See “Risk Factors” for a discussion of risks that may have materially affected and may affect in the future the Company’s business, results of operations or financial condition, or cause the Company’s actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.
The DAC balance associated with the variable and universal life policies as of December 31, 2009 was $123 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.
See “Results of Operations” for a discussion of the impact of DAC amortization on our results of the life and annuities products.
changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate. For example, the dividends received deduction, or DRD, reduces the amount of dividend income subject to tax and is
See Note 2 to the Financial Statements for a discussion of recently adopted accounting pronouncements, including the adoption of revised authoritative guidance for disclosing fair value of financial instruments, the recognition and presentation of other-than-temporary impairments and fair value measurements and disclosures.
Total assets increased $1.206 billion, from $4.234 billion at December 31, 2008 to $5.440 billion at December 31, 2009. Separate account assets increased $955 million, from $2.306 billion at December 31, 2008 to $3.262 billion at December 31, 2009, primarily driven by positive net flows and improvements in equity markets.
Fixed maturities increased by $258 million from $796 million at December 31, 2008 to $1.054 billion at December 31, 2009. This increase was primarily driven by investment of cash flows from business operations, reinvestment of investment income and unrealized gains on fixed maturities in the current year resulting from a narrowing of credit spreads that increased the market value of these securities. Partially offsetting this increase were transfers of account balances to the separate account variable investment options from the fixed investment options backed by our general account due to an automatic rebalancing element on certain variable annuity contracts.
Reinsurance recoverables increased by $21 million from $301 million at December 31, 2008 to $322 million at December 31, 2009 driven by the impact of an increase in LIBOR swap rates and the change in non-performance risk (NPR) in the valuation of embedded derivatives that are classified as reinsurance recoverables. We are required to incorporate the risk of non-performance of our affiliates’ in the valuation of the embedded derivatives associated with the living benefit features of variable annuity policies and no lapse features in our universal life policies. In light of first quarter 2009 developments, including rating agency downgrades to claims-paying ratings of affiliates’, we updated the discount rate used in these valuations to reflect the market-perceived increase in our affiliates’ non-performance risk. As of September 30, 2009, we used a higher discount rate in the valuation as a result of the increase in their non-performance risk, thereby reducing the value of the embedded derivative assets. This was partially offset by increased reinsurance recoverables due to continued growth in the term life in force covered under the Prudential Arizona Reinsurance Captive Company, or “PARCC” agreements.
Net income increased $11 million from income of $25 million in 2008 to $36 million in 2009. This decline was driven by a $16 million increase in income from operations before income taxes, primarily due to improved earnings on variable products which benefited from lower amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, driven by the impact of more favorable equity markets in 2009 on separate account fund performance. Separate account fund performance above expected levels results in an increase in total expected gross profits on which the amortization of deferred policy acquisition costs net of the amortization of unearned revenue reserves is based, and accordingly, lower amortization in the current period. The prior year period contained higher amortization of deferred policy acquisition costs, net of higher amortization of unearned revenue reserves in comparison to the current year, due to separate account fund performance that was below expected levels. Net Income also benefited from higher earnings in 2009 associated with growth in term and universal life insurance in force, partially offset by a $5 million increase in income tax expense driven by higher pre-tax income. Net income for 2009 also includes a benefit of $3 million from annual reviews of the assumptions used in our estimate of total gross profits as discussed below. Results for 2008 include a benefit of $1 million from the annual assumption review.
Individual Life and Other revenues are relatively unchanged compared to the prior year.
Policy charges and fee income, consisting primarily of mortality and expense and other insurance charges assessed on general and separate account policyholders’ fund balances, decreased by $6 million from $58 million in 2008 to $52 million in 2009. The current year included lower amortization of unearned revenue reserves of $4 million and the prior year include lower amortization of unearned revenue reserves of $3 million due to updates to our assumptions related to the amortization of unearned revenue reserves based on the annual reviews as discussed below. Absent this item, policy charges and fee income decreased $7 million in 2009, primarily driven by lower amortization of unearned revenue reserves reflecting the impact of more favorable equity markets in 2009 on variable product separate account fund performance and higher amortization of unearned revenue reserves in 2008 due to the impact of unfavorable equity markets on separate account fund performance. The decrease in fees was, partially offset by continued growth in our universal life insurance in force resulting in higher policy charges as well as higher average policyholder fund balances and associated net investment income.
