We own our headquarters building located at 751 Broad Street, Newark, New Jersey, which comprises approximately 0.6 million square feet. Excluding our headquarters building and properties used by the International Insurance division and Asset Management segment, which are discussed below, we own 8 and lease 11 other principal properties throughout the U.S., some of which are used for home office functions. Our domestic operations also lease approximately 190 other locations throughout the U.S.
On February 1, 2011, we acquired the Star and Edison Businesses from American International Group, Inc. The results of these companies are reported with the Gibraltar Life operations and are included in the results presented below from the date of acquisition.
Our Gibraltar Life operations use a November 30 fiscal year end. Consolidated balance sheet data as of December 31, 2011, 2010, 2009, 2008 and 2007 includes Gibraltar Life assets and liabilities as of November 30. Consolidated income statement data for 2011, 2010, 2009, 2008 and 2007 includes Gibraltar Life results for the twelve months ended November 30, 2011, 2010, 2009, 2008 and 2007, respectively.
For purposes of this computation, earnings are defined as income from continuing operations before income taxes excluding undistributed income (loss) from equity method investments, fixed charges and interest capitalized. Also excludes earnings attributable to noncontrolling interests. Fixed charges are the sum of gross interest expense, interest credited to policyholders’ account balances and an estimated interest component of rent expense. Due to the Company’s loss for the year ended December 31, 2008, the ratio coverage was less than 1:1 and is therefore not presented. Additional earnings of $935 million would have been required for the year ended December 31, 2008 to achieve a ratio of 1:1.
Concurrently with our demutualization, Prudential Holdings, LLC, a wholly-owned subsidiary of Prudential Financial that owns the capital stock of Prudential Insurance, issued $1.75 billion in senior secured notes, which we refer to as the IHC debt. The net proceeds from the issuances of the Class B Stock and IHC debt, except for $72 million used to purchase a guaranteed investment contract to fund a portion of the bond insurance cost associated with that debt, were allocated to the Financial Services Businesses. However, we expect that the IHC debt will be serviced by the net cash flows of the Closed Block Business over time, and we include interest expenses associated with the IHC debt when we report results of the Closed Block Business.
The Closed Block Business is not a separate legal entity from the Financial Services Businesses; however, they are operated as separate entities and are separated for financial reporting purposes. The Financial Services Businesses are not obligated to pay dividends on Closed Block policies. Dividends on Closed Block policies reflect the experience of the Closed Block over time and are subject to adjustment by Prudential Insurance’s Board of Directors. Further, our plan of demutualization provides that we are not required to pay dividends on policies within the Closed Block from assets that are not within the Closed Block and that the establishment of the Closed Block does not represent a guarantee that any certain level of dividends will be maintained.
Our profitability depends principally on our ability to price and manage risk on insurance and annuity products, our ability to attract and retain customer assets and our ability to manage expenses. Specific drivers of our profitability include:
Financial and Economic Environment. Our businesses and results of operations are impacted by general economic and market conditions and are sensitive to the pace of and extent of changes in equity markets, interest rates and real estate valuations, as well as the changes in behavior of individuals and institutions that these changes in economic and market conditions may cause. Recent years have been affected by adverse global market conditions, and uncertainty continues to be a factor in the market environment. This uncertainty, particularly in the equity markets, has led to, among other things, increased demand for guaranteed retirement income, fixed income and stable value products, and defined benefit risk transfer solutions.
to changes in existing laws and regulations, and regulatory frameworks affecting our international businesses. The Financial Services Agency, the insurance regulator in Japan, has implemented revisions to the solvency margin requirements that will revise risk charges for certain assets and change the manner in which an insurance company’s core capital is calculated. These changes are effective for the fiscal year ending March 31, 2012. We anticipate further changes in solvency regulation from jurisdiction to jurisdiction based on regulatory developments in the U.S., the European Union, and recommendations by an international standard setting body for the insurance regulators, as well as regulatory requirements for those companies deemed to be systemically important financial institutions, or SIFIs, in the U.S. or abroad. In addition, local regulations, primarily in Japan, may apply heightened scrutiny to non-domestic companies. Internationally, regulators are also increasingly adopting measures to provide greater consumer protection and privacy rights.
Demographics. Japan has a rapidly aging population as well as a large pool of household assets invested in low yielding deposit and savings vehicles. The aging of Japan’s population as well as strains on government pension programs have led to a growing demand for insurance products with a savings element to meet savings and retirement needs as the population transitions to retirement. The growing demand for retirement oriented products has led to higher premiums with more of a savings component. We are seeing a similar shift to retirement oriented products in Korea and Taiwan, each of which also has an aging population.
Competitive Environment. The life insurance markets in Japan and Korea are mature. We generally compete more on service provided to the customers than on price. The aging of Japan’s population creates an increasing need for product innovation, introducing insurance products which allow for savings and income as the population transitions to retirement. The ability to sell through multiple and complementary distribution channels is a competitive advantage. However, competition for sales personnel as well as access to third party distribution channels is intense.
On February 1, 2011, Prudential Financial completed the acquisition from American International Group, Inc., or AIG, of AIG Star Life Insurance Co., Ltd., or “Star”, AIG Edison Life Insurance Company, or “Edison”, and certain other AIG subsidiaries (collectively, the “Star and Edison Businesses”) pursuant to the stock purchase agreement dated September 30, 2010 between Prudential Financial and AIG. The total purchase price was $4,709 million, comprised of $4,213 million in cash and $496 million in assumed third party debt, substantially all of which is expected to be repaid, over time, with excess capital of the acquired entities. On January 1, 2012, the Star and Edison companies were merged into Gibraltar Life. See “-Results of Operations for Financial Services Businesses by Segment-International Insurance Division-International Insurance” for more information on this acquisition.
On March 11, 2011, Japan experienced a massive earthquake followed by a tsunami which caused extensive damage and loss of life. Our results include a pre-tax charge of $61 million for the year ended December 31, 2011 associated primarily with estimated claims from our operations in Japan arising from these events. We have not experienced and do not expect a significant impact to the valuation of our investments or our ability to operate our Japanese businesses as a result of these events.
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 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 upon market conditions and other considerations, and the repurchases may be effected in the open market, through derivative, accelerated repurchase and other negotiated transactions and through prearranged trading plans designed to comply with Rule 10b5-1(c) under the Exchange Act.
On October 20, 2011, the Company announced it had entered into an agreement to sell its stake in Afore XXI, S.A. de C.V., a private pension fund manager in Mexico, to Banorte, a major bank based in Mexico. This sale was completed on December 2, 2011. We recorded a pre-tax gain on the sale of $96 million in 2011 reflected in adjusted operating income of our International Insurance segment.
Net income of our Financial Services Businesses attributable to Prudential Financial, Inc. for the year ended December 31, 2011 was $3,531 million compared to $2,714 million for 2010.
Pre-tax net realized investment gains and related charges and adjustments of the Financial Services Businesses were $685 million of net gains in 2011 primarily reflecting the impact of changes in foreign currency exchange rates on certain assets and liabilities for which we economically hedge the foreign currency exposure and net increases in the market value of derivatives used to manage investment portfolio duration. These gains were partially offset by other-than-temporary impairments of fixed maturity and equity securities and net losses related to the embedded derivatives and related hedge positions associated with certain of our variable annuity contracts.
Management expects that results in 2012 will continue to reflect the quality of our individual businesses and their prospects, as well as our overall business mix and effective capital management. In 2012, we continue to focus on long-term strategic positioning and growth opportunities, including the following:
International Markets. We continue to concentrate on deepening our presence in the markets in which we currently operate, such as Japan, and expanding our distribution capabilities, including through the integration of the acquired Star and Edison Businesses. We seek to capitalize on opportunities arising in international markets as changing demographics and public policy have resulted in a growing demand for retirement income products.
We analyze performance of the segments and Corporate and Other operations of the Financial Services Businesses using a measure called adjusted operating income. See “-Consolidated Results of Operations-Segment Measures” for a discussion of adjusted operating income and its use as a measure of segment operating performance.
Individual Life segment results for 2011 increased in comparison to 2010 primarily driven by a greater benefit in 2011 from annual updates of our actuarial assumptions resulting in lower amortization of deferred policy acquisition costs, net of related amortization of unearned revenue reserves, and a net decrease in insurance reserves. The 2011 benefit was $75 million, compared to a benefit of $52 million in 2010. Absent the impact of these annual reviews, results for 2011 decreased $6 million from 2010 primarily due to an increase in amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, largely reflecting the impact of equity markets on separate account fund performance in the respective periods, partially offset by the impact of less unfavorable mortality experience.
Corporate and Other operations resulted in an increased loss for 2011 as compared to 2010 primarily due to a higher level of expenses in other corporate activities, including a $93 million increase in expenses for estimated payments arising from use of new Social Security Master Death File matching criteria to identify deceased policyholders and contractholders and a $20 million charge related to a voluntary contribution to an insurance industry insolvency fund, related to Executive Life Insurance Company of New York.
Income from continuing operations before income taxes in the Closed Block Business decreased $528 million in 2011 compared to 2010, primarily reflecting an increase in the policyholder dividend obligation expense.
DAC associated with the non-participating whole life and term life policies of our Individual Life segment and the non-participating whole life, term life, endowment and health policies of our International Insurance segment is amortized in proportion to gross premiums. We evaluate the recoverability of our DAC related to these policies as part of our premium deficiency testing. If a premium deficiency exists, we reduce DAC 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 reduce the DAC balance to zero and increase the reserve for future policy benefits by the excess, by means of a charge to current period earnings. Generally, we do not expect significant deterioration in future experience, and therefore do not expect significant writedowns to the related DAC.
As mentioned above, this change in our hedging strategy also led to a change in the components included in our estimate of total gross profits used to determine the DAC and DSI amortization rates. Beginning in the third quarter of 2010, management’s best estimate of the total gross profits associated with these optional living benefit features and related hedge positions is based on the updated hedge target definition as described above. However, total gross profits for these purposes includes the difference between the change in the value of the hedge target liability and the change in the asset value only to the extent this net amount is determined by management to be other-than-temporary, as well as the impact of assumption updates on the valuation of the hedge target liability. The determination of whether the difference between the change in the value of the hedge target liability and the change in the asset value is other-than-temporary is based on an evaluation of the effectiveness of the hedge program. Management generally expects differences between the value of the hedge target liability and asset value to be temporary and to reverse over time. Such differences would not be included in total gross profits for purposes of determining the amortization rates. However, based on the effectiveness of the hedge program, management may determine that the difference between the value of the hedge target liability and the asset value is other-than-temporary and would include that amount in our best estimate of total gross profits for setting the DAC and DSI amortization rates.
Management may also decide to temporarily hedge to an amount that differs from the hedge target definition, given overall capital considerations of the Company and prevailing market conditions. The impact from temporarily hedging to an amount that differs from the hedge target definition, as well as the results of the capital hedge program we began in the second quarter of 2009 and modified in 2010, are not considered in calculating total gross profits used to determine amortization rates nor included in actual gross profits used in calculating current period amortization as these items are related to capital considerations and are not directly related to product profits.
Annually, during the third quarter, we perform a comprehensive review of the assumptions used in estimating gross profits for future periods. Although we review these assumptions on an ongoing basis throughout the year, we generally only update these assumptions and adjust the DAC and DSI balances during the third quarter, unless a material change that we feel is indicative of a long term trend is observed in an interim period. Over the last several years, the Company’s most significant assumption updates resulting in a change to expected future gross profits and the amortization of DAC and DSI have been related to lapse experience and other contractholder behavior assumptions, mortality, and revisions to expected future rates of returns on investments. We expect these assumptions to be the ones most likely to cause potential significant changes in the future. The impact on our results of operations of changes in these assumptions can be offsetting and we are unable to predict their movement or offsetting impact over time.
The near-term future rate of return assumptions used in evaluating DAC and DSI for our domestic variable annuity and variable life insurance products are derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider actual returns over a period of time and initially adjust future projected returns over the next four years (the “near-term”) so that the assets are projected to grow at the long-term expected rate of return for the entire period. Unless there is a sustained interim deviation, our long-term expected rate of return assumptions are generally not impacted by short-term market fluctuations. If the near-term projected future rate of return is greater than our near-term maximum future rate of return, we use our maximum future rate of return. The following table sets forth the weighted average rate of return assumptions, per annum, for our domestic variable annuity and variable life insurance businesses as of December 31, 2011.
The weighted average rate of return assumptions reflected in the table above are determined independently for variable annuities and variable life insurance and consider many factors specific to each business, including actual rates of return, liability durations, asset allocations and other factors. We update the rates of return and our estimate of total gross profits each quarter to reflect the result of the reversion to the mean approach. These market performance related adjustments to our estimate of total gross profits result in cumulative adjustments to prior amortization, reflecting the application of the new required rate of amortization to all prior periods’ gross profits. The new required rate of amortization is also applied prospectively to future gross profits in calculating amortization in future periods.
The DAC balance associated with the variable and universal life policies of our Individual Life segment as of December 31, 2011 was $2.5 billion. The following table provides a demonstration of the sensitivity of that DAC balance relative to our future mortality assumptions by quantifying the adjustments that would be required, assuming both an increase and decrease in our future mortality rate by 1%. While the information below is for illustrative purposes only and does not reflect our expectations regarding future mortality assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change. This information considers only the direct effect of changes in our mortality assumptions on the DAC balance, with no changes in any other assumptions such as persistency, future rate of return, or expenses included in our evaluation of DAC, and does not reflect changes in reserves, such as the unearned revenue reserve, which would partially offset the adjustments to the DAC balance reflected below. The impact of the unearned revenue reserve is discussed in more detail below in “-Policyholder Liabilities.”
For a discussion of DAC adjustments related to our Individual Life segment for the years ended December 31, 2011, 2010 and 2009, see “-Results of Operations for Financial Services Businesses by Segment-U.S. Individual Life and Group Insurance Division-Individual Life.”
DAC and DSI balances and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC and DSI. Further, this information does not reflect changes in reserves, such as the reserves for the guaranteed minimum death and optional living benefit features of our variable annuity products, or the impact that changes in such reserves may have on the DAC and DSI balances.
In addition to DAC and DSI, we also recognize an asset for value of business acquired, or VOBA. VOBA includes an explicit adjustment to reflect the cost of capital attributable to the acquired insurance contracts, and represents an adjustment to the stated value of inforce insurance contract liabilities to present them at fair value, determined as of the acquisition date. As of December 31, 2011, VOBA was $3,845 million, and included $3,490 million related to the acquisition from AIG of the Star and Edison Businesses on February 1, 2011. See Note 3 for additional information on the acquisition from AIG of the Star and Edison Businesses. The remaining $355 million relates to previously-acquired traditional life, deferred annuity, defined contribution and defined benefit businesses. VOBA is amortized over the effective life of the acquired contracts. For additional information about VOBA including details on items included in our estimates of future cash flows for the various acquired businesses and its bases for amortization, see Note 2 and Note 8 to the Consolidated Financial Statements. VOBA is also subject to recoverability testing at the end of each reporting period to ensure that the balance does not exceed the present value of anticipated gross profits. Based on this recoverability testing, in 2009 we impaired the entire remaining VOBA asset related to the variable annuity contracts acquired from Allstate. For additional information regarding this charge, see “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities.”
Accounting guidance allows a reporting unit to perform a qualitative assessment to determine if its goodwill is impaired. Factors such as macroeconomic conditions; industry and market considerations; cost factors; and others are used to assess the validity of the goodwill. If it is determined that the reporting unit’s fair value is not more likely than not below its carrying amount (equity attributed to a business to support its risk), the test is complete and no impairment is recorded. If this assertion cannot be made, a quantitative analysis must be performed. A reporting unit may bypass the qualitative analysis and begin their impairment analysis with the quantitative calculation. This option is unconditional and a reporting unit may resume performing the qualitative assessment in any subsequent period.
