For our International Insurance segment, which includes our international insurance operations as well as our international investment operations, we own 6 home offices located in Japan, Korea, Taiwan, Brazil and Argentina, and lease 7 home offices located in Japan, China, Taiwan, Italy, Mexico, India and Poland. We also
own approximately 170 and lease approximately 760 other properties, primarily field offices, located throughout these same countries. For our Asset Management segment, we lease 12 international principal properties located in Brazil, Mexico, Japan, Hong Kong, Singapore, Korea, China, Germany and the United Kingdom, in addition to approximately 10 other branch offices within Europe and Asia.
We derived the selected consolidated income statement data for the years ended December 31, 2011, 2010 and 2009 and the selected consolidated balance sheet data as of December 31, 2011 and 2010 from our Consolidated Financial Statements included elsewhere herein. We derived the selected consolidated income statement data for the years ended December 31, 2008 and 2007 and the selected consolidated balance sheet data as of December 31, 2009, 2008 and 2007 from consolidated financial statements not included herein.
our ability to price our insurance and annuity 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;
our actual policyholder behavior experience, including persistency, and benefit utilization and withdrawal rates for our variable annuity contracts, which could deviate significantly from our pricing assumptions;
the amount of our assets under management and changes in their fair value, which affect the amount of asset management fees we receive;
Prudential Financial, a financial services leader with approximately $900.7 billion of assets under management as of December 31, 2011, has operations in the United States, Asia, Europe and Latin America. Through our subsidiaries and affiliates, we offer a wide array of financial products and services, including life insurance, annuities, retirement-related services, mutual funds, and investment management. We offer these products and services to individual and institutional customers through one of the largest distribution networks in the financial services industry.
Regulatory Environment. Our businesses are subject to comprehensive regulation and supervision. The financial market dislocations we have experienced have produced, and are expected to continue to produce, extensive changes in existing laws and regulations, and regulatory frameworks applicable to our businesses. In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law on July 21, 2010 made comprehensive changes to the regulation of financial services in the U.S. and subjects us to substantial additional federal regulation. In addition, state insurance laws regulate all aspects of our U.S. insurance businesses and our insurance products are substantially affected by federal and state tax laws. Insurance regulators have begun to implement significant changes in the way in which industry participants must determine statutory reserves and statutory capital, particularly for products with embedded options and guarantees such as variable annuities, and are considering further potentially significant changes in these requirements for life insurance products. In addition, there is general uncertainty regarding U.S. taxes both for individuals and corporations in light of the fact that many tax provisions recently enacted or extended will sunset by the end of 2012. In addition, the recommendations made by the President’s bipartisan National Commission on Fiscal Responsibility and Reform and other deficit reduction panels suggest the need to reform the U.S. Tax Code. Congress has held a number of hearings devoted to tax reform. Some of those hearings have discussed lowering the tax rates and broadening the base by reducing or eliminating certain tax expenditures. Reducing or eliminating certain tax expenditures could make our products less attractive to customers. It is unclear whether or when Congress may take up overall tax reform and what would be the impact of reform on the Company and its products.
Competitive Environment. Our annuities, retirement and asset management businesses operate in a highly competitive environment. For the annuities business, market volatility in recent years led many companies within the industry to reduce risk in product features and increase costs. However, in 2011, certain of our competitors became more aggressive in product design and pricing, while we implemented modifications to scale back benefits and increase pricing for certain product features. In spite of this, we believe our current product offerings remain competitively positioned and that our differentiated risk management strategies will continue to provide us with an attractive risk and profitability profile. All of our new variable annuity sales, as well as a significant portion of our in force business, where an optional living benefit has been elected, include an automatic rebalancing feature, which is a feature that is valued in the variable annuity market. Our retirement and asset management businesses compete on price, service and investment performance. The full service retirement markets are mature, with few dominant players. We have seen a trend toward unbundling of the purchase decision related to the recordkeeping and investment offerings, where the variety of available funds and their performance are the key selection criteria of plan sponsors and intermediaries. Additionally, changes in the regulatory environment have driven more transparent fee disclosures, which have heightened pricing pressures and may accelerate the trend toward unbundling of services. Market disruption and rating agency downgrades have caused some of our institutional investment product competitors to withdraw from the market, creating significant growth opportunities for us in certain markets, including the investment-only stable value market. The recovery of the equity, fixed income, and commercial real estate markets has positively impacted asset managers by increasing assets under management and corresponding fee levels. In addition, institutional fixed income managers have generally experienced positive flows as investors have re-allocated assets into fixed income to reduce risk, including the reduction of risk in pension plans.
The individual life and group life and disability markets are mature and, due to the large number of competitors, competition is driven mainly by price and service. The economy has exacerbated pressure on pricing, creating an even greater challenge of maintaining pricing discipline. This has limited growth of our individual life sales, in an industry which has shifted toward non-proprietary distribution channels, which are more price sensitive than proprietary distribution channels. For group products, rate guarantees have become the industry norm, with rate guarantee durations trending upward, primarily for group life insurance, as a general industry practice. There is also an increased demand from clients for bundling of products and services to streamline administration and save costs by dealing with fewer carriers. As employers are attempting to control costs and shift benefit decisions and funding to employees, who continue to value benefits offered in the workplace, employee-pay (voluntary) product offerings and services are becoming increasingly important in the group market. Industry sales of voluntary products, as well as our own, were up again in 2011 despite the adverse economic conditions.
On April 6, 2011, Prudential Financial entered into a stock and asset purchase agreement to sell all of the issued and outstanding shares of capital stock of its subsidiaries that conduct its Global Commodities Business and certain assets that are primarily used in connection with the Global Commodities Business. This sale was completed on July 1, 2011. The Company recorded a pre-tax loss on the sale of $18 million. As a result of the sale, we have reflected the results of the Global Commodities Business, including the loss on the sale, as discontinued operations for all periods presented.
On November 8, 2011, Prudential Financial declared an annual dividend for 2011 of $1.45 per share of Common Stock, reflecting an increase of approximately 26% from the 2010 Common Stock dividend.
On December 6, 2011, the Company sold its real estate brokerage franchise and relocation services businesses, which was comprised of Prudential Real Estate and Relocation Services, Inc. (“PRERS”) and its subsidiaries, to Brookfield Asset Management, Inc. (“Brookfield”). We retained ownership of a financing subsidiary of PRERS with debt and equity investments in a limited number of real estate brokerage franchises. The Company recorded a pre-tax gain on the sale of $49 million. As a result of the sale, we have reflected the results of the real estate brokerage franchise and relocation services businesses, including the pre-tax gain on the sale, as a divested business for all periods presented.
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, Prudential Financial, as a savings and loan holding company, became subject to the examination, enforcement and supervisory authority of the Board of Governors of the Federal Reserve System (“FRB”), effective as of July 21, 2011. However, we intend to limit the operations of Prudential Bank & Trust, FSB to trust services prior to effectiveness of the Volcker rule on July 21, 2012, permitting us to continue our institutional asset management business without the restrictions that might otherwise apply under the Volcker Rule. Such limitation will allow us to deregister as a savings and loan holding company. See “Business-Regulation” for more information regarding the potential impact of the Dodd-Frank Act on the Company.
Our financial condition and results of operations for the year ended December 31, 2011 reflect the following:
Net unrealized gains on general account fixed maturity investments of the Financial Services Businesses amounted to $10.493 billion as of December 31, 2011, compared to net unrealized gains of $5.726 billion as of December 31, 2010. Gross unrealized gains increased from $8.826 billion as of December 31, 2010 to $14.749 billion as of December 31, 2011 and gross unrealized losses increased from $3.100 billion to $4.256 billion for the same periods. Net unrealized gains on general account fixed maturity investments of the Closed Block Business amounted to $3.876 billion as of December 31, 2011, compared to net unrealized gains of $1.671 billion as of December 31, 2010.
Individual Annuity total account values were $113.5 billion as of December 31, 2011. Gross sales were $20.3 billion in 2011 compared to $21.8 billion in 2010, and net sales were $13.1 billion in 2011 compared to $14.6 billion in 2010.
Asset Management total third party institutional and retail net flows were $20.2 billion in 2011 compared to $35.0 billion in 2010, contributing to the segment’s assets under management of $619.1 billion as of December 31, 2011.
Individual Life annualized new business premiums were $278 million in 2011, compared to $260 million in 2010.
Group Insurance annualized new business premiums were a record high of $690 million in 2011, compared to $607 million in 2010.
As of December 31, 2011, Prudential Financial, the parent holding company, had cash and short-term investments of $4.944 billion.
U.S. Insurance Market. We continue to focus on writing high-quality business and expect to continue to benefit from expansion of our distribution channels and deepening our relationships with third-party distributors. We also seek to capitalize on opportunities for additional voluntary life purchases in the group insurance market, as institutional clients are focused on controlling their benefit costs.
Individual Annuities segment results for 2011 decreased in comparison to 2010 primarily reflecting the impact of adjustments to the amortization of deferred policy acquisition and other costs and to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, which were unfavorable in 2011 and favorable in 2010. These adjustments were primarily driven by the impact of market performance on the estimated profitability of the business, as well as the impact of annual reviews and updates of assumptions and updates to reflect current period experience. Excluding these items, results increased in comparison to the prior year, primarily reflecting higher fee income resulting from the impact of positive net flows on variable annuity account values.
Retirement segment results for 2011 increased in comparison to 2010. The increase reflects higher fee income due to higher fee-based investment-only stable value account values in our institutional investment products business primarily from net additions and an increase in average full service fee-based retirement account values resulting primarily from market appreciation. This increase was partially offset by lower net investment spread results, higher general and administrative expenses, net of capitalization, and the unfavorable impact of annual reviews and updates of the assumptions used in amortizing deferred policy acquisition costs and value of business acquired.
Asset Management segment results improved in 2011 in comparison to 2010 primarily from improved results from the segment’s commercial mortgage and strategic investing activities and increased asset management fees.
International Insurance segment results for 2011 improved from 2010. Results from the segment’s Life Planner operations improved in 2011, reflecting the continued growth of our Japanese Life Planner operation and lower expenses, partially offset by claims resulting from the March 2011 earthquake and tsunami and less favorable mortality experience. Results from the segment’s Gibraltar Life and Other operations reflect the comparative impact of a $237 million benefit to 2011 results compared to a $66 million benefit to 2010 resulting from partial sales of our investment, through a consortium, in China Pacific Group. Also contributing to the increase in adjusted income was $354 million of earnings from operations of the acquired Star and Edison Businesses, excluding claims resulting from the March 2011 earthquake and tsunami, and a $96 million gain on sale of our investment in Afore XXI. These benefits were partially offset by $213 million of Star and Edison acquisition- and integration-related expenses and $49 million of charges primarily resulting from claims associated with the earthquake and tsunami in Japan. The remainder of the improvements in results compared to the prior year quarter came primarily from a greater contribution from investment results, reflecting business growth including higher earnings from our fixed annuities business and from expanding bank channel sales of protection products.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or U.S. 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 Consolidated Financial Statements could change significantly.
DAC associated with the traditional participating products of our Closed Block Business is amortized over the expected lives of those contracts in proportion to estimated gross margins. Gross margins consider premiums, investment returns, benefit claims, costs for policy administration, changes in reserves, and dividends to policyholders. We evaluate our estimates of future gross margins and adjust the related DAC balance with a corresponding charge or credit to current period earnings for the effects of actual gross margins and changes in our expected future gross margins. We also evaluate the recoverability of the DAC balance at the end of each reporting period. These DAC adjustments generally have not created significant volatility in our results of operations since many of the factors that affect gross margins are also included in the determination of our dividends to these policyholders and, during most years, the Closed Block has recognized a cumulative policyholder dividend obligation expense in “Policyholders’ dividends,” for the excess of actual cumulative earnings over expected cumulative earnings as determined at the time of demutualization. However, if actual cumulative earnings fall below expected cumulative earnings in future periods, thereby eliminating the cumulative policyholder dividend obligation expense, changes in gross margins and DAC amortization would result in a net impact to the Closed Block Business results of operations. As of December 31, 2011, the excess of actual cumulative earnings over the expected cumulative earnings was $762 million.
DAC and DSI associated with the variable and universal life policies of our Individual Life and International Insurance segments and the variable and fixed annuity contracts of our Individual Annuities and International Insurance segments are amortized over the expected life of these policies in proportion to total gross
profits. DAC and DSI are also subject to recoverability testing which we perform at the end of each reporting period to ensure that each balance does not exceed the present value of 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 costs related to our guaranteed minimum death and guaranteed minimum income benefits. Total gross profits include both actual experience and estimates of gross profits for future periods. We regularly evaluate and adjust the related DAC and DSI balances 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 and DSI balances include the impact to our estimate of total gross profits of the annual review of assumptions, our quarterly adjustments for current period experience, and our quarterly adjustments for market performance. Each of these adjustments is further discussed below in “-Annual assumptions review and quarterly adjustments.”
In addition to the gross profit components mentioned above, we also include the impact of the embedded derivatives associated with certain of the optional living benefit features of our variable annuity contracts and related hedging activities in actual gross profits used as the basis for calculating current period amortization. Prior to the third quarter of 2010, we also included the impact of these embedded derivatives and related hedging activities, excluding the impact of the market-perceived risk of our own non-performance, in our estimate of total gross profits used to determine the DAC and DSI amortization rates. In the third quarter of 2010, we revised our hedging strategy, which resulted in a change in how certain gross profit components are used to determine the DAC and DSI amortization rates. Prior to the third quarter of 2010 our hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by U.S. GAAP, excluding the impact of the market-perceived risk of our own non-performance, with capital market derivatives. Under our current hedging strategy, our hedge target continues to be grounded in a U.S. GAAP/capital markets valuation framework but incorporates two modifications to the U.S. GAAP valuation assumptions. We add a credit spread to the U.S. GAAP risk-free rate of return assumption used to estimate future growth of bond investments in the customer separate account funds to account for the fact that the underlying customer separate account funds which support these living benefits are invested in assets that contain risk. We also adjust our volatility assumption to remove certain risk margins embedded in the valuation technique used to determine the fair value of the embedded derivative liability under U.S. GAAP, as we believe the increase in the liability driven by these margins is temporary and does not reflect the economic value of the liability. For a discussion of the change in our hedging strategy and the results of our hedging program, see “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities-Net impact of embedded derivatives related to our living benefit features and related hedge positions.”
Fixed income expected rate of return for our variable annuities business is a levelized rate, blending current rates and long-term expected returns. Fixed income expected rate of return for our variable life insurance business is the long-term expected return, as a blend does not materially affect results due to the long duration of the liability.
Blend is based on the long-term expected distribution of funds between equity and fixed income funds.
As of December 31, 2011, more than half of our variable annuities business and the majority of our variable life insurance business had near-term mean reversion rates of return based on the blended maximum expected rate of return assumption.
For variable annuity contracts, DAC and DSI are more sensitive to changes in our future rate of return assumptions due primarily to the significant portion of our 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. The DAC and DSI balances associated with our domestic variable annuity contracts were $2.7 billion and $1.0 billion, respectively, as of December 31, 2011. The following table provides a demonstration of the sensitivity of each of these balances relative to our future rate of return assumptions by quantifying the adjustments to each balance that would be required assuming both an increase and decrease in our future rate of return by 100 basis points. The sensitivity includes an increase and decrease of 100 basis points to both the near-term future rate of return assumptions used over the next four years, and the long-term expected rate of return used thereafter. 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. This information considers only the direct effect of changes in our future rate of return on the
The sensitivity balances reflected in the table are based on DAC accounting guidance as of December 31, 2011. As noted previously, new authoritative guidance was adopted effective January 1, 2012, which will reduce our DAC balances and corresponding sensitivities.
As of December 31, 2011, our goodwill balance of $888 million is reflected in the following four reporting units: $444 million related to our Retirement Full Service business, $238 million related to our Asset Management business, $184 million related to our International Insurance Gibraltar business and $22 million related to our International Insurance Life Planner business.
We test goodwill for impairment on an annual basis as of December 31 of each year and more frequently if events occur or circumstances change that would indicate the potential for impairment is more likely than not. The test is performed at the reporting unit level which is equal to or one level below our operating segments.
A qualitative assessment was performed by International Insurance’s Gibraltar business. After consideration of the relevant macro economic factors, as well as conditions specific to the insurance industry and the reporting unit, it was determined that the fair value of the reporting unit was not more likely than not below its carrying value and accordingly, there was no impairment of goodwill.
The Retirement Full Service business also elected to bypass the qualitative assessment and complete their impairment analysis using a discounted cash flow approach. The discounted cash flow approach calculates the value of a business by applying a discount rate reflecting the market expected weighted average rate of return to the projected future cash flows of the reporting unit. These projected future cash flows were based on our internal forecasts, an expected growth rate and a terminal value. The weighted average rate of return, or WARR, represents the required rate of return on total capitalization. It is comprised of a required rate of return on equity of a company and the current tax-affected cost of debt, which are then weighted by the relative percentages of equity and debt assumed in the capital structure. To estimate the return on equity, we applied the Capital Asset Pricing Model, or CAPM. The CAPM is a generally accepted method for estimating an equity investor’s return requirement, and hence a company’s cost of equity capital. CAPM is determined by beginning with the long-term risk-free rate of return then applying adjustments that consider the equity risk premium required for large company common stock investments as well as company specific adjustments to address volatility, small company premiums and other risks particular to a specific company. The WARR calculation is applied to a group of companies considered peers of the reporting unit to develop a weighted average rate of return for the peer group which is then used to estimate the market expected weighted average rate of return for the reporting unit. This process resulted in a discount rate of 12% which was then applied to the expected future cash flows of the Retirement Full Service business to estimate its fair value.
