The Company markets individual interest-sensitive life insurance, variable life insurance, term insurance, and variable annuities through Prudential Insurance's sales force in New Jersey and New York. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressures as the legal barriers which have historically segregated the markets of the financial services industry have been changed through both legislative and judicial processes. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("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 may change significantly.
Valuation of investments A large portion of our investments is reflected at fair value in the statements of financial position based on quoted market prices or estimates from independent pricing services. However, when such information is not available, for example, with respect to private placement fixed maturity securities, which comprises 23.6% of our investments at December 31, 2002, fair value is estimated, typically by using a discounted cash flow model, which considers current market credit spreads for publicly traded issues with similar terms by companies of comparable credit quality. Consequently, changes in estimated future cash flows or in our assessment of the issuer's credit quality will result in changes in fair value estimates. For fixed maturities and equity securities classified as available for sale, the impact of such changes is recorded in "Accumulated other comprehensive income (loss)," a separate component of equity. However, the carrying value of these securities is reduced, with a corresponding charge to earnings, when a decline in value is considered to be other than temporary. Factors we consider in determining whether a decline in value is other than temporary include: whether the decline is substantial, the length of time the fair value has been less than cost, generally six months; and the financial condition and near-term prospects of the issuer. This corresponding charge is referred to as an impairment and is reflected in "Realized investment losses, net" in the statements of operations. The level of impairment losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
Policyholder liabilities and deferred policy acquisition costs The liability for "Future policy benefits and other policyholder liabilities" represents 5.7% of total liabilities as of December 31, 2002. Changes in this liability are generally reflected in the "Policyholders' benefits" caption in our statements of operations. This liability is primarily comprised of the present value of estimated future payments to holders of life insurance and annuity products where the timing and amount of payment depends on policyholder mortality or surrender experience. For life insurance and annuity products, expected mortality is generally based on the Company's historical experience or standard industry tables. Interest rate assumptions are based on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are "locked-in" upon the issuance of new insurance or annuity business with fixed and guaranteed terms, significant changes in experience or assumptions may require us to provide for expected future losses on a product by establishing loss recognition reserves.
For example, expected profitability is a significant estimate in evaluating deferred acquisition costs related to annuity products. Expected profitability considers, among other assumptions, our best estimate of future asset returns to estimate the future fees we expect to earn, the costs associated with minimum death benefit guarantees we expect to incur and other profitability factors. For the average remaining life of our variable annuity contracts in force as of December 31, 2002, our evaluation of deferred policy acquisition costs is based on a 9.25% annual blended rate of return that reflects an assumed rate of return of 11.5% for equity type assets. Continuation of current market conditions or further deterioration in market conditions may result in increases in the amortization of deferred policy acquisition costs, while a significant improvement in market conditions may result in a decrease in the amortization of deferred policy acquisition costs. These changes in DAC balances are included as a component of "General, administrative and other expenses" in our statements of operations.
Pruco Life Insurance Company of New Jersey meets the conditions set forth in General Instruction H(1)(a) and (b) on Form 10-Q and is filing this form with reduced disclosure.
Total liabilities of the Company increased $36 million from $2.318 billion to $2.354 billion. Policyholder Account balances increased $72 million mainly from annuity deposits. Future policy benefits increased $15 million due to increases to reserves for term insurance. Corresponding with the asset change, separate account liabilities decreased by $41 million resulting from market value declines of $197 million, policy and other charges of $46 million, offset by net contributions (contributions less surrenders, withdrawals and transfers) of $202 million. Included in contributions is the sale of $190 million of Corporate Owned Life Insurance (COLI) to Prudential Insurance. Other liabilities decreased by $10 million mainly due to the funding of policy credits to the separate account policyholders, which had been accrued in other liabilities at December 31, 2001.
Total assets of the Company decreased $304 million during 2001, the majority of which relates to a $174 million decrease in separate accounts primarily from stock market declines, as described below. Fixed maturities decreased by $130 million primarily from an extraordinary dividend of $186 million paid to Pruco Life of Arizona in December 2001, of which $159.5 million was paid with fixed maturities. The Company reclassified held-to-maturity fixed maturities, amounting to $7.5 million at January 1, 2001, to the available-for-sale category.
Total liabilities of the Company decreased $127 million during the year from $2.445 billion to $2.318 billion. Corresponding with the asset change, separate account liabilities decreased by $174 million due to net investment losses of $146 million, policy and other charges of $47 million, partially offset by net contributions of $19 million. Net separate account contributions in 2000 were $95 million. The current year decline in net contributions reflects activity related to the Discovery Select exchange program, which was terminated in May 2000. This decrease was partially offset by an increase of $20 million in PruSelect III contributions.
