Management’s narrative addresses the financial condition of Pruco Life Insurance Company of New Jersey as of December 31, 2010, compared with December 31, 2009, and its results of operations for the years ended December 31, 2010 and 2009.
Our businesses are impacted by financial markets, economic conditions, regulatory oversight, and a variety of trends that affect the industries where we compete.
our reinsurance affiliates’ ability to manage risk and exposures, including the degree to which, and the effectiveness of, hedging these risks and exposures.
We update the projected future rate of return and our estimate of total gross profits 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 contracts and variable life policies, as of December 31, 2010, our expected blended rate of return for the next four years across all asset types is 7.6% and 8.6% per annum, respectively. These blended rates represent a weighted average of our expected rates of return across all contract groups. For some contract groups, our expected blended 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 and 2010, the expected blended rate of return over the next four years is under 7.6% per annum, reflecting the impact of more favorable markets in 2009 and 2010 and the reversion to the mean approach.
The DAC balance associated with the variable and universal life policies as of December 31, 2010 was $117 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 direct effect of changes in our mortality assumptions on the DAC balance 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.
Our investment portfolio consists of public and private fixed maturity securities, commercial mortgage loans, equity securities, derivative financial instruments, and other long-term investments. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or the values of securities. Derivative financial instruments we generally use include swaps, options, and futures which are contracted over-the-counter with an affiliate. We are also party to financial instruments that contain derivative instruments that are “embedded” in the financial instruments. Management believes the following accounting policies related to investments, including derivatives, are most dependent on the application of estimates and assumptions. Each of these policies is discussed further within other relevant disclosures related to the investments and derivatives, as referenced below.
We present our investments classified as available for sale, including fixed maturity and equity securities, our investments classified as trading and derivatives, including embedded derivatives at fair value in the statements of financial position. 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 Note 10 to the Financial Statements.
In establishing reserves for guaranteed minimum death and income benefits related to variable annuity contracts, we must make estimates and assumptions about the timing of annuitization, contract lapses and contractholder mortality, as well as interest rates and equity market returns. Assumptions relating to contractholder behavior, such as the timing of annuitization and contract lapses, are based on our experience by contract group, and vary by product type and year of issuance. Our dynamic lapse rate assumption applies a different lapse rate on a contract by contract basis based on a comparison of the guaranteed minimum death or income benefit and the current policyholder account value as well as other factors such as the applicability of any surrender charges. In-the-money contracts are those with a guaranteed minimum benefit in excess of the current policyholder account value. Since in-the-money contracts are less likely to lapse, we apply a lower lapse rate assumption to these contracts. As an example, the lapse rate assumptions for contracts that are not in-the-money and out of their surrender charge period average between 8% and 12% per year, and the lapse rate assumptions for contracts that are in-the-money and out of their surrender charge period average between 0% and 12% per year. Mortality assumptions are generally based on our historical experience or standard industry tables, and also vary by contract group. Unless a material change in contractholder behavior or mortality experience that we feel is indicative of a long term trend is observed in an interim period, we
generally update assumptions related to contractholder behavior and mortality in the third quarter of each year by considering the actual results that have occurred during the period from the most recent update to the expected amounts. Over the last several years, the Company’s most significant assumption updates that have resulted in changes to our reserves for guaranteed minimum death and income benefits have been related to lapse experience and other contractholder behavior assumptions and revisions to expected future rates of returns on investments. The Company expects these assumptions to be the ones most likely to cause significant changes in the future. Changes in these assumptions can be offsetting and can also impact our DAC and other balances as discussed above. Generally, we do not expect our actual mortality trends to change significantly in the short-term, and to the extent these trends may change we expect such changes to be gradual over the long-term.
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 tax year expired on April 30, 2009. The statute of limitations for the 2003 tax year expired on July 31, 2009. The statute of limitations for the 2004 through 2007 tax years will expire in February 2012, unless extended. Tax years 2008 and 2009 are still open for IRS examination. See Note 9 to the Financial Statements for a discussion of the impact in 2009 of changes to our total unrecognized tax benefits related to tax years for which the statute of limitations has expired.