After completion of Step 1 of the quantitative tests, it was determined that fair values exceeded the carrying amounts for each of the three reporting units and it was concluded there was no impairment as of December 31, 2011. The Asset Management, International Insurance’s Life Planner and Retirement Full Service businesses had estimated fair values that exceeded their carrying amounts by 425%, 27% and 5%, respectively.
tested, further market declines or other events impacting the fair value of these businesses, including discount rates, interest rates and growth rate assumptions or increases in the level of equity required to support these businesses, could result in goodwill impairments, resulting in a charge to income.
As of December 31, 2011, the Company experienced a market capitalization that was below its consolidated book value. An analysis was performed in order to confirm the reasonableness of the reporting unit fair values calculated in the goodwill impairment tests discussed above. The Company considered the fact that certain reporting units that do not contain goodwill have lower estimated fair values due to the nature of the risks in their businesses and also considered the negative impact of our Corporate & Other operations on the overall fair value of the Company. The Company also considered the amount of control premium necessary to estimate a fair value equal to book value. When comparing this control premium to actual control premiums experienced in recent insurance company acquisitions, as well as the impact of the lower market environment which can increase industry control premiums, the Company concluded that the calculated control premium reflected an amount which we believe is within a range of reasonableness. Based on these factors, the Company concluded that the reporting unit fair values calculated in the goodwill impairment test were reasonable.
Commercial mortgage and other loans are carried primarily at unpaid principal balances, net of unamortized deferred loan origination fees and expenses and unamortized premiums or discounts and a valuation allowance for losses. For a discussion of our policies regarding the valuation allowance for commercial mortgage and other loans see “-Realized Investment Gains and Losses and General Account Investments-General Account Investments-Commercial Mortgage and Other Loans-Commercial Mortgage and Other Loan Quality.”
The future policy benefit reserves for the traditional participating life insurance products of our Closed Block Business, which as of December 31, 2011, represented 31% of our total future policy benefit reserves are determined using the net level premium method as prescribed by U.S. GAAP. Under this method, the future policy benefit reserves are accrued as a level proportion of the premium paid by the policyholder. In applying this method, we use mortality assumptions to determine our expected future benefits and expected future premiums, and apply an interest rate to determine the present value of both the expected future benefit payments and the expected future premiums. The mortality assumptions used are based on data from the standard industry mortality tables that were used to determine the cash surrender value of the policies, and the interest rates used are the contractually guaranteed interest rates used to calculate the cash surrender value of the policies. Gains or losses in our results of operations resulting from deviations in actual experience compared to the experience assumed in establishing our reserves for this business are recognized in the determination of our annual dividends to these policyholders. These gains or losses generally have not created significant volatility in our results of operations since, during most years, the Closed Block has recognized a cumulative policyholder dividend obligation expense in “Policyholders’ dividends,” for the excess of actual cumulative earnings over expected cumulative earnings as determined at the time of demutualization. However, if actual cumulative earnings fall below expected cumulative earnings in future periods, thereby eliminating the cumulative policyholder dividend obligation expense, these gains or losses could result in greater volatility in the Closed Block Business results of operations. As of December 31, 2011, the excess of actual cumulative earnings over the expected cumulative earnings was $762 million.
The future policy benefit reserves for our International Insurance segment and Individual Life segment, which as of December 31, 2011, represented 55% of our total future policy benefit reserves combined, relate primarily to non-participating whole life and term life products and endowment contracts, and are determined in accordance with U.S. GAAP as the present value of expected future benefits to, or on behalf of, policyholders plus the present value of future maintenance expenses less the present value of future net premiums. The expected future benefits and expenses are determined using assumptions about mortality, lapse, and maintenance expense. Reserve assumptions are based on best estimate assumptions as of the date the policy is issued or acquired with provisions for the risk of adverse deviation. After our reserves are initially established, we perform premium deficiency tests using best estimate assumptions as of the testing date without provisions for adverse deviation. If reserves determined based on these best estimate assumptions are greater than the net U.S. GAAP liabilities (i.e., reserves net of any DAC asset), the existing net U.S. GAAP liabilities are adjusted by first reducing the DAC asset by the amount of the deficiency or to zero through a charge to current period earnings. If the deficiency is more than the DAC balance, we then increase the reserve by the excess, by means of a charge to current period earnings. Our best estimate assumptions are determined by product group. Mortality assumptions are generally based on the Company’s historical experience or standard industry tables, as applicable; our expense assumptions are based on current levels of maintenance costs, adjusted for the effects of inflation; and our interest rate assumptions are based on current and expected net investment returns. Unless a material change in mortality experience is observed in an interim period that we feel is indicative of a long term trend, we generally update our mortality assumptions annually in the third quarter of each year. Generally, we do not expect our 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.
The remaining 4% of the reserves for future policy benefits as of December 31, 2011 represented reserves for the guaranteed minimum death benefit (“GMDB”) and optional living benefit features of the variable annuity products in our Individual Annuities segment, and group life and disability and long-term care benefits in our Group Insurance segment. 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 20 to the Consolidated Financial Statements and “-Valuation of Assets and Liabilities-Fair Value of Assets and Liabilities-Variable Annuity Optional Living Benefit Features.”
In establishing reserves for GMDBs and guaranteed minimum income benefits (“GMIB”s) 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 GMDB or GMIB 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 GMDB or GMIB 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 are out of their surrender charge period average between 7% and 20% per year, and the lapse rate assumptions for contracts that are in-the-money and are out of their surrender charge period average between 0% and 20% 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 GMDBs and GMIBs 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.
For a discussion of adjustments to the reserves for GMDBs and GMIBs related to our Individual Annuities segment for the years ended December 31, 2011, 2010 and 2009, see “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities.”
Our liability for unpaid claims and claim adjustment expenses of $2.7 billion as of December 31, 2011 is reported as a component of “Future policy benefits” and relates primarily to the group long-term disability products of our Group Insurance segment. This liability represents our estimate of future disability claim payments and expenses as well as estimates of claims that we believe have been incurred, but have not yet been reported as of the balance sheet date. We do not establish loss liabilities until a loss has occurred. As prescribed by U.S. GAAP, our liability is determined as the present value of expected future claim payments and expenses. Expected future claim payments are estimated using assumed mortality and claim termination factors and an assumed interest rate. The mortality and claim termination factors are based on standard industry tables and the Company’s historical experience. Our interest rate assumptions are based on factors such as market conditions and expected investment returns. Of these assumptions, our claim termination assumptions have historically had the most significant effect on our level of liability. We review our claim termination assumptions compared to actual terminations annually. These studies review actual claim termination experience over a number of years with more weight placed on the actual experience in the more recent years. Recently, our claim termination experience has been impacted by increased volatility driven by the economic downturn. If actual experience results in a different assumption, we adjust our liability for unpaid claims and claims adjustment expenses accordingly with a charge or credit to current period earnings.
Our unearned revenue reserve, or URR, reported as a component of “Policyholders’ account balances,” is $1.7 billion as of December 31, 2011. This reserve primarily relates to variable and universal life products within our Individual Life segment and represents policy charges for services to be provided in future periods. The charges are deferred as unearned revenue and amortized over the expected life of the contract in proportion to the product’s estimated gross profits, similar to DAC as discussed above.
Our effective tax rate is based on income, non-taxable and non-deductible items, statutory tax rates and tax planning opportunities available in the various jurisdictions in which we operate. Inherent in determining our annual tax rate are judgments regarding business plans, planning opportunities and expectations about future outcomes. The Company does not provide U.S. income taxes on unremitted foreign earnings of its non-U.S. Operations, other than its operations in Japan and certain operations in India, Germany, and Taiwan.
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 consolidated income from continuing operations before equity in earnings of operating joint ventures in 2011 of $51 million.
See Note 2 to our Consolidated Financial Statements for a complete discussion of newly issued accounting pronouncements, including further discussion of the new authoritative guidance addressing which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral.
2011 to 2010 Annual Comparison. Income from continuing operations for the Financial Services Businesses increased $875 million, from $2,693 million in 2010 to $3,568 million in 2011. Results for 2011 compared to 2010 reflect the following:
Higher net pre-tax earnings resulting from the impact of foreign currency exchange rate movements on certain non-yen denominated assets and liabilities within our Japanese insurance operations, for which we economically hedge the foreign currency exposure, driven by the strengthening of the yen during 2011;
Net pre-tax gains in 2010 compared to net pre-tax losses in 2009 associated with our general account portfolio and hedging programs, reflecting the impact of financial market conditions in each period;
The direct equity adjustment, as described above, increased income from continuing operations available to holders of the Common Stock for earnings per share purposes by $36 million for 2010 compared to $43 million for 2009.
2010 to 2009 Annual Comparison. Income (loss) from continuing operations for the Closed Block Business for 2010, was $480 million, or $222.00 per share of Class B Stock, compared to a loss of $287 million, or $(165.00) per share of Class B Stock, for 2009. The direct equity adjustment decreased income from continuing operations available to the Class B Stock holders for earnings per share purposes by $36 million for 2010 compared to $43 million for 2009. For a discussion of the results of operations for the Closed Block Business, see “-Results of Operations of Closed Block Business,” below.
understanding of our overall results of operations. Adjusted operating income is not a substitute for income determined in accordance with U.S. GAAP, and our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability of the Financial Services Businesses.
Revenues exclude related charges which represent payments related to the market value adjustment features of certain of our annuity products. Benefits and expenses exclude related charges which represent the unfavorable (favorable) impact of Realized investment gains (losses), net, on changes in reserves and the amortization of deferred policy acquisition costs, deferred sales inducements and value of business acquired.
2011 to 2010 Annual Comparison. Adjusted operating income decreased $333 million, from $1,046 million in 2010 to $713 million in 2011. The decrease in adjusted operating income was driven by the impacts of a $232 million net charge in the current year, and a $348 million net benefit in the prior year, from adjustments to amortization of deferred policy acquisition costs (“DAC”) and other costs and to the reserves for the guaranteed minimum death benefit (“GMDB”) and guaranteed minimum income benefit (“GMIB”) features of our variable annuity products, primarily driven by the impact to the estimated profitability of the business of quarterly adjustments to reflect current period market performance and experience, as well as the impact of annual reviews and updates of the assumptions used in estimating the profitability of our business. Results for both years include the impact of these items which are discussed in more detail below.
As shown in the following table, adjusted operating income for 2011 included $232 million of net charges from adjustments to the amortization of DAC and other costs and to the reserves for the GMDB and GMIB features of our variable annuity products, compared to $348 million of net benefits included in 2010.
Overall lower than expected returns in 2011 decreased our estimate of total gross profits used as a basis for amortizing DAC and other costs and increased our estimate of future expected claims costs associated with the GMDB and GMIB features of our variable annuity products, by establishing a new, lower starting point for the variable annuity account values used in estimating those items for future periods. This change results in a higher required rate of amortization and higher 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. Overall higher than expected returns in 2010 had opposite impacts, resulting in an increase to our estimate of total gross profits used as a basis for amortizing DAC and other costs and a decrease to our estimate of future expected claims costs associated with the GMDB and GMIB features of our variable annuity products. This change resulted in a lower required rate of amortization and lower required reserve provisions, which were applied to all prior periods.
As discussed and shown in the table above, results for both years include the impact of the annual reviews performed in the third quarter of the assumptions used in the reserves for the GMDB and GMIB features of our variable annuity products and in our estimate of total gross profits used as a basis for amortizing DAC and other costs. The third quarter of 2011 included $20 million of net benefits from these annual reviews, primarily related to a reduction of the assumption of the percentage of contracts with a GMIB feature that will annuitize based on the guaranteed value, partially offset by a reduction of the weighted average future return assumption to 4.3% on fixed rate portfolios. The reduction in the weighted average future return assumption on fixed rate portfolios was driven by a refinement to our rate-setting methodology to reflect a lower interest rate assumption for the next five years to reflect current market conditions, and use the long-term assumed rate thereafter in determining the blended future return on fixed rate investments of 4.3%. The third quarter of 2010 included $177 million of benefits from these annual reviews, primarily related to reductions in lapse rate assumptions and more favorable assumptions relating to fee income.
As noted previously, the quarterly adjustments to reflect current period market performance and experience and other updates, and the annual reviews and updates of assumptions impact the estimated profitability of our business. Therefore, in addition to the current period impacts discussed above, these items will also drive changes in our GMDB and GMIB reserves and the amortization of DAC and other costs in future periods. Additionally, in the third and fourth quarters of 2011, we evaluated the results of our living benefits hedging program and determined the difference between the change in the value of the hedge target liability and the change in the fair value of the hedge assets to be other-than-temporary. As a result, we included these amounts in our best estimate of total gross profits used for setting amortization rates, which will also drive changes in the amortization of DAC and other costs in future periods. The table above excludes the impacts of resetting the amortization rates for this item, as both the hedge results and related amortization of DAC and other costs are excluded from adjusted operating income. However, adjusted operating income in the fourth quarter of 2011 includes the subsequent impact to base amortization from resetting the amortization rates at the end of the third quarter. Base amortization is calculated by applying the new rates to actual gross profits for the quarter. See “-Net impact of embedded derivatives related to our living benefit features and related hedge positions” for additional details on the impact of our hedge results that are excluded from adjusted operating income.
Partially offsetting the increase in adjusted operating income was a $31 million lower benefit related to adjustments to the reserves for the GMDB and GMIB features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing DAC and other costs. As shown in the following table, adjusted operating income for 2010 included $348 million of benefits from these adjustments, compared to $379 million of benefits included in 2009. This variance is discussed in more detail below.
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $443 million, from $3,195 million in 2010 to $3,638 million in 2011. Policy charges and fees and asset management fees and other income increased $576 million driven by higher average variable annuity account values invested in separate accounts due to positive net flows and net transfers of balances from the general account to the separate accounts primarily driven by an automatic rebalancing element, also referred to as an asset transfer feature, in some of our optional living benefit features. Partially offsetting the increase in revenues was a decrease in net investment income of $88 million, reflecting lower average annuity account values in the general account also resulting from transfers from the general account to the separate accounts. Premiums also decreased $45 million, reflecting a decline in annuitizations of our variable annuity contracts.
2010 to 2009 Annual Comparison Benefits and expenses increased $391 million, from $1,758 million in 2009 to $2,149 million in 2010. Absent the net $31 million increase related to the adjustments to the reserves for the GMDB and GMIB features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing DAC and other costs, benefits and expenses increased $360 million. General and administrative expenses, net of capitalization, increased $240 million primarily driven by higher distribution and asset management costs, reflecting higher average variable annuity asset balances invested in separate accounts and higher variable annuity sales. Interest expense also increased $53 million driven by higher intercompany borrowings to fund operating costs and new business sales. The amortization of DAC increased $36 million reflecting the impact of higher gross profits used as a basis for amortization driven by higher fee income. Insurance and annuity benefits increased $34 million driven by an increase in annuitizations primarily from contracts with the GMIB feature partially offset by lower reserves on the GMDB and GMIB features due to the impact of favorable markets on account values during 2010. Lower interest credited to policyholders’ account balances driven by lower average annuity account values in the fixed-rate accounts of the general account was mostly offset by higher amortization of deferred sales inducements, reflecting the impact of higher gross profits primarily from fee income.
The following table sets forth changes in account values for the individual annuity business, for the periods indicated. For our individual annuity business, assets are reported at account value, and net sales (redemptions) are gross sales minus redemptions or surrenders and withdrawals, as applicable. Gross sales do not correspond to revenues under U.S. GAAP, but are used as a relevant measure of business activity.
2010 to 2009 Annual Comparison. Total account values for fixed and variable annuities amounted to $106.2 billion as of December 31, 2010, representing an increase of $22.2 billion from December 31, 2009. The increase was driven by positive variable annuity net flows and increases in the market value of customers’ variable annuities due to favorable equity markets for 2010. Individual variable annuity gross sales increased $5.5 billion, from $16.1 billion in 2009 to $21.6 billion in 2010. The increase reflects our product strength, customer value proposition, and position as the primary provider of living benefit guarantees based on highest daily customer account value as well as the further expansion of our distribution networks. Additionally, we benefited from some of our competitors implementing product modifications to increase pricing and scale back product features due to market disruptions in late 2008 and the first half of 2009. Individual variable annuity surrenders and withdrawals increased by $1.1 billion, from $5.8 billion in 2009 to $6.9 billion in 2010, reflecting the overall impact of higher account values in 2010 due to market appreciation during that period.
The net amount at risk is generally defined as the present value of the guaranteed minimum benefit amount in excess of the contractholder’s current account balance. Changes in the global financial markets can create volatility in the net amounts at risk embedded in our variable annuity products that include optional living benefit and GMDB features. As part of our risk management strategy, we hedge or limit our exposure to certain of the risks associated with these products, primarily through a combination of product design elements, such as an automatic rebalancing element, and externally purchased hedging instruments. Our hedging program is discussed below in “-Net impact of embedded derivatives related to our living benefit features and related hedge positions.” The rate of return we realize from our variable annuity contracts can vary by contract based on our risk management strategy, including the impact of any capital market movements that we may hedge, the impact on that portion of our variable annuity contracts that benefit from the automatic rebalancing element, the impact of risks we have deemed suitable to retain and the impact of risks that are not able to be hedged.