Estimating the fair value of reporting units is a subjective process that involves the use of estimates and judgments. The Retirement Full Service business’ quantitative test is sensitive to a number of key assumptions. For example, a decline in its forecasted cash flows of 4%, an increase in the discount rate above 12.5%, or an increase in the equity attributed to support this business (representing the carrying value) of 5% could result in failing Step 1 of the quantitative test and therefore require a Step 2 assessment. Regarding all four reporting units
For our investments classified as available-for-sale, the impact of changes in fair value is recorded as an unrealized gain or loss in “Accumulated other comprehensive income (loss), net,” a separate component of equity. For our investments classified as trading, the impact of changes in fair value is recorded within “Asset management fees and other income.” In addition, investments classified as available-for-sale, as well as those classified as held-to-maturity, are subject to impairment reviews to identify when a decline in value is other-than-temporary. For a discussion of our policies regarding other-than-temporary declines in investment value and the related methodology for recording other-than-temporary impairments of fixed maturity and equity securities, see Note 2 to the Consolidated Financial Statements, “-Realized Investment Gains and Losses and General Account Investments-General Account Investments-Fixed Maturity Securities-Other-than-Temporary Impairments of Fixed Maturity Securities” and “-Realized Investment Gains and Losses and General Account Investments-General Account Investments-Equity Securities-Other-than-Temporary Impairments of Equity Securities.”
We establish reserves for future policy benefits to, or on behalf of, policyholders in the same period in which the policy is issued. These reserves relate primarily to the traditional participating whole life policies of our Closed Block Business and the non-participating whole life, term life, and life contingent structured settlement and group annuity products of our Financial Services Businesses.
The reserves for future policy benefits of our Retirement segment, which as of December 31, 2011 represented 10% of our total future policy benefit reserves, relate to our non-participating life contingent group annuity and structured settlement products. These reserves are generally determined as the present value of expected future benefits and expenses based on assumptions about mortality, retirement, maintenance expense, and interest rates. Reserves are based on best estimate assumptions as of the date the contract is issued with provisions for the risk of adverse deviation. After our reserves are initially established, we perform premium
deficiency testing by product group using best estimate assumptions as of the testing date without provisions for adverse deviation. If reserves determined based on these assumptions are greater than the existing reserves, the existing reserves are adjusted to the greater amount. Our best estimate assumptions are determined by product group. Our mortality and retirement assumptions are based on Company or industry experience; 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. Although we review our mortality and retirement assumptions on an ongoing basis throughout the year, we generally only update these assumptions annually during the third quarter unless a material change in mortality or retirement experience is observed in an interim period that we feel is indicative of a long term trend. Generally, we do not expect our actual mortality or retirement 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.
only and does not reflect our expectations regarding future rate of return assumptions, it is a near-term, reasonably likely 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 operating results due to the change in the reserve balance and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of the reserves, or any changes on DAC or other balances, discussed above in “-Deferred Policy Acquisition and Other Costs.”
For the variable and universal life policies of our Individual Life segment, a significant portion of our gross profits is derived from mortality margins. As a result, our estimates of future gross profits are significantly influenced by our mortality assumptions. Our mortality assumptions represent our expected claims experience over the life of these policies and are developed based on Company experience or standard industry tables. Unless a material change in mortality experience that we feel is indicative of a long term trend is observed in an interim period, we generally update our mortality assumptions annually in the third quarter. Updates to our mortality assumptions in future periods could have a significant adverse or favorable effect on the results of our operations in the Individual Life segment.
URR balance relative to our future mortality assumptions by quantifying the adjustments that would be required, assuming both an increase and decrease in our future mortality rate by 1%. While the information below is for illustrative purposes only and does not reflect our expectations regarding future mortality assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change on the URR balance and does not reflect the offsetting impact of such a change on the DAC balance as discussed above in “-Deferred Policy Acquisition and Other Costs.” This information considers only the direct effect of changes in our mortality assumptions on the URR balance and not changes in any other assumptions such as persistency, future rate of return, or expenses included in our evaluation of URR.
For a discussion of URR adjustments related to our Individual Life segment for the years ended December 31, 2011, 2010, and 2009, see “-Results of Operations for Financial Services Businesses by Segment-U.S. Individual Life and Group Insurance Division-Individual Life.”
We determine 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. See Note 18 to our Consolidated Financial Statements for our actual asset allocations by asset category and the asset allocation ranges prescribed by our investment policy guidelines for both our pension and other postretirement benefit plans. Our assumed long-term rate of return for 2011 was 7.00% for our pension plans and 7.00% for our other postretirement benefit plans. Given the amount of plan assets as of December 31, 2010, the beginning of the measurement year, if we had assumed an expected rate of return for both our pension and other postretirement benefit plans that was 100 basis points higher or 100 basis points lower than the rates we assumed, the change in our net periodic costs would have been as shown in the table below. The information provided in the table below considers only changes in our assumed long-term rate of return given the level and mix of invested assets at the beginning of the measurement year, without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed long-term rate of return.
We determine our discount rate, used to value the pension and postretirement benefit obligations, based upon rates commensurate with current yields on high quality corporate bonds. See Note 18 to our Consolidated Financial Statements for information regarding the December 31, 2010 methodology we employed to determine our discount rate for 2011. Our assumed discount rate for 2011 was 5.60% for our pension plans and 5.35% for our other postretirement benefit plans. Given the amount of pension and postretirement obligation as of December 31, 2010, the beginning of the measurement year, if we had assumed a discount rate for both our pension and other postretirement benefit plans that was 100 basis points higher or 100 basis points lower than the rates we assumed, the change in our net periodic costs would have been as shown in the table below. The information provided in the table below considers only changes in our assumed discount rate without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed discount rate.
For a discussion of our expected rate of return on plan assets and discount rate for our qualified pension plan in 2011, see “-Results of Operations for Financial Services Businesses by Segment-Corporate and Other.”
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%.
Our liability for income taxes includes the liability for unrecognized tax benefits and interest that relate to tax years still subject to review by the IRS or other taxing authorities. The completion of review or the expiration of the Federal statute of limitations for a given audit period could result in an adjustment to our liability for income taxes. The Federal statute of limitations for the 2002 tax year expired on April 30, 2009. The Federal statute of limitations for the 2003 tax year expired on July 31, 2009. The Federal statute of limitations for the 2004 through 2007 tax years will expire in June 2012, unless extended. Tax years 2008 through 2010 are still open for IRS examination. See Note 19 to the Consolidated Financial Statements for a discussion of the impact in 2009 and 2011 of changes to our total unrecognized tax benefits. We do not anticipate any significant changes within the next 12 months to our total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.
See Note 2 to our Consolidated Financial Statements for a discussion of recently adopted accounting pronouncements.
In October 2010, the FASB issued authoritative guidance to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The Company adopted this guidance effective January 1, 2012, and will apply the retrospective method of adoption. We estimate that if the new guidance were adopted as of December 31, 2011, retrospective adoption would reduce deferred policy acquisition costs by approximately $3.6 billion to $4.4 billion for the Financial Services Businesses and by approximately $0.2 billion for the Closed Block Business, increase policy reserves for certain limited pay contracts by approximately $0.2 billion to $0.3 billion for the Financial Services Businesses, and reduce total equity by approximately $2.6 billion to $3.0 billion for the Financial Services Businesses and approximately $0.1 billion for the Closed Block Business. Subsequent to the adoption of the guidance, the lower level of costs qualifying for deferral may be only partially offset by a lower level of amortization of deferred policy acquisition costs, and, as such, may initially result in lower earnings in future periods, primarily within the International Insurance and Individual Annuities segments. The impact to the International Insurance segment largely reflects lower deferrals of allocated costs of its proprietary distribution system, while the impact to the Individual Annuities segment mainly reflects lower deferrals of its wholesaler costs. While the adoption of this amended guidance changes the timing of when certain costs are reflected in the Company’s results of operations, it has no effect on the total acquisition costs to be recognized over time and will have no impact on the Company’s cash flows.
Higher net pre-tax gains associated with our general account portfolio, excluding the impact of the hedging program associated with certain variable annuities as described below, primarily reflecting higher gains from changes in the market value of derivatives used to manage the investment portfolio duration resulting from declining interest rates in 2011, and higher gains from changes in the market value of currency derivatives due to foreign currency exchange rate movements;
A $96 million pre-tax gain on the sale of our investment in Afore XXI, an operating joint venture in our International Insurance segment; and
A net increase in premiums and policy charges and fee income, net of an increase in policyholders’ benefits, including changes in reserves, reflecting business growth, as well as the impact of favorable currency fluctuations, in our International Insurance operations.
A $722 million unfavorable variance, before taxes, reflecting the net impact from the mark-to-market of our embedded derivatives, including the impact of non-performance risk, and related hedge positions associated with certain variable annuities, the impact on amortization of deferred policy acquisition and other costs and the impact of temporarily hedging to an amount that differs from our hedge target definition;
A $580 million unfavorable variance, before taxes, from adjustments to deferred policy acquisition and other costs and the reserves for guaranteed minimum death and income benefit features of our variable annuity products, reflecting updates to the estimated profitability of the business primarily resulting from market performance and the impact of an annual review and update of assumptions; and
A $93 million pre-tax expense for estimated payments arising from use of new Social Security Master Death File matching criteria to identify deceased policy and contract holders.
The direct equity adjustment increased income from continuing operations available to holders of the Common Stock for earnings per share purposes by $24 million for 2011, compared to $36 million for 2010. As described more fully in Note 16 to the Consolidated Financial Statements, the direct equity adjustment modifies earnings available to holders of the Common Stock and the Class B Stock for earnings per share purposes. The holders of the Common Stock will benefit from the direct equity adjustment as long as reported administrative expenses of the Closed Block Business are less than the cash flows for administrative expenses determined by the policy servicing fee arrangement that is based upon insurance and policies in force and statutory cash premiums.
Generally, as statutory cash premiums and policies in force in the Closed Block Business decline, we expect the benefit to the Common Stock holders from the direct equity adjustment to decline accordingly. If the reported administrative expenses of the Closed Block Business exceed the cash flows for administrative expenses determined by the policy servicing fee arrangement, the direct equity adjustment will reduce income available to holders of the Common Stock for earnings per share purposes.
2010 to 2009 Annual Comparison. Income from continuing operations for the Financial Services Businesses decreased $703 million, from $3,396 million in 2009 to $2,693 million in 2010. Results for 2009 include a $1,457 million after tax gain on the sale of our minority joint venture interest in Wachovia Securities to Wells Fargo. Absent the effect of this item, income from continuing operations for the Financial Services Businesses for 2010 increased $754 million from 2009 reflecting the following:
A net increase in premiums and policy charges and fee income, net of an increase in policyholders’ benefits, including changes in reserves, reflecting business growth, as well as the impact of currency fluctuations, in our International Insurance operations and higher life-contingent structured settlement and single premium annuity sales in our retirement business; and
Increases in other income and benefits and expenses due to changes in value of recorded assets and liabilities that are expected to ultimately accrue to contractholders.
On a diluted per share basis, income from continuing operations attributable to the Financial Services Businesses for 2010 of $5.68 per share of Common Stock decreased from $7.67 per share of Common Stock for 2009.
2011 to 2010 Annual Comparison. Income from continuing operations for the Closed Block Business for 2011, was $135 million, or $55.50 per share of Class B Stock, compared to $480 million, or $222.00 per share of Class B Stock, for 2010. The direct equity adjustment decreased income from continuing operations available to the Class B Stock holders for earnings per share purposes by $24 million for 2011, compared to $36 million for 2010. For a discussion of the results of operations for the Closed Block Business, see “-Results of Operations of Closed Block Business,” below.
In managing our business, we analyze operating performance separately for our Financial Services Businesses and our Closed Block Business. For the Financial Services Businesses, we analyze our segments’ operating performance using “adjusted operating income.” Results of the Closed Block Business for all periods are evaluated and presented only in accordance with U.S. GAAP. Adjusted operating income does not equate to “income (loss) from continuing operations before income taxes and equity in earnings of operating joint ventures” or “net income” as determined in accordance with U.S. GAAP but is the measure of segment profit or loss we use to evaluate segment performance and allocate resources, and consistent with authoritative guidance, is our measure of segment performance. The adjustments to derive adjusted operating income are important to an
Revenues exclude Realized investment gains (losses), net, and related adjustments, which include the net impact of embedded derivatives related to our living benefit features and related hedge positions as described below. See “-Realized Investment Gains and Losses and General Account Investments-Realized Investment Gains and Losses.”
Excluding the items discussed above, adjusted operating income increased $247 million. The increase was driven by higher fee income, net of distribution costs, due to higher average variable annuity account values invested in separate accounts primarily driven by positive net flows. See “-Account Values” below for a further discussion of our account values and sales. The higher fee income was partially offset by higher general and administrative expenses, net of capitalization, reflecting higher costs to support business growth and higher financing expenses, and the impact of a $25 million benefit in 2010 from refinements based on a review and settlement of reinsurance contracts related to acquired business.
Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the GMDB / GMIB features of our variable annuity products.
For a further discussion of the assumptions, including our current near-term and long-term projected rates of return, used in estimating total gross profits used as the basis for amortizing DAC and other costs, and for estimating future expected claims costs associated with the GMDB and GMIB features of our variable annuity products, see “-Accounting Policies and Pronouncements-Application of Critical Accounting Estimates.”
The $36 million and $68 million of benefits in 2011 and 2010, respectively, shown in the table above, reflect the quarterly adjustments for current period experience and other updates, also referred to as experience true-up adjustments. The experience true-up adjustments for 2011 include reductions to both the amortization of DAC and other costs and the reserves related to the GMDB and GMIB features of our variable annuity products. The reduction to the amortization of DAC and other costs was driven by higher than expected gross profits primarily from lower than expected lapses, higher than expected fee income and higher than expected general account spreads. The reduction to the reserves related to the GMDB and GMIB features of our variable annuity products was driven by lower than expected actual contract guarantee claim costs, higher than expected fee income and higher than expected general account spreads, partially offset by lower than expected lapses. The experience true-up adjustments for 2010 included a reduction in the amortization of DAC and other costs driven by higher than expected gross profits primarily from higher than expected fee income, and a reduction to the reserves related to the GMDB and GMIB features of our variable annuity products driven by lower than expected actual contract guarantee claim costs, more favorable lapse experience and higher than expected fee income.
2010 to 2009 Annual Comparison. Adjusted operating income increased $289 million, from $757 million in 2009 to $1,046 million in 2010. The increase in adjusted operating income was primarily due to an increase in fee income, net of higher distribution costs, driven by higher average variable annuity account values invested in separate accounts due to positive net flows and net market appreciation.
Amounts reflect (charges) or benefits for (increases) or decreases, respectively, in the amortization of DAC and other costs resulting from adjustments to our estimate of total gross profits.
The $103 million and $331 million of benefits for 2010 and 2009, respectively, relating to the quarterly market performance adjustments shown in the table above are attributable to changes to our estimate of total gross profits to reflect actual fund performance. The following table shows the actual quarterly rates of return on variable annuity account values compared to our previously expected quarterly rates of return used in our estimate of total gross profits for the periods indicated.
Actual returns exceeded our expected returns for 2010 which increased our estimates of total gross profits and decreased our estimate of future expected claims costs associated with the GMDB and GMIB features of our variable annuity products, by establishing a new, higher starting point for the variable annuity account values used in estimating those items for future periods. The expected rates of return in 2010 for some contract groups were based upon our maximum future rate of return under the reversion to the mean approach. The overall increase in our estimate of total gross profits and decrease in our estimate of future expected claims costs results in a lower required rate of amortization and lower required reserve provisions, which are applied to all prior periods. The resulting cumulative adjustment to prior amortization and reserve provisions was a $103 million benefit for 2010 as shown in the table above.
The $331 million of benefits for 2009 relating to the quarterly market performance adjustments is attributable to a similar impact on gross profits of market value increases in the underlying assets associated with our variable annuity products, reflecting financial market conditions during the period. The benefit in 2009 is higher than that in 2010 due to a greater difference in 2009 between the actual rates of return and the expected rates of return. Also, the $54 million decrease in amortization of DAC and other costs in 2009 is net of a $73 million charge to impair the entire remaining balance of value of business acquired, or VOBA, related to the variable annuity contracts acquired from The Allstate Corporation, or Allstate, in the second quarter of 2006. The additional charge was required in the first quarter of 2009, as the declines in estimated future gross profits related to market performance caused the present value of estimated gross profits for these contracts to fall below zero. Since the VOBA balance was completely amortized for these contracts, it cannot be reestablished for market value appreciation in subsequent periods.
