Management's Discussion and Analysis of Financial Condition and Results of Operations or, "MD&A," addresses the consolidated financial condition of Pruco Life Insurance Company as of December 31, 2004, compared with December 31, 2003, and its consolidated results of operations for the years ended December 31, 2004 and 2003.
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 called Prudential Credit Enhanced, or "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 our mortality and morbidity experience on individual life insurance and annuity products;
o our ability to earn commissions and fees from the distribution and servicing of annuities, retirement products, and other investment products at a level that enables us to earn a margin over the expense of providing such services;
o our ability to generate favorable investment results through asset/liability management and strategic and tactical asset allocation; and
As prescribed by GAAP, we present our fixed maturity investments classified as available for sale, at fair value in the statements of financial position. The fair values for our public fixed maturity securities are based on quoted market prices or estimates from independent pricing services. However, for our investments in private securities such as private placement fixed maturity securities, which comprised 14% of our investments as of December 31, 2004, this information is not available. For these private fixed maturities, fair value is determined 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, and an additional spread component for the reduced liquidity associated with private placements. This additional spread component is determined based on surveys of various third party financial institutions.
The future policy benefit reserves at December 31, 2004 represented 5% of our total liabilities and relate primarily to term life products and are determined in accordance with GAAP as the present value of expected future benefits to or on behalf of policyholders plus the present value of future expenses less the present value of future net premiums. The expected future benefits are based on mortality, lapse, maintenance expense and, interest rate assumptions, and also consider the risk of adverse deviation in our actual results from the results assumed in establishing our reserves. Our mortality assumptions are generally based on the Company's historical experience or standard industry tables, as applicable. Our interest rate assumptions are based on factors such as market conditions and expected investment returns. Collectively, these assumptions are "locked-in" upon the issuance of new policies and continue to be used in subsequent periods to establish the reserves. We review our assumptions to determine whether the reserves together with the expected future premiums are sufficient to provide for the expected future benefit payments and expenses. In particular, we review our mortality assumptions annually and conduct full actuarial studies every three years. 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. If, based on our review, there have been significant adverse changes in actual experience compared to the experience we assumed at the time the policy was issued we may be required to provide for expected future losses by establishing premium deficiency reserves. The assumptions used to establish premium deficiency reserves represent our current best estimate of experience with no provision for adverse deviation. Once established, premium deficiency reserves are not reduced for subsequent improvement in experience but may be increased for subsequent adverse deviations in experience. As of December 31, 2004, we do not have material premium deficiency reserves related to these products.
To demonstrate the sensitivity of our variable annuity DAC balance relative to our future rate of return, increasing or decreasing our future rate of return by 100 basis points would have required us to consider adjustments, subject to our application of the corridor approach, to that DAC balance as follows. The information provided in the table below considers only the effect of changes in our future rate of return and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service and other taxing jurisdictions for audits on-going or not yet commenced. We anticipate that the Internal Revenue Service will complete its examination of 1997 through 2001 during the first half of 2005. Although the results of these audits are not final, based on currently available information, we believe that the outcome will not have an adverse effect on our financial position, cash flows or results of operations.
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.
The Company's Changes in Financial Condition and Results of Operations are described below.
See Note 2, "Summary of Significant Accounting Policies," of the Notes to Consolidated Financial Statements.
Deferred acquisition costs increased by $48 million from December 31, 2003 driven by $221 million in net capitalization of acquisition expenses, largely offset by $187 million of amortization. Capitalization in the Life business reflects a $151 million reduction as a result of a new coinsurance agreement with Prudential Arizona Reinsurance Captive Company or, "PARCC." DAC also increased $14 million from the implementation of SOP 03-1 and a change in unrealized gains. These amounts are shown in the amortization and other non-cash items line on the Statements of Cash Flows.