The automatic rebalancing element, also referred to as an asset transfer feature, included in the design of certain optional living benefits, transfers assets between certain variable investments selected by the annuity contractholder and, depending on the benefit feature, the fixed-rate account in the general account or a bond portfolio within the separate accounts. The automatic rebalancing element associated with currently-sold products transfers assets between certain variable investments selected by the annuity contractholder and a designated bond portfolio within the separate accounts. The transfers are based on the static mathematical formula used with the particular benefit which considers a number of factors, including, but not limited to, the impact of investment performance on the contractholder’s total account value. In general, negative investment performance may result in transfers to either the fixed-rate account in the general account or a bond portfolio within the separate accounts, and positive investment performance may result in transfers back to contractholder-selected variable investments. Overall, the automatic rebalancing element helps to mitigate our exposure to equity market risk and market volatility. Beginning in 2009, all offerings of optional living benefit features associated with currently-sold variable annuity products include an automatic rebalancing element, and in 2009 we discontinued any new sales of optional living benefit features without an automatic rebalancing element.
The following table sets forth the account values of our variable annuities with living benefit features and the net amount at risk of the living benefit features split between those that include an automatic rebalancing element and those that do not, as of the dates indicated.
The increase in account values that include an automatic rebalancing element as of December 31, 2011 compared to prior periods primarily reflects sales of our latest product offerings which include this feature. The increase in the net amount at risk for these contracts as of December 31, 2011 compared to prior periods reflects overall growth in our variable annuity business and account value performance during 2011.
As mentioned above, in addition to our automatic rebalancing element, we also manage certain risks associated with our variable annuity products through our hedging programs. In our living benefit hedging program, we purchase interest rate swaps, swaptions, floors and caps as well as equity options and futures to hedge certain living benefit features accounted for as embedded derivatives against changes in certain capital market assumptions such as interest rates, equity markets and market volatility. Prior to the third quarter of 2010, our hedging strategy sought to generally match certain capital market sensitivities of the embedded derivative liability as defined by U.S. GAAP, excluding the impact of the market’s perception of our own non-performance risk (“NPR”), with capital market derivatives. In the third quarter of 2010, we revised our hedging strategy as, in a low interest rate environment, we do not believe that the U.S. GAAP value of the embedded derivative liability is an appropriate measure for defining the hedge target. Our current hedge target definition is grounded in a U.S. GAAP/capital markets valuation framework but incorporates two modifications to the U.S. GAAP valuation assumptions. We add a credit spread to the U.S. GAAP risk-free rate of return assumption used to estimate future growth of bond investments in the customer separate account funds to account for the fact that the underlying customer separate account funds which support these living benefits are invested in assets that contain risk. We also adjust our volatility assumption to remove certain risk margins embedded in the valuation technique used to determine the fair value of the embedded derivative liability under U.S. GAAP, as we believe the impact on the liability driven by these margins is temporary and does not reflect the economic value of the liability. This hedging strategy results in differences each period between the change in the value of the embedded derivative liability as defined by U.S. GAAP and the change in the value of the hedge positions, potentially increasing volatility in U.S. GAAP earnings.
In addition, we evaluate hedge levels versus our hedge target based on the overall capital considerations of the Company and prevailing capital market conditions, and may decide to temporarily hedge to an amount that differs from our hedge target definition. Based on these considerations, beginning in the latter half of 2010, we decided to temporarily hedge to an amount less than our hedge target definition to be consistent with our long-term economic view. From the inception of this decision through December 31, 2011, we have experienced cumulative increases in the hedge target liability of approximately $1.4 billion related to the under-hedged risk, with no corresponding hedge asset increase. This cumulative impact includes $1.7 billion of losses attributable to 2011, partially offset by $0.3 billion of gains attributable to 2010. Because this decision is based on the overall capital considerations of the Company as a whole, the impact on results from temporarily hedging to an amount that differs from our hedge target definition is reported within Corporate and Other operations, as described in “-Corporate and Other.”
As of December 31, 2011, the fair value of the living benefit embedded derivative under U.S. GAAP was a $2.8 billion liability. Excluding the impact of the cumulative adjustment for NPR of $5.5 billion, the value of the living benefit embedded derivative was an $8.3 billion liability. As of December 31, 2011, the value of our hedge target, based on our hedge target definition, was a $7.1 billion liability. The difference between the value of the hedge target and the value of the living benefit embedded derivative under U.S. GAAP, excluding NPR, as of December 31, 2011 is primarily attributable to the impact of the margins and return assumptions as discussed above.
The net impact of both the change in the value of the embedded derivative liabilities associated with our living benefit features and the change in fair value of the related derivative hedge positions are included in “Realized investment gains (losses), net, and related adjustments” and the related impact to the amortization of
Beginning with the third quarter of 2010, represents the change in value based on our hedge target definition as described above, excluding the impacts of temporarily hedging to an amount that differs from our hedge target definition and assumption updates. Prior to the third quarter of 2010, our hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by U.S. GAAP, excluding the impact of NPR.
The net benefit of $1,279 million in 2011 included a net charge of $1,297 million resulting from the net impact of hedging, excluding the unhedged portions and assumption updates, driven by significant capital markets volatility in the second half of 2011. Also included in the net benefit of $1,279 million was a net charge of $457 million attributable to the difference between the valuation of the embedded derivative liability as defined by U.S. GAAP and the valuation of the hedge target liability, which we choose not to hedge. These charges were offset by a $4,786 million adjustment to the embedded derivative liability to reflect NPR, primarily from a higher base of embedded derivative liabilities, driven by significant declines in risk-free interest rates and the impact of account value performance, as well as an overall widening of the credit spreads used in valuing NPR, which reflect the financial strength ratings of our insurance subsidiaries. Partially offsetting these items was a net charge of $1,736 million from the inclusion of these items in current period gross profits used in calculating the amortization of DAC. In the third and fourth quarters of 2011, we also determined that the cumulative difference between the change in the value of the hedge target liability, excluding the unhedged portions and assumption updates, and the change in the fair value of the hedge assets was other-than-temporary.
The net benefit of $33 million in 2010 included a net benefit of $140 million resulting from the net impact of hedging, excluding the unhedged portions and assumption updates, driven by differences in the actual performance of the underlying separate accounts funds relative to the performance of the market indices we utilized as a basis for developing our hedging strategy. Also included in the net benefit of $33 million was a net benefit of $387 million attributable to the difference between the valuation of the embedded derivative liability as defined by U.S. GAAP and the valuation of the hedge target liability, which we choose not to hedge, and a net charge of $902 million related to reductions in the expected lapse rate assumption based on actual experience. These items were partially offset by a $412 million adjustment to the embedded derivative liability to reflect NPR, primarily resulting from an increase in the value of embedded derivatives in a liability position, reflecting an increase in the present value of future expected benefit payments driven by lower interest rates and a reduction in the expected lapse rate assumption. Partially offsetting these items was a net charge of $4 million from the inclusion of these items in current period gross profits used in calculating the amortization of DAC.
The net benefit of $126 million in 2009 included a net benefit of $334 million resulting from the net impact of hedging, excluding assumption updates, driven by differences in the actual performance of the underlying separate accounts funds relative to the performance of the market indices we utilized as a basis for developing our hedging strategy. Also included in the net benefit of $126 million was a net charge of $110 million from updates to the expected lapse rate and equity volatility assumptions based on actual experience. These items were partially offset by a $312 million adjustment to the embedded derivative liability to reflect NPR, reflecting the initial incorporation of an additional spread over LIBOR to reflect NPR in the valuation of the embedded derivative liability in 2009. Partially offsetting these items was a net charge of $410 million from the inclusion of these items in current period gross profits used in calculating the amortization of DAC.
For additional information regarding the methodologies used in determining the fair value of the embedded derivative liability associated with our living benefit features as defined by U.S. GAAP, and for calculating the impact of NPR, see Note 20 to the Consolidated Financial Statements and “-Valuation of Assets and Liabilities-Fair Value of Assets and Liabilities-Variable Annuity Optional Living Benefit Features.”
Benefits and expenses exclude related charges which represent the unfavorable (favorable) impact of Realized investment gains (losses), net, on changes in reserves and the amortization of deferred policy acquisition costs.
Results for both 2011 and 2010 include the impact of annual reviews performed in the third quarter of the assumptions used in our estimate of total gross profits which forms the basis for amortizing deferred policy
acquisition costs and value of business acquired, as well as the impact of our quarterly adjustments to total gross profits for current period experience. Adjusted operating income for 2011 and 2010 included charges of $24 million and $18 million, respectively, from the annual reviews. The quarterly adjustments for current period experience had no net impact on 2011 earnings and resulted in an $11 million benefit in 2010, reflecting the cumulative impact on amortization of differences between actual gross profits and previously estimated expected gross profits. Together, these items resulted in a net charge of $24 million in 2011 and a net charge of $7 million in 2010. The net charge of $24 million in 2011 was driven by changes to expense and net cash flow assumptions which decreased expected future gross profits, while the net charge of $7 million in 2010 was driven by changes in lapse rate and fee-based profit margin assumptions which also decreased expected future gross profits.
Improved net investment spread results were driven by lower crediting rates on general account liabilities in our full service business and increased income from alternative investments. Lower crediting rates on general account liabilities in our full service business resulted from rate resets in the third quarter of 2009 and first quarter of 2010. Also contributing to the increase in net investment spread results were increased net settlements on floating-rate to fixed-rate interest rate swaps used to manage the duration of the investment portfolio. The increase in net swap settlements resulted from the generally favorable impact of lower interest rates on the swaps used to manage the duration of the investment portfolio primarily for our institutional investment products business. Partially offsetting the improvement in net investment spread results was the negative impact of a lower base of invested assets in our general account reflecting scheduled withdrawals from guaranteed investment products in our institutional investment products business partially offset by the positive impact of net additions in our structured settlement product and increases in balances in our full service general account stable value products.
2010 to 2009 Annual Comparison. Revenues increased $524 million, from $4,659 million in 2009 to $5,183 million in 2010. Premiums increased $464 million, driven by higher life-contingent structured settlement and single premium annuity sales which resulted in a corresponding increase in policyholders’ benefits, including the change in policy reserves, as discussed below. Policy charges and fee income and asset management fees and other income increased $131 million, primarily driven by an increase in asset-based fees due to an increase in average full service fee-based retirement account values and an increase in fee-based investment-only stable value account values in our institutional investment products business, as well as increased income from net settlements on interest rate swaps, as discussed above.
2011 to 2010 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” decreased $338 million, from $4,611 million in 2010 to $4,273 million in 2011. Absent the impact of the annual reviews and other adjustments to the amortization of deferred policy acquisition costs and value of business acquired discussed above, which account for a $17 million increase, benefits and expenses decreased $355 million. Policyholders’ benefits, including the change in policy reserves, decreased $254 million, primarily reflecting a decrease in change in policy reserves associated with the decrease in premiums as discussed above. Interest credited to policyholders’ account balances decreased $119 million including a refinement to the methodology applied in calculating reserves for certain structured settlement contracts, with an equally offsetting impact to amortization of deferred policy acquisition costs. Also contributing to the decrease were lower crediting rates on full service general account stable value account values due to rate resets and the impact of scheduled withdrawals on account values of our general account guaranteed investment products in our institutional investment products business, partially offset by the impact of higher account values from our full service general account stable value products and our structured settlement products. The amortization of deferred policy acquisition costs increased $24 million primarily driven by a refinement to the methodology applied in calculating the amortization of deferred policy acquisition costs for certain structured settlement contracts, as mentioned above. Also, general and administrative expenses, net of capitalization, decreased $3 million, driven by lower commission expenses due to a decline in life contingent structured settlement sales and lower charges related to certain cost reduction initiatives, partially offset by higher costs related to legal matters and strategic initiatives. In addition, interest expense decreased $3 million, reflecting lower interest rates.
Additions include $500 million in 2009 representing transfers of externally-managed client balances to accounts we manage. These additions are offset within Other, as there is no net impact on ending account values for these transfers.
Other includes transfers from (to) the Asset Management segment of $(415) million, $(164) million and $(11) million for 2011, 2010 and 2009, respectively. Other also includes $78 million, $752 million and $(12) million for 2011, 2010 and 2009, respectively, representing net transfers of externally-managed client balances from/(to) accounts we manage. These transfers are offset within Additions or Withdrawals and benefits, as there is no net impact on ending account values for this transfer. Remaining amounts for all periods presented primarily represent changes in asset balances for externally-managed accounts.
Account values in our institutional investment products business amounted to $90.1 billion as of December 31, 2011, representing an increase of $25.9 billion from December 31, 2010. The increase was driven by additions of our fee-based investment-only stable value and structured settlements products, as well as sales of our longevity reinsurance product, which we introduced in 2011. To a lesser extent, the increase in account values was also driven by increases in the market value of customer funds primarily from declines in fixed income yields, partially offset by decreases in account values from declines in general account guaranteed investment product account values due to scheduled withdrawals and benefit payments. Net additions increased $13.3 billion, from $8.3 billion in 2010 to $21.6 billion in 2011 primarily reflecting higher sales of our fee-based investment-only stable value and longevity reinsurance products, and lower general account guaranteed investment product scheduled withdrawals.
Account values in our institutional investment products business amounted to $64.2 billion as of December 31, 2010, an increase of $12.3 billion from December 31, 2009. The increase in account values was primarily driven by additions of fee-based investment-only stable value products and increases in the market value of customer funds, primarily from a decline in fixed income market yields and interest credited on general account liabilities. These increases were partially offset by declines in general account guaranteed investment product account values due to scheduled withdrawals. Net additions (withdrawals) increased $8.4 billion, from net withdrawals of $31 million in 2009 to net additions of $8.3 billion in 2010 primarily reflecting higher sales of fee-based investment-only stable value products and lower general account guaranteed investment product scheduled withdrawals.
Consists of fees from: (a) individual mutual funds and both variable annuities and variable life insurance asset management revenues from our separate accounts; (b) funds invested in proprietary mutual funds through our defined contribution plan products; and (c) third-party sub-advisory relationships. Revenues from fixed annuities and the fixed-rate accounts of both variable annuities and variable life insurance are included in the general account.
2010 to 2009 Annual Comparison. Revenues increased $631 million, from $1,257 million in 2009 to $1,888 million in 2010. Asset management fees increased $224 million primarily from institutional and retail customer assets as a result of higher asset values from market appreciation and positive net asset flows. Commercial mortgage revenues increased $181 million primarily reflecting lower net credit and valuation-related charges on interim loans, as discussed above. Service, distribution and other revenues increased $118 million primarily from higher mutual fund service fees and assets under management, with a corresponding increase in expense. Also contributing to the increase were higher revenues in certain consolidated real estate funds, which were fully offset by higher expenses related to noncontrolling interests in these funds. Strategic investing revenues increased $90 million reflecting improved results in real estate and fixed income investments, as discussed above. In addition, incentive fees increased $22 million primarily related to institutional real estate funds. A portion of these incentive-based fees are offset in incentive compensation expense in accordance with the terms of the contractual agreements. Certain of our incentive fees continue to be subject to positive or negative future adjustment based on cumulative fund performance in relation to specified benchmarks. As of December 31, 2010, $146 million of cumulative incentive fee revenue, net of compensation, is subject to future adjustment, compared to $150 million as of December 31, 2009.
2011 to 2010 Annual Comparison. Expenses, as shown in the table above under “-Operating Results,” increased $251 million, from $1,401 million in 2010 to $1,652 million in 2011 primarily driven by increased compensation costs, from increased revenues, as discussed above, and increased headcount, as well as increases in other costs supporting the business. In addition, expenses related to revenues associated with certain consolidated funds and mutual funds services increased, as discussed above.
The following tables set forth assets under management by asset class and source as of the dates indicated and net additions, excluding money market activity, by source for the periods indicated. In managing our business, we analyze assets under management, which do not correspond to U.S. GAAP assets, because the principal source of revenues are fees based on assets under management.
As of December 31, 2011, 2010, and 2009, includes $10.0 billion, $10.2 billion, and $0.7 billion, respectively, of net additions related to investment-only stable value products.
2011 to 2010 Annual Comparison. Assets under management were $619.1 billion at December 31, 2011, an increase of $81.8 billion from December 31, 2010. Institutional assets under management increased $33.8 billion from 2010 to 2011 driven by market appreciation of $19.7 billion, as well as net additions of $16.7 billion from third party clients, primarily from positive flows into fixed income accounts, including $10.0 billion of net additions associated with investment-only stable value products. Retail assets under management increased $16.7 billion from 2010 to 2011 primarily from a net increase in affiliated assets under management of $14.1 billion, primarily from variable annuity assets rebalancing into a fixed income fund, as well as net additions of $3.5 billion from third party clients. General account assets increased $31.3 billion primarily driven by $15.2 billion in net additions from the acquisition of the Star and Edison Businesses and fixed income market appreciation of $17.2 billion.
As of December 31, 2011 and 2010, excludes $10 million and $29 million, respectively, of commitments for future fundings that would need to be disbursed if borrowers meet the conditions for these fundings and $44 million and $69 million, respectively, of commercial real estate held for sale related to foreclosed interim loans.
A stabilized value and projected net operating income are used in the calculation of the loan-to-value and debt service coverage ratios.
For those loans where the loan amount is greater than the collateral value, the excess of the loan amount over the collateral value was $42 million and $171 million as of December 31, 2011 and 2010, respectively.
2011 to 2010 Annual Comparison. Adjusted operating income increased $17 million, from $500 million in 2010 to $517 million in 2011. Results for both periods include a benefit from lower amortization of deferred policy acquisition costs, net of related unearned revenue reserves and net decreases in insurance reserves, reflecting updates of our actuarial assumptions based on annual reviews. The annual reviews cover assumptions used in our estimates of total gross profits which form the basis for amortizing deferred policy acquisition costs and unearned revenue reserves, as well as the reserve for the guaranteed minimum death benefit feature in certain contracts. Results in 2011 included a $75 million benefit from the annual reviews, primarily reflecting updates to our persistency assumptions as a result of more favorable lapse experience on variable life policies, and improved mortality based on experience. Adjusted operating income for 2010 included a $52 million benefit from the annual reviews, primarily reflecting methodology refinements to the treatment of certain investment income in our assumptions, as well as improved mortality based on experience.