As discussed and shown in the table above, results for both periods also 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. 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. 2009 included $49 million of charges from these annual reviews, primarily related to reductions in the future rate of return assumptions applied to the underlying assets associated with our variable annuity products. Partially offsetting the impact of the updated future rate of return assumptions for 2009 were benefits related to the impact of lower mortality and higher investment spread assumptions.
The $68 million benefit for 2010 and the $97 million benefit for 2009 for the quarterly adjustments for current period experience and other updates shown in the table above primarily reflect the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as an update for current and future expected claims costs associated with the GMDB and GMIB features of our variable annuity products. To the extent each period’s actual experience differs from the previous estimate for that period, the assumed level of total gross profits may change, and a cumulative adjustment to previous periods’ amortization, also referred to as an experience true-up adjustment, may be required in the current period.
This adjustment to previous periods’ amortization is in addition to the direct impact of actual gross profits on current period amortization and the market performance related adjustment to our estimates of gross profits for future periods. The experience true-up adjustments for deferred policy acquisition and other costs for 2010 reflect a reduction in amortization due to better than expected gross profits, resulting primarily from higher than expected fee income. The adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in 2010 primarily reflects a reserve decrease driven by lower than expected actual contract guarantee claim costs, more favorable lapse experience, and higher than expected fee income. The experience true-up adjustments for deferred policy acquisition and other costs for 2009 reflect a reduction in amortization due to better than expected gross profits. The adjustment for the reserves for the GMDB and GMIB features of our variable annuity products in 2009 primarily reflects higher than expected fee income due to market value increases, partially offset by higher than expected actual contract guarantee claims costs due to lower than expected lapses.
See “-Account Values” below for a further discussion of our account values and sales, and “-Variable Annuity Net Amount at Risk” below for a further discussion of the automatic rebalancing element in some of our optional living benefit features.
Variable annuities include only those sold as retail investment products. Investments sold through defined contribution plan products are included with such products within the Retirement segment.
Includes cumulative reclassifications of $267 million in 2010 and $259 million in 2009 from variable annuity to fixed annuity account values to conform presentation of certain contracts in annuitization status to current reporting practices.
2011 to 2010 Annual Comparison. Total account values for variable and fixed annuities amounted to $113.5 billion as of December 31, 2011, representing an increase of $7.4 billion from December 31, 2010. The increase was driven by positive variable annuity net flows, partially offset by decreases in the market value of customers’ variable annuities due to unfavorable equity markets and higher policy charges driven by the growing account value base. Gross sales of our variable annuities decreased $1.4 billion, driven by the impacts of modifications we implemented in the first quarter of 2011 to scale back benefits and increase pricing, and increased competition as certain of our competitors became more aggressive in product design and pricing. Despite these impacts, we believe that our current product offerings remain competitively positioned and expect our living benefit features will provide us an attractive risk and profitability profile, as all of our currently-sold optional living benefit features include an automatic rebalancing element. Our automatic rebalancing element occurs at the contractholder level, rather than at the fund level, which we believe enhances our risk management capabilities. Individual variable annuity surrenders and withdrawals were relatively flat despite the increase in account values, as the newly acquired business experienced lower lapse rates. See “-Variable Annuity Net Amount at Risk” for a more detailed discussion of our automatic rebalancing element.
As of December 31, 2011, 2010 and 2009, asset values that have rebalanced to the general account or a separate account bond portfolio due to the automatic rebalancing element represent 30% or $20.9 billion of the $70.3 billion total account value, 12% or $6.7 billion of the $57.3 billion total account value and 23% or $8.2 billion of the $34.9 billion total account value, respectively.
Our GMDBs guarantee a minimum return on the contract value or an enhanced value, if applicable, to be used solely for purposes of determining benefits payable in the event of death. The net amount at risk associated with the GMDBs provided by our variable annuity contracts includes risk we have deemed suitable to retain. However, certain of these account values are affected by an automatic rebalancing element because the contractholder selected a living benefit feature which includes an automatic rebalancing element. All of the variable annuity account values with living benefit features shown in the table above also contain GMDBs. An additional $21.1 billion, $24.0 billion and $24.4 billion of variable annuity account values, as of December 31, 2011, 2010 and 2009, respectively, contain GMDBs, but no living benefit features. The following table sets forth the account values of our variable annuities with GMDBs and the net amount at risk of these benefits split between those that are affected by an automatic rebalancing element and those that are 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 2010 reflects overall growth in our variable annuity business and account value performance during 2011.
Net impact of embedded derivatives related to our living benefit features and related hedge positions
As described above, our hedging strategy uses capital markets instruments to generally match certain capital market sensitivities of the portion of the hedge target liability we choose to hedge. As of December 31, 2011, the fair value of our hedge positions was a net asset position of $5.3 billion. Due to cash flow timing differences between our hedging instruments and the corresponding hedge target, as well as our decision to temporarily hedge to an amount that differs from our hedge target definition and other factors, the amount of hedge assets compared to our hedge target measured as of any specific point in time will be different, and is not expected to be fully offsetting.
DAC and other costs is included in “Related charges,” both of which are excluded from adjusted operating income. The following table shows the net impact of changes in the embedded derivative liability and related hedge positions, as well as the related amortization of DAC and other costs, for the years ended December 31, 2011, 2010 and 2009 for the Individual Annuities segment.
Represents the impact attributable to the difference between the value of the hedge target liability, based on our hedge target definition, and the value of the embedded derivative liability as defined by U.S. GAAP, before adjusting for NPR.
To reflect NPR, we incorporate an additional spread over LIBOR into the discount rate used in the valuation of those individual living benefit contracts in a liability position and not to those in a contra-liability position. As of December 31, 2011, the value of the embedded derivatives, before the adjustment for NPR, was a net liability of $8.3 billion. This net liability was comprised of $8.5 billion of individual living benefit contracts in a liability position, net of $0.2 billion of individual living benefit contracts in a contra-liability position.
Represents the impact of temporarily hedging to an amount that differs from our hedge target definition. This amount is not reported in the Individual Annuities segment. See “-Corporate and Other” for details.
As shown in the table above, the net impacts from changes in the embedded derivative liability and hedge positions, after the impact of DAC and other costs, reported in the Individual Annuities segment were net benefits of $1,279 million, $33 million and $126 million for 2011, 2010 and 2009, respectively.
As a result, we included the cumulative differences in our best estimate of total gross profits, which resulted in an increase in our DAC amortization rates. For a further discussion of the assumptions used in estimating total gross profits used as the basis for amortizing DAC and other costs, see “-Accounting Policies and Pronouncements-Application of Critical Accounting Estimates.”
In the second quarter of 2009, we began the expansion of our hedging program to include a portion of the market exposure related to the overall capital position of our variable annuity business, including the impact of certain statutory reserve exposures. These capital hedges, which primarily consisted of equity-based total return swaps, were designed to partially offset changes in our capital position resulting from market driven changes in certain living and death benefit features of our variable annuity products. During the second quarter of 2010, we removed the equity component of our capital hedge within the Individual Annuities segment by terminating the equity-based total return swaps, as part of a new program to more broadly address the equity market exposure of the statutory capital of the Company as a whole, under stress scenarios. Since the new program incorporates capital implications across a number of businesses, the results of that program are reported within Corporate and Other operations. Consequently, see “-Corporate and Other” for a discussion of the results of the current program. See “-Liquidity and Capital Resources-Liquidity and Capital Resources of Subsidiaries-Domestic Insurance Subsidiaries” for a further discussion of the capital hedge program. The results of the Individual Annuities segment included $21 million and $180 million for 2010 and 2009, respectively, of mark-to-market losses on these capital hedges prior to their termination, driven by favorable market conditions which resulted in an increase in our capital position. The results of these hedges are included in “Realized investment gains (losses), net and related adjustments” and have been excluded from adjusted operating income. We continue to assess the composition of the hedging program on an ongoing basis.
Revenues exclude Realized investment gains (losses), net, and related adjustments. See “-Realized Investment Gains and Losses and General Account Investments-Realized Investment Gains and Losses” and “-Experience-Rated Contractholder Liabilities, Trading Account Assets Supporting Insurance Liabilities and Other Related Investments.”
2011 to 2010 Annual Comparison. Adjusted operating income increased $26 million, from $572 million in 2010 to $598 million in 2011. The increase primarily reflects higher asset-based fee income, partially offset by lower net investment spread results and higher general and administrative expenses, net of capitalization. Also offsetting the increase in adjusted operating income is an unfavorable impact from 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.
Lower net investment spread results were driven by lower reinvestment rates, and the unfavorable impact of changes in the market values of alternative investments and equity investments in certain separate accounts. Partially offsetting these declines were the impact of lower crediting rates driven by rate resets in the first quarter of 2011 and higher general account stable value account values in our full service business. The impact of higher structured settlement product balances in our institutional investment products business was essentially offset by lower balances from guaranteed investment product scheduled withdrawals.
Higher general and administrative expenses, net of capitalization, were driven by costs related to legal matters and strategic initiatives. These increases in expenses were partially offset by a decline in charges related to certain cost reduction initiatives.
2010 to 2009 Annual Comparison. Adjusted operating income increased $78 million, from $494 million in 2009 to $572 million in 2010, primarily reflecting higher asset-based fee income and improved net investment spread results partially offset by an increase in general and administrative expenses, net of capitalization, and a less favorable benefit from reserve refinements.
Higher asset-based fees were driven by an increase in average full service fee-based retirement account values due to market appreciation and net additions, and higher fee-based investment-only stable value account values in our institutional investment products business driven by net additions.
Partially offsetting these increases in adjusted operating income was an increase in general and administrative expenses, net of capitalization, driven by expenses incurred in 2010 related to certain cost reduction initiatives. Also partially offsetting these increases in adjusted operating income was a less favorable benefit from reserve refinements, primarily due to a benefit in 2009 related to updates of client census data on our group annuity blocks of business.
Results for both 2010 and 2009 also include the impact of annual reviews of the assumptions used in our estimate of total gross profits used as a 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 2010 and 2009 included charges of $18 million and $3 million, respectively, from the annual reviews. The quarterly adjustments for current period experience resulted in an $11 million benefit in 2010 compared to a $5 million charge in 2009, reflecting the cumulative impact on amortization of differences between actual gross profits for the period and the previously estimated expected gross profits for the period. Together, these items resulted in net charges included in adjusted operating income of $7 million for 2010 and $8 million in 2009. The net charge of $7 million in 2010 was driven by changes in lapse rate and fee-based profit margin assumptions which both decreased expected future gross profits.
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” decreased $312 million, from $5,183 million in 2010 to $4,871 million in 2011. Premiums decreased $286 million, driven by lower life-contingent structured settlement and single premium annuity sales, partially offset by higher sales of non-participating group annuity separate accounts. The decrease in premiums resulted in a corresponding decrease in policyholders’ benefits, including the change in policy reserves, as discussed below. Net investment income decreased $60 million primarily reflecting lower portfolio yields and the unfavorable
impact of changes in the market values of equity method alternative investments and equity investments in certain separate accounts. Policy charges and fee income and asset management fees and other income increased $34 million, primarily driven by an increase in asset-based fees due to an increase in fee-based investment-only stable value account values in our institutional investment products business, and an increase in average full service fee-based retirement account values. These increases were partially offset by the unfavorable impact of changes in the market values of certain alternative investments accounted for under the fair value option.
Ending total account value for the full service business includes assets of Prudential’s retirement plan of $5.8 billion, $5.8 billion and $5.4 billion as of December 31, 2011, 2010 and 2009, respectively.
Other activity includes $469 million in 2011 representing the addition of Prudential’s non-qualified pension plan transferred from a third party administrator.
Ending total account value for the institutional investment products business includes assets of Prudential’s retirement plan of $5.8 billion, $5.4 billion and $5.2 billion as of December 31, 2011, 2010 and 2009, respectively. Ending total account value for the institutional investment products business also includes $1.5 billion as of December 31, 2011, 2010 and 2009 related to collateralized funding agreements issued to the Federal Home Loan Bank of New York (FHLBNY), and $0.5 billion, $1.0 billion and $1.8 billion as of December 31, 2011, 2010 and 2009, respectively, related to affiliated funding agreements issued using the proceeds from the sale of Prudential Financial retail medium-term notes. For additional information regarding the FHLBNY and the retail medium-term notes program see, “-Liquidity and Capital Resources.”
Withdrawals and benefits include $(78) million, $(752) million and $(488) million for 2011, 2010 and 2009, respectively, representing transfers of client balances from accounts we manage to externally-managed accounts. These withdrawals are offset within Other, as there is no net impact on ending account values for these transfers.
Ending total account value for the institutional investment products business includes investment-only stable value account values of $41.3 billion, $17.7 billion and $4.8 billion as of December 31, 2011, 2010 and 2009, respectively. Net additions (withdrawals) for the institutional investment products business include investment-only stable value account value additions of $23.9 billion, $12.6 billion and $4.8 billion for 2011, 2010 and 2009, respectively.
2011 to 2010 Annual Comparison. Adjusted operating income increased $172 million, from $487 million in 2010 to $659 million in 2011. Results in 2011 reflect an increase in asset management fees, before associated expenses, of $194 million primarily from retail and institutional customer assets as a result of higher asset values due to positive net asset flows primarily into fixed income accounts as well as market appreciation. In addition, results from the segment’s commercial mortgage activities increased $77 million primarily driven by lower net credit and valuation-related charges on interim loans of $64 million resulting primarily from loan payoffs in 2011 and $20 million of higher gains on sales of foreclosed commercial real estate assets in 2011. Also contributing to the increase in adjusted operating income was an increase in results of the segment’s strategic investing activities of $68 million primarily due to a $64 million gain resulting from the partial sale of a real estate seed investment in 2011.
These increases were partially offset by increased operating expenses, primarily related to compensation as well as other costs supporting the business.
2010 to 2009 Annual Comparison. Adjusted operating income increased $432 million, from $55 million in 2009 to $487 million in 2010 primarily reflecting more favorable results from commercial mortgage activities and more favorable investment results from strategic investing activities, as well as increased asset management fees. Asset management fees increased $224 million, before associated expenses, primarily from retail and institutional customer assets as a result of higher asset values due to market appreciation and positive net asset flows. Results from the segment’s commercial mortgage activities increased primarily driven by lower net credit and valuation-related charges on interim loans of $190 million.
Results from strategic investing activities increased $103 million, from a loss of $70 million in 2009 to income of $33 million in 2010, primarily due to improved results in real estate and fixed income investments. Real estate strategic investing results in 2009 reflect losses of $70 million, compared to income of $16 million in 2010, primarily reflecting the impact of declines in real estate values on co-investments and seed investments in the prior year. Results in 2009 also reflect losses of $11 million in a fixed income fund compared to zero in 2010. The Asset Management segment redeemed its entire investment in the fixed income fund as of June 30, 2009. In addition, strategic investing fixed income investment results in 2009 included impairments of $10 million on collateralized debt obligations, which as of December 31, 2010, have an amortized cost of zero.
The following tables set forth the Asset Management segment’s revenues, presented on a basis consistent with the table above under “-Operating Results,” by type and asset management fees by source for the periods indicated.
Includes payments from Wells Fargo under an agreement dated as of July 30, 2004 implementing arrangements with respect to money market mutual funds in connection with the combination of our retail securities brokerage and clearing operations with those of Wells Fargo. The agreement extends for ten years after termination of the Wachovia Securities joint venture, which occurred on December 31, 2009. The revenue from Wells Fargo under this agreement was $74 million in 2011, $66 million in 2010 and $61 million in 2009.