Policyholder Account balances increased $23 million mainly from interest credited as net sales were relatively flat. Future policy benefits increased $11 million as a result of increases to reserves for term and extended term insurance. Other liabilities increased $11 million due to adjustments to separate account policy values in the form of policy credits, related to the demutualization.
Net Income Net income for the year ended December 31, 2002 of $15.4 million is flat when compared to prior year net income of $15.6 million. Benefiting net income in 2002 is higher policy charges and premiums and lower tax expense. Policy charges are $20.6 million higher due to increases in the in-force business, and in particular an affiliated sale to Prudential Insurance of Corporate Owned Life Insurance ("COLI"), which generated $12 million in policy fees. The total income effect of this transaction in 2002 was $7.1 million after adjusting for reserves and deferred acquisition costs (DAC). Tax expense is $11.7 million lower when compared to the prior year due to reduced income from operations before taxes and a refinement of the estimated benefits from nontaxable investment income. Offsetting these increases are higher amortization of deferred acquisition costs ("DAC"), lower net investment income, higher realized investment losses, and increases in policyholder benefits and general and administrative expenses.
Revenues Revenues increased by $18.6 million from the prior year. Policy charges and fee income increased by $20.6 million, as discussed above, primarily driven by the affiliated COLI sale of $12 million and an increase in life insurance charges of $10.2 million for assuming mortality and expense risks due to the growth in the in-force business of our life insurance products. The life insurance in-force (excluding term insurance) grew to $8.9 billion at December 31, 2002 from $6.9 billion at December 31, 2001. This was partially offset by a decrease in annuity policy charges and fees of $1.6 million due to decreased fund values as a result of unfavorable market performance. Premiums increased $12.0 million from higher term insurance sales and renewals of the Term Essential and Term Elite products, as these are newer products launched at the end of 2000.
The guaranteed minimum death benefit feature provides annuity contract holders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically the greatest of these values, depending on features offered in various contracts and elected by the contract holders. These contracts generally require payment of additional charges for guarantees other than those based on net deposits paid into the contract. To the extent that the guaranteed minimum death benefit is higher than the current account value at the time of death, the Company incurs a cost. This results in increased annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. Current accounting literature does not prescribe advance recognition of the expected future net costs associated with these guarantees, and accordingly we currently do not record a liability corresponding to these projected future obligations for death benefits in excess of annuity account values. However, we consider the expected net costs associated with these guarantees in our calculations of expected gross profits on variable annuity business, on which our periodic evaluations of unamortized policy acquisition costs are based. A proposed AICPA Statement of Position, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate accounts" (the "Proposed SOP"), would require recording of a liability for the expected net costs associated with these guarantees under certain circumstances, if adopted as proposed. We are currently evaluating the impact of the Proposed SOP, which has a proposed effective date for fiscal years beginning after December 15, 2003. We are currently evaluating the impact of this Proposed SOP. As of December 31, 2002, the death benefit coverage in force (representing the amount we would have to pay if all annuitants had died on that date) was approximately $0.2 billion. The death benefit coverage in force represents the excess of the guaranteed benefit amount over the fair value of the underlying mutual fund investments.
General, administrative and other expenses increased by $18.1 million from the prior year, primarily the result of increased DAC amortization of $9.2 million. Of the DAC amortization increase, $5.0 million was related to our annuity products. These charges reflect our lower estimates of future gross profits from greater expected costs from minimum death benefit guarantees and lower expected fees under these contracts due to declines in asset values and decreased future asset returns. The remaining increase in DAC amortization is associated with our life products and is primarily due to the growth of the in-force. In addition, general and administrative expenses increased due to the growth of the in-force business.
Revenues Revenues decreased by $9.5 million from the prior year comparable period. As mentioned above, realized investment losses increased by $8.6 million as writedowns for other than temporary impairments of fixed maturities grew $6.5 million, losses on the sale of Enron fixed maturities were $3.7 million, and derivative losses were $4.7 million higher than the prior year. Partially offsetting these losses were higher gains on sales of fixed maturities of $6.7 million as a result of selling in an environment of declining interest rates. The elimination of PSF asset management fees reduced revenues by $7.8 million. Policy charges and fee income, primarily consisting of expense, mortality, loading and other insurance charges assessed on policyholder account balances, decreased by $5.4 million primarily driven by a decrease in mortality and expense charges as a result of the decline in separate account liabilities due to unfavorable market returns.
Benefits and Expenses Total benefits and expenses increased by $4.7 million. Policyholder benefits increased $4.9 million due to increased reserve provisions for term and extended term premiums and higher surrender benefits for reduced paid up insurance policies. Interest credited increased by $1.2 million due to higher general account liabilities. General, administrative and other expenses decreased by $1.5 million from the prior year. The elimination of asset management expenses resulted in a decrease of $3.1 million. Commission and distribution expenses, net of capitalization, decreased $.5 million as a result of a change to market based pricing as of April 1, 2000 and higher capitalization of commissions due to increased sales. Offsetting this was an increase in DAC of $2.5 million driven by lower projected future gross profits from continued market declines.