The changes in our estimates of total gross profits arising from separate account fund performance, as discussed above, reflects the impact on our estimates of total gross profits of the difference between our actual quarterly rate of return on separate accounts compared to our previously expected quarterly rate of return. The
Absent the effect of these items, adjusted operating income in 2010 decreased $29 million, including $33 million from mortality experience, net of reinsurance, which was slightly unfavorable relative to expected levels in 2010, compared to favorable mortality experience in 2009. The decrease in adjusted operating income also reflects a $17 million increase in amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, reflecting a net expense of $1 million in 2010 compared to a net benefit of $16 million in 2009, resulting from changes in our estimates of total gross profits primarily from variable products arising from separate account fund performance and policyholder experience. This increase in amortization largely reflects the impact of equity markets on separate account fund performance in the respective periods, partially offset by the impact of policyholder persistency which in 2010 returned to levels that are more consistent with expectations. The decline in our in force block of variable life business also contributed to the decrease in adjusted operating income. Partially offsetting the decrease in adjusted operating income was higher net investment income from an increase in assets supporting our term and universal life products, growth in universal life policyholder account balances and the impact of gains in 2010 on investments in real property separate account funds compared to losses in 2009.
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $85 million, from $2,815 million in 2010 to $2,900 million in 2011. Net investment income increased $75 million reflecting higher asset balances supporting growth in our universal life insurance products including higher account balances resulting from increased policyholder deposits and higher regulatory capital requirements. Policy charges and fees and asset management fees and other income increased $8 million. This
2010 to 2009 Annual Comparison. Sales of new life insurance, measured as described above, decreased $99 million, from $359 million in 2009 to $260 million in 2010. The decrease in sales is primarily due to a $66 million decrease in term life product sales and a $36 million decrease in sales of universal life products driven by lower third party distribution sales. Sales from the third party distribution channel were $88 million lower than 2009 due to lower sales of universal life and term life products, both of which were impacted by price increases implemented in 2009. Sales by Prudential Agents were $11 million lower than 2009 primarily due to lower sales of both universal life products and term life products.
2010 to 2009 Annual Comparison. The total cash value of surrenders decreased $158 million, from $855 million in 2009 to $697 million in 2010, as surrenders in 2010 returned to levels that are more consistent with expectations compared to 2009. 2009 reflects a greater volume of surrenders, including lapses to extended term, of variable life insurance, due primarily to market conditions at the time and policyholders electing to surrender their policies rather than make premium payments or the contractually required deposits needed to keep the policies in force. The level of surrenders as a percentage of mean future policy benefit reserves, policyholders’ account balances and separate account balances decreased from 4.2% in 2009 to 3.0% in 2010, driven by a decrease in the total cash value of surrenders as described above, as well as higher average account balances primarily driven by market appreciation during 2010.
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $610 million, from $5,458 million in 2010 to $6,068 million in 2011. Group life premiums and policy charges and fee income increased $526 million, from $3,539 million in 2010 to $4,065 million in 2011. This increase primarily reflects higher premiums from non-retrospectively experience-rated contracts reflecting growth in the business from new sales and continued strong persistency of 95.8% in 2011 compared to 92.1% in 2010, as well as higher premiums from retrospectively experience-rated contracts resulting from the increase in policyholder benefits on these contracts, as discussed below. 2011 also includes an increase of $14 million from premium adjustments on two large group life non-retrospectively experience-rated cases, as discussed above. In addition, group disability premiums and policy charges and fee income, which include long-term care and dental products, increased by $71 million, from $1,146 million in 2010 to $1,217 million in 2011 primarily reflecting growth of business in force and from new sales partially offset by higher premiums in 2010 associated with the assumption of existing liabilities from third parties, which is offset in policyholders’ benefits, as discussed below. Also, contributing to the increase in revenue is higher investment income in 2011 primarily from higher invested assets due to growth in the businesses offset by lower portfolio yields and lower income on alternative investments in 2011.
2010 to 2009 Annual Comparison. Revenues increased by $173 million, from $5,285 million in 2009 to $5,458 million in 2010. Group life premiums and policy charges and fee income increased by $125 million, from $3,414 million in 2009 to $3,539 million in 2010, primarily reflecting higher premiums from retrospectively experience-rated group life business resulting from the increase in policyholder benefits on these contracts as discussed below. Also contributing to the increase were higher premiums from non-retrospectively experience-rated group life business primarily reflecting growth of business in force resulting from new sales, partially offset by a decrease in premiums associated with the assumption of existing liabilities from third parties, which is offset in policyholders’ benefits, as discussed below, as well as the lapse of certain business and repricing of other business up for renewal, as discussed above. Group disability premiums and policy charges and fee income, which include long-term care and dental products, increased by $25 million, from $1,121 million in 2009 to $1,146 million in 2010. This increase primarily reflects higher premiums due to growth of business in force resulting from new sales, and continued strong persistency of 92.1% in 2010 compared to 90.9% in 2009, partially offset by a decrease in premiums associated with the assumption of existing liabilities from third parties, which is offset in policyholders’ benefits, as discussed below.
competitive market, partially offset by the favorable impact of the reserve refinements. The group disability benefits ratio deteriorated 5.8 percentage points from 2009 to 2010, primarily due to less favorable long-term disability claims experience combined with an unfavorable impact from reserve refinements, including the impact of the annual reviews. The group life administrative operating expense ratio was relatively unchanged from 2009 to 2010. The group disability administrative operating expense ratio deteriorated 3.0 percentage points from 2009 to 2010, primarily due to higher costs to support disability operations and expansion into the group dental market, lower premiums associated with the assumption of existing liabilities from third parties, as well as an unfavorable impact from the refinement of a premium tax estimate.
The operations of our International Insurance Division are subject to currency fluctuations that can materially affect their U.S. dollar-equivalent earnings from period to period even if earnings on a local currency basis are relatively constant. We enter into forward currency derivative contracts, and hold “dual currency” and “synthetic dual currency” investments, as part of our strategy to effectively fix the currency exchange rates for a
We also seek to mitigate the impact of foreign currency exchange rate movements on our U.S. dollar-equivalent equity in foreign subsidiaries through various hedging strategies. In our Japanese insurance subsidiaries, we hedge a portion of the estimated available economic capital of the business using a variety of instruments, including U.S. dollar-denominated assets financed by the combination of U.S. GAAP equity and yen-denominated liabilities. We may also hedge using instruments held in our U.S. domiciled entities, such as U.S. dollar-denominated debt that has been swapped to yen. We are evaluating the hedging strategy related to our Japanese insurance subsidiaries to consider the Japanese operations’ relative contribution to the Company’s overall return on equity which may result in a change in the amount of yen exposure we hedge. In our Taiwan insurance operation, the U.S. GAAP equity exposure is mitigated by holding a variety of instruments, including U.S. dollar-denominated investments. During 2009 and 2010, we terminated our hedges of the U.S. GAAP equity exposure of our other foreign operations, excluding our Japan and Taiwan insurance operations, due to a variety of considerations including a desire to limit the potential for cash settlement outflows that would result from strengthening foreign currencies. For further information on the various instruments used to mitigate the risks of foreign currency exchange rate movements on our U.S. dollar-equivalent equity in foreign subsidiaries, see “-Impact of foreign currency exchange rate movements on equity.”
As of both December 31, 2011 and 2010, the notional amounts of these forward currency contracts were $3.0 billion, of which $2.5 billion were related to our Japanese insurance operations.
Below is the fair value of these instruments as reflected on our balance sheet for the periods indicated.
The table below presents as of December 31, 2011, the yen-denominated earnings subject to our dual currency and synthetic dual currency investments and the related weighted average exchange rates applicable at the time these investments were acquired.
Yen amounts are imputed from the contractual U.S. dollar-denominated interest cash flows.
comprehensive income (loss),” whereas the non-yen denominated liabilities are remeasured for foreign currency exchange rate movements, and the related change in value is recorded in earnings within “Asset management fees and other income.” Investments designated as held-to-maturity under U.S. GAAP, are recorded at amortized cost on the balance sheet, but are remeasured for foreign currency exchange rate movements, with the related change in value recorded in earnings within “Asset management fees and other income.” Due to this non-economic volatility that is reflected in U.S. GAAP, the change in value due to changes in foreign currency exchange rate movements, or remeasurement, of these non-yen denominated assets and related liabilities associated with these products is excluded from adjusted operating income and included in “Realized investment gains (losses), net, and related adjustments.” For the years ended December 31, 2011 and 2010, “Realized investment gains (losses), net, and related adjustments” includes net gains of $784 million and $85 million, respectively, reflecting the remeasurement of these non-yen denominated insurance liabilities, which are presented in the table below, and the remeasurement of certain non-yen denominated related assets, and were primarily driven by the strengthening of the yen against the U.S. and Australian dollar.
The table below presents the carrying value of insurance liabilities related to products offered in non-local currencies within our Japanese insurance operations as of the periods indicated.
As of December 31, 2011, includes $11.3 billion of insurance liabilities for U.S. dollar-denominated products issued by Star and Edison, which are supported by U.S. dollar-denominated assets.
As of December 31, 2011, includes $2.7 billion of insurance liabilities for Australian dollar-denominated products issued by Star and Edison, which are supported by Australian dollar-denominated assets.
As of December 31, 2011 and 2010, $4.5 billion and $3.5 billion, respectively, of insurance liabilities for U.S. dollar-denominated products presented in the table above are associated with Prudential of Japan and coinsured to our U.S. domiciled insurance operations. These U.S. dollar-denominated liabilities are supported by U.S. dollar-denominated assets and are not subject to the remeasurement mismatch described above.
The table below presents the composition of instruments that serve to hedge the impact of foreign currency exchange movements on our U.S. dollar-equivalent equity in our Japanese insurance subsidiaries for the periods indicated.
Excludes “Accumulated other comprehensive income (loss)” components of equity and certain other adjustments.
The investments designated as held-to-maturity under U.S. GAAP are recorded at amortized cost on the balance sheet, but are remeasured for foreign currency exchange rate movements, with the related change in value recorded within “Asset management fees and other income.” The remeasurement related to the change in value for foreign currency exchange rate movements for these investments is excluded from adjusted operating income.
For U.S. dollar-denominated investments recorded on the books of yen-based entities, foreign currency exchange movements will impact their value. To the extent the value of the yen strengthens as compared to the U.S. dollar, the value of these U.S. dollar-denominated investments will decrease. Upon the ultimate sale or maturity of the U.S. dollar-denominated investments, any realized change in value related to changes in the foreign currency exchange rates will be included in “Realized investment gains (losses), net” within the income statement and excluded from adjusted operating income. Similarly, changes in the foreign currency exchange rates that result in other-than-temporary impairments on these investments will be included in “Realized investment gains (losses), net” within the income statement and, as such, excluded from adjusted operating income. See “-Realized Investment Gains and Losses and General Account Investments-General Account Investments-Fixed Maturity Securities-Other-than-Temporary Impairments of Fixed Maturity Securities” for a discussion of our policies regarding impairments. We seek to mitigate the risk that future unfavorable foreign currency exchange rate movements will decrease the value of our U.S. dollar-denominated investments and negatively impact the equity of our yen-based entities by employing internal hedging strategies between a subsidiary of Prudential Financial and certain of our yen-based entities. See “-Liquidity and Capital Resources-Liquidity and Capital Resources of Subsidiaries-International Insurance and Investments Subsidiaries” for a discussion of our internal hedging strategies.
The results of our International Insurance operations are translated on the basis of weighted average monthly exchange rates, inclusive of the effects of the intercompany arrangement discussed above. To provide a better understanding of operating performance within the International Insurance segment, where indicated below, we have analyzed our results of operations excluding the effect of the year over year change in foreign currency exchange rates. Our results of operations excluding the effect of foreign currency fluctuations were derived by translating foreign currencies to U.S. dollars at uniform exchange rates for all periods presented,
Revenues exclude Realized investment gains (losses), net, and related adjustments. Realized investment gains (losses), net, and related adjustments includes gains and losses from changes in value of certain assets and liabilities relating to foreign currency exchange movements that have been economically hedged, as discussed above. See “-Realized Investment Gains and Losses and General Account Investments-Realized Investment Gains and Losses.”
The addition of these operations increases our scale in the Japanese insurance market and provides complementary distribution opportunities. We also expect these businesses to provide attractive returns primarily driven from in force business and cost synergies. Star and Edison’s bank channel distribution will be transferred and integrated with the bank channel operations of Prudential Gibraltar. The Star and Edison companies were merged into Gibraltar Life on January 1, 2012. We expect pre-tax integration costs of approximately $500 million to be incurred over a five-year period. We incurred $174 million of integration costs during 2011 and expect to incur approximately $200 million during 2012. After the integration is completed, we expect annual cost savings of approximately $250 million, and expect to achieve approximately two-thirds of the annual savings by the end of 2012. Actual integration costs may exceed, and actual costs savings may fall short of, such expectations.
fluctuations. Results for 2011 benefited from $354 million of earnings from the acquired Star and Edison Businesses, excluding the impact of estimated claims associated with the earthquake and tsunami in Japan. Adjusted operating income for both 2011 and 2010 reflect the impact of partial sales of our investment, through a consortium, in China Pacific Group, which contributed a $237 million benefit to 2011 results compared to a $66 million benefit to 2010 results. Also contributing to the increase in adjusted income was a $96 million gain on sale of our investment in an operating joint venture, Afore XXI, a private pension fund manager in Mexico. These favorable items were partially offset by transaction and integration costs of $213 million in 2011 relating to the Star and Edison acquisition and $49 million of charges associated with claims and expenses arising from the March 2011 earthquake and tsunami in Japan.
Excluding the effect of the items discussed above, adjusted operating income from our Gibraltar Life and Other operations increased $132 million, reflecting business growth, including expanding sales of protection products, and improved investment results, including a greater contribution from our fixed annuity products reflecting growth of that business and lower amortization of deferred policy acquisition costs. The lower amortization of deferred policy acquisition costs associated with our fixed annuity products was primarily driven by lower amortization rates reflecting an increase in prior period investment results included in total gross profits used as a basis for determining amortization rates. Partially offsetting these favorable variances were higher development costs supporting bank and agency distribution channel growth and unfavorable results from our insurance joint venture in India and our asset management-related joint venture in China.
2010 to 2009 Annual Comparison. Adjusted operating income from our Life Planner operations increased $48 million, from $1,221 million in 2009 to $1,269 million in 2010, including a net favorable impact of $11 million from currency fluctuations. Excluding the impact of currency fluctuations, adjusted operating income increased $37 million primarily reflecting the growth of business in force and continued strong persistency in our Japanese Life Planner operation, partially offset by an unfavorable variance of $27 million, reflecting the impact of a $6 million net charge in 2010 and a $21 million net benefit in 2009 from reserve refinements related to the implementation of a new policy valuation system. Also impacting adjusted operating income is a $6 million lower benefit in 2010 from a reduction in amortization of deferred policy acquisition costs primarily reflecting improved mortality assumptions, which benefited both periods, associated with our annual review of estimated gross profits used to amortize deferred policy acquisition costs.
Adjusted operating income from our Gibraltar Life and Other operations increased $169 million, from $647 million in 2009 to $816 million in 2010, including a favorable impact of $22 million from currency fluctuations. In December 2010, a consortium of investors including Prudential that holds a minority interest in China Pacific Insurance (Group) Co., Ltd sold approximately 16% of its holdings, which contributed a pre-tax benefit of $66 million to results. Absent the effect of this item and the impact of currency fluctuations, adjusted operating income increased $81 million, primarily reflecting the continued growth in our fixed annuity products, which are primarily denominated in U.S. dollars, and growth in protection products driven by expanding bank channel distribution, as well as a higher contribution from non-coupon investments. Results for 2010 also include $11 million of expenses associated with the acquisition of the Star and Edison Businesses which were more than offset by a lower level of benefits and expenses including the absence of net charges of $5 million related to a 2009 guaranty fund assessment and net charges of $8 million in 2009 from unfavorable reserve refinements related to the implementation of a new policy valuation system.
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $7,568 million, from $12,220 million in 2010 to $19,788 million in 2011, including a net favorable impact of $1,024 million relating to currency fluctuations. Excluding the impact of currency fluctuations, revenues increased $6,544 million, from $12,633 million in 2010 to $19,177 million in 2011.
Revenues from our Life Planner operations increased $948 million, from $7,266 million in 2010 to $8,214 million in 2011, including a net favorable impact of $401 million from currency fluctuations. Excluding the impact of currency fluctuations, revenues increased $547 million, from $7,436 million in 2010 to $7,983 million in 2011. This increase in revenues came primarily from increases in premiums and policy charges and fee income of $393 million, from $6,080 million in 2010 to $6,473 million in 2011. Premiums and policy charges and fee
income from our Japanese Life Planner operation increased $337 million, from $4,635 million in 2010 to $4,972 million in 2011, primarily reflecting growth of business in force and continued strong persistency. Net investment income increased $118 million, from $1,268 million in 2010 to $1,386 million in 2011, primarily due to investment portfolio growth, partially offset by lower yields in our investment portfolio compared to the prior year.
Revenues from our Life Planner operations increased $823 million, from $6,443 million in 2009 to $7,266 million in 2010, including a net favorable impact of $296 million from currency fluctuations. Excluding the impact of currency fluctuations, revenues increased $527 million, from $6,909 million in 2009 to $7,436 million in 2010. This increase in revenues came primarily from increases in premiums and policy charges and fee income of $363 million, from $5,717 million in 2009 to $6,080 million in 2010. Premiums and policy charges and fee income from our Japanese Life Planner operation increased $274 million, from $4,361 million in 2009 to $4,635 million in 2010, primarily reflecting growth of business in force and continued strong persistency, partially offset by a benefit recognized in the prior year from the migration to a new policy valuation system discussed above. Net investment income increased $132 million, from $1,136 million in 2009 to $1,268 million in 2010, primarily due to investment portfolio growth, partially offset by lower yields in our Japanese investment portfolio compared to the prior year.