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $423 million, from $1,888 million in 2010 to $2,311 million in 2011. Asset management fees increased $194 million primarily from institutional and retail customer assets as a result of higher asset values from positive net asset flows and market appreciation. Service, distribution and other revenues increased $100 million from higher mutual fund service fees, a portion of which are offset with a corresponding increase in expenses. Service, distribution and other revenues also includes higher revenues from certain consolidated funds, which were fully offset by higher expenses related to noncontrolling interest in these funds. Commercial mortgage revenues increased $69 million primarily reflecting lower net credit and valuation-related charges on interim loans and higher gains on sales of foreclosed real estate assets, as discussed above. Strategic investing revenues increased $69 million resulting from a $64 million gain on a partial sale of a real estate seed investment in 2011.
2010 to 2009 Annual Comparison. Expenses increased $199 million, from $1,202 million in 2009 to $1,401 million in 2010 primarily driven by increased compensation costs due to higher incentive compensation, from increased revenues, as discussed above. In addition, expenses related to revenues associated with certain consolidated real estate funds and mutual funds services increased, as discussed above.
As of December 31, 2011, 2010, and 2009, includes $29.7 billion, $17.7 billion, and $4.0 billion, respectively, of assets under management related to investment-only stable value products.
Consists of: (a) individual mutual funds and both variable annuities and variable life insurance assets in our separate accounts; (b) funds invested in proprietary mutual funds through our defined contribution plan products; and (c) third-party sub-advisory relationships. 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. Assets under management were $537.3 billion at December 31, 2010, an increase of $80.5 billion from December 31, 2009. Institutional assets under management increased $46.9 billion from 2009 to 2010 driven by market appreciation of $20.6 billion, as well as net additions of $28.6 billion from third party clients, primarily from positive flows into fixed income accounts, including $10.2 billion of net additions associated with investment-only stable value products. Retail assets under management increased $16.8 billion from 2009 to 2010 driven primarily by market appreciation of $10.9 billion, as well as third-party net additions of $6.4 billion, primarily from positive net flows into equity accounts from existing clients. General account assets increased $16.8 billion driven by market appreciation.
The following table sets forth information regarding the interim loan portfolio of the Asset Management segment’s commercial mortgage operations as of the dates indicated.
Absent the effect of these items, adjusted operating income for 2011 decreased $6 million from 2010 including a $23 million increase in amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, resulting from changes in our estimates of total gross profits arising from separate account fund performance, which is described in more detail below. This increase in amortization largely reflects the impact of equity markets on separate account fund performance in the respective periods. The decrease in adjusted operating income also reflects the decline in earnings from our variable products primarily due to the runoff of variable policies in force. These decreases to adjusted operating income were partially offset by higher net investment spread income driven by higher asset balances supporting growth in our universal life insurance products, as well as the impact from mortality experience, net of reinsurance, which was $12 million less unfavorable relative to expected levels, compared to 2010.
following table shows the actual quarterly rate of return on separate accounts for the four quarters of 2011 and 2010 compared to our previously expected quarterly rate of return used in our estimates of total gross profits.
The overall lower than expected market returns in 2011 resulted in a decrease in total future gross profits by establishing a lower starting point for the fund balances used in estimating those profits in future periods. The decrease in our estimates of total gross profits resulted in a $9 million net expense in 2011 reflecting a higher required rate of amortization of deferred policy acquisition costs, partially offset by a higher required rate of amortization of unearned revenue reserves. The overall actual rate of return on separate account funds for 2010 was higher than our expected rate of return which resulted in an increase in total future gross profits by establishing a higher starting point for the fund balances used in estimating those profits in future periods. The increase in our estimates of total gross profits resulted in a $14 million net benefit in 2010 reflecting a lower required rate of amortization of deferred policy acquisition costs, partially offset by a lower required rate of amortization of unearned revenue reserves. For a further discussion of the assumptions, including our current near-term and long-term projected rates of return, used in estimating total gross profits used as the basis for amortizing deferred policy acquisition costs and unearned revenue reserves, see “-Accounting Policies & Pronouncements-Application of Critical Accounting Estimates.”
2010 to 2009 Annual Comparison. Adjusted operating income decreased $62 million, from $562 million in 2009 to $500 million in 2010. Results in 2010 included a $52 million benefit from lower amortization of net deferred policy acquisition costs and unearned revenue reserves, as well as a decrease in reserves for the guaranteed minimum death benefit feature in certain contracts, reflecting updates of our actuarial assumptions based on an annual review, compared to a $55 million benefit from the annual review in 2009. 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 2009 also included a $30 million benefit from compensation received based on multi-year profitability of third-party products we distribute. These compensation arrangements are subject to renegotiations periodically which will affect the amount of additional compensation we are eligible to receive. The largest of these arrangements was renegotiated in 2008 and the profit opportunities were reduced significantly in 2010 and beyond resulting in a benefit of less than $1 million in 2010.
increase included a $24 million reduction in amortization of unearned revenue reserves due to annual reviews of assumptions. Absent this item, policy charges and fees and asset management fees and other income increased $32 million driven by an increase in current period amortization of unearned revenue reserves due to changes in our estimates of total gross profits primarily reflecting the impact of less favorable market conditions on separate account fund performance in 2011 compared to 2010, as well as the impact of higher actual gross profits during the period. These increases were partially offset by a decline in revenue from our variable insurance products, primarily due to the runoff of variable policies in force.
2011 to 2010 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” increased $68 million, from $2,315 million in 2010 to $2,383 million in 2011. Absent the impact of annual reviews conducted in both periods, benefits and expenses increased $115 million, from $2,468 million in 2010 to $2,583 million in 2011. On this basis, amortization of deferred policy acquisition costs increased $26 million driven by changes in estimated total gross profits primarily reflecting the impact of less favorable market conditions on separate account fund performance in 2011 compared to 2010, as well as the impact of higher actual gross profits on current period amortization. Absent the impact of the annual reviews, policyholders’ benefits, including interest credited to policyholders’ account balances, increased $15 million primarily reflecting an increase in interest credited to policyholders from higher universal life account balances from increased policyholder deposits and increases in policyholder reserves driven by growth in our term and universal life blocks of business. Partially offsetting the increase in policyholders’ benefits, including interest credited to policyholders’ account balances, was less unfavorable mortality experience of $12 million in 2011 compared to 2010. Interest expense increased $52 million primarily reflecting higher borrowings related to the financing of regulatory capital requirements associated with statutory reserves for certain term and universal life insurance policies.
2010 to 2009 Annual Comparison. Benefits and expenses increased $109 million, from $2,206 million in 2009 to $2,315 million in 2010. Absent the net $28 million decrease from the impacts of the annual reviews conducted in both periods, benefits and expenses increased $137 million, from $2,331 million in 2009 to $2,468 million in 2010. Absent the impact of the annual reviews, policyholders’ benefits, including interest credited to policyholders, increased $141 million due to growth in universal life and variable policyholder account balances, increases in policyholder reserves, and growth in our in force block of term and universal life business. In addition, mortality experience was slightly unfavorable, relative to expected levels in 2010, compared to favorable mortality experience in 2009 contributing $33 million to the increase in policyholder benefits. Also absent the impact of the annual reviews, amortization of deferred policy acquisition costs increased $23 million primarily due to the less favorable impact of equity markets on separate account fund performance, partially offset by both the impact of policyholder persistency which in 2010 returned to levels more consistent with expectations, as well as mortality experience. Partially offsetting these items was a decrease in interest expense of $19 million primarily driven by a decline in interest rates on floating rate debt. This floating rate debt is swapped to a fixed rate using interest rate swaps.
2011 to 2010 Annual Comparison. Sales of new life insurance, measured as described above, increased $18 million, from $260 million in 2010 to $278 million in 2011, primarily driven by increased sales in the third party distribution channel reflecting a $18 million increase in sales of universal life insurance products driven by a change in the competitive position of our products due to pricing.
2011 to 2010 Annual Comparison. Adjusted operating income decreased $7 million, from $215 million in 2010 to $208 million in 2011. Reserve refinements in both group life and group disability businesses, including the impact of annual reviews, contributed a $26 million benefit to adjusted operating income in 2011 compared to a benefit of $28 million in 2010. Excluding these reserve refinements, adjusted operating income decreased $5 million primarily from less favorable group disability underwriting results in 2011 primarily related to an increase in the number and severity of long-term disability claims reflecting the continued economic downturn. In addition, the decrease in adjusted operating income reflects higher operating expenses in 2011 resulting from business growth and strategic initiatives as well as a decrease in investment results in 2011 due to less favorable results from alternative investments and the impact of the current low interest rate environment on portfolio yields. These decreases were partially offset by more favorable underwriting results in 2011 in our group life business related to favorable claims experience and growth in our non-retrospectively experience-rated business. In addition, 2011 included a $14 million benefit from cumulative premium adjustments relating to prior periods on two large group life non-retrospectively experience-rated cases.
2011 to 2010 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” increased $617 million, from $5,243 million in 2010 to $5,860 million in 2011. This increase reflects a $566 million increase in policyholders’ benefits, including the change in policy reserves, from $4,259 million in 2010 to $4,825 million in 2011. Our group life business reflected an increase in policyholders’ benefits primarily from growth in the business, including an increase in benefits on retrospectively experience-rated business that resulted in increased premiums, as discussed above. Our group disability business reflected an increase in policyholders’ benefits primarily from an increase in the number and severity of disability claims, as well as growth in the business, partially offset by the effect of the assumption of existing liabilities from third parties in 2010, which is offset in premiums, as discussed above. Also contributing to the increase in benefits and expenses were higher operating expenses primarily related to business growth and strategic initiatives.
The group life benefits ratio improved 0.2 percentage points from 2010 to 2011, primarily due to favorable claims experience, partially offset by an unfavorable variance from the impact of reserve refinements, including the impact of annual reviews, in 2011, as discussed above. The group disability benefits ratio deteriorated 2.8 percentage points from 2010 to 2011 primarily due to unfavorable long-term disability claims experience, partially offset by a favorable variance from the impact of reserve refinements, including the impact of annual reviews, in 2011, as discussed above. The group life administrative operating expense ratio improved 0.5 percentage points from 2010 to 2011 due to business growth without a commensurate increase in expenses and a favorable impact from the refinement of a premium tax estimate. The group disability administrative operating expense ratio was relatively unchanged from 2010 to 2011 as the impact from higher expenses in 2011 primarily from business growth and strategic initiatives was offset by a favorable impact from the refinement of a premium tax estimate.
2010 to 2009 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” increased by $289 million, from $4,954 million in 2009 to $5,243 million in 2010. This increase reflects a $243 million increase in policyholders’ benefits, including the change in policy reserves, from $4,016 million in 2009 to $4,259 million in 2010, from both group life and group disability businesses. Our group life business reflected an increase in policyholders’ benefits from less favorable claims experience, including an increase in benefits on retrospectively experience-rated business that resulted in increased premiums, partially offset by the benefit of reserve refinements in 2010 and a decrease in policyholder benefits associated with the assumption of existing liabilities from third parties, which is offset in premiums, as discussed above. Our group disability business also reflected less favorable claims experience, partially offset by a decrease in policyholder benefits associated with the assumption of existing liabilities from third parties, which is offset in premiums, as discussed above. Also contributing to the increase in benefits and expenses were higher operating expenses, as discussed above.
The group life benefits ratio deteriorated 1.3 percentage points from 2009 to 2010, due to less favorable claims experience due to an increase in the number and severity of claims, as well as the lapse of certain business and repricing of other business up for renewal with favorable claims experience in 2009, reflecting the
As a U.S.-based company with significant business operations outside the U.S., particularly in Japan, we are subject to foreign currency exchange rate movements that could impact our U.S. dollar-equivalent earnings or our equity in foreign subsidiaries. We seek to mitigate this impact through various hedging strategies, including the use of derivative contracts and through holding U.S. dollar-denominated assets in certain of our foreign subsidiaries.
The table below presents the aggregate amount of instruments that serve to hedge the impact of foreign currency exchange movements on our U.S. dollar-equivalent earnings and U.S. dollar-equivalent equity in our Japanese insurance subsidiaries for the periods indicated.
Excludes $24.5 billion and $10.2 billion as of December 31, 2011 and 2010, respectively, of U.S. dollar assets supporting U.S. dollar liabilities related to U.S. dollar-denominated products issued by our Japanese insurance operations, of which $11.7 billion as of December 31, 2011 supports U.S. dollar-denominated products issued by Star and Edison.
Results of Corporate and Other operations include any differences between the translation adjustments recorded by the segment at the fixed rate and the gains or losses recorded from the forward currency contracts that settled during the period, which includes the impact of any over or under hedging of actual earnings that differ from projected earnings. The table below presents, for the periods indicated, the increase (decrease) to revenues and adjusted operating income for the International Insurance segment and for Corporate and Other operations, reflecting the impact of this intercompany arrangement.
Represents the difference between non-U.S. dollar-denominated earnings translated on the basis of weighted average monthly currency exchange rates versus fixed currency exchange rates determined in connection with the forward currency hedging program.
In addition, our Japanese insurance operations hold dual currency investments in the form of fixed maturities and loans. The principal of these dual currency investments are yen-denominated while the related
interest income is U.S. dollar-denominated. These investments are the economic equivalent of exchanging what would otherwise be fixed streams of yen-denominated interest income for fixed streams of U.S. dollar-denominated interest income. Our Japanese insurance operations, excluding Star and Edison, also hold yen-denominated investments that have been coupled with cross-currency coupon swap agreements, creating synthetic dual currency investments. The yen/U.S. dollar exchange rate is effectively fixed, as we are obligated in future periods to exchange fixed amounts of Japanese yen interest payments generated by the yen-denominated investments for fixed amounts of U.S. dollar interest payments at the yen/U.S. dollar exchange rates specified by the cross-currency coupon swap agreements. As of December 31, 2011 and 2010, the notional amount of these investments was ¥280 billion, or $2.5 billion, and ¥357 billion, or $3.2 billion, respectively, based upon the foreign currency exchange rates applicable at the time these investments were acquired. The weighted average yields generated by these investments were 3.0%, 2.8% and 2.9% for the years ended December 31, 2011, 2010 and 2009, respectively.
Our international insurance operations primarily offer products denominated in local currency. However, our Japanese insurance operations also offer products denominated in non-local currencies, primarily comprised of U.S. and Australian dollar-denominated products. The non-yen denominated insurance liabilities related to these products are supported by investments denominated in corresponding currencies, including a significant portion designated as available-for-sale, and other related non-yen denominated net assets, including accrued investment income, to support these products. These assets and liabilities are impacted by foreign currency exchange rate movements, as they are non-yen denominated items on the books of yen-based entities. While these non-yen denominated assets and liabilities are economically hedged, the accounting for changes in the value of these assets and liabilities due to changes in foreign currency exchange rate movements differs, resulting in volatility in U.S. GAAP earnings. For example, available-for-sale investments under U.S. GAAP are carried at fair value with changes in fair value (except as described below for impairments), including those from changes in foreign currency exchange rate movements, recorded as unrealized gains or losses in “Accumulated other
Excludes $24.5 billion and $10.2 billion as of December 31, 2011 and 2010, respectively, of U.S. dollar assets supporting U.S. dollar liabilities related to U.S. dollar-denominated products issued by our Japanese insurance operations.
Available-for-sale investments under U.S. GAAP are carried at fair value with unrealized changes in fair value (except as described below for impairments), including those from changes in foreign currency exchange rate movements, recorded as unrealized gains or losses in “Accumulated other comprehensive income (loss).” Changes in the U.S. GAAP equity of our Japanese insurance operations due to foreign currency exchange rate movements are also recorded in “Accumulated other comprehensive income (loss)” as a “Foreign currency translation adjustment,” and can serve as an offset to the unrealized changes in fair value of the available-for-sale investments. For the portion of available-for-sale investments that support our Japanese insurance operations’ U.S. GAAP equity, this offset creates a “natural equity hedge.” If U.S. dollar-denominated investments, including available-for-sale investments, supporting the hedge are in excess of our U.S. GAAP equity, then there is no offsetting impact to equity. In addition, the impact of foreign currency exchange rate movements on the U.S. GAAP equity of our Japanese insurance operations is partially offset by foreign currency exchange related changes in designated yen-denominated debt and other hedging instruments held in our U.S. domiciled entities and recorded in “Accumulated other comprehensive income (loss)” as a “Foreign currency translation adjustment.”
