alternate sources of liquidity. However, a continuation or worsening of the disruptions in the credit and capital markets could adversely affect our ability to access sources of liquidity, as well as threaten to reduce our capital below a level that is consistent with our existing ratings objectives. Therefore, we may need to take additional actions, which may include but are not limited to: (1) additional capital management activities; (2) further access to our alternative sources of liquidity; (3) limiting or curtailing sales of certain products and/or restructuring existing products; and (4) seeking temporary or permanent changes to regulatory rules. Certain of these actions may require regulatory approval.
We believe that the cash flows from our operations are adequate to satisfy the current liquidity requirements of these operations, including under reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors such as future securities market conditions, changes in interest rate levels, policyholder perceptions of our financial strength, and the relative safety of competing products (including those with enhancements under EESA), each of which could lead to reduced cash inflows or increased cash outflows. In addition, market volatility can impact the level of capital required to support our businesses. Our cash flows from investment activities result from repayments of principal, proceeds from maturities and sales of invested assets, net of amounts reinvested. The primary liquidity risks with respect to these cash flows are the risk of default by debtors or bond insurers, our counterparties’ willingness to extend repurchase and/or securities lending arrangements, commitments to invest and market volatility. We closely manage these risks through our credit risk management process and regular monitoring of our liquidity position.
In managing our liquidity, we also consider the risk of policyholder and contractholder withdrawals of funds earlier than our assumptions when selecting assets to support these contractual obligations. We use surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of withdrawals of funds by customers from annuity contracts and deposit liabilities.
Liquid assets include cash, cash equivalents, short-term investments, fixed maturities that are not designated as held to maturity and public equity securities. As of December 31, 2008 and December 31, 2007, the Company had liquid assets of $10.2 billion and $1.5 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 $0.3 billion and $0.1 billion as of December 31, 2008 and December 31, 2007, 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 domestic insurance 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 short-term 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.
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 up to limits established with the New Jersey Department of Banking and Insurance.