General, administrative and other expenses decreased by $4 million, from $12 million in 2008 to $8 million in 2009, primarily driven by higher net reinsurance expense allowances resulting from growth in the term products, partially offset by higher expenses to support growth in business.
Policyholders’ benefits and expenses increased $4 million, from $22 million for in 2008 to $26 million in 2009, primarily due to term life and universal life reserve growth attributable to continued sales and in force growth.
Interest credited to policyholders’ account balances increased $4 million, from $11 million in 2008 to $15 million in 2009, primarily driven by increased deferred sales inducement (“DSI”) amortization due to higher gross profits used to amortize DSI including the impact of the change in non-performance risk in the valuation of embedded derivatives and higher interest credited on fixed investment options backed by the general account as discussed above.
General, administrative and other expenses increased by $3 million, from $7 million in 2008 to $10 million in 2009, primarily due to higher expenses to support growth in business.
(2) Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the guaranteed minimum death and income benefit, or GMDB / GMIB, features of both our variable life and annuity products.
As shown in the table above, results for both periods include quarterly updates for the impact of fund performance on our DAC amortization net of unearned revenue reserves and GMDB/GMIB reserves for our variable life and variable annuity products. 2009 included $4 million of lower net DAC amortization and other costs associated with these quarterly updates due to favorable market performance. 2008 updates resulted in a charge of $6 million due to unfavorable market performance.
We derive our near-term future rate of return assumptions used in our quarterly and annual updates using a reversion to the mean approach. 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. However, beginning in the fourth quarter of 2008 and continuing through the third quarter of 2009, the projected future annual rate of return calculated using the reversion to the mean approach for most contract groups was greater than our maximum future rate of return assumption across all asset types for this business. In those cases, we utilize the maximum future rate of return over the four year period, thereby limiting the impact of the reversion to the mean on our estimate of total gross profits. As part of our annual reviews, the near-term maximum future rate of return under the reversion to the mean approach was reduced in the third quarter of 2009 from 10.5% to 9.7% for variable annuity products and from 10.9% to 10.1% for variable life products. Included in this revised blended rate are assumptions for returns on various asset classes, including a 13% maximum annual return on equity investments for both our variable life and variable annuity products. Continued market volatility could result in additional market value changes within our separate account assets and corresponding changes to our gross profits, as well as additional adjustments to the amortization of deferred policy acquisition and other costs, associated with our variable life and variable annuity products and the costs relating to the reserves for the guaranteed minimum death and income benefit features on our variable annuity products.
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 increased 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.
This recent negative market conditions unfavorably impacted our liquidity and capital plans, results of operations, and financial position. The adverse market conditions also negatively impacted our level of capital, as a result of asset value declines and the need to strengthen reserves, particularly in our annuity productses.
Prudential Financial and the Company continue to operate with significant cash and short-term investments on the balance sheet and have access to alternate sources of liquidity. However, should the recent improvements in the capital markets prove temporary and the severity of prior markets return, such market disruptions could potentially 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 certain actions, especially in the event of such disruptions which may include but are not limited to: (1) further access our alternative sources of liquidity; (2) access external sources of capital;
(3) limit or curtail sales of certain products and/or restructure existing products; (4) undertake asset sales; (5) seek temporary or permanent changes to regulatory rules; and (6) other capital management activities including reinsurance transactions. Certain of these activities may require regulatory approval and/or have economic costs associated with them.
We believe that the cash flows from our insurance and annuity 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 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, particularly in our annuity products. Our cash flows from investment activities result from repayments of principal, proceeds from maturities and sales of invested assets and investment income, 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. Further, the level of new business sales can also impact liquidity and additional financing, if necessary, may be required due to the potential increase in annuity sales as previous discussed.
Liquid assets include cash, cash equivalents, short-term investments, fixed maturities and public equity securities as of December 31, 2009 and December 31, 2008; our insurance operations had liquid assets of $1.1 billion and $876.8 million, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $61.0 million and $78.0 million as of December 31, 2009 and December 31, 2008, respectively. As of December 31, 2009, $947 billion, or 90%, of the fixed maturity investments company general account portfolios were rated investment grade. The remaining $107 million, or 10%, 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.