We also incorporate the impact of foreign currency exchange rate movements on the remaining U.S. dollar-denominated net asset position of our Japanese insurance operations, which primarily relates to accrued investment income, as part of our overall application of the hedge strategy. These U.S. dollar-denominated assets and liabilities are remeasured for foreign currency exchange rate movements, as they are non-yen denominated items on the books of yen-based entities, and the related change in value is recorded within “Asset management fees and other income.” The remeasurement related to the change in value for foreign currency exchange rate movements for these items is excluded from adjusted operating income.
including for constant dollar information discussed below. The exchange rates used were Japanese yen at a rate of 85 yen per U.S. dollar and Korean won at a rate of 1180 won per U.S. dollar, both of which were determined in connection with the foreign currency income hedging program discussed above. In addition, for constant dollar information discussed below, activity denominated in U.S. dollars is reported based on the amounts as transacted in U.S. dollars. Annualized new business premiums presented on a constant exchange rate basis in the “Sales Results” section below reflect translation based on these same uniform exchange rates.
Revenues exclude related charges resulting from payments related to market value adjustment features of certain of our annuity products and the impact of Realized investment gains (losses), net, on the amortization of unearned revenue reserves. Benefits and expenses exclude related charges that represent the element of “Dividends to policyholders” that is based on a portion of certain realized investment gains required to be paid to policyholders and the impact of Realized investment gains (losses), net, on the amortization of deferred policy acquisition costs.
On April 6, 2011, the Company entered into a stock and asset purchase agreement to sell all of the issued and outstanding shares of capital stock of the Company’s subsidiaries that conduct its Global Commodities Business and certain assets that are primarily used in connection with the Global Commodities Business. As a result, we have reflected the results of the Global Commodities Business as discontinued operations for all periods presented. This sale was completed on July 1, 2011.
On February 1, 2011, Prudential Financial completed the acquisition from American International Group, Inc., or AIG, of AIG Star Life Insurance Co., Ltd., or Star, AIG Edison Life Insurance Company, or Edison, and certain other AIG subsidiaries (collectively, the “Star and Edison Businesses”) pursuant to the stock purchase agreement dated September 30, 2010 between Prudential Financial and AIG. The total purchase price was $4,709 million, comprised of $4,213 million in cash and $496 million in assumed third party debt, substantially all of which is expected to be repaid, over time, with excess capital of the acquired entities. All acquired entities are Japanese corporations and their businesses are in Japan.
The Gibraltar Life operations, including the Star and Edison Businesses, use a November 30 fiscal year end for purposes of inclusion in the Company’s Consolidated Financial Statements. Therefore, operating results presented in the table above includes results for Gibraltar Life for the twelve months ended November 30, 2011, 2010 and 2009, and include earnings for the Star and Edison Businesses from the February 1, 2011 acquisition date through November 30, 2011.
On May 1, 2009, our Gibraltar Life operations acquired Yamato Life, a Japanese life insurance company that declared bankruptcy in October 2008. Gibraltar Life served as the reorganization sponsor for Yamato and under the reorganization agreement acquired Yamato by contributing $72 million of capital to Yamato. Concurrent with our acquisition, substantially all of Yamato’s insurance liabilities were restructured under a plan of reorganization to include special surrender penalties on existing policies. These surrender charges were 20% in the first year and decline by 2% each year thereafter. Subsequent to the acquisition, we renamed the acquired company The Prudential Gibraltar Financial Life Insurance Company, Ltd., or Prudential Gibraltar.
Adjusted operating income from our Gibraltar Life and Other operations increased $520 million, from $816 million in 2010 to $1,336 million in 2011, including a favorable impact of $29 million from currency
Revenues from our Gibraltar Life and Other operations increased $6,620 million, from $4,954 million in 2010 to $11,574 million in 2011, including a favorable impact of $623 million from currency fluctuations. Excluding the impact of currency fluctuations, revenues for Gibraltar Life increased $5,997 million, from $5,197 million in 2010 to $11,194 million in 2011. This increase reflects a $4,714 million increase in premiums and policy charges and fee income, from $3,652 million in 2010 to $8,366 million in 2011, of which $2,920 million was associated with the acquired Star and Edison Businesses. Excluding Star and Edison, the increase in premiums and policy charges and fee income was primarily driven by growth in protection products within the bank distribution channel including $1,062 million higher sales of single premium whole life. Also contributing to the increase in revenues is favorable investment income primarily reflecting $816 million of income on the acquired assets from Star and Edison and continued growth of our fixed annuity products, as well as higher other income reflecting the impact of the partial sales of our indirect investment in China Pacific Group and the sale of the investment in Afore XXI, discussed above.
In some of the markets in which we operate, it is difficult to find appropriate long-duration assets to match the characteristics of our long-duration product liabilities. In Japan, we have historically sought to increase the duration of our Japanese yen investment portfolio by employing various strategies, including investing in longer-term securities or by entering into long-duration floating-to-fixed interest rate swaps. These strategies better support the characteristics of our long-dated product liabilities and have resulted in higher portfolio yields. Based on an evaluation of market conditions, beginning in the fourth quarter of 2008 and continuing into the first quarter of 2009, we terminated or offset many of these interest rate swaps in consideration of, among other things, the interest rate environment. The resulting realized investment gains from terminating or offsetting these interest rate swaps will be recognized in adjusted operating income over periods that generally approximate the expected terms of the derivatives. For 2011, 2010 and 2009, we recognized gains of $55 million, $38 million, and $30 million, respectively, in adjusted operating income related to these realized investment gains (losses). As of December 31, 2011, $657 million of deferred gains remain to be recognized in adjusted operating income over a weighted average period of 29 years. We continue to manage the interest rate risk profile of our businesses in the context of market conditions and relative opportunities, and may implement these hedging strategies to lengthen the duration of our Japanese investment portfolio as our assessment of market conditions dictates. As we do so, the impact to our portfolio yields will depend on the interest rate environment at that time.
2010 to 2009 Annual Comparison. Revenues increased $1,628 million, from $10,592 million in 2009 to $12,220 million in 2010, including a net favorable impact of $491 million relating to currency fluctuations. Excluding the impact of currency fluctuations, revenues increased $1,137 million, from $11,496 million in 2009 to $12,633 million in 2010.
Revenues from our Gibraltar Life and Other operations increased $805 million, from $4,149 million in 2009 to $4,954 million in 2010, including a favorable impact of $195 million from currency fluctuations. Excluding the impact of currency fluctuations, revenues for Gibraltar Life increased $610 million, from $4,587 million in
2009 to $5,197 million in 2010. This increase reflects a $417 million increase in premiums, from $3,150 million in 2009 to $3,567 million in 2010, as premiums benefited from $50 million of renewal premiums from the acquisition of Yamato, higher first year premiums of $229 million due to stronger sales of protection products primarily through our bank distribution channels, as well as $173 million in higher sales of single premium whole life products. Partially offsetting these favorable variances in premiums was a decrease of $101 million, reflecting the completion of the special dividend arrangement in the second quarter of 2010 established as part of Gibraltar Life’s reorganization in 2001. Substantially all of the premiums recognized as additional face amounts of insurance issued pursuant to the special dividend arrangement were offset by a corresponding charge to increase reserves for the affected policies. Also contributing to the increase in revenues is favorable investment income reflecting the continued growth of our fixed annuity products and higher other income primarily reflecting the pre-tax benefit of $66 million related to the partial sale of our indirect investment in China Pacific Group discussed above.
2011 to 2010 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” increased $6,948 million, from $10,135 million in 2010 to $17,083 million in 2011, including a net unfavorable impact of $989 million related to currency fluctuations. Excluding the impact of currency fluctuations, benefits and expenses increased $5,959 million, from $10,326 million in 2010 to $16,285 million in 2011.
Benefits and expenses of our Gibraltar Life and Other operations increased $636 million, from $3,502 million in 2009 to $4,138 million in 2010, including an unfavorable impact of $173 million from currency fluctuations. Excluding the impact of currency fluctuations, benefits and expenses increased $463 million, from $3,787 million in 2009 to $4,250 million in 2010. This increase reflects an increase in policyholder benefits, including changes in reserves, of $371 million reflecting higher single premium whole life sales in 2010 and the acquisition of Yamato, offset by the effects of the special dividend arrangement discussed above. Also contributing to the increase in benefits and expenses is higher amortization of deferred policy acquisition costs related to growth of our protection products and the increase in single premium whole life sales, as well as higher general and administrative expenses including $11 million of expenses associated with the acquisition of the Star and Edison Businesses. Included in general and administrative expenses for Gibraltar Life is $18 million of expenses, unchanged from the prior year, related to the recently completed information processes and technology systems initiative discussed above.
In managing our international insurance business, we analyze revenues, as well as annualized new business premiums, which do not correspond to revenues under U.S. GAAP. Annualized new business premiums measure the current sales performance of the segment, while revenues primarily reflect the renewal persistency of policies written in prior years and net investment income, in addition to current sales. Annualized new business premiums include 10% of first year premiums or deposits from single pay products. No other adjustments are made for limited pay contracts. The following table sets forth annualized new business premiums on an actual and constant exchange rate basis for the periods indicated.
The year ended December 31, 2011 includes ten months of annualized new business premiums for the Star and Edison Businesses, acquired February 1, 2011.
Australian dollars. The addition of the Star and Edison Businesses, with historical product offerings primarily comprised of individual life insurance, fixed annuities and certain health products with fixed benefits, significantly increases our scale in the Japanese insurance marketplace and also provides complementary distribution capabilities through an increased captive agency force, expanded bank channel distribution, as well as the addition of an established independent agency channel.
The table below present annualized new business premiums on a constant exchange rate basis, by product and distribution channel, for the periods indicated.
2011 to 2010 Annual Comparison. On a constant exchange rate basis, annualized new business premiums increased $1,170 million, from $1,870 million in 2010 to $3,040 million in 2011.
Annualized new business premiums, on a constant exchange rate basis, from our Gibraltar Life operations increased $1,046 million, from $897 million in 2010 to $1,943 million in 2011, with Star and Edison contributing $728 million to this increase. Annualized new business premiums for Star include approximately $120 million of sales from an increasing term product that was discontinued upon completion of the merger with Gibraltar. Excluding Star and Edison, the increase in annualized new business premiums was driven by higher bank channel sales of $220 million, primarily due to increased sales of protection products including $129 million
The number of Life Planners increased by 227 from 6,565 as of December 31, 2010 to 6,792 as of December 31, 2011, driven by an increase of 84 in Brazil due to stronger recruitment, as well as increases of 62 in Korea, 32 in Poland, 31 in Italy and 15 in Japan. Over the past twelve months, there were 35 Japanese Life Planners transferred to Gibraltar Life, primarily in support of our efforts to expand our bank channel distribution and to service orphaned policyholders. Prior to December 31, 2010, an additional 396 Japanese Life Planners were transferred to Gibraltar Life.
The number of Life Advisors increased by 6,510 from 6,281 as of December 31, 2010 to 12,791 as of December 31, 2011, primarily driven by the Star and Edison acquisition. As of December 31, 2011, 6,550 Life Advisors were associated with the acquired businesses of Star and Edison, reflecting a decrease of 719 from the 7,269 Life Advisors as of the February 1, 2011 date of acquisition as recruitments were more than offset by terminations and resignations.
Includes medical insurance, cancer insurance and accident & sickness riders. The years ended December 31, 2010 and 2009 includes $211 million and $89 million, respectively, of annualized new business premiums from cancer insurance products.
We base premiums and cash values in most countries in which we operate on mandated mortality and morbidity tables. Our mortality and morbidity experience in the International Insurance segment on an overall basis in the years ended December 31, 2011, 2010 and 2009 was well within our pricing assumptions and below the guaranteed levels reflected in the premiums we charge.
Corporate and Other includes corporate operations, after allocations to our business segments.
2011 to 2010 Annual Comparison. The loss from Corporate and Other operations, on an adjusted operating income basis, increased $204 million, from $923 million in 2010 to $1,127 million in 2011. Corporate and Other operations recorded a $93 million increase in expenses 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. Corporate and Other operations also recorded a $20 million charge related to a voluntary contribution to an insurance industry insolvency fund, related to Executive Life Insurance Company of New York. Greater net charges from other corporate activities, primarily reflecting increased retained corporate expenses, including corporate advertising, contributed to the increased loss. The increase in net charges from other corporate activities was partially offset by more favorable results from corporate foreign currency hedging activities and reduced charges compared to the prior period for certain retained obligations relating to pre-demutualization policyholders to whom we had previously agreed to provide insurance for reduced or no premium in accordance with contractual settlements related to prior individual life insurance sales practices remediation. Capital debt interest expense increased $67 million due to a greater level of capital debt, which includes the issuance in November 2010 of $1 billion of debt for the acquisition of the Star and Edison Businesses. Investment income, net of interest expense, excluding capital debt interest expense, increased $39 million due to higher income in our corporate investment portfolio including higher income on equity method investments. Higher levels of short-term liquidity have been maintained throughout 2010 and into 2011 to provide additional flexibility to address our cash needs in view of changing financial market conditions. On February 1, 2011, we used a portion of cash and short-term investments in Corporate and Other operations to partially fund the purchase price related to our recent acquisition of the Star and Edison Businesses. Also, 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. During 2011, the Company made share repurchases of $999.5 million. See “-Liquidity and Capital Resources” for additional details.
Results from Corporate and Other operations pension income and employee benefits decreased $7 million. The decrease reflects increases in employee benefits costs partially offset by an increase in income from our qualified pension plan. Income from our qualified pension plan increased $13 million, from $308 million in 2009 to $321 million in 2010.
Corporate and Other operations includes the results of our Capital Protection Framework, which includes, among other things, the capital hedge program. The capital hedge program broadly addresses the equity market exposure of the statutory capital of the Company as a whole, under stress scenarios, as described under “-Liquidity and Capital Resources-Liquidity and Capital Resources of Subsidiaries-Domestic Insurance Subsidiaries.” This hedge program resulted in charges for amortization of derivative costs of $21 million and $8 million for the years ended December 31, 2011 and 2010, respectively. The market value changes of these derivatives included in “Realized investment gains (losses), net and related adjustments” was a gain of $9 million and a loss of $7 million for the years ended December 31, 2011 and 2010, respectively.
In addition, we manage certain risks associated with our variable annuity products through our living benefit hedging program, which is described under “-U.S. Retirement Solutions and Investment Management Division-Individual Annuities.” We evaluate hedge levels versus our hedge target based on the overall capital considerations of the Company and prevailing capital market conditions. The GAAP/capital markets valuation framework underlying our hedge target assumes that current interest rate levels remain for the full projection period with no reversion to longer term averages. Due to the recent low interest rate environment, we decided to temporarily hedge to an amount that differs from our hedge target definition to be consistent with our long-term economic view. Because this decision was 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. For the years ended December 31, 2011 and 2010, “Realized investment gains (losses), net, and related adjustments” includes a loss of $1,662 million and a gain of $306 million, respectively, resulting from our decision to temporarily hedge to a different target and the change in interest rates during the years. Through our Capital Protection Framework, we have access to on-balance sheet capital and contingent sources of capital that is available to meet capital needs arising from our decision to temporarily hedge to an amount that differs from our hedge target definition, including funding of the after-tax realized investment losses incurred in 2011. For more information on the Company’s Capital Protection Framework, see “-Liquidity and Capital Resources.”
change in value of derivatives, including interest rate swaps and futures. 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.”
2011 to 2010 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” decreased $71 million, from $7,086 million in 2010 to $7,015 million in 2011, principally driven by a $89 million decrease in premiums, with a related decrease in changes in reserves, primarily due to the expected in force decline as policies terminate and the $33 million decrease in net investment income primarily due to lower portfolio yields. Partially offsetting these items was an increase of $51 million in net realized investment gains, as discussed above.
2010 to 2009 Annual Comparison. Revenues, as shown in the table above under “-Operating Results,” increased $1,841 million, from $5,245 million in 2009 to $7,086 million in 2010, principally driven by the $2,079 million increase in net realized investment gains (losses) and an increase of $69 million in net investment income, as discussed above. Partially offsetting these items was a decline in premiums, with a related decrease in changes in reserves, primarily due to a lower amount of dividends available for policyholders to purchase additional insurance, as a result of the 2010 dividend scale reduction, and to a lesser extent, the expected in force decline as policies terminate.