Benefits and expenses of our Gibraltar Life and Other operations increased $6,100 million, from $4,138 million in 2010 to $10,238 million in 2011, including an unfavorable impact of $594 million from currency fluctuations. Excluding the impact of currency fluctuations, benefits and expenses increased $5,506 million, from $4,250 million in 2010 to $9,756 million in 2011. Policyholder benefits, including changes in reserves, increased $3,697 million and was primarily driven by the acquisition of the Star and Edison Businesses, higher single premium whole life sales in 2011 and $37 million of charges associated with claims resulting from the March 2011 earthquake and tsunami in Japan. General and administrative expenses, net of capitalization, increased $1,225 million primarily driven by the impact of the Star and Edison acquisition including $213 million of transaction and integration costs related to the acquisition, higher development costs supporting bank and agency distribution channel growth and $12 million of expenses resulting from the earthquake and tsunami discussed above. Also contributing to the increase in benefits and expenses is higher amortization of deferred policy acquisition costs and interest credited to policyholders’ account balances primarily reflecting the impact of the Star and Edison acquisition.
2010 to 2009 Annual Comparison. Benefits and expenses increased $1,411 million, from $8,724 million in 2009 to $10,135 million in 2010, including a net unfavorable impact of $458 million related to currency fluctuations. Excluding the impact of currency fluctuations, benefits and expenses increased $953 million, from $9,373 million in 2009 to $10,326 million in 2010.
Benefits and expenses of our Life Planner operations increased $775 million, from $5,222 million in 2009 to $5,997 million in 2010, including a net unfavorable impact of $285 million from currency fluctuations. Excluding the impact of currency fluctuations, benefits and expenses increased $490 million, from $5,586 million in 2009 to $6,076 million in 2010. Benefits and expenses of our Japanese Life Planner operation increased $356 million, from $4,082 million in 2009 to $4,438 million in 2010, primarily reflecting an increase in policyholder benefits due to changes in reserves, which was driven by the growth in business in force. Included in 2010 general and administrative expenses for the Life Planner operations is $4 million of expenses, a
decrease of $8 million from the prior year, related to a recently completed initiative in Japan to enhance our information processes and technology systems in order to improve efficiency and lower costs.
With a diversified product mix supporting the growing demand for retirement and savings products, our international insurance operations offer various traditional whole life, term, endowment policies (which provide for payment on the earlier of death or maturity) and retirement income life insurance products that combine an insurance protection element similar to that of term life policies with a retirement income feature. In most of our operations, we also offer certain health products with fixed benefits, some of which include a high savings element, as well as annuity products, which are primarily represented by U.S. and Australian dollar-denominated fixed annuities in our Gibraltar Life operations.
Our Life Planners’ primary objective is to sell protection-oriented life insurance products on a needs basis to mass affluent and affluent customers, as well as to small businesses, whereas Gibraltar’s Life Advisors have primarily sold individual protection products to the broad middle income market in Japan, particularly through relationships with affinity groups. Supplementing our core Life Planner and Life Advisor distribution channels, bank distribution channel sales primarily consist of products intended to provide premature death protection and retirement income, as well as fixed annuity products primarily denominated in U.S. dollars, and increasingly,
Historically, growth in annualized new business premiums was closely correlated to growth of our Life Planner and Life Advisor distribution force. Recently, growth in annualized new business premiums is being driven by increased average premium per new policy resulting in part from the growing demand for retirement-oriented products, as well as expanded distribution through third party channels, especially banks. As noted in the table below, bank channel sales contain a disproportionate number of single pay or limited pay contracts which tend to be larger policies and therefore have higher average premiums per policy. Our expectation is that this trend will continue.
Single pay life annualized new business premiums, which include 10% of first year premiums, and 3-year limited pay annualized new business premiums, which include 100% of new business premiums, represented 30% and 50%, respectively, of total bank distribution channel annualized new business premiums, excluding annuity products, for the year ended December 31, 2011, and 1% and 64%, respectively, of total bank distribution channel annualized new business premiums, excluding annuity products, for the year ended December 31, 2010.
Annualized new business premiums, on a constant exchange rate basis, from our Life Planner operations increased $124 million, from $973 million in 2010 to $1,097 million in 2011, including $78 million of higher sales in Japan driven by growth in average premium per policy reflecting the increasing demand for both yen and U.S. dollar-denominated retirement income products. Sales in Korea increased $21 million driven by growth in average premium per policy resulting from increased sales of retirement income products and variable annuity products. In Brazil, sales increased $13 million primarily driven by sales of whole life products due in part to an increase in the number of Life Planners.
from single premium whole life sales due in part to increased sales in advance of a premium increase on our yen-denominated product effective early February, 2011, and $55 million in whole life products. Historically, a significant amount of sales through our bank channel distribution was derived through a single Japanese mega-bank; however, certain of our other bank channel relationships are also contributing to the more recent sales growth. Excluding Star and Edison, independent agency distribution sales increased $81 million with the vast majority from sales of cancer insurance products and Life Advisor sales increased $17 million, primarily reflecting higher sales of retirement income and annuity products.
Single pay life annualized new business premiums, which include 10% of first year premiums, and 3-year limited pay annualized new business premiums, which include 100% of new business premiums, represented 1% and 64%, respectively, of total bank distribution channel annualized new business premiums, excluding annuity products, for the year ended December 31, 2010, and 1% and 48%, respectively, of total bank distribution channel annualized new business premiums, excluding annuity products, for the year ended December 31, 2009.
2010 to 2009 Annual Comparison. On a constant exchange rate basis, annualized new business premiums increased $375 million, from $1,495 million in 2009 to $1,870 million in 2010.
Annualized new business premiums, on a constant exchange rate basis, from our Gibraltar Life operation increased $285 million, primarily due to higher sales of protection products in our bank distribution channels and sales related to a recently introduced cancer whole life product, a portion of which were sold through the independent agency channel.
The number of Life Planners decreased by 44, or 1%, from 6,609 as of December 31, 2009 to 6,565 as of December 31, 2010, driven by decreases of 76 in Taiwan, 53 in Poland and 31 in Argentina, partially offset by increases of 43 in Italy, 36 in Brazil and 28 in Japan. Over the past twelve months, we transferred 92 Japanese Life Planners to Gibraltar, primarily in support of our efforts to expand our bank channel distribution and to service orphaned policyholders. Factoring in these transfers, the number of Japanese Life Planners would have increased 4%, from December 31, 2009 to December 31, 2010. Prior to December 31, 2009, an additional 304 Japanese Life Planners were transferred to Gibraltar.
Many of our insurance products sold in international markets provide for the buildup of cash values for the policyholder at mandated guaranteed interest rates. Authorities in some jurisdictions regulate interest rates guaranteed in our insurance contracts. The regulated guaranteed interest rates do not necessarily match the actual returns on our underlying investments that support these products. The spread between the actual investment returns and these guaranteed rates of return to the policyholder is an element of the profit or loss that we will experience on these products. With regulatory approval, guaranteed rates may be changed on new business which enhances our ability to set rates commensurate with available investment returns. However, the major sources of profitability for many of our products, particularly those sold by Prudential of Japan, are margins on mortality, morbidity and expense charges rather than investment spreads.
Equity in earnings of operating joint ventures are included in adjusted operating income but excluded from income from continuing operations before income taxes and equity in earnings of operating joint ventures as they are reflected on a U.S. GAAP basis on an after-tax basis as a separate line in our Consolidated Statements of Operations. Earnings attributable to noncontrolling interests are excluded from adjusted operating income but included in income from continuing operations before income taxes and equity in earnings of operating joint ventures as they are reflected on a U.S. GAAP basis as a separate line in our Consolidated Statements of Operations. Earnings attributable to noncontrolling interests represent the portion of earnings from consolidated entities that relates to the equity interests of minority investors.
Results from Corporate and Other operations pension income and employee benefits decreased $31 million primarily due to a decrease in income from our qualified pension plan. Income from our qualified pension plan decreased $31 million, from $321 million in 2010 to $290 million in 2011, due to a decrease in the expected rate of return on plan assets from 7.50% in 2010 to 7.00% in 2011, partially offset by the effect on expected return due to the growth in plan assets.
For purposes of calculating pension income from our own qualified pension plan for the year ended December 31, 2012, we will decrease the discount rate to 4.85% from 5.60% in 2011. The expected rate of return on plan assets will decrease to 6.75% in 2012 from 7.00% in 2011, and the assumed rate of increase in compensation will remain unchanged at 4.5%. We determined our expected rate of return on plan assets based upon a building block approach that considers inflation, real return, term premium, credit spreads, equity risk premium and capital appreciation as well as expenses, expected asset manager performance and the effect of rebalancing for the equity, debt and real estate asset mix applied on a weighted average basis to our pension asset portfolio. Giving effect to the foregoing assumptions and other factors, we expect, on a consolidated basis, income from our own qualified pension plan will continue to contribute to adjusted operating income in 2012, but at a level of about $55 million to $65 million lower than in 2011. Other postretirement benefit expenses will increase in a range of $15 million to $25 million. The increase is driven primarily by demographic updates, a decrease in the discount rate to 4.60% from 5.35% and the effect of a decrease in plan assets. In 2012, pension and other postretirement benefit service costs related to active employees will continue to be allocated to our business segments.
2010 to 2009 Annual Comparison. The loss from Corporate and Other operations, on an adjusted operating income basis, increased $144 million, from $779 million in 2009 to $923 million in 2010. Capital debt interest expense increased $59 million due to a greater level of capital debt, which includes the issuance in
September 2009 of $500 million of exchangeable surplus notes, and reflects the use of a portion of the proceeds from prior sales of retail medium-term notes for general corporate purposes beginning in the second quarter of 2009, as well as the deployment of additional corporate borrowings for capital purposes. Investment income, net of interest expense, excluding capital debt interest expense, decreased $9 million. Net investment income, net of interest expense, excluding capital debt interest expense was also impacted by our repurchase of substantially all of our convertible senior notes during 2009. Also contributing to the greater loss from corporate operations in 2010 compared to the prior year are greater net charges from other corporate activities, primarily reflecting less favorable results from corporate hedging activities, increased corporate advertising expenses and other retained corporate expenses.
As of December 31, 2011, the excess of actual cumulative earnings over the expected cumulative earnings was $762 million, which was recorded as a policyholder dividend obligation. Actual cumulative earnings, as required by U.S. GAAP, reflect the recognition of realized investment gains and losses in the current period, as well as changes in assets and related liabilities that support the Closed Block policies. Additionally, the accumulation of net unrealized investment gains that have arisen subsequent to the establishment of the Closed Block have been reflected as a policyholder dividend obligation of $3,846 million at December 31, 2011, to be paid to Closed Block policyholders unless offset by future experience, with an offsetting amount reported in “Accumulated other comprehensive income (loss).”
Income (Loss) from Continuing Operations Before Income Taxes and Equity in Earnings of Operating Joint Ventures
2011 to 2010 Annual Comparison. Income from continuing operations before income taxes and equity in earnings of operating joint ventures decreased $528 million from $725 million in 2010 to $197 million in 2011. Results for 2011 include a $636 million policyholder dividend obligation expense as actual cumulative earnings were higher than expected cumulative earnings. This expense was $510 million higher than the policyholder dividend obligation expense of $126 million in 2010. As noted above, as of December 31, 2011, the excess of actual cumulative earnings over the expected cumulative earnings was $762 million. If actual cumulative earnings fall below expected cumulative earnings in future periods, earnings volatility in the Closed Block Business, which is primarily due to changes in investment results, may not be offset by changes in the cumulative earnings policyholder dividend obligation. Results also included a $40 million increase in reserves for estimated payments arising from use of new Social Security Master Death File matching criteria to identify deceased policy and contract holders. See Note 23 to the Notes to Consolidated Financial Statements for further details regarding this matter. Partially offsetting these items, was an increase of $51 million in net realized investment gains, from $794 million in 2010 to $845 million in 2011, primarily resulting from higher trading gains as part of a change in asset allocation of the portfolios and lower impairment losses, partially offset by lower investment gains from the
2010 to 2009 Annual Comparison. Income (loss) from continuing operations before income taxes and equity in earnings of operating joint ventures increased $1,205 million, from a loss of $480 million in 2009 to income of $725 million in 2010. Results for 2010 include an increase of $2,079 million in net realized investment gains (losses), from losses of $1,285 million in 2009 to gains of $794 million in 2010, primarily due to lower impairments and credit losses, as well as a net increase in the market value of derivatives used in duration management programs. For a discussion of Closed Block Business realized investment gains (losses), net, see “-Realized Investment Gains and Losses and General Account Investments-Realized Investment Gains and Losses.” Net investment income, net of interest expense, increased $67 million, primarily due to an increase in income on joint ventures and limited partnership investments accounted for under the equity method, partially offset by lower portfolio yields. In addition, dividends paid and accrued to policyholders decreased primarily due to a decrease in the 2010 dividend scale. The impact of these items contributed to the actual cumulative earnings which, when compared to the expected cumulative earnings, resulted in an increase in the cumulative earnings policyholder dividend obligation expense of $977 million, from 2009 compared to 2010. As of December 31, 2010, the excess of actual cumulative earnings over the expected cumulative earnings was $126 million.
2010 to 2009 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” increased $636 million, from $5,725 million in 2009 to $6,361 million in 2010. This increase included an $849 million increase in dividends to policyholders reflecting an increase in the cumulative earnings policyholder dividend obligation expense of $977 million, representing an $851 million reduction in the cumulative earnings policyholder dividend obligation in 2009, compared to a $126 million increase in the cumulative earnings policyholder dividend obligation in 2010. This increase was partially offset by a decrease in
dividends paid and accrued to policyholders of $128 million, primarily due to a decrease in the 2010 dividend scale. Policyholders’ benefits, including changes in reserves, decreased $250 million driven by a decline in premiums, as discussed above.
Included within net income are the results of businesses which are reflected as discontinued operations under U.S. GAAP. Income (loss) from discontinued operations, net of taxes, was $35 million, $33 million and $(19) million for the years ended December 31, 2011, 2010 and 2009, respectively.
Our income from continuing operations includes results from several businesses that have been or will be sold or exited that do not qualify for “discontinued operations” accounting treatment under U.S. GAAP. The results of these divested businesses are reflected in our Corporate and Other operations, but excluded from adjusted operating income. For a further description of these divested businesses, see “Business-Corporate and Other.” A summary of the results of these divested businesses that have been excluded from adjusted operating income is as follows for the periods indicated:
On December 6, 2011, we sold our real estate brokerage franchise and relocation services business which was comprised of PRERS to Brookfield Asset Management, Inc. We retained ownership of PREFSA, a finance subsidiary of PRERS with debt and equity investments in a limited number of real estate brokerage franchises. The results of these operations, inclusive of PREFSA, are reflected as a divested business for all periods presented. The proceeds from the sale, before transaction related expenses, were $108 million and resulted in a pre-tax gain of approximately $49 million.
Certain products included in the Retirement and International Insurance segments are experience-rated in that investment results associated with these products are expected to ultimately accrue to contractholders. The
Decreases to contractholder liabilities due to asset value changes are limited by certain floors and therefore do not reflect cumulative declines in recorded asset values of $7 million, $9 million and $35 million as of December 31, 2011, 2010 and 2009, respectively. We have recovered and expect to recover in future periods these declines in recorded asset values through subsequent increases in recorded asset values or reductions in crediting rates on contractholder liabilities.
Included in the amounts above related to the change in the liability to contractholders as a result of commercial mortgage and other loans are increases of $55 million, $108 million and $105 million for the years ended December 31, 2011, 2010 and 2009, respectively. As prescribed by U.S. GAAP, changes in the fair value of commercial mortgage and other loans held for investment in our general account, other than when associated with impairments, are not recognized in income in the current period, while the impact of these changes in fair value are reflected as a change in the liability to fully participating contractholders in the current period.
The amount of Level 3 assets taken as a percentage of total assets measured at fair value on a recurring basis totaled 5% and 2% for the Financial Services Businesses and Closed Block Business, respectively. Excluding separate account assets for which the risk is borne by the policyholder, the amount of Level 3 assets taken as a percentage of total assets measured at fair value on a recurring basis totaled 2% for the Financial Services Businesses. The amount of Level 3 liabilities was immaterial to our balance sheet.
For additional information regarding the balances of assets and liabilities measured at fair value by hierarchy level see Note 20 to the Consolidated Financial Statements.
The determination of fair value, which for certain assets and liabilities is dependent on the application of estimates and assumptions, can have a significant impact on our results of operations. As discussed in more detail below, the determination of fair value for certain assets and liabilities may require the application of a greater degree of judgment depending on market conditions, as the ability to value assets and liabilities can be significantly impacted by a decrease in market activity or a lack of transactions executed in an orderly manner.
Public fixed maturity securities are generally valued using the price provided by independent pricing services under our normal pricing protocol. Securities with prices based on validated quotes from pricing services are generally reflected within Level 2. Public fixed maturity securities included in Level 3 in our fair value hierarchy are generally priced based on internally-developed valuations or non-binding broker quotes. For certain private fixed maturity and equity securities, the discounted cash flow or other valuation model uses significant unobservable inputs, and accordingly, such securities are included in Level 3 in our fair value hierarchy.