During the year, liabilities increased by $2,596 million from $23,400 million to $25,996 million. Corresponding with the asset change, Separate account liabilities increased by $1,554 million, as described above. Policyholder account balances increased by $540 million due primarily to the reclassification of MVA contracts as described above and by positive net sales of annuity products with fixed rate options and life general account products. Future policy benefits increased by $257 million due to increased reserves for the Taiwan business, the establishment of guaranteed minimum death and income benefits in the annuity business and increases to life reserves as a result of sales and renewals of term and the newer universal life products. Income taxes payable, net, were higher by $98 million as a result of income tax expense and a tax refund received in 2003 from Prudential Financial. In accordance with the tax sharing agreement with Prudential Financial, the Company was reimbursed for operating losses utilized in the consolidated federal tax return. There was a decrease in total securities lending activity of $73 million and a change in the mix between cash collateral for loaned securities and securities sold under agreements to repurchase, as there are less treasury securities in the portfolio. Treasury securities are commonly used for lending activities, especially in the securities sold under agreements to repurchase category.
Revenues Consolidated revenues increased by $53 million, from $1.077 billion in 2003 to $1.130 billion. Policy charges and fee income, consisting primarily of mortality and expense, loading and other insurance charges assessed on general and separate account policyholders' fund balances, increased by $72 million. The increase was the result of a $37 million increase for individual life products and a $35 million increase 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 gross variable life in force business grew in excess of 8% to $77 billion at December 31, 2004 from $71 billion at December 31, 2003. Annuity fees are mainly asset based fees which are dependent on the fund balances that are affected by net sales as well as asset depreciation or appreciation on the underlying investment funds in which the customer has the option to invest. Average annuity separate account fund balances are nearly 17% higher than in the prior year as a result of favorable market performance and positive net sales.
Net premiums decreased by $59 million from $142 million in 2003, due to increased reinsurance premiums resulting from the coinsurance agreement with PARCC, an affiliate, to reinsure 90% of the entire term book of business. This agreement replaced the previous coinsurance with Pruco Reinsurance Ltd., which reinsured only certain term business. The new agreement covers 90% of all term policies written by both the Company and its wholly owned subsidiary, Pruco Life Insurance Company of New Jersey. All term business not previously covered by the Pruco Re Coinsurance agreement was reinsured with yearly renewable term reinsurance carrying lower premiums than coinsurance. In addition, extended term premiums decreased by $13 million due to lower policy lapses from better market performance.
Realized investment gains (losses) improved by $8 million, from realized losses of $3 million in 2003 to realized gains in 2004 of $5 million, largely as a result of continued improvement in the credit environment in 2004. The current year fixed maturity net realized gains resulted primarily from a $10 million decline in impairments partly offset by a slight decline in realized gains on sales.
Total policyholders' benefits decreased by $57 million from $332 million in 2003 to $ 275 million in 2004, as a result of lower total benefits for the life and annuity businesses of $52 million and $5 million, respectively.
Policyholders' benefits for life insurance products decreased by $27 million, down from $205 million in 2003, driven by lower net death benefits of $18 million and lower surrenders of reduced paid up policies of $9 million. While net term death benefits rose $15 million from a 50% increase in the term in force, net variable and universal death benefits were $33 million lower than the prior year, due to lower mortality and an increase in the ceded in force for these products in 2004. Annuity death benefits of $32 million in 2004 were lower by $10 million, primarily due to lower guaranteed minimum death benefits driven by higher fund values as a result of market appreciation.
General, administrative, and other expenses increased by $61 million from $398 million in 2003 to $459 million in 2004. The primary reason was increased DAC amortization of $56 million, up from $130 million in 2003. DAC amortization for life and annuity products was higher by $39 million and $17 million, respectively. The increase in amortization in the life business was driven by growth in the term and universal in force and less favorable fund performance compared to 2003 partly offset by reduced amortization resulting from ceded DAC associated with the new coinsurance treaty with PARCC described in note 13 below. The increase in amortization in the annuity business was driven by higher gross profits from higher spread revenue and lower guaranteed minimum death benefits in 2004 as compared to 2003, partly offset by a lower deferred bonus unlocking in 2004.
General, administrative and other expenses, excluding DAC amortization, increased $5 million from the prior year as a result of more new business and the growing in force. Partly offsetting the growth in general and administrative expenses are lower net distribution costs resulting from increased reinsurance expense allowances, net of capitalization, in the life business as a result of the PARCC coinsurance agreement mentioned above. These allowances are included in net distribution expense within operating expenses.