2011 to 2010 Annual Comparison. Benefits and expenses, as shown in the table above under “-Operating Results,” increased $457 million, from $6,361 million in 2010 to $6,818 million in 2011. This increase included a $500 million increase in dividends to policyholders reflecting an increase in the policyholder dividend obligation expense of $510 million, from $126 million in 2010 to $636 million in 2011, partially offset by a decrease in dividends paid and accrued to policyholders of $10 million, primarily due to a decline in policies in force. Partially offsetting this increase was a decrease in policyholders’ benefits, including changes in reserves of $30 million primarily due to the impact of the decline in premiums, partially offset by an 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, as discussed above. Also, amortization of deferred policy acquisition costs decreased $13 million reflecting the impact of lower investment gains in the calculation of actual gross profits for the period compared to the prior period.
Our income tax provision amounted to an income tax expense of $1,599 million in 2011 compared to $1,303 million in 2010. The increase in income tax expense reflects the increase in pre-tax income from continuing operations before income taxes and equity in earnings of operating joint ventures for the year ended December 31, 2011. In addition, our 2011 income tax expense includes an additional U.S. tax expense of $246 million related to the realization of a portion of the local deferred tax assets existing on the opening balance sheet for the Star and Edison Businesses. The local utilization of the deferred tax asset coupled with the repatriation assumption for the applicable earnings of our Japanese entities, creates the effect of a “double tax” for U.S. GAAP purposes. In addition, 2011 income tax expense includes a charge for the remeasurement of the deferred tax liabilities in the amount of $28 million related to a tax rate increase in Korea. These increases in annual tax expense were partially offset by a 2011 tax benefit of $42 million for the reversal of the valuation allowance against deferred tax assets for loss carryforwards of a Japanese insurance subsidiary and a $70 million tax benefit for the release of a liability for unrecognized tax benefits related to the conclusion of the federal tax audit for tax years 2004 through 2006. Furthermore, income tax expense for 2010 included a charge for the reduction of deferred tax assets in the amount of $94 million related to the Medicare Part D subsidy. In 2010, the Company recognized a higher tax expense of $21 million reflecting an increased valuation allowance against the state and local deferred tax assets of certain non-insurance subsidiaries.
Primarily represents commercial mortgage securitization operations and Prudential Securities Capital Markets and exchange traded shares previously held by Prudential Equity Group.
majority of investments supporting these experience-rated products are classified as trading and are carried at fair value. These trading investments are reflected on the statements of financial position as “Trading account assets supporting insurance liabilities, at fair value” (“TAASIL”). Realized and unrealized gains and losses for these investments are reported in “Asset management fees and other income.” Interest and dividend income for these investments is reported in “Net investment income.” To a lesser extent, these experience-rated products are also supported by derivatives and commercial mortgage and other loans. The derivatives that support these experience-rated products are reflected on the statement of financial position as “Other long-term investments” and are carried at fair value, and the realized and unrealized gains and losses are reported in “Realized investment gains (losses), net.” The commercial mortgage and other loans that support these experience-rated products are carried at unpaid principal, net of unamortized discounts and an allowance for losses, and are reflected on the statements of financial position as “Commercial mortgage and other loans.” Gains and losses on sales and changes in the valuation allowance for commercial mortgage and other loans are reported in “Realized investment gains (losses), net.”
As shown in the table above, the net impacts for the Retirement segment of changes in experience-rated contractholder liabilities and investment gains and losses on trading account assets supporting insurance liabilities and other related investments were net losses of $51 million and $74 million and net gains of $527 million for the years ended December 31, 2011, 2010 and 2009, respectively. These impacts primarily reflect timing differences between the recognition of the mark-to-market adjustments and the recognition of the recovery of these adjustments in future periods through subsequent increases in asset values or reductions in crediting rates on contractholder liabilities for partially participating products. These impacts also reflect the difference between the fair value of the underlying commercial mortgage and other loans and the amortized cost, less any valuation allowance, of these loans, as described above.
As shown in the table above, the International Insurance segment includes offsetting impacts, in all periods, from changes in investment gains and losses on trading account assets supporting insurance liabilities and experience-rated contractholder liabilities.
The authoritative guidance related to fair value established a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three levels. The level in the fair value hierarchy within
which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. See Note 20 to the Consolidated Financial Statements for a description of these levels.
The tables below present the balances of assets and liabilities measured at fair value on a recurring basis, as of December 31, 2011 and 2010, split between the Financial Services Businesses and Closed Block Business, by fair value hierarchy level. See Note 20 to the Consolidated Financial Statements for the balances of assets and liabilities measured at fair value on a recurring basis presented on a consolidated basis.
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 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 3% for our Financial Services Businesses. The amount of Level 3 liabilities was immaterial to our balance sheet.
For a description of the key estimates and assumptions used in our determination of fair value, see Note 20 to the Consolidated Financial Statements. The following sections provide additional information regarding certain assets and liabilities of our Financial Services Businesses and our Closed Block Business which are valued using Level 3 inputs and could have a significant impact on our results of operations. Information regarding separate account assets is excluded as the risk of assets for these categories is primarily borne by our customers and policyholders.
The impact our determination of fair value for fixed maturity and equity securities has on our results of operations is dependent on our classification of the security as either trading, available-for-sale, or held-to-maturity. For our investments classified as trading, the impact of changes in fair value is recorded within “Asset management fees and other income.” For our investments classified as available-for-sale, the impact of changes in fair value is recorded as an unrealized gain or loss in “Accumulated other comprehensive income (loss),” a separate component of equity. Our investments classified as held-to-maturity are carried at amortized cost.
Derivatives classified as Level 3 include first-to-default credit basket swaps, look-back equity options and other structured products. These derivatives are valued based upon models with some significant unobservable market inputs or inputs from less actively traded markets. Derivatives classified within Level 3 are validated through periodic comparison of our fair values to broker-dealer values. The fair values of OTC derivative assets and liabilities classified as Level 3 totaled approximately $84 million and $3 million, respectively, as of December 31, 2011 and $126 million and $3 million, respectively, as of December 31, 2010, without giving consideration to the impact of netting.
All realized and unrealized changes in fair value of derivatives, with the exception of the effective portion of qualifying cash flow hedges and hedges of net investments in foreign operations, are recorded in current earnings. Generally, the changes in fair value of non-dealer related derivatives, excluding those that qualify for hedge accounting, are recorded in “Realized investment gains (losses), net.” For additional information regarding the impact of changes in fair value of derivative instruments on our results of operations see “-Realized Investment Gains and Losses and General Account Investments-Realized Investment Gains and Losses.” Dealer related derivative activity related to the Company’s former global commodities group is reported in “Income (loss) from discontinued operations, net of taxes.”
We are also required to incorporate the market-perceived risk of our own non-performance (“NPR”) in the valuation of the embedded derivatives associated with our optional living benefit features. Since insurance liabilities are senior to debt, we believe that reflecting the financial strength ratings of our insurance subsidiaries in the valuation of the liability appropriately takes into consideration our NPR. To reflect the NPR, we incorporate an additional credit spread over LIBOR rates into the discount rate used in the valuations of the embedded derivative liability. The additional credit spread over LIBOR rates incorporated into the discount rate as of December 31, 2011 generally ranged from 150 to 250 basis points for the portion of the interest rate curve most relevant to these liabilities. This additional spread is applied at an individual contract level and only to those individual living benefit contracts in a liability position and not to those in a contra-liability position. We also adjust these spreads to remove any illiquidity risk premium, subject to a floor based on a percentage of the credit spread.
As of December 31, 2011, the value of the embedded derivatives associated with the optional living benefit features of the Individual Annuities segment, before the adjustment for NPR, was a net liability of $8,341 million. This net liability was comprised of $8,555 million of individual living benefit contracts in a liability position, net of $214 million of individual living benefit contracts in a contra-liability position. As of December 31, 2011, our adjustment for NPR resulted in a $5,509 million cumulative decrease to the embedded derivative liability for the Individual Annuities segment, reflecting the additional credit spread over LIBOR rates we incorporated into the discount rate used in the valuations of those individual living benefit contracts in a liability position. This adjustment for NPR represents an increase of $4,786 million in 2011 for the Individual Annuities segment primarily resulting 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 spreads used in valuing NPR, which reflect the financial strength ratings of our insurance subsidiaries. Partially offsetting these items was a $506 million charge relating to a refinement to the calculation of the NPR that we implemented in the fourth quarter of 2011, which incorporates a floor to the illiquidity risk premium reduction at a percentage of the credit spread.
Realized investment gains and losses are generated from numerous sources, including the sale of fixed maturity securities, equity securities, investments in joint ventures and limited partnerships and other types of investments, as well as adjustments to the cost basis of investments for other-than-temporary impairments. Realized investment gains and losses are also generated from prepayment premiums received on private fixed maturity securities, recoveries of principal on previously impaired securities, net changes in the allowance for losses, as well as gains and losses on sales, certain restructurings and foreclosures on commercial mortgage and other loans, fair value changes on commercial mortgage loans carried at fair value, and fair value changes on embedded derivatives and free-standing derivatives that do not qualify for hedge accounting treatment, except those derivatives used in our capacity as a broker or dealer.
The level of other-than-temporary impairments generally reflects economic conditions and is expected to increase when economic conditions worsen and to decrease when economic conditions improve. Historically, the causes of other-than-temporary impairments have been specific to each individual issuer and have not directly resulted in impairments to other securities within the same industry or geographic region. As discussed in more detail below, certain of the other-than-temporary impairments recognized for the year ended December 31, 2011 related to foreign currency translation losses on securities that are approaching maturity, as well as adverse financial conditions of the respective issuer on asset-backed securities collateralized by sub-prime mortgages and Japanese commercial mortgage-backed securities. Other-than-temporary impairments recognized for the year ended December 31, 2010 were primarily related to asset-backed securities collateralized by sub-prime
mortgages and Japanese commercial mortgage-backed securities that reflect adverse financial conditions of the respective issuers, foreign currency translation losses related to foreign denominated securities that are approaching maturity, and the intent to sell securities, primarily related to asset-backed securities collateralized by sub-prime mortgages.
commercial mortgage and other loans in 2010 were $35 million and primarily related to a net decrease in the loan loss reserves of $103 million and mark-to-market net gains on our interim loan portfolio. These net gains were partially offset by net realized losses on loan modifications, payoffs, and foreclosures within our Asset Management business. For additional information regarding our commercial mortgage and other loan loss reserves see “-General Account Investments-Commercial Mortgage and Other Loans-Commercial Mortgage and Other Loan Quality.”
Net realized gains on derivatives were $2,095 million in 2011, compared to net realized gains of $601 million in 2010. The net derivative gains in 2011 include net gains of $1,375 million related to product embedded derivatives and related hedge positions primarily associated with certain variable annuity contracts. See “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities” for additional information. Also, contributing to the net derivative gains were net mark-to-market gains of $498 million on interest rate derivatives used to manage duration as interest rates declined during 2011, and net gains of $214 million on foreign currency forward contracts used in our Star and Edison businesses to hedge portfolio assets primarily due to the strengthening of the Japanese yen against the U.S. dollar and Australian dollar. The net derivative gains in 2010 primarily reflect net gains of $521 million on interest rate derivatives used to manage duration as interest rates declined and net gains of $325 million primarily related to embedded derivatives and related hedge positions associated with certain variable annuity contracts. See “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities” for additional information. Also contributing to the 2010 gains are net derivative gains of $99 million on currency derivatives used to hedge foreign-denominated investments and net gains of $43 million on embedded derivatives associated with certain externally-managed investments in the European market. Partially offsetting the 2010 gains were net derivative losses of $319 million on foreign currency forward contracts used to hedge the future income of non-U.S. businesses primarily in Japan and net losses of $75 million on credit derivatives as credit spreads tightened.
Net realized gains on other investments were $47 million in 2011, which included a $64 million gain on the partial sale of a real estate seed investment, partially offset by $33 million of other other-than-temporary impairments on joint ventures and partnerships and real estate investments. Net realized losses on other investments were $30 million in 2010, which reflected $30 million of other other-than-temporary impairments on joint ventures and partnerships and real estate investments.
Related adjustments include that portion of “Realized investment gains (losses), net” that are included in adjusted operating income and that portion of “Asset management fees and other income” and “Net investment income” that are excluded from adjusted operating income. The adjustments are made to arrive at “Realized investment gains (losses), net, and related adjustments” which are excluded from adjusted operating income. Related adjustments to realized investment gains (losses) were a net positive adjustment of $535 million in 2011. Adjustments for that portion of “Realized investment gains (losses), net” that are included in adjusted operating income were a net negative adjustment of $240 million, driven by $154 million of gains that represent a principal source of earnings for certain of our businesses, including $64 million from the partial sale of a real estate seed investment, as well as $259 million of gains primarily from settlements on interest rate and currency swaps, partially offset by $175 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 $775 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.
Charges that relate to “Realized investment gains (losses), net” are also excluded from adjusted operating income. Related charges were net negative adjustments of $1,836 million and $178 million in 2011 and 2010, respectively. The $1,836 million in 2011 was primarily driven by that portion of amortization of deferred policy acquisition and other costs relating to the net gain (loss) on embedded derivatives and related hedge positions associated with certain variable annuity contracts. The $178 million in 2010 was primarily driven by payments associated with the market value adjustment features related to certain variable annuity products we sell.
Excludes the portion of other-than-temporary impairments recorded in “Other comprehensive income (loss),” representing any difference between the fair value of the impaired debt security and the net present value of its projected future cash flows at the time of impairment.
Excludes the portion of other-than-temporary impairment recorded in “Other comprehensive income (loss),” representing any difference between the fair value of the impaired debt security and the net present value of its projected future cash flows at the time of impairment.
Primarily represents circumstances where securities with foreign currency translation losses approach maturity or where we intend to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis.
For the Closed Block Business, net realized investment gains in 2011 were $845 million, compared to net realized investment gains of $794 million in 2010.
Net realized gains on commercial mortgage and other loans in 2011 were $33 million related to a net decrease in the loan loss reserve of $42 million, partially offset by net realized losses on related foreclosures. Net realized gains on commercial mortgage and other loans in 2010 were $18 million related to a net decrease in the loan loss reserve of $22 million, partially offset by net realized losses on related foreclosures. For additional information regarding our loan loss reserves see “-General Account Investments-Commercial Mortgage and Other Loans-Commercial Mortgage and Other Loan Quality.”
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. Net trading gains on sales and maturities of fixed maturity securities of $469 million in 2009 were primarily due to sales of government bonds in our International Insurance business and sales within our Individual Annuities segment. Sales of fixed maturity securities in our Individual Annuities segment were primarily due to transfers of investments out of our general account and into separate accounts relating to an automatic rebalancing element embedded in the 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 2010 and 2009.
Net realized gains on derivatives were $601 million in 2010, compared to net realized gains of $171 million in 2009. The net derivative gains in 2010 primarily reflect net gains of $521 million on interest rate derivatives used to manage duration as interest rates declined during 2010, and net gains of $325 million primarily related to embedded derivatives and related hedge positions associated with certain variable annuity contracts. See “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities” for additional information. Also contributing to these gains are net derivative gains of $99 million on currency derivatives used to hedge foreign denominated investments and net gains of $43 million on embedded derivatives associated with certain externally-managed investments in the European market. Partially offsetting these gains were net derivative losses of $319 million on foreign currency forward contracts used to hedge the future income of non-U.S. businesses primarily in Japan and net losses of $75 million on credit derivatives as credit spreads tightened. The net derivative gains in 2009 primarily reflect net gains of $376 million on embedded derivatives and related hedge positions associated with certain variable annuity contracts. Also contributing to the net derivative gains in 2009 were net gains of $196 million on embedded derivatives associated with certain externally-managed investments in the European market and net gains of $87 million on mark-to-market adjustments from credit derivatives. Partially offsetting these gains were net mark-to-market losses of $376 million on interest rate derivatives used to manage duration and net losses of $121 million on currency derivatives used to hedge foreign denominated investments.
