Office space is provided by Prudential Insurance, as is described in the Notes to the Consolidated Financial Statements.
The Company sells interest-sensitive individual life insurance and variable life insurance, term life insurance, individual variable annuities, and a non-participating guaranteed interest contract ("GIC") called Prudential Credit Enhanced ("PACE") primarily through the Prudential Insurance sales force in the United States. 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 pressure 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 Company also marketed individual life insurance through its branch office in Taiwan. The Taiwan branch was transferred to an affiliated Company on January 31, 2001, as described in the Notes to the Financial Statements. Beginning February 1, 2001, all insurance activity of the Taiwan branch has been ceded to the affiliated Company.
o the cost of administering insurance contracts and providing asset management products and services;
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 16.2% of our investments at December 31, 2003, 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.
Deferred policy acquisition costs For most life insurance and annuity products that we sell, we defer costs that vary with and are related primarily to the production of new business to the extent these costs are deemed recoverable from future profits, and we record these costs as an asset known as deferred policy acquisition costs or "DAC" ", which is 5.5% of total assets as of December 31, 2003. We amortize this DAC asset over the expected lives of the contracts, based on the level and timing of either estimated profits or premiums, depending on the type of contract. For products with amortization based on future premiums, the amortization rate is locked-in when the product is sold. For products with amortization based on estimated profits, the amortization rate is periodically updated to reflect current period experience or changes in assumptions that affect future profitability, such as lapse rates, investment returns, mortality experience, expense margins and surrender charges.
Reserves for contingencies A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under GAAP, reserves for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial reserve reflects management's best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure. In situations in which the Company is to be indemnified by Prudential Insurance, there will be no financial impact on the statement of operations.
was a mortgage prepayment gain in 2003 of $1.7 million. The prior year had fixed maturity losses of $56.0 million consisting of $27.8 million of impairments and $28.2 million of credit related losses. The current year had fixed maturity gains of $1.6 million consisting of $12.4 million of impairments offset by $14.0 million of gains on sales.
Policy charges and fee income, consisting primarily of mortality and expense ("M&E"), loading and other insurance charges assessed on General and Separate Account policyholder fund balances, increased by $40.3 million. The increase was a result of a $44.6 million increase for individual life products offset partially by a $4.3 million decrease for annuity products. Policy charges for life products increased as a result of growth in the in-force business, the favorable impact of increases in the market value of variable life insurance assets, and the sale of newer interest-sensitive products that generally carry higher expense charges in the first few years of the contract. The life in-force business (excluding term insurance) grew to $71.1 billion at December 31, 2003 from $65.2 billion at December 31, 2002. In contrast, annuity fees are mainly asset-based fees, which are dependent on the fund balances. Annuity separate account fund balances have increased during the current year as a result of favorable market performance and positive net sales. However, the average balance for the current year is lower than the prior year average balance as the favorable 2003 market performance did not completely offset the unfavorable performance during 2002.
Premiums increased by $13.3 million mainly from higher term insurance sales and renewals of $34.4 million partially offset by lower extended term premiums. Term insurance gross premiums increased by $74.1 million due to increased sales and a growing renewal base offset by an increase of $39.7 million in ceded premiums driven by the coinsurance agreement with an affiliate, Pruco Re Ltd. This contract became effective at the end of the 3rd quarter of 2003. Extended term insurance premiums decreased by $19.4 million from decreased policy lapses as a result of favorable market conditions in 2003. Extended term policies represent term insurance the Company issued under policy provisions to customers who previously had lapsing variable life insurance with the Company. The policyholder can purchase extended term or reduced paid-up life insurance based on the amount that can be purchased with the remaining cash value of the contract (if the policyholder does not elect to receive the remaining cash value as a cash distribution). The application of the remaining cash value to purchase such coverage is recorded as premium revenue in the Statement of Operations. Future policy benefit reserves are also increased by the amount of these premiums.
Net investment income increased by $10.1 million as a result of increased income from fixed maturities due to an increase in the portfolio balance from the investment of positive operating and financing cash flows into the fixed maturity portfolio. This was significantly offset by the effect of lower reinvestment rates for fixed maturities and short-term investments due to the lower interest rate environment.
Benefits and Expenses Policyholder benefits increased by $56.9 million primarily from increased reserve provisions of $29.0 million mainly for life insurance reserves and higher death claims primarily from life products of $27.9 million.
The guaranteed minimum death benefit (GMDB) 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. Previously, accounting literature did not prescribe the recognition of a liability for the expected future net costs associated with GMDB provisions. However, effective January 1, 2004, we will adopt SOP 03-01 which requires us to record such a liability based on application of an expected loss ratio to "cumulative assessments" through the balance sheet date, and then subtracting "cumulative excess payments" from that date. We currently estimate this liability to be approximately $45 million. However, in our periodic evaluation of unamortized deferred policy acquisition costs associated with our variable annuity business, we considered the expected net costs associated with the guaranteed minimum death benefits in our calculation of expected gross profits from this business. Accordingly, the effect of establishing the guaranteed minimum death benefit reserve related to this business will be partially offset by an estimated increase of approximately $23 million in unamortized deferred policy acquisition costs, resulting in higher future amortization.
crediting rates. Upon adoption of SOP 03-01, the Company will reclassify this liability from "Separate Account Liabilities" to "Policyholders' Account Balances" and reduce it to reflect accreted value, which excludes the effect of unrealized gains and losses in contract value resulting from changes in crediting rates. We currently estimate the impact of the reduction in liability associated with the MVA feature to be a benefit of approximately $7 million.
Interest credited to policyholder account balances increased by $23.2 million due to growth in policyholders' account balances, especially for the annuity products, which accounted for $20.2 million of the increase. Life general account policyholder balances also increased providing a $4.4 million increase in interest credited. GIC policyholder account balances decreased during 2003 due to scheduled withdrawals causing a decrease of $1.4 million in interest credited. Overall net interest spread revenue, representing net investment income less interest credited, has declined from last year as investment yields on general account assets have declined as described above.
General, administrative, and other expenses decreased by $106.2 million from the prior year. The primary reason was a decrease in DAC amortization of $138.5 million. DAC amortization for annuity products was $118.7 million less as the prior year included an additional charge of $117 million for DAC amortization while the current year had a benefit to net income of $15 million. The charge in 2002 reflected 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 during 2002. In 2003, the benefit reflected our higher estimates of future gross profits from favorable market performance during the current year. In addition, there was an increase in annuity DAC amortization in 2003 of approximately $13 million related to increased capital gains. DAC amortization on life insurance products was lower by $19.8 million due to the favorable fund performance partially offset by the increasing amortization on the growing term and universal life business.
General, administrative and other expenses, excluding DAC amortization, increased $32.3 million from the prior year due to an increase in distribution expenses of $8.3 million and allocated operating expenses of $24 million. Distribution expenses, net of capitalization increased $8.3 million, as renewal commissions on term insurance, which have been growing due to the increasing renewal base, are not fully capitalizable. Operating expenses, in particular salary related expenses, are higher as a result of new business and the growing in-force business.