Total assets increased $2.022 billion, from $5.440 billion at December 31, 2009 to $7.462 billion at December 31, 2010. Separate account assets increased $1.776 billion, from $3.262 billion at December 31, 2009 to $5.038 billion at December 31, 2010, primarily driven by both increased annuity deposits that resulted in positive net flows, and improvements in equity markets.
Commercial mortgage loans increased $14.5 million, from $168 million at December 31, 2009, to $182 million at December 31, 2010, during the current period due to continued investment in commercial loans.
Deferred policy acquisition costs increased by $60 million from $306 million at December 31, 2009, to $366 million at December 31, 2010, primarily due to the capitalization of acquisition costs from the growth in sales of annuity products due to the implementation of the aforementioned change in sales strategy.
Total liabilities increased by $1.908 billion, from $4.927 billion at December 31, 2009 to $6.835 billion at December 31, 2010, primarily due to an increase in separate account liabilities of $1.776 billion, driven mainly by both positive net flows and improvements in equity markets described above. Policyholder account balances increased $29 million, from $1.025 billion at December 31, 2009 to $1.054 billion at December 31, 2010, primarily driven by continued growth in universal life in force.
2010 to 2009 Annual Comparison. Income from Operations before Income Taxes increased $44 million from $26 million in 2009 to $70 million in 2010. The increase included a $22 million favorable variance in the mark-to-market of embedded derivatives associated with our non-reinsured living benefit features, including the impact of our market-perceived non-performance risk. This favorable variance was primarily driven by a decrease in the present value of future expected benefit payments resulting from favorable market conditions. Also contributing to the increase was $18 million of lower amortization of deferred policy acquisition costs (“DAC”) and deferred sales inducements (“DSI”) driven by the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives, including reinsured living benefits and related hedge positions in the reinsurance affiliate, as discussed below. In addition fee income increased, net of distribution expenses, driven by higher average variable annuity asset balances invested in separate accounts. The increase in separate account balances was due to positive net flows and net market appreciation. Partially offsetting these items was an unfavorable variance 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 DAC/DSI. These adjustments are discussed in more detail below.
As mentioned above the increase in income from operations in 2010 included an $18 million favorable variance in the amortization of DAC/DSI related to the impact of the mark-to-market of living benefit embedded derivatives, including any reinsured liabilities, and related hedge positions. This impact primarily relates to updates to the inputs used in the valuation of the reinsured liability for living benefit embedded derivatives, primarily due to reductions in the expected lapse rate assumption based on actual experience in 2010. Also contributing to lower DAC/DSI amortization is the impact of a change in our market-perceived non-performance risk (NPR).
As mentioned above, and as shown in the following table, income from operations for 2010 included $7.5 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 DAC and DSI, compared to $8.4 million of benefits for 2009, resulting in a $1 million unfavorable variance.
(1) Amounts reflect (charges) or benefits for (increases) or decreases, respectively, in the amortization of deferred policy acquisition, or DAC, and other assets.
As shown in the table above, results for both periods include the impact of the annual reviews of the assumptions used in the reserve for the guaranteed minimum death and income benefit features of our variable annuity products and in our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs. Results for 2010 included $3 million of benefits from these annual reviews, primarily related to reductions in lapse rate assumptions and more favorable assumptions relating to fee income. Results for 2009 included $1 million of charges from these annual reviews, primarily related to reductions in the future rate of return assumptions applied to the underlying assets associated with our variable annuity products. Partially offsetting the impact of the updated future rate of return assumptions for 2009 were benefits related to the impact of lower mortality and higher investment spread assumptions.