Level 3 fixed maturity securities included approximately $3.2 billion as of December 31, 2011 and $2.1 billion as of December 31, 2010 of public fixed maturities, with values primarily based on non-binding broker-quotes, and approximately $1.6 billion as of December 31, 2011 and $1.4 billion as of December 31, 2010 of private fixed maturities, with the majority of values based on internally-developed models. Significant unobservable inputs used included: issue specific credit adjustments, material non-public financial information, management judgment, estimation of future earnings and cash flows, default rate assumptions, liquidity assumptions and non-binding quotes from market makers. These inputs are usually considered unobservable, as not all market participants will have access to this data.
The fair value of real estate held in consolidated investment funds is determined through an independent appraisal process. The appraisals generally utilize a discounted cash flow model, following an income approach that incorporates various assumptions including rental revenue, operating expenses and discount rates. The appraisals also include replacement cost estimates and recent sales data as alternate methods of fair value. These appraisals and the related assumptions are updated at least annually, and incorporate historical property experience and any observable market data, including any market transactions. Since many of the assumptions utilized are unobservable and are considered to be significant inputs to the valuation, the real estate investments within other long-term investments have been reflected within Level 3 in our fair value hierarchy. Consolidated real estate investment funds classified as Level 3 totaled approximately $0.4 billion as of both December 31, 2011 and December 31, 2010. Our direct investment in these funds is not material, and the majority of the assets recorded as a result of the consolidation of these funds are offset by a noncontrolling interest reflected as a separate component of equity. The noncontrolling interest is not considered to be fair valued and therefore is not included in fair value reporting above. The fair value of fund investments, where the fair value option has been elected, is primarily determined by the fund managers. Since the valuations may be based on unobservable market inputs and cannot be validated by the Company, these investments have also been included within Level 3 in our fair value hierarchy. Investments in these funds included in Level 3 totaled approximately $0.4 billion as of December 31, 2011 and $0.3 billion as of December 31, 2010.
Derivatives are recorded at fair value either as assets, within “Other trading account assets,” or “Other long-term investments,” or as liabilities, within “Other liabilities,” except for embedded derivatives which are recorded with the associated host contract. The fair values of derivative contracts are determined based on quoted
prices in active exchanges or through the use of valuation models, and are affected by changes in market factors including non-performance risk. The majority of our derivative positions are traded in the over the counter (OTC) derivative market and are classified within Level 2 in our fair value hierarchy since their significant inputs have bid and ask prices that are actively quoted or can be readily obtained from external market data providers. Our policy is to use mid-market pricing consistent with our best estimate of fair value.
The change in fair value of the GMAB, GMWB and GMIWB resulted in a net liability of $2,886 million as of December 31, 2011, compared to a net contra-liability of $204 million as of December 31, 2010. The change primarily reflects a higher base of embedded derivative liabilities driven by significant declines in risk-free interest rates and the impact of account value performance, as well as an overall widening of the spreads used in valuing NPR, as noted above, which were primarily in our Individual Annuities segment as described in more detail under “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities.”
For a further discussion of our policies regarding other-than-temporary declines in investment value and the related methodology for recording fixed maturity other-than-temporary impairments, see “-General Account Investments-Fixed Maturity Securities-Other-Than-Temporary Impairments of Fixed Maturity Securities” below. For a further discussion of our policies regarding other-than-temporary declines in investment value and the related methodology for recording equity impairments, see “-General Account Investments-Equity Securities-Other-than-Temporary Impairments of Equity Securities” below. For a further discussion of our policy regarding commercial mortgage and other loans, see “-General Account Investments-Commercial Mortgage and Other Loans-Commercial Mortgage and Other Loan Quality” below.
We may realize additional credit and interest rate related losses through sales of investments pursuant to our credit risk and portfolio management objectives. Other-than-temporary impairments, interest rate related losses and credit related losses on sales (other than those related to certain of our businesses which primarily originate investments for sale or syndication to unrelated investors) are excluded from adjusted operating income.
We require most issuers of private fixed maturity securities to pay us make-whole yield maintenance payments when they prepay the securities. Prepayments are driven by factors specific to the activities of our borrowers as well as the interest rate environment.
We use interest rate and currency swaps and other derivatives to manage interest and currency exchange rate exposures arising from mismatches between assets and liabilities, including duration mismatches. We use derivative contracts to mitigate the risk that unfavorable changes in currency exchange rates will reduce U.S. dollar equivalent earnings generated by certain of our non-U.S. businesses. We also use equity-based and interest rate derivatives to hedge the risks embedded in some of our annuity products. Derivative contracts also include forward purchases and sales of to-be-announced mortgage-backed securities primarily related to our dollar roll program. Many of these derivative contracts do not qualify for hedge accounting, and consequently, we recognize the changes in fair value of such contracts from period to period in current earnings, although we do not necessarily account for the related assets or liabilities the same way. Accordingly, realized investment gains and losses from our derivative activities can contribute significantly to fluctuations in net income.
Adjusted operating income generally excludes “Realized investment gains (losses), net,” subject to certain exceptions (realized investment gains or losses within certain of our businesses for which such gains or losses are a principal source of earnings and those associated with terminating hedges of foreign currency earnings and current period yield adjustments), and related charges and adjustments.
Net trading gains on sales and maturities of fixed maturity securities of $277 million in 2011 were primarily due to sales within our Retirement and Individual Annuities segments. Included in the gross gains on sales and maturities of fixed maturity securities were $35 million of gross gains related to the sale of asset-backed securities collateralized by sub-prime mortgages. Net trading gains on sales and maturities of fixed maturity securities of $207 million in 2010 were primarily due to sales within our Retirement and Individual Annuities segments. Included in the gross gains on sales and maturities of fixed maturity securities were $4 million of gross gains related to the sale of asset-backed securities collateralized by sub-prime mortgages. Sales of fixed maturity securities in our Individual Annuities segment in both years were primarily due to transfers of investments out of our general account and into separate accounts relating to an automatic rebalancing element associated with certain living benefit features of some of our variable annuity products. See below for additional information regarding the other-than-temporary impairments of fixed maturity securities in 2011 and 2010.
Net realized losses on equity securities were $120 million in 2011, of which other-than-temporary impairments were $94 million and net trading losses on sales of equity securities were $26 million. Net trading losses in 2011 were primarily due to public equity sales within our International Insurance operations. Net realized gains on equity securities were $11 million in 2010, of which net trading gains on sales of equity securities were $89 million, partially offset by other-than-temporary impairments of $78 million. Net trading gains in 2010 were primarily due to private equity sales within our Corporate and Other and International Insurance operations. See below for additional information regarding the other-than-temporary impairments of equity securities in 2011 and 2010.
Net realized gains on commercial mortgage and other loans in 2011 were $89 million, primarily related to a net decrease in the loan loss reserves of $169 million, which was largely offset by $139 million of realized losses on related restructurings and sales within our Asset Management and International Insurance businesses. In addition, there were $32 million of mark-to-market gains on our interim loan portfolio. Net realized gains on
Related adjustments to realized investment gains (losses) were a net negative adjustment of $140 million in 2010. Adjustments for that portion of “Realized investment gains (losses), net” that are included in adjusted operating income were a net negative adjustment of $167 million, driven by $243 million of gains primarily from settlements on interest rate and currency swaps, partially offset by $93 million of losses related to the settlements of swaps used to hedge foreign-denominated earnings. Adjustments for that portion of “Asset management fees and other income” and “Net investment income” that are excluded from adjusted operating income were a net positive adjustment of $27 million, primarily driven by the impact of changes in foreign currency exchange rates on certain assets and liabilities for which we economically hedge the foreign currency exposure.
During 2011, we recorded other-than-temporary impairments of $558 million in earnings, compared to other-than-temporary impairments of $672 million recorded in earnings in 2010. The following tables set forth, for the periods indicated, the composition of other-than-temporary impairments recorded in earnings attributable to the Financial Services Businesses by asset type, and for fixed maturity securities, by reason.
Fixed maturity other-than-temporary impairments in 2011 were concentrated in asset-backed securities collateralized by sub-prime mortgages, Japanese commercial mortgage-backed securities, and the retail and wholesale, services, and manufacturing sectors of our corporate securities. The 2011 other-than-temporary impairments were primarily related to securities with unrealized foreign currency translation losses that are approaching maturity or related to securities with liquidity concerns, downgrades in credit, bankruptcy or other adverse financial conditions of the respective issuers, which have caused, or we believe will lead to, a deficiency in the contractual cash flows related to the investment. Our Japanese insurance operations hold foreign currency-denominated investments which in some cases, due primarily to the strengthening of the yen, are currently in an unrealized loss position. As they approach maturity and remain in an unrealized loss position, it becomes less likely that the exchange rates will recover and more likely that losses will be realized upon maturity and therefore we record an other-than-temporary impairment. During 2011, we recorded other-than-temporary impairments of $184 million in earnings related to securities with an unrealized foreign currency translation loss that are approaching maturity. As of December 31, 2011, gross unrealized losses related to those securities maturing between January 1, 2012 and December 31, 2014 are $625 million. Based on December 31, 2011 fair values, absent a change in currency rates, impairments of approximately $191 million would be recorded in earnings in 2012 and approximately $142 million in 2013 on these securities. Fixed maturity other-than-temporary impairments in 2010 were concentrated in asset-backed securities collateralized by sub-prime mortgages, Japanese commercial mortgage-backed securities, and the services, manufacturing, and finance sectors of our corporate securities. The 2010 other-than-temporary impairments were primarily driven by asset-backed securities collateralized by sub-prime mortgages that reflect adverse financial conditions of the respective issuers, the impact of the rising forward LIBOR curve and the intent to sell securities. Additionally, other-than-temporary impairments were driven by Japanese commercial mortgage-backed securities that reflect adverse financial conditions of the respective issuers, and foreign currency translation losses related to foreign denominated securities that are approaching maturity.
Amounts exclude prepayment premiums, other-than-temporary impairments, and credit related losses through sales of investments pursuant to our credit risk and portfolio management objectives.
Net realized gains on derivatives were $199 million in 2011 compared to net realized gains of $489 million in 2010. The net derivative gains in 2011 primarily reflect net gains of $135 million on interest rate derivatives used to manage duration as interest rates declined, and $53 million on “to be announced” (“TBA”) forward contracts as interest rates declined. Also, contributing to these gains are net derivative gains of $23 million on currency derivatives used to hedge foreign denominated investments as the U.S. dollar strengthened against the euro. Partially offsetting these gains were net derivative losses of $11 million on embedded derivatives associated with certain externally-managed investments in the European market. Derivative gains in 2010 primarily reflect net mark-to-market gains of $404 million on interest rate derivatives used to manage duration as interest rates declined and net derivative gains of $74 million on currency derivatives used to hedge foreign denominated investments. Also, contributing to the net derivative gains in 2010 were net realized gains of $17 million on embedded derivatives associated with certain externally-managed investments in the European market.
During 2011, we recorded other-than-temporary impairments of $127 million in earnings, compared to other-than-temporary impairments of $208 million recorded in earnings in 2010. The following tables set forth, for the periods indicated, the composition of other-than-temporary impairments recorded in earnings attributable to the Closed Block Business by asset type, and for fixed maturity securities, by reason.
Fixed maturity other-than-temporary impairments of $104 million in 2011 were concentrated in asset-backed securities collateralized by sub-prime mortgages, and the public utilities and services sectors of our corporate securities and were primarily driven by liquidity concerns, downgrades in credit, bankruptcy or other adverse financial conditions of the respective issuers, which have caused, or we believe will lead to, a deficiency in the contractual cash flows related to the investment. Fixed maturity other-than-temporary impairments in 2010 were concentrated in asset-backed securities collateralized by sub-prime mortgages that reflect adverse financial conditions of the respective issuers as well as our intent to sell certain asset-backed securities collateralized by sub-prime mortgages.
Equity security other-than-temporary impairments in 2011 and 2010 were primarily due to circumstances where the decline in value was maintained for one year or greater.
Net realized losses on fixed maturity securities were $361 million in 2010, compared to net realized losses of $823 million in 2009, as set forth in the following table:
Net realized gains on equity securities were $11 million in 2010, of which net trading gains on sales of equity securities were $89 million, partially offset by other-than-temporary impairments of $78 million. Net trading gains in 2010 were primarily due to private equity sales within our Corporate and Other business and sales within our International Insurance business. Net realized losses on equity securities were $402 million in 2009, of which other-than-temporary impairments were $389 million and net trading losses on sales of equity securities were $13 million. Net trading losses in 2009 were primarily due to sales within our International Insurance business. See below for additional information regarding the other-than-temporary impairments of equity securities in 2010 and 2009.
During 2010 we recorded other-than-temporary impairments of $672 million in earnings, compared to total other-than-temporary impairments of $1,611 million recorded in earnings in 2009. The following tables set forth, for the periods indicated, the composition of other-than-temporary impairments recorded in earnings attributable to the Financial Services Businesses by asset type, and for fixed maturity securities, by reason.
Equity security other-than-temporary impairments in 2010 and 2009 were primarily driven by circumstances where the decline in value was maintained for one year or greater or where we intend to sell the security. Equity security other-than-temporary impairments in 2010 were primarily in our Japanese insurance operations equity portfolios. Equity security other-than-temporary impairments in 2009 were primarily driven by declines in value of fund shares representing our interest in high yield bond funds of certain of our separate account investments supporting corporate owned life insurance and circumstances where we lack the ability or intent to retain the security to recovery.
Net trading gains on sales and maturities of fixed maturity securities were $263 million in 2010. See below for additional information regarding the other-than-temporary impairments of fixed maturity securities in 2010 and 2009.
Net realized gains on equity securities were $174 million in 2010. Net trading gains on sales of equity securities were $208 million, partially offset by other-than-temporary impairments of $34 million. Net realized losses on equity securities were $473 million in 2009, of which other-than-temporary impairments were $613 million, partially offset by net trading gains on sales of equity securities of $140 million. Net trading gains reflect improved equity markets throughout 2010 and 2009 coupled with the current equity trading strategy which produced gains as the years progressed. See below for additional information regarding the other-than-temporary impairments of equity securities in 2010 and 2009.
Net realized gains on derivatives were $489 million in 2010, compared to net realized losses of $298 million in 2009. Derivative gains in 2010 primarily reflect net mark-to-market gains of $404 million on interest rate derivatives used to manage duration as interest rates declined and net derivative gains of $74 million on currency derivatives used to hedge foreign denominated investments as the US dollar strengthened versus the euro. Also, contributing to the net derivative gains were net realized gains of $17 million on embedded derivatives associated with certain externally-managed investments in the European market. Derivative losses in 2009 primarily reflect net mark-to-market losses of $218 million on interest rate derivatives used to manage the duration of the fixed maturity investment portfolio and net losses of $149 million related to currency derivatives used to hedge foreign denominated investments. Partially offsetting these losses were net gains of $52 million on embedded derivatives associated with certain externally-managed investments in the European market.
Net realized losses on other investments were $4 million in 2010, which included $6 million of other-than-temporary impairments on joint ventures and partnerships investments. Net realized losses on other investments were $48 million in 2009 of which $51 million was related to other-than-temporary impairments on joint ventures and partnerships investments.
our intent to sell certain asset-backed securities collateralized by sub-prime mortgages. Fixed maturity other-than-temporary impairments in 2009 were concentrated in asset-backed securities collateralized by sub-prime mortgages, and the manufacturing and services sectors of our corporate securities and were primarily driven by liquidity concerns, downgrades in credit, bankruptcy or other adverse financial conditions of the respective issuers, which have caused, or we believe will lead to, a deficiency in the contractual cash flows related to the investment.
Equity security other-than-temporary impairments in 2010 and 2009 were primarily due to circumstances where the decline in value was maintained for one year or greater.
maximizing the portfolio book yield within risk constraints over time; and
The Investment Committee of our Board of Directors oversees our proprietary investments. It also reviews performance and risk positions periodically. Our portfolio management groups work with our Risk Management group to develop the investment policies for the general account assets of our domestic and international insurance subsidiaries, oversee the investment process for our general account and have the authority to initiate tactical shifts within exposure ranges approved annually by the Investment Committee.
The portfolio management groups, which are integrated within our businesses, work closely with Risk Management to ensure that the specific characteristics of our products are incorporated into their processes and to develop investment objectives, including performance factors and measures and asset allocation ranges. We adjust this dynamic process as products change, as customer behavior changes and as changes in the market environment occur. We develop asset strategies for specific classes of product liabilities and attributed or accumulated surplus, each with distinct risk characteristics. Most of our products can be categorized into the following three classes:
participating individual and experience-rated group products in which customers participate in actual investment and business results through annual dividends, interest or return of premium; and
Our investment portfolio consists of public and private fixed maturity securities, commercial mortgage and other loans, equity securities and other invested assets. The composition of our general account reflects, within the discipline provided by our risk management approach, our need for competitive results and the selection of diverse investment alternatives available primarily through our Asset Management segment. The size of our portfolio enables us to invest in asset classes that may be unavailable to the typical investor.
On February 1, 2011, Prudential Financial completed the acquisition from AIG of the Star and Edison Businesses. Our Financial Services Businesses’ general account portfolio as of December 31, 2011 includes
As of December 31, 2011, the average duration of our general account investment portfolio attributable to the domestic Financial Services Businesses, including the impact of derivatives, is between 4 and 5 years. The general account investments attributable to the Financial Services Businesses increased in 2011 primarily due to the acquisition of the Star and Edison Businesses, portfolio growth as a result of reinvestment of net investment income, and a net increase in fair value driven by a decrease in interest rates. The general account investments attributable to the Closed Block Business increased in 2011 primarily due to portfolio growth as a result of reinvestment of net investment income and an increase in fair value driven by a decrease in interest rates, partially offset by net operating outflows. For information regarding the methodology used in determining the fair value of our fixed maturities, see Note 20 to the Consolidated Financial Statements.