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. These 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. Our Japanese insurance operations hold U.S. dollar-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 2010, we recorded other-than-temporary impairments of $143 million in earnings related to securities with an unrealized foreign currency translation loss that are approaching maturity. As of December 31, 2010, gross unrealized losses related to those securities maturing between January 1, 2011 and December 31, 2012 are $201 million. Based on December 31, 2010 fair values, absent a change in currency rates, impairments of approximately $169 million would be recorded in earnings in 2011. 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.
For the Closed Block Business, net realized investment gains in 2010 were $794 million, compared to net realized investment losses of $1,285 million in 2009.
During 2010 we recorded other-than-temporary impairments of $208 million in earnings, compared to other-than-temporary impairments of $1,184 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 Closed Block Business by asset type, and for fixed maturity securities, by reason.
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
We maintain diversified investment portfolios in our insurance companies to support our liabilities to customers in our Financial Services Businesses and the Closed Block Business, as well as our other general liabilities. Our general account does not include: (1) assets of our trading and banking operations; (2) assets of our asset management operations, including assets managed for third parties; and (3) those assets classified as “Separate account assets” on our balance sheet.
The general account portfolio is managed pursuant to the distinct objectives and investment policy statements of the Financial Services Businesses and the Closed Block Business. The primary investment objectives of the Financial Services Businesses include:
While we continue to look to maximize book yield and match the liability characteristics of our major products, our portfolio management approach also reflects a consideration of the capital and tax implications of portfolio activity, our assertions regarding our ability and intent to hold equity securities to recovery, and our lack of any intention or requirement to sell debt securities before anticipated recovery. In consideration of the potential impact on capital and tax positions, beginning in the fourth quarter of 2008 we temporarily curtailed the active trading policy previously employed in the Closed Block Business and certain portfolios of the Financial Services Businesses. Starting in the second quarter of 2009, we resumed a more restricted trading program in these portfolios, and continue to evaluate trading strategies for these portfolios. For a further discussion of our policies regarding other-than-temporary impairments, including our assertions regarding our ability and intent to hold equity securities to recovery and any intention or requirement to sell debt securities before anticipated recovery, see “-Fixed Maturity Securities-Other-than-Temporary Impairments of Fixed Maturity Securities” and “-Equity Securities-Other-than-Temporary Impairments of Equity Securities,” below.
We design asset mix strategies and derivative strategies for our general account to match the characteristics of our products and other obligations and seek to closely approximate the interest rate sensitivity, but not necessarily the exact cash flow characteristics, of the assets with the estimated interest rate sensitivity of the product liabilities. In certain markets, primarily outside the U.S., capital market limitations hinder our ability to acquire assets that closely approximate the duration of some of our liabilities. We achieve income objectives through asset/liability management, strategic and tactical asset allocations and derivative strategies within a disciplined risk management framework. Derivative strategies are employed within our risk management framework to help manage duration gaps, currency, and other risks between assets and liabilities. For a discussion of our risk management process see “Quantitative and Qualitative Disclosures About Market Risk-Risk Management, Market Risk and Derivative Instruments, and-Other Than Trading Activities-Insurance and Annuity Products Asset/Liability Management.”
Our asset allocation also reflects our desire for broad diversification across asset classes, sectors and issuers. The Asset Management segment manages virtually all of our investments, other than those managed by our International Insurance segment, under the direction and oversight of the Asset Liability Management and Risk Management groups. Our International Insurance segment manages the majority of its investments locally, within enterprise risk constraints, in most cases using our international and domestic asset management capabilities.
$44,843 million of invested assets at carrying value of the Star and Edison Businesses, which consists of $40,257 million of fixed maturity securities, $1,526 million of other long-term investments, $938 million of equity securities, $790 million of commercial mortgage and other loans, $570 million of policy loans, $542 million of trading account assets, primarily supporting insurance liabilities, and $220 million of short-term investments. Since completing the acquisition, we have been repositioning the portfolios for the Star and Edison Businesses in order to improve the interest rate exposure profile relative to liabilities, diversify credit and risk asset exposures, and reduce unhedged currency positions. We substantially completed that repositioning by year-end 2011 and, as of January 1, 2012, the Star and Edison portfolios have been integrated with the Gibraltar portfolio.
Includes invested assets of trading and banking operations, real estate and relocation services and asset management operations. Excludes assets of our asset management operations managed for third parties and those assets classified as “Separate account assets” on our balance sheet. For additional information regarding these investments, see “-Invested Assets of Other Entities and Operations” below.
We have substantial insurance operations in Japan, with 50% and 38% of our Financial Services Businesses’ general account investments relating to our Japanese insurance operations as of December 31, 2011 and December 31, 2010, respectively. The following table sets forth the composition of the investments of our Japanese insurance operations’ general account as of the dates indicated.
As of December 31, 2011, the average duration of our general account investment portfolio related to our Japanese insurance operations, including the impact of derivatives, was approximately 10 years. The increase in general account investments related to our Japanese insurance operations in 2011 was primarily attributable to the impact of the acquisition of the Star and Edison Businesses, gains on foreign currency exchange rates on yen assets, portfolio growth as a result of business inflows and the impact of declining interest rates, partially offset by yen strengthening on non-yen assets.
As of December 31, 2011, our Japanese insurance operations had $6.4 billion, at fair value, of investments denominated in Australian dollars that support liabilities denominated in Australian dollars. As of December 31, 2010, our Japanese insurance operations had $1.8 billion, at fair value, of investments denominated in Australian dollars that support liabilities denominated in Australian dollars. The $4.6 billion increase of Australian dollar investments at fair value from December 31, 2010 is primarily driven by $2.6 billion from the Star and Edison Businesses’ Australian dollar-denominated assets supporting Australian dollar liabilities.
Principally represents Italian government securities owned by our Italian insurance operations.
The following tables set forth the income yield and investment income, excluding realized investment gains (losses) and non-hedge accounting derivative results, for each major investment category of our general account for the periods indicated.
Yields are weighted for ten months of income and assets related to the Star and Edison Businesses.
The decrease in yield on the Japanese insurance portfolio for 2011 compared to 2010 is primarily attributable to lower fixed maturity reinvestment rates in both the U.S. and Japan, and the impact from the acquisition of the Star and Edison portfolios.
The decrease in yield on the Japanese insurance portfolio for 2010 compared to 2009 is primarily attributable to lower fixed maturity reinvestment rates and a lower interest rate environment both in the U.S. and Japan, as well as less favorable results in joint ventures and limited partnerships.
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 table sets forth the breakdown of the amortized cost of our fixed maturity securities portfolio in total by contractual maturity as of December 31, 2011.
Includes $345 million of gross unrealized gains and $98 million of gross unrealized losses as of December 31, 2011, compared to $319 million of gross unrealized gains and $68 million of gross unrealized losses as of December 31, 2010 on securities classified as held-to-maturity.
As of December 31, 2011 and 2010, based on amortized cost, 84% and 83%, respectively, represent Japanese government bonds held by our Japanese insurance operations, with no other individual country representing more than 6% and 8%, respectively of the balance.
The table above excludes fixed maturity securities classified as trading. See “-Trading Account Assets Supporting Insurance Liabilities” and “-Other Trading Account Assets” for additional information.
The change in net unrealized gains and losses from December 31, 2010 to December 31, 2011, was primarily due to a decrease in interest rates in both the U.S. and Japan.
The change in net unrealized gains and losses from December 31, 2010 to December 31, 2011, was primarily due to a decrease in interest rates.
Included within asset-backed securities attributable to the Financial Services Businesses are securities collateralized by sub-prime mortgages. While there is no market standard definition, we define sub-prime mortgages as residential mortgages that are originated to weaker quality obligors as indicated by weaker credit scores, as well as mortgages with higher loan-to-value ratios, or limited documentation. The significant deterioration of the U.S. housing market, high interest rate resets, higher unemployment levels, and relaxed underwriting standards for some originators of sub-prime mortgages have led to higher delinquency rates, particularly for those mortgages issued in 2006 and 2007. Recently there has been significant attention given to potential deficiencies in lenders’ foreclosure documentation, causing delays in the foreclosure process. Many lenders have indicated that the issues are administrative and they do not expect significant delays in their foreclosure proceedings. From the perspective of an investor in securities backed by sub-prime collateral, any significant delays in foreclosure proceedings could result in increased servicing costs which could negatively affect the value of the impacted securities. Separately, as an investor in sub-prime securities, we are evaluating our legal options with respect to potential remedies arising from any potential deficiencies related to the original lending and securitization practices. The following tables set forth the amortized cost and fair value of our asset-backed securities attributable to the Financial Services Businesses as of the dates indicated, by credit quality, and for asset-backed securities collateralized by sub-prime mortgages, by year of issuance (vintage).
As of December 31, 2011, includes collateralized debt obligations with amortized cost of $115 million, with none secured by sub-prime mortgages. Also includes asset-backed securities collateralized by education loans, equipment leases, franchises, timeshares, and aircraft.
On an amortized cost basis, asset-backed securities collateralized by sub-prime mortgages attributable to the Financial Services Businesses decreased from $3.424 billion as of December 31, 2010, to $2.634 billion as of December 31, 2011, primarily reflecting sales, principal paydowns and other-than-temporary impairments recognized. Gross unrealized losses related to our asset-backed securities collateralized by sub-prime mortgages attributable to the Financial Services Businesses were $906 million as of December 31, 2011, and $882 million as of December 31, 2010. For additional information regarding other-than-temporary impairments of asset-backed securities collateralized by sub-prime mortgages see “-Realized Investment Gains and Losses” above. For information regarding the methodology used in determining the fair value of our asset-backed securities collateralized by sub-prime mortgages, see Note 20 to the Consolidated Financial Statements.
The weighted average estimated subordination percentage of our asset-backed securities collateralized by sub-prime mortgages attributable to the Financial Services Businesses, excluding those supported by guarantees from monoline bond insurers, was 30% 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 63% of the asset-backed securities collateralized by sub-prime mortgages attributable to the Financial Services Businesses have estimated credit subordination percentages of 20% or more, and 41% have estimated credit subordination percentages of 30% or more.
As of December 31, 2011, includes collateralized debt obligations with amortized cost of $50 million, with none secured by sub-prime mortgages. Also includes asset-backed securities collateralized by franchises, timeshares, manufacturing and aircraft.
On an amortized cost basis, asset-backed securities collateralized by sub-prime mortgages attributable to the Closed Block Business decreased from $2.757 billion as of December 31, 2010 to $2.290 billion as of December 31, 2011, primarily reflecting sales, principal paydowns and other-than-temporary impairments recognized. Gross unrealized losses related to our asset-backed securities collateralized by sub-prime mortgages attributable to the Closed Block Business were $789 million as of December 31, 2011 and $673 million as of December 31, 2010. For additional information regarding other-than-temporary impairments of asset-backed securities collateralized by sub-prime mortgages see “-Realized Investment Gains and Losses” above. For information regarding the methodology used in determining the fair value of our asset-backed securities collateralized by sub-prime mortgages, see Note 20 to the Consolidated Financial Statements.
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 $2.290 billion of asset-backed securities collateralized by sub-prime mortgages attributable to the Closed Block Business as of December 31, 2011, were $545 million of securities, on an amortized cost basis, that represent front pay or second pay securities, depending on the overall structure of the securities.
As of December 31, 2011, of these collateralized mortgage obligations, for the Financial Services Businesses, 68% have credit ratings of A or above, 7% have BBB credit ratings and the remaining 25% have below investment grade ratings, and as of December 31, 2010, 38% have credit ratings of A or above, 7% have BBB credit ratings and the remaining 55% have below investment grade ratings. As of
December 31, 2011, for the Closed Block Business, 16% have A credit ratings or above, 34% have BBB credit ratings, and 50% have below investment grade ratings, and as of December 31, 2010, 39% have A credit ratings or above, 35% have BBB credit ratings, and 26% have below investment grade ratings.
The commercial real estate market was severely impacted by the financial crisis and the subsequent recession. However, market fundamentals appear to have bottomed and are showing signs of improvement since late 2010. Commercial real estate vacancy rates have declined from their peak, rent growth has turned positive for certain sectors, and prices of commercial real estate appear to be stabilizing and improving in some sectors. Additionally, the elevated delinquency rate on mortgages in the commercial mortgage-backed securities market is slowing and refinancing activity has increased, at least partially reflecting the improvement in these fundamentals. The loans included in new issues seem to reflect better underwriting and lower levels of leverage compared to 2007.
Although there are some positive signs in commercial real estate, there are still some significant challenges for this market, including numerous future loan workouts, a large wave of refinancings for over-leveraged properties and numerous legislative changes. To ensure our investment objectives and asset strategies are maintained, we consider these market factors in making our investment decisions on commercial mortgage-backed securities.
Included in the table above as of December 31, 2011 are downgraded super senior securities with amortized cost of $408 million in AA and $144 million in A.
Included in the table above as of December 31, 2011 are agency commercial mortgage-backed securities with amortized cost of $256 million all rated AA.
Excluded from the table above are available-for-sale commercial mortgage-backed securities held outside the general account in other entities and operations. For additional information regarding commercial mortgage-backed securities held outside the general account, see “-Invested Assets of Other Entities and Operations” below. Also excluded from the table above are commercial mortgage-backed securities classified as trading and carried at fair value. See “-Trading Account Assets Supporting Insurance Liabilities” for additional information regarding these securities.
Included in the table above are commercial mortgage-backed securities collateralized by non-U.S. properties all related to Japanese commercial mortgage-backed securities held by our Japanese insurance operations with an amortized cost of $13 million in AAA, $4 million in A, $17 million in BBB and $13 million in BB and below as of December 31, 2011, and $12 million in AAA, $3 million in A, $18 million in BBB and $104 million in BB and below as of December 31, 2010.
Included in the table above are commercial mortgage-backed securities collateralized by U.S. properties all related to commercial mortgage-backed securities held by the acquired Edison business with an amortized cost of $441 million in AAA, $184 million in AA, $122 million in A and $5 million in BBB as of December 31, 2011.
The tables above provide ratings as assigned by nationally recognized rating agencies as of December 31, 2011, including Standard & Poor’s, Moody’s, Fitch, and Realpoint.
In addition to enhanced subordination, certain securities within the super senior class benefit from the prioritization of principal cash flows. The super senior class is generally structured such that shorter duration time tranches have priority over longer duration time tranches as to all principal cash flows (repayments, prepayments, and recoveries on defaulted loans) until the deal reaches 30% cumulative net loss, at which point all super senior securities are paid pro rata. As a result, short of reaching 30% cumulative net losses, the “shorter duration super senior” tranches must be completely repaid before the “longest duration super senior” tranche receives any principal cash flows. We have generally focused our purchases of recent vintage commercial mortgage-backed securities on “shorter duration super senior” tranches that we believe have sufficient priority to ensure that in most scenarios our positions will be fully repaid prior to the structure reaching the 30% cumulative net loss threshold. The following table sets forth the amortized cost of our AAA commercial mortgage-backed securities attributable to the Financial Services Businesses as of the dates indicated, by type and by year of issuance (vintage).
Included in the table above as of December 31, 2011 are downgraded super senior securities with amortized cost of $73 million in AA and $64 million in A.
Included in the table above as of December 31, 2011 are agency commercial mortgage-backed securities with amortized cost of $5 million all rated AA.
The amortized cost of our public and private fixed maturities attributable to the Closed Block Business considered other than high or highest quality based on NAIC or equivalent rating totaled $4.4 billion, or 10%, of the total fixed maturities as of December 31, 2011 and $5.6 billion, or 13%, 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 51% of the gross unrealized losses attributable to the Closed Block Business as of December 31, 2011, and 44% as of December 31, 2010. As of December 31, 2011, the amortized cost of our public and private below investment grade fixed maturities attributable to the Closed Block Business, based on the lowest of external rating agency ratings, totaled $5.5 billion, or 13%, 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 $282 million of gross unrealized gains and $97 million gross unrealized losses as of December 31, 2011, compared to $272 million of gross unrealized gains and $67 million of gross unrealized losses as of December 31, 2010 on securities classified as held-to-maturity.