The Company's investment portfolio supports its insurance and annuity liabilities and other obligations to customers for which it assumes investment related risks. The portfolio was comprised of total investments amounting to $746.1 million at December 31, 2002, versus $685.1 million at December 31, 2001. A diversified portfolio of publicly traded bonds, private placements, is managed under strategies intended to maintain a competitive asset mix consistent with current and anticipated cash flow requirements of the related obligations. The risk tolerance reflects the Company's aggregate capital position, exposure to business risk, liquidity and rating agency considerations.
- ------------- (1) Other long-term investments consist of the Company's interest in separate account investments.
The overall income yield on our invested assets after investment expenses, excluding realized investment gains (losses), was 6.61% for the year ended December 31, 2002 and 7.15% for 2001. The decline in yield on the portfolio in 2002 from 2001 is primarily attributable to reinvestment activities over the last two years in a declining interest rate environment.
- -------------- (1) Yields are based on quarterly average carrying values except for fixed maturities, equity securities and securities lending activity. Yields for fixed maturities are based on amortized cost. Yields for securities lending activity are calculated net of corresponding liabilities and rebate expenses. Yields for prior year are presented on a basis consistent with our current reporting practices.
Our fixed maturity securities portfolio consists principally of public and private fixed maturities across an array of industry categories. As of December 31, 2002, we held approximately 74% of assets in fixed maturity securities (versus 72% as of December 31, 2001) with a total amortized cost of $525.9 million and an estimated fair value of $553.9 million, compared to an amortized cost of $479.0 million and estimated fair value of $490.7 million as of December 31, 2001. Our investments in public fixed maturities as of December 31, 2002 were $358.1 million at amortized cost and $378.0 million at estimated fair value compared to $285.5 million at amortized cost and $291.0 million at estimated fair value as of December 31, 2001. Our investments in private fixed maturities as of December 31, 2002 were $167.7 million at amortized cost and $175.9 million at estimated fair value compared to $193.5 million at amortized cost and $199.7 million at estimated fair value as of December 31, 2001.
As a percentage of amortized cost, fixed maturity investments as of December 31, 2002 consist primarily of 23% manufacturing sector, 17% finance sector, 13% asset-backed securities and 12% utilities sector compared to 18% manufacturing sector, 16% finance sector, 21% asset-backed securities and 18% utilities sector as of December 31, 2001. 100% of the mortgage-backed securities were publicly traded agency pass-through securities. The Company did not invest in collateralized mortgage obligations as of December 31, 2002 and 2001.
The gross unrealized losses related to our fixed maturity portfolio were $3.0 million as of December 31, 2002 compared to $4.5 million as of December 31, 2001. The gross unrealized losses in 2002 were concentrated primarily in the utilities, asset-backed securities, manufacturing and services sectors while gross unrealized losses in 2001 were concentrated in the asset-backed securities, transportation, utilities and services sectors. Non-investment grade securities represented 62% of the gross unrealized losses in 2002 versus 59% of gross unrealized losses in 2001.
The amortized cost of our public and private below-investment grade fixed maturities totaled $63.8 million, or 12%, of the total fixed maturities as of December 31, 2002, compared to $45.6 million, or 10%, of total fixed maturities as of December 31, 2001. The increase in the amount of below-investment grade fixed maturities at December 31, 2002 from a year earlier came primarily from negative credit migration over the period.
Gross unrealized losses of fixed maturity securities where estimated fair value has been 20% or more below amortized cost was $1.3 million in both 2002 and 2001. The gross unrealized losses in 2002 were primarily concentrated in the utilities, manufacturing, and retail and wholesale sectors while the gross unrealized losses in 2001 were concentrated in the transportation, services, and manufacturing sectors.
When we determine that there is an other-than-temporary impairment, we record a writedown to estimated fair value which reduces the cost basis. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. Estimated fair values for fixed maturities, other than private placement securities are based on quoted market prices or prices obtained from independent pricing services.
As of December 31, -------------------- 2002 2001 ---- ---- (in millions) Borrowings: General obligations $ - $ - Total asset-based financing 57 55 ----- ----- Total borrowings and asset-based financings $ 57 $ 55 ===== =====
We capitalize costs that vary with and are related primarily to the production of new insurance and annuity business. These costs include commissions, costs to issue and underwrite the policies and certain variable field office expenses. The capitalized amounts are known as deferred policy acquisition costs, or DAC. Our total DAC, including the impact of unrealized investment gains and losses, amounted to $137.1 million and $119.0 million as of December 31, 2002 and 2001, respectively.