Our Japanese insurance operations use the yen as their functional currency, as it is the currency in which they conduct the majority of their operations. Although the majority of the Japanese general account is invested in yen-denominated investments, our Japanese insurance operations also hold significant investments denominated in U.S. and Australian dollars.
As of December 31, 2011, our Japanese insurance operations had $38.4 billion, at fair value, of investments denominated in U.S. dollars, including $4.4 billion that were hedged to yen through third party derivative contracts and $25.9 billion that support liabilities denominated in U.S. dollars. As of December 31, 2010, our Japanese insurance operations had $18.9 billion, at fair value, of investments denominated in U.S. dollars,
including $0.7 billion that were hedged to yen through third party derivative contracts and $10.7 billion that support liabilities denominated in U.S. dollars. The $19.5 billion increase of U.S. dollar investments at fair value from December 31, 2010 is primarily driven by $14.6 billion from the Star and Edison Businesses’ U.S. dollar-denominated assets supporting U.S. dollar liabilities.
For additional information regarding U.S. dollar investments held in our Japanese insurance operations, see “-Results of Operations for Financial Services Businesses by Segment-International Insurance Division.”
The following tables set forth the composition of our gross direct exposure to the Eurozone region, by country of incorporation, attributable to our general account, as of December 31, 2011.
For the Financial Services Businesses, of the $13,273 million of amortized cost represented above, 86% is related to fixed maturities, 7% is related to trading account assets supporting insurance liabilities, and the remaining 7% is related to all other asset types. For the Closed Block Business, of the $3,961 million of amortized cost represented above, 93% is related to fixed maturities, and the remaining 7% is related to all other asset types.
Financial institutions include banking, brokerage, non-captive consumer and diversified finance, health insurance, life insurance, property and casualty insurance, other finance and real estate investment trusts.
See below for a discussion of the change in the Financial Services Businesses’ yields. The decrease in net investment income yield attributable to the Closed Block Business for 2011 compared to 2010, was primarily due to lower interest rates on floating rate investments due to rate resets and lower fixed income reinvestment rates.
The increase in net investment income yield attributable to the Closed Block Business for 2010 compared to 2009, was primarily due to investments in joint ventures and limited partnerships, driven by appreciation and gains on the underlying assets, partially offset by the impact of lower interest rates on floating rate investments due to rate resets and lower fixed income reinvestment rates.
investments and cash equivalents are calculated net of liabilities and rebate expenses corresponding to securities lending activity. Yields exclude investment income on assets other than those included in invested assets. Prior period’s yields are presented on a basis consistent with the current period presentation.
Includes investment income of trading and banking operations, real estate and relocation services and asset management operations.
The decrease in net investment income yield attributable to the Financial Services Businesses’ general account, excluding the Japanese operations’ portfolio, for 2010 compared to 2009 was primarily a result of lower interest rates on floating rate investments from rate resets and lower fixed maturity reinvestment rates, partially offset by an increase in other investment yields driven by favorable joint venture and limited partnership earnings driven by appreciation on the underlying assets.
Both the U.S. dollar-denominated and Australian dollar-denominated fixed maturities that are not hedged to yen through third party derivative contracts provide a yield that is substantially higher than the yield on comparable yen-denominated fixed maturities. The average amortized cost of U.S. dollar-denominated fixed maturities that are not hedged to yen through third party derivative contracts for the years ended December 31, 2011 and 2010, was approximately $24.2 billion and $12.3 billion, respectively. The majority of U.S. dollar-denominated fixed maturities support liabilities that are denominated in U.S. dollars. The average amortized cost
of Australian dollar-denominated fixed maturities that are not hedged to yen through third party derivative contracts for the years ended December 31, 2011 and 2010, was approximately $4.8 billion and $1.2 billion, respectively. The Australian dollar-denominated fixed maturities support liabilities that are denominated in Australian dollars.
As of both December 31, 2011 and 2010, based on amortized cost, no individual foreign country represented more than 8% of the balance.
As of December 31, 2011, includes collateralized debt obligations with fair value of $112 million, with none secured by sub-prime mortgages. Also includes asset-backed securities collateralized by education loans, equipment leases, franchises, timeshares, and aircraft.
In addition to subordination, certain securities, referred to as front pay or second pay securities, benefit from the prioritization of principal cash flows within the senior tranches of the structure. In most instances, these shorter duration senior securities have priority to principal cash flows over other securities in the structure, including longer duration senior securities. Included within the $2.634 billion of asset-backed securities collateralized by sub-prime mortgages attributable to the Financial Services Businesses as of December 31, 2011 were $549 million of securities, on an amortized cost basis, that represent front pay or second pay securities, depending on the overall structure of the securities.
Included within the $2.3 billion of asset-backed securities collateralized by sub-prime mortgages as of December 31, 2011 are $7 million of securities collateralized by second-lien exposures.
As of December 31, 2011, includes collateralized debt obligations with fair value of $50 million, with none secured by sub-prime mortgages. Also includes asset-backed securities collateralized by franchises, timeshares, manufacturing and aircraft.
The weighted average estimated subordination percentage of asset-backed securities collateralized by sub-prime mortgages attributable to the Closed Block Business, excluding those supported by guarantees from monoline bond insurers, was 31% as of December 31, 2011. The subordination percentage represents the current weighted average estimated percentage of the capital structure subordinated to our investment holding that is available to absorb losses before the security incurs the first dollar loss of principal. As of December 31, 2011, based on amortized cost, approximately 67% of the asset-backed securities collateralized by sub-prime mortgages attributable to the Closed Block Business have estimated credit subordination percentages of 20% or more, and 43% have estimated credit subordination percentages of 30% or more.
As of December 31, 2011, of these securities, for the Financial Services Businesses, $5.408 billion are supported by U.S. government and $1.931 billion are supported by foreign governments. As of December 31, 2010, of these securities, for the Financial Services Businesses, $5.954 billion were supported by the U.S. government and $1.488 billion were supported by foreign governments. For the Closed Block Business all of these securities are supported by the U.S. government as of December 31, 2011 and 2010.
Includes alternative residential mortgage loans of $38 million and $46 million in the Financial Services Businesses, and $93 million and $108 million in the Closed Block Business, for 2011 and 2010, respectively.
Based on lowest external rating agency rating. In August 2011, S&P downgraded U.S. debt securities from AAA to AA+.
The weighted average estimated subordination percentage of our commercial mortgage-backed securities attributable to the Financial Services Businesses was 32% as of December 31, 2011. The subordination percentage represents the current weighted average estimated percentage of the capital structure subordinated to our investment holding that is available to absorb losses before the security incurs the first dollar loss of principal. The weighted average estimated subordination percentage includes an adjustment for that portion of the capital structure, which has been effectively defeased by U.S. Treasury securities. As of December 31, 2011, based on amortized cost, approximately 95% of the commercial mortgage-backed securities attributable to the Financial Services Businesses have estimated credit subordination percentages of 20% or more, and 76% have estimated credit subordination percentages of 30% or more. The following tables set forth the weighted average estimated subordination percentage, adjusted for that portion of the capital structure which has been effectively defeased by U.S. Treasury securities, of our commercial mortgage-backed securities collateralized by U.S. and Non-U.S. properties, attributable to the Financial Services Businesses based on amortized cost as of December 31, 2011, by rating and vintage.
U.S. Commercial Mortgage-Backed Securities-Subordination Percentages by Rating and Vintage-Financial Services Businesses
Non- U.S. Commercial Mortgage-Backed Securities-Subordination Percentages by Rating and Vintage-Financial Services Businesses
The Securities Valuation Office, or SVO, of the NAIC, evaluates the investments of insurers for statutory reporting purposes and assigns fixed maturity securities to one of six categories called “NAIC Designations.” In general, NAIC Designations of “1” highest quality, or “2” high quality, include fixed maturities considered investment grade, which include securities rated Baa3 or higher by Moody’s or BBB- or higher by Standard & Poor’s. NAIC Designations of “3” through “6” generally include fixed maturities referred to as below investment grade, which include securities rated Ba1 or lower by Moody’s and BB+ or lower by Standard & Poor’s. However, in the fourth quarter of 2009 the NAIC adopted rules which changed the methodology for determining the NAIC Designations for non-agency residential mortgage-backed securities, including our asset-backed securities collateralized by sub-prime mortgages. Under these rules, rather than being based on the rating of a third party rating agency, as of December 31, 2009 the NAIC Designations for such securities are based on security level expected losses as modeled by an independent third party (engaged by the NAIC) and the statutory carrying value of the security, including any purchase discounts or impairment charges previously recognized. The modeled results used in determining NAIC Designations as of December 31, 2009 were updated and utilized for reporting as of December 31, 2010. In the fourth quarter of 2010, the NAIC adopted rules which changed the methodology for determining the NAIC Designations for commercial mortgage-backed securities, similar to what was done in the fourth quarter of 2009 for residential mortgage-backed securities. Both methodologies remained unchanged and were utilized for December 31, 2011.
The amortized cost of our public and private fixed maturities attributable to the Financial Services Businesses considered other than high or highest quality based on NAIC or equivalent rating totaled $9.3 billion, or 5%, of the total fixed maturities as of December 31, 2011 and $8.7 billion, or 6%, of the total fixed maturities as of December 31, 2010. Fixed maturities considered other than high or highest quality based on NAIC or
equivalent rating represented 30% and 27% of the gross unrealized losses attributable to the Financial Services Businesses as of December 31, 2011 and 2010, respectively. As of December 31, 2011, the amortized cost of our public and private below investment grade fixed maturities attributable to the Financial Services Businesses, based on the lowest of external rating agency ratings, totaled $10.9 billion, or 5%, of the total fixed maturities, and includes securities considered high or highest quality by the NAIC based on the new rules for residential mortgage-backed securities described above.
Includes, as of December 31, 2011 and 2010, 10 securities with amortized cost of $2 million (fair value, $12 million) and 17 securities with amortized cost of $11 million (fair value, $20 million), respectively, that have been categorized based on expected NAIC designations pending receipt of SVO ratings.
Includes, as of December 31, 2011 and 2010, 100 securities with amortized cost of $815 million (fair value, $840 million) and 160 securities with amortized cost of $1,776 million (fair value, $1,800 million), respectively, that have been categorized based on expected NAIC designations pending receipt of SVO ratings.
Includes $63 million of gross unrealized gains and $1 million of gross unrealized losses as of December 31, 2011, compared to $47 million of gross unrealized gains and $1 million of gross unrealized losses as of December 31, 2010 on securities classified as held-to-maturity.
On an amortized cost basis, as December 31, 2011 includes $419 million in securitized bank loans and $244 million in commercial asset finance securities.
Includes, as of December 31, 2011 and 2010, 56 securities with amortized cost of $926 million (fair value, $968 million) and 103 securities with amortized cost of $1,523 million (fair value, $1,506 million), respectively, that have been categorized based on expected NAIC designations pending receipt of SVO ratings.
The following table sets forth both our public and private corporate securities by NAIC designation attributable to the Financial Services Businesses as of the dates indicated.
In a credit derivative, we sell credit protection on an identified name, and in return receive a quarterly premium. With single name credit default derivatives, this premium or credit spread generally corresponds to the difference between the yield on the referenced name’s public fixed maturity cash instruments and swap rates, at the time the agreement is executed.
The referenced names in the credit derivatives where we have sold credit protection, as well as all the counterparties to these agreements, are investment grade credit quality and our credit derivatives generally have maturities of ten years or less. Credit derivative contracts are recorded at fair value with changes in fair value, including the premium received, recorded in “Realized investment gains (losses), net.” The premium received for the credit derivatives we sell attributable to the Financial Services Businesses was $6 million and $7 million for the years ended December 31, 2011 and 2010, respectively, and were included in adjusted operating income as an adjustment to “Realized investment gains (losses), net.”
The following table sets forth our exposure where we have sold credit protection through credit derivatives in the Closed Block Business portfolios by NAIC designation of the underlying credits as of the dates indicated.
In addition to selling credit protection, we have purchased credit protection using credit derivatives in order to hedge specific credit exposures in our investment portfolio, including exposures relating to certain guarantees from monoline bond insurers. As of December 31, 2011 and 2010, the Financial Services Businesses had $1.598 billion and $1.785 billion of outstanding notional amounts, reported at fair value as an asset of $2 million and $2 million, respectively. As of December 31, 2011 and 2010, the Closed Block Business had $381 million and $399 million of outstanding notional amounts, reported at fair value as an asset of less than $1 million and a liability of $1 million, respectively. The premium paid for the credit derivatives we purchase attributable to the Financial Services Businesses was $43 million and $50 million for the years ended December 31, 2011 and 2010, respectively, and was included in adjusted operating income as an adjustment to “Realized investment gains (losses), net.” See Note 21 to the Consolidated Financial Statements for additional information regarding credit derivatives and an overall description of our derivative activities.
$847 million relating to asset-backed securities collateralized by sub-prime mortgages. Gross unrealized losses attributable to the Financial Services Businesses where the estimated fair value had declined and remained below amortized cost by 20% or more as of December 31, 2011, also includes $80 million of gross unrealized losses on securities with amortized cost of $132 million where the estimated fair value had declined and remained below amortized cost by 50% or more, of which, $23 million was included in the less than three months timeframe, $22 million was included in the three months or greater but less than six months timeframe, $1 million was included in the six months or greater but less than nine months timeframe, and $34 million was included in the greater than twelve months timeframe. We have not recognized the gross unrealized losses shown in the tables above as other-than-temporary impairments in earnings based on our detailed analysis of the underlying credit and cash flows on each of these securities. The gross unrealized losses are primarily attributable to foreign currency movements, general credit spread widening in the structured credit marketplace and liquidity discounts, and we believe the recoverable value of these investments based on the expected future cash flows is greater than or equal to our remaining amortized cost. At December 31, 2011, we do not intend to sell these securities and it is not more likely than not that we will be required to sell these securities before the anticipated recovery of its remaining amortized cost basis. See “-Other-Than-Temporary Impairments of Fixed Maturity Securities” for a discussion of the factors we consider in making these determinations.
In evaluating whether a decline in value is other-than-temporary, we consistently consider several factors including, but not limited to, the following:
Other-than-temporary impairments of general account fixed maturity securities attributable to the Financial Services Businesses that were recognized in earnings were $431 million and $564 million for the years ended December 31, 2011 and 2010, respectively. Included in the other-than-temporary impairments of general account fixed maturities attributable to the Financial Services Businesses for the years ended December 31, 2011 and 2010, were $118 million and $209 million, respectively, of other-than-temporary impairments on asset-backed securities collateralized by sub-prime mortgages.
Other-than-temporary impairments of fixed maturity securities attributable to the Closed Block Business that were recognized in earnings were $104 million and $168 million for the years ended December 31, 2011 and 2010, respectively. Included in the other-than-temporary impairments of fixed maturities attributable to the Closed Block Business for the years ended December 31, 2011 and 2010, were $67 million and $133 million, respectively, of other-than-temporary impairments on asset-backed securities collateralized by sub-prime mortgages. For a further discussion of other-than-temporary impairments, see “-Realized Investment Gains and Losses” above.
As of December 31, 2011, includes collateralized debt obligations with fair value of $31 million, none of which is secured by sub-prime mortgages. Also includes asset-backed securities collateralized by timeshares, franchises, education loans, and equipment leases.
Included in the table above as of December 31, 2011 are downgraded super senior securities with amortized cost of $53 million in AA.
The commercial real estate market was severely impacted by the financial crisis and the subsequent recession, though the flow of capital to commercial real estate has been strong since 2010. Portfolio lenders are actively originating loans on the highest quality properties in primary markets, resulting in an increase in the liquidity and availability of capital in the commercial mortgage loan market. For certain property types, the market fundamentals are stabilizing to slightly improving, while other property types have farther to go in this recovery. In addition, the commercial banks are active and there has been new loan origination activity by securitization lenders. These conditions have led to greater competition for portfolio lenders such as our general
coverage ratio compares a property’s net operating income to its debt service payments. Debt service coverage ratios less than 1.0 times indicate that property operations do not generate enough income to cover the loan’s current debt payments. A larger debt service coverage ratio indicates a greater excess of net operating income over the debt service payments.
For loans with collateral under construction, renovation or lease-up, a stabilized value and projected net operating income are used in the calculation of the loan-to-value and debt service coverage ratios. Our commercial and agricultural mortgage loan portfolio attributable to the Financial Services Businesses included approximately $0.5 billion of such loans as of December 31, 2011 and $0.6 billion of such loans as of December 31, 2010, and our commercial and agricultural mortgage loan portfolio attributable to the Closed Block Business included approximately $0.2 billion of such loans as of December 31, 2011 and 2010. All else being equal, these loans are inherently more risky than those collateralized by properties that have already stabilized. As of December 31, 2011, there are no loan-specific reserves related to these loans attributable to either the Financial Services Businesses or the Closed Block Business. In addition, these unstabilized loans are included in the calculation of our portfolio reserve as discussed below. For information regarding similar loans we hold as part of our commercial and agricultural mortgage operations, see “-Invested Assets of Other Entities and Operations.” The following tables set forth the gross carrying value of our general account investments in commercial and agricultural mortgage loans attributable to the Financial Services Businesses and the Closed Block Business as of the dates indicated by loan-to-value and debt service coverage ratios.