The $3 million benefit for 2010 and the $4 million benefit for 2009 for the quarterly adjustments for current period experience shown in the table above primarily reflect the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as an update for current and future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products. The unfavorable variance related to the amortization of DAC/DSI was primarily driven by more favorable market conditions in 2009 compared to 2010. The unfavorable variance related to the adjustment to the GMDB/GMIB reserves was primarily driven by more favorable differences in actual lapse experience and contract guarantee claim costs in 2009 compared to 2010.
2010 to 2009 Annual Comparison. Benefits and expenses decreased $2 million from $35 million in 2009 to $33 million in 2010.
Amortization of deferred policy acquisition costs (“DAC”) decreased by $8 million, from $10 million in 2009 to $2 million in 2010. This decrease was primarily driven by lower DAC amortization from the impact of the mark-to-market of the reinsured for living benefit embedded derivatives, including reinsured liabilities, and related hedge positions, as discussed above.
General, administrative and other expenses increased $9 million from $10 million in 2009 to $19 million in 2010, primarily due to higher commission expense and marketing and new business support expenses driven by higher sales due to the implementation of the aforementioned change in sales strategy.
2010 to 2009 Annual Comparison. Income (loss) from Operations before Income Taxes increased $21 million from income of $50 million in 2009 to $71 million in 2010. Results for 2010 included a $6 million benefit from lower amortization of net deferred policy acquisition costs and unearned revenue reserves, as well as a decrease in reserves for the guaranteed minimum death benefit feature in certain contracts, reflecting updates of our actuarial assumptions based on an annual review, compared to a $3 million benefit from the annual review in 2009. The annual reviews cover assumptions used in our estimate of total gross profits which forms the basis for amortizing deferred policy acquisition costs and unearned revenue reserves, as well as the assumptions utilized in the development of certain actuarial reserve valuations.
2010 to 2009 Annual Comparison Revenues decreased $6 million from $121 million in 2009 to $115 million in 2010.
Net realized investment gains/ (losses) increased by $15 million from a loss of $8 million in 2009 to a gain of $7 million in 2010, primarily driven by the impact of gains on investments in derivatives and fixed maturities compared to losses in 2009.
Net investment income increased $9 million, due to an increase in assets supporting our term and universal life products and growth in universal life and variable policyholder account balances due to increased policyholder deposits.
Liquidity refers to a company’s ability to generate sufficient cash flows to meet the needs of its operations. Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of those operations. We segment our investment portfolios and employ an asset/liability management approach specific to the requirements of our product lines. This enhances the discipline applied in managing the liquidity, as well as the interest rate and credit risk profiles, of each portfolio in a manner consistent with the unique characteristics of the product liabilities. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact of Prudential Funding, LLC’s financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company.
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 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. As a result of the launch of its new annuity product line in March 2010, as discussed above, the Company has seen and expects to continue to see the overall level of these activities to increase.
Liquid assets include cash, cash equivalents, short-term investments, fixed maturities and public equity securities. As of December 31, 2010 and December 31, 2009; our insurance operations had liquid assets of $1.2 billion and $1.1 billion, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $95.4 million and $61.0 million as of December 31, 2010 and December 31, 2009, respectively. As of December 31, 2010, $973 million, or 91%, of the fixed maturity investments company general account portfolios were rated investment grade. The remaining $91 million, or 9%, of these fixed maturity investments were rated non-investment grade. 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 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.
Prudential Financial recently changed the focus of the capital hedge program from the equity price risk associated with the annuities business to a broader view of equity market exposure of the statutory capital of Prudential Financial and its subsidiaries, as a whole. In the second quarter of 2010, the capital hedge program was terminated and equity index-linked derivative transactions were entered into that are designed to mitigate the overall impact on statutory capital of a severe equity market stress event on Prudential Financial and its subsidiaries, as a whole. The program now focuses on tail risk rather than general equity market declines in order to protect statutory capital in a more cost-effective manner under stress scenarios. Prudential Financial assesses the composition of the hedging program on an ongoing basis and may change it from time to time based on an evaluation of its risk position or other factors.