We establish an allowance for losses to provide for the risk of credit losses inherent in the lending process. The allowance includes loan specific reserves for loans that are determined to be impaired as a result of our loan review process, and a portfolio reserve for probable incurred but not specifically identified losses for loans which are not on the watch list. We define an impaired loan as a loan for which we estimate it is probable that amounts due according to the contractual terms of the loan agreement will not be collected. The loan specific portion of the loss allowance is based on our assessment as to ultimate collectability of loan principal and interest. Valuation allowances for an impaired loan are recorded based on the present value of expected future cash flows discounted at the loan’s effective interest rate or based on the fair value of the collateral if the loan is collateral dependent. The portfolio reserve for incurred but not specifically identified losses considers the current credit composition of the portfolio based on the internal quality ratings mentioned above. The portfolio reserves are determined using past loan experience, including historical credit migration, loss probability, and loss severity factors by property type. These factors are reviewed and updated as appropriate. The valuation allowance for commercial mortgage and other loans can increase or decrease from period to period based on these factors. The following tables set forth the aging schedule of our general account investments in commercial mortgage and other loans, based upon the recorded investment gross of allowance for credit losses, attributable to the Financial Services Businesses and Closed Block Business as of the dates indicated.
The following table sets forth the change in valuation allowances for our commercial mortgage and other loan portfolio as of the dates indicated:
As of December 31, 2011, the $250 million valuation allowance for our commercial mortgage and other loan portfolio attributable to the Financial Services Businesses included $91 million related to loan specific reserves and $159 million related to the portfolio reserve for probable incurred but not specifically identified losses. As of December 31, 2010, the $333 million valuation allowance for our commercial mortgage and other loan portfolio attributable to the Financial Services Businesses included $143 million related to loan specific reserves and $190 million related to the portfolio reserve for probable incurred but not specifically identified losses.
As of December 31, 2011, the $60 million valuation allowance for our commercial mortgage and other loan portfolio attributable to the Closed Block Business included $2 million related to loan specific reserves and $58 million related to the portfolio reserve for probable incurred but not specifically identified losses. As of December 31, 2010, the $102 million valuation allowance for our commercial mortgage and other loan portfolio attributable to the Closed Block Business included $17 million related to loan specific reserves and $85 million related to the portfolio reserve for probable incurred but not specifically identified losses. The decrease in the allowance for both the Financial Services Businesses and the Closed Block Business primarily reflects positive credit migration for certain mortgages.
During 2011, perpetual preferred stocks of $0.1 billion were reclassified to “Other trading account assets.” Prior periods were not restated.
The following table sets forth the cost and gross unrealized losses of our equity securities attributable to the Financial Services Businesses where the estimated fair value had declined and remained below cost by 20% or more for the following timeframes:
The gross unrealized losses as of December 31, 2011, were primarily concentrated in the other, manufacturing, and finance sectors compared to December 31, 2010, where the gross unrealized losses were primarily concentrated in the finance and public utilities sectors. Gross unrealized losses attributable to the Financial Services Businesses where the estimated fair value had declined and remained below cost by 20% or more of $131 million as of December 31, 2011, also include $3 million of gross unrealized losses on securities with amortized cost of $5 million where the estimated fair value had declined and remained below cost by 50% or more. The gross unrealized losses of $3 million were included in the less than three months timeframe. Included in the December 31, 2010 amounts above are perpetual preferred securities. Perpetual preferred securities have characteristics of both debt and equity securities. Since we apply to these securities an impairment model similar to our fixed maturity securities, we have not recognized an other-than-temporary impairment on certain of these perpetual preferred securities that have been in a continuous unrealized loss position for twelve months or more as of December 31, 2010. We have not recognized the gross unrealized losses shown in the table above as other-than-temporary impairments. See “-Other-Than-Temporary Impairments of Equity Securities” for a discussion of the factors we consider in making these determinations.
The following table sets forth the cost and gross unrealized losses of our equity securities attributable to the Closed Block Business where the estimated fair value had declined and remained below cost by 20% or more for the following timeframes:
We generally recognize other-than-temporary impairments for securities with declines in value greater than 50% maintained for six months or greater or with any decline in value maintained for one year or greater. In addition, in making our determinations we continue to analyze the financial condition and near-term prospects of the issuer, including an assessment of the issuer’s capital position, and consider our ability and intent to hold the investment for a period of time to allow for a recovery of value.
Impairments of equity securities attributable to the Financial Services Businesses were $94 million and $78 million for the years ended December 31, 2011 and 2010, respectively. Impairments of equity securities attributable to the Closed Block Business were $18 million and $34 million for years ended December 31, 2011 and 2010, respectively. For a further discussion of impairments, see “-Realized Investment Gains and Losses” above.
Less than $1 million of commercial mortgage-backed securities held outside the general account are classified as other trading account assets as of December 31, 2011, all of which have AAA credit ratings. An additional $31 million of asset-backed securities held outside the general account as of December 31, 2011 are classified as other trading account assets, and all have AAA credit ratings.
Our asset management operations include our commercial mortgage operations, which provide mortgage origination, asset management and servicing for our general account, institutional clients, and government sponsored entities such as Fannie Mae, the Federal Housing Administration, and Freddie Mac. Through the third quarter of 2008, we had originated shorter-term interim loans for spread lending that are collateralized by assets generally under renovation or lease up. Due to unfavorable market conditions experienced at that time and the inherent risk of these loans, we suspended the origination of interim loans. Our interim loans are generally paid off through refinancing or the sale by the borrower of the underlying collateral. These loans are inherently more risky than those collateralized by properties that have already stabilized. As of December 31, 2011 and December 31, 2010, the interim loans had an unpaid principal balance of $0.6 billion and $1.3 billion, respectively, and an allowance for losses or credit related market value losses totaling $44 million and $168 million, respectively. The weighted average loan-to-value ratio was 93% as of December 31, 2011 and 108% as of December 31, 2010, indicating that, in aggregate, the loan amount was reduced to below the collateral value during the year, and the weighted average debt service coverage ratio was 1.52 times as of December 31, 2011 and 1.24 times as of December 31, 2010. A stabilized value and projected net operating income are used in the calculation of the loan-to-value and debt service coverage ratios. As of December 31, 2011, we also hold $44 million of commercial real estate held for sale related to foreclosed interim loans, which is reported in “Other long-term investments.” The mortgage loans of our commercial mortgage operations are included in “Commercial mortgage and other loans,” with related derivatives and other hedging instruments primarily included in “Other trading account assets” and “Other long-term investments.”
We continue to refine our metrics for capital management. These refinements to the current framework, which is primarily based on statutory risk based capital measures, are designed to more appropriately reflect risks associated with our businesses on a consistent basis across the Company. In addition, we continue to use an economic capital framework for making certain business decisions.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, could result in the imposition of new capital, liquidity and other requirements on Prudential Financial and its subsidiaries. See “Business-Regulation” for information regarding the potential impact of the Dodd-Frank Act on the Company.
million. Of the total sale proceeds, $91 million was received by Prudential Financial and the remaining proceeds were received by a related financing subsidiary that the Company continues to own. This financing subsidiary continues to hold debt and equity investments in a limited number of real estate brokerage franchises. In connection with the sale, we agreed to provide certain Brookfield affiliates with transitional financing for the transferred relocation services business pursuant to: a six-month receivables purchase facility of up to $250 million; a six-month credit facility of up to $25 million; and a three-year credit facility of up to $155 million. We expect to fund draws under these credit facilities using cash on hand or proceeds from the alternative sources of liquidity described below. As of December 31, 2011 the amounts drawn under the facilities were $157 million, $15 million and $72 million, respectively.
The principal sources of funds available to Prudential Financial, the parent holding company, are dividends, returns of capital and interest income from its subsidiaries, and cash and short-term investments. These sources of funds may be supplemented by Prudential Financial’s access to the capital markets and credit facilities, as well as the “-Alternative Sources of Liquidity” described below.
The primary uses of funds at Prudential Financial include servicing our debt, operating expenses, capital contributions and obligations to subsidiaries, and the payment of declared shareholder dividends, as well as repurchases of outstanding shares of Common Stock if executed under Board authority.
Includes dividends and/or returns of capital of $1,592 million from Prudential Insurance, $478 million from international insurance and investment subsidiaries, $588 million from Prudential Annuities Life Assurance Corporation, $468 million from asset management subsidiaries and $116 million from other subsidiaries.
Includes net repayments of $322 million by Prudential Securities Group (previously supporting the global commodities business), $282 million by Prudential Real Estate and Relocation, $169 million by our asset management subsidiaries, and $100 million by Prudential Arizona Reinsurance Term Company (previously funding statutory reserves required under Regulation XXX), partially offset by net borrowings of $336 million by Pruco Life Insurance Company. The remainder represents net borrowings by other subsidiaries as well as net activity in our intercompany liquidity account described above.
Includes capital contributions of $1,005 million to international insurance and investment subsidiaries, $64 million to Pruco Reinsurance, $62 million to asset management subsidiaries and $45 million to an investment subsidiary.
Represents payments under the transitional financing arrangements provided in connection with the sale of the real estate brokerage franchise and relocation business.
In June 2011, Prudential Financial’s Board of Directors authorized the Company to repurchase at management’s discretion up to $1.5 billion of its outstanding Common Stock through June 2012. As of December 31, 2011, 19.8 million shares of our common stock were repurchased under this authorization at a total cost of $999.5 million. The timing and amount of any additional share repurchases will be determined by management based on market conditions and other considerations. Repurchases may be effected in the open market, through derivative, accelerated repurchase and other negotiated transactions and through plans designed to comply with Rule 10b5-1(c) under the Exchange Act. Numerous factors could affect the timing and amount of any future repurchases under the share repurchase program, including increased capital needs of our businesses due to opportunities for growth and acquisitions, as well as adverse market conditions.
As a result of Gibraltar Life’s reorganization in 2001, in addition to regulatory requirements, certain other restrictions precluded Gibraltar Life from paying common stock dividends to Prudential Financial. We anticipate that following the merger of Gibraltar, Star and Edison, the merged entity will be able to pay common stock dividends to Prudential Financial, subject to legal and regulatory restrictions. However, we do not anticipate receiving dividends from the merged entity for several years as it may return capital to Prudential Financial through other means, such as the repayment of subordinated debt or preferred stock obligations held by Prudential Financial or other affiliates. In August 2011, Gibraltar Life repaid ¥24 billion, or $313 million, of subordinated debt held by an intermediate holding company, of which $119 million was used to repay a loan from Prudential Insurance and the remainder was paid to Prudential Financial.
See “Liquidity and Capital Resources of Our Subsidiaries” below for additional details on the liquidity of our domestic insurance subsidiaries, international insurance subsidiaries and asset management subsidiaries.
The daily average commercial paper outstanding under these programs during 2011 and 2010 was $1,368 million and $1,208 million, respectively.
The weighted average interest rate on borrowings for the years ended December 31, 2011 and 2010 was 0.37 % and 0.42%, respectively, for Prudential Financial and 0.20 % and 0.31%, respectively, for Prudential Funding.
As of December 31, 2011, our domestic insurance entities had assets eligible for the securities lending program of $81.4 billion, of which $8.9 billion were on loan. Taking into account market conditions and
outstanding loan balances as of December 31, 2011, we believe approximately $28.3 billion of the remaining eligible assets are readily lendable, of which approximately $19.0 billion relates to the Financial Services Businesses; however, these amounts are subject to potential regulatory constraints and to changes in market conditions.
As of December 31, 2011, $199 million of the FHLBNY outstanding advances is reflected in “Short-term debt” and matures in December 2012 and the remaining $725 million is in “Long-term debt” and matures in December 2015. As of December 31, 2011, $650 million of these proceeds were used to support the operating needs of our businesses and $274 million were used to purchase investments, including the FHLBNY activity-based stock. The funding agreements issued to the FHLBNY, which are reflected in “Policyholders’ account balances,” have priority claim status above debt holders of Prudential Insurance. These funding agreements currently serve as a substitute funding source for a product of our Retirement segment, which earns investment spread that was previously funded by retail medium-term notes issued by Prudential Financial.
The Connecticut Department of Insurance, or CTDOI, permits PRIAC to pledge up to $2.6 billion in qualifying assets to secure FHLBB borrowings through December 31, 2011. PRIAC must seek re-approval from CTDOI prior to borrowing additional funds after that date. Based on available eligible assets as of December 31, 2011, PRIAC had an estimated maximum borrowing capacity, after taking into consideration required collateralization levels and required purchases of activity-based FHLBB stock, of approximately $1.2 billion.
In managing the liquidity of our domestic insurance operations, we also consider the risk of policyholder and contractholder withdrawals of funds earlier than our assumptions when selecting assets to support these
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, 2011 and 2010, our domestic insurance operations had liquid assets of $144.8 billion and $138.5 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 $6.6 billion and $5.8 billion as of December 31, 2011 and 2010, respectively. As of December 31, 2011, $124.6 billion, or 92.4%, of the fixed maturity investments that are not designated as held-to-maturity within our domestic insurance company general account portfolios were considered high or highest quality based on NAIC or equivalent rating. The remaining $10.3 billion, or 7.6%, of these fixed maturity investments were considered other than high or highest quality based on NAIC or equivalent rating. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures 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 reasonably foreseeable stress scenarios.
The Risk Based Capital, or RBC, ratio is a primary measure by which we evaluate the capital adequacy of Prudential Insurance and our other domestic life insurance subsidiaries, which includes businesses in both the Financial Services Businesses and the Closed Block Business. We manage Prudential Insurance’s and our other domestic life insurance subsidiaries’ RBC ratios to a level consistent with their ratings targets. RBC is determined by statutory guidelines and formulas that consider, among other things, risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products and liabilities, interest rate risks and general business risks. The RBC ratio calculations are intended to assist insurance regulators in measuring the adequacy of an insurer’s statutory capitalization. As of December 31, 2011, the RBC ratio for Prudential Insurance was approximately 490%, which exceeded the minimum levels required by applicable insurance regulations. In addition, all of our other domestic life insurance subsidiaries have RBC ratios that exceed the minimum level required by applicable insurance regulations. The reporting of RBC measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities.
The level of statutory capital of our domestic life insurance subsidiaries can be materially impacted by interest rate and equity market fluctuations, changes in the values of derivatives, the level of impairments recorded and credit quality migration of the investment portfolio, among other items. Further, the recapture of business subject to reinsurance arrangements due to defaults by, or credit quality migration affecting, the reinsurers could result in higher required statutory capital levels. The level of statutory capital of our domestic life insurance subsidiaries is also affected by statutory accounting rules, which are subject to change by insurance regulators.
During 2010, as part of our Capital Protection Framework, we developed a broad view of the impact of market distress on the statutory capital of the Company. Beginning in the second quarter of 2010, we have entered into equity index-linked derivative transactions that are designed to mitigate the impact of a severe equity market stress event on statutory capital. The program focuses on tail risk to protect our capital in a cost-effective manner under stress scenarios. We assess the composition of our hedging program on an ongoing basis, and we may change it from time to time based on our evaluation of the Company’s risk position or other factors.
Reinsurance credit reserve requirements can move materially in either direction due to changes in equity markets and interest rates, actuarial assumptions and other factors. Higher reinsurance credit reserve requirements would necessitate depositing additional assets in the statutory reserve credit trusts, while lower reinsurance credit reserve requirements would allow assets to be removed from the statutory reserve credit trusts. Lower interest rates in 2011 led to an increase in our need to fund the captive reinsurance trusts by an amount of $569 million for the year ended December 31, 2011, primarily relating to business sold by PALAC and PLNJ. We satisfied the overall increase in funding requirements in 2011 with available cash and by re-hypothecating assets into the trust that were otherwise pledged by our affiliates under hedging positions related to our living benefit features.
In October 2011, we established a new reinsurance arrangement with our captive reinsurance company domiciled in New Jersey, whereby the New Jersey captive reinsures 90% of the short-term risks under the policies in Prudential Insurance’s Closed Block. These short-term risks represent the impact of variations in experience of the Closed Block that are expected to be recovered over time as a result of corresponding adjustments to policyholder dividends. The new reinsurance arrangement is intended to alleviate the short-term surplus volatility within Prudential Insurance resulting from the Closed Block, including volatility caused by the impact of any unrealized mark-to-market losses or realized credit losses within the investment portfolio of the Closed Block.
passed along to policyholders over time through the annual policyholder dividend, we believe that any draw under the letter of credit is unlikely. Our ability to obtain a letter of credit under the facility is subject to the continued satisfaction of customary conditions, including the maintenance at all times by Prudential Insurance of total adjusted capital of at least $5.5 billion based on statutory accounting principles prescribed under New Jersey law and Prudential Financial’s maintenance of consolidated net worth of at least $19.0 billion, based on U.S. GAAP stockholders’ equity, excluding “Accumulated other comprehensive income (loss).”
On February 1, 2011, we completed our acquisition of the Star and Edison Businesses. Gibraltar Life and Prudential of Japan each contributed $400 million to payment of the acquisition purchase price, with the remaining funding provided by Prudential Financial and other subsidiaries. Although these contributions reduced local solvency margin ratios in Gibraltar and Prudential of Japan, the solvency margins for these companies remain in excess of our targets. The contributions did not materially impact Gibraltar Life’s or Prudential of Japan’s liquidity as their investment portfolios were positioned to provide the funding.
As of December 31, 2011 and 2010, $4.5 billion and $3.5 billion, respectively, of the insurance-related liabilities for Prudential of Japan are associated with U.S. dollar-denominated products that are coinsured to our U.S. domiciled insurance operations and supported by U.S. dollar-denominated assets.
Our Japanese operations did not have a material amount of general account annuity reserves or deposit liabilities subject to discretionary withdrawal as of December 31, 2011 and 2010. Additionally, we believe that the individual life insurance policies sold by our Japanese operations do not have significant withdrawal risk because policyholders may incur surrender charges and must undergo a new underwriting process in order to obtain a new insurance policy.