On amortized cost basis, as of December 31, 2011 includes $185 million in emerging markets securities and $70 million in securitized bank loans.
Includes, as of December 31, 2011 and 2010, 11 securities with amortized cost of $11 million (fair value, $13 million) and 15 securities with amortized cost of $9 million (fair value, $10 million), respectively, that have been categorized based on expected NAIC designations pending receipt of SVO ratings.
On an amortized cost basis, as of December 31, 2011, includes $290 million in securitized bank loans and $182 million in emerging markets securities.
On an amortized cost basis, as of December 31, 2011, includes $290 million in securitized bank loans and $272 million in commercial asset finance securities.
Excludes embedded derivatives contained in certain externally-managed investments in the European market. See Note 21 to the Consolidated Financial Statements for additional information regarding these derivatives.
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 of $2.642 billion as of December 31, 2011, include
The gross unrealized losses were primarily concentrated in asset-backed securities as of December 31, 2011 and 2010. Gross unrealized losses attributable to the Closed Block Business where the estimated fair value had declined and remained below amortized cost by 20% or more of $817 million as of December 31, 2011, include $730 million relating to asset-backed securities collateralized by sub-prime mortgages. Gross unrealized losses attributable to the Closed Block Business where the estimated fair value had declined and remained below amortized cost by 20% or more as of December 31, 2011, does not include any gross unrealized losses on securities where the estimated fair value had declined and remained below amortized cost by 50% or more. 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 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.
the financial condition of and near-term prospects of the issuer; and
Included within the $157 million of asset-backed securities collateralized by sub-prime mortgages at fair value as of December 31, 2011 are $0 million of securities collateralized by second-lien exposures at fair value.
“Other trading account assets, at fair value” consist primarily of certain financial instruments that contain an embedded derivative where we elected to classify the entire instrument as a trading account asset rather than bifurcate. These instruments are carried at fair value, with realized and unrealized gains and losses reported in “Asset management fees and other income,” and excluded from adjusted operating income. Interest and dividend income from these investments is reported in “Net investment income,” and is included in adjusted operating income. The following table sets forth the composition of our other trading account assets as of the dates indicated.
As of December 31, 2011, on an amortized cost basis 82% of asset-backed securities classified as “Other trading account assets” attributable to the Financial Services Businesses have credit ratings of A or above, 9% have BBB and the remaining 9% have BB and below credit ratings. As of December 31, 2011, on an amortized cost basis 75% of asset-backed securities classified as “Other trading account assets” attributable to the Closed Block Business have credit ratings of A or above and the remaining 25% have BBB credit ratings.
As of December 31, 2011 and 2010 we held approximately 10% and 11%, respectively, of our general account investments in commercial mortgage and other loans. This percentage is net of a $310 million and $435 million allowance for losses as of December 31, 2011 and 2010, respectively. The following table sets forth the composition of our commercial mortgage and other loans portfolio, before the allowance for losses, as of the dates indicated.
account, though underwriting remains conservative. While there is still weakness in commercial real estate fundamentals that are dependent on employment recovery, delinquency rates on our commercial mortgage loans remain relatively stable. For additional information see “- Realized Investment Gains and Losses.”
As of December 31, 2011, our general account investments in commercial and agricultural mortgage loans attributable to the Financial Services Businesses had a weighted average debt service coverage ratio of 1.88 times, and a weighted average loan-to-value ratio of 59%. As of December 31, 2011, approximately 98% of commercial and agricultural mortgage loans attributable to the Financial Services Businesses were fixed rate loans. As of December 31, 2011, our general account investments in commercial and agricultural mortgage loans attributable to the Closed Block Business had a weighted average debt service coverage ratio of 1.90 times, and a weighted average loan-to-value ratio of 55%. As of December 31, 2011, approximately 99% of commercial and agricultural mortgage loans attributable to the Closed Block Business were fixed rate loans. For those general account commercial and agricultural mortgage loans attributable to the Financial Services Businesses that were originated in 2011, the weighted average debt service coverage ratio was 2.09 times and the weighted average loan-to-value ratio was 59%.
The following table sets forth the breakdown of our commercial mortgage and other loan portfolio by contractual maturity as of December 31, 2011.
Ongoing review of the portfolio is performed and loans are placed on watch list status based on a predefined set of criteria, where they are assigned to one of the following categories. We place loans on early warning status in cases where, based on our analysis of the loan’s collateral, the financial situation of the borrower or tenants or other market factors, we believe a loss of principal or interest could occur. We classify loans as closely monitored when we determine there is a collateral deficiency or other credit events that may lead to a potential loss of principal or interest. Loans not in good standing are those loans where we have concluded that there is a high probability of loss of principal, such as when the loan is in the process of foreclosure or the borrower is in bankruptcy. In our domestic operations, our workout and special servicing professionals manage the loans on the watch list. As described below, in determining our allowance for losses we evaluate each loan on the watch list to determine if it is probable that amounts due according to the contractual terms of the loan agreement will not be collected. In our international portfolios, we monitor delinquency in consumer loans on a pool basis and evaluate any servicing relationship and guarantees the same way we do for commercial mortgage loans.
During 2011, perpetual preferred stocks of $1.2 billion were reclassified to “Other trading account assets.” Prior periods were not restated.
Hedge funds and other alternative investments are included in “Other long-term investments.”
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 less than 20% for the following timeframes:
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 less than 20% for the following timeframes:
Includes only perpetual preferred stocks as of December 31, 2010. During 2011, perpetual preferred stocks were reclassified to “Other trading account assets.” Prior periods were not restated.
The gross unrealized losses as of December 31, 2011, were primarily concentrated in the manufacturing and finance sectors compared to December 31, 2010, where the gross unrealized losses were primarily concentrated in the services, manufacturing, and finance sectors. Gross unrealized losses attributable to the Closed Block Business where the estimated fair value had declined and remained below cost by 20% or more of $105 million as of December 31, 2011 does not include any gross unrealized losses on securities where the estimated fair value had declined and remained below cost by 50% or more. 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 extent and the duration of the decline; including, but not limited to, the following general guidelines:
Primarily includes investment in office buildings within our Japanese insurance operations.
The table above includes the invested assets of our trading, banking, and asset management operations. Assets of our asset management operations managed for third parties and those assets classified as “Separate account assets” on our balance sheet are not included.
Fixed maturity securities primarily include investments related to our non-retail banking operations, where customer deposit liabilities are primarily supported by fixed maturity and short-term investments, in addition to cash and cash equivalents.
The following table sets forth the composition of the portion of our fixed maturity securities portfolio by industry category attributable to our other entities and operations.
Other trading account assets primarily include trading positions held by our derivatives trading operations used in a non-dealer capacity. The positions maintained by our derivatives trading operations are used to manage interest rate, currency, credit and equity exposures in our insurance, investment and international businesses, and treasury operations.
Other long-term investments primarily include strategic investments made as part of our asset management operations. We make these strategic investments in real estate, as well as fixed income, public equity and real estate securities, including controlling interests. Certain of these investments are made primarily for purposes of co-investment in our managed funds and structured products. Other strategic investments are made with the intention to sell or syndicate to investors, including our general account, or for placement in funds and structured products that we offer and manage (seed investments). As part of our asset management operations we also make loans to our managed funds that are secured by equity commitments from investors or assets of the funds.
Similar to our planning and management process for liquidity, we ensure the availability of adequate capital under reasonably foreseeable stress scenarios using our “Capital Protection Framework.” We use our Capital Protection Framework to assess potential capital needs arising from severe market related distress and sources of capital available to us to meet those needs. Potential sources include on-balance sheet capital, derivatives and other contingent sources of capital.
On February 1, 2011, we completed the acquisition from American International Group, Inc., or AIG, of AIG Star Life Insurance Co., Ltd., AIG Edison Life Insurance Company and certain other AIG subsidiaries. The total purchase price was approximately $4,709 million, comprising $4,213 million in cash and $496 million in the assumption of third-party debt, substantially all of which is expected to be repaid, over time, with excess capital of the acquired entities. To partially fund the acquisition purchase price, in November 2010, Prudential Financial completed a public offering and sale of 18,348,624 shares of Common Stock and $1.0 billion of medium-term notes, resulting in aggregate proceeds of approximately $2.0 billion. The remainder of the purchase price was funded with approximately $2.2 billion of cash and short-term investments.
On July 1, 2011, we completed the sale of our Global Commodities Business to Jefferies Group, Inc., or Jefferies, and received cash proceeds of $422 million, which includes a final purchase price true-up of $2 million received post-closing on October 21, 2011. Of the total sale proceeds, $415 million was received by Prudential Securities Group LLC, a subsidiary of Prudential Insurance and the former parent company of the Global Commodities’ U.S. and U.K. based entities. The remaining proceeds were received by Pramerica Hong Kong Holdings Limited, the former parent company of the Bache Hong Kong-based business. In addition, immediately prior to closing, Prudential Bache Commodities, LLC paid a dividend of $112 million to Prudential Securities Group. On September 30, 2011, Prudential Securities Group distributed $500 million to Prudential Insurance.
Sale of Prudential Real Estate and Relocation Services to Brookfield Asset Management, Inc.
On December 6, 2011, we sold our real estate brokerage franchise and relocation services business to Brookfield Asset Management, Inc., and received cash proceeds, before transaction related expenses, of $108
As of December 31, 2011, Prudential Financial had cash and short-term investments of $4,944 million, a decrease of $1,728 million from December 31, 2010, primarily resulting from funding a portion of the purchase price for the Star and Edison Businesses. Included in the cash and short-term investments of Prudential Financial is $1,407 million held in an intercompany liquidity account that is designed to optimize the use of cash by facilitating the lending and borrowing of funds between Prudential Financial and its subsidiaries on a daily basis. Also included are short-term investments of $1,098 million, consisting primarily of government agency securities and money market funds.
On November 8, 2011, Prudential Financial’s Board of Directors declared an annual dividend for 2011 of $1.45 per share of Common Stock, representing an increase of approximately 26 percent from the 2010 Common Stock dividend. The table below presents declaration, record, and payment dates, as well as per share and aggregate dividend amounts, for the Common Stock dividend for the last five years.
The primary components of capitalization for the Financial Services Businesses consist of the equity we attribute to the Financial Services Businesses (excluding accumulated other comprehensive income related to unrealized gains and losses on investments and pension/postretirement benefits), outstanding junior subordinated debt and outstanding capital debt of the Financial Services Businesses. Capital debt consists of borrowings that are used or will be used to meet the capital requirements of Prudential Financial, as well as borrowings invested in equity or debt securities of direct or indirect subsidiaries of Prudential Financial and subsidiary borrowings utilized for capital requirements. As shown in the table below, as of December 31, 2011, the Financial Services Businesses had $42.9 billion in capital, all of which was available to support the aggregate capital requirements of its three divisions and its Corporate and Other operations. Based on our assessment of these businesses and operations, we believe this level of capital was consistent with the “AA” ratings targets of our regulated operating entities as of December 31, 2011.
We seek to capitalize all of our subsidiaries and businesses in accordance with their ratings targets, and we believe Prudential Financial’s capitalization and use of financial leverage are consistent with those ratings targets. Management uses the ratio of capital debt to total capital (as such amounts are reflected in the table
above) as a primary measure of the use of financial leverage. As of December 31, 2011, our capital debt to total capital ratio was 25.3%. The terms of our outstanding junior subordinated debt have certain features that result in their treatment as hybrid securities by the rating agencies. As a result, for purposes of calculating the capital debt to total capital ratio, 25% of our outstanding junior subordinated debt is treated as equity and the remaining 75% is treated as capital debt, based on Moody’s current criteria for these types of hybrid securities. As discussed under “-Accounting Policies & Pronouncements-Future Adoption of New Accounting Pronouncements,” the Company adopted amended authoritative guidance regarding the deferral of costs relating to the acquisition of new or renewal insurance contracts effective January 1, 2012, and will apply retrospective method of adoption. We estimate that if the new guidance were adopted as of December 31, 2011, retrospective adoption would reduce total equity by approximately $2.6 billion to $3.0 billion for the Financial Services Businesses and approximately $0.1 billion for the Closed Block Business, resulting in a capital debt to total capital ratio of approximately 27% as of December 31, 2011.
Our long-term senior debt rating targets for Prudential Financial are “A” for Standard & Poor’s Rating Services, or S&P, Moody’s Investors Service, Inc., or Moody’s, and Fitch Ratings Ltd., or Fitch, and “a” for A.M. Best Company, or A.M. Best. Our financial strength rating targets for our domestic life insurance companies are “AA/Aa/AA” for S&P, Moody’s and Fitch, respectively, and “A+” for A.M. Best. Currently, some of our ratings are below these targets. For a description of material rating actions that have occurred from the beginning of 2011 through the date of this filing and a discussion of the potential impacts of ratings downgrades, see “-Ratings.”
Our insurance and various other companies are subject to regulatory limitations on the payment of dividends and other transfers of funds to affiliates. With respect to Prudential Insurance, New Jersey insurance law provides that, except in the case of extraordinary dividends (as described below), all dividends or other distributions paid by Prudential Insurance may be paid only from unassigned surplus, as determined pursuant to statutory accounting principles, less unrealized investment gains and losses and revaluation of assets as of the prior calendar year-end. As of December 31, 2011 and 2010, Prudential Insurance’s unassigned surplus was $5,070 million and $4,224 million, respectively, and it recorded applicable adjustments for cumulative unrealized investment gains of $2,184 million and $1,499 million, respectively. Prudential Insurance must give prior notification to the New Jersey Department of Banking and Insurance, or NJDOBI, or the Department, of its intent to pay any dividend or distribution. Also, if any dividend, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the prior calendar year’s statutory surplus or (ii) the prior calendar year’s statutory net gain from operations excluding realized investment gains and losses, the dividend is considered to be an “extraordinary dividend” and the prior approval of the Department is required for payment of the dividend. Prudential Insurance’s statutory surplus as of December 31, 2011 was $8,160 million and its statutory net gain from operations, excluding realized investment gains and losses, for the year ended December 31, 2011 was $584 million. In addition to the regulatory limitations, the terms of the IHC debt contain restrictions potentially limiting dividends by Prudential Insurance applicable to the Financial Services Businesses in the event the Closed Block Business is in financial distress and under certain other circumstances. The laws regulating dividends of the other states and foreign jurisdictions where our other insurance companies are domiciled are similar, but not identical, to New Jersey’s.
On May 16, 2011, Prudential Insurance paid an ordinary dividend of $527 million and an extraordinary dividend of $704 million to its parent, Prudential Holdings, LLC. From this amount, Prudential Holdings paid dividends to Prudential Financial of $1,073 million in May 2011 and $19 million in December 2011. On November 18, 2011, Prudential Insurance paid an additional extraordinary dividend of $500 million to Prudential Holdings, all of which was ultimately paid to Prudential Financial. Prudential Annuities Life Assurance Corporation paid a $270 million extraordinary dividend on June 30, 2011 and a $318 million ordinary dividend on November 30, 2011, in each case to Prudential Financial. On December 2, 2011, Prudential Retirement Insurance and Annuity Company paid an ordinary dividend of $270 million and an extraordinary dividend of $105 million to its parent, Prudential Insurance.
On September 20, 2011, Prudential of Japan paid a dividend of ¥16 billion, or $208 million, to its parent, Prudential Holdings of Japan, of which $190 million was ultimately paid to Prudential Financial.
Prudential Financial and Prudential Funding, LLC, or Prudential Funding, a wholly-owned subsidiary of Prudential Insurance, have commercial paper programs with an authorized issuance capacity of $3.0 billion and $7.0 billion, respectively. Prudential Financial commercial paper borrowings generally have been used to fund the working capital needs of our subsidiaries. Prudential Funding commercial paper borrowings have generally served as an additional source of financing to meet the working capital needs of Prudential Insurance and its subsidiaries. Prudential Funding also lends to other subsidiaries of Prudential Financial up to limits agreed with the NJDOBI.
While we continue to consider commercial paper one of our alternative sources of liquidity due to the low cost and efficient financing it provides, over the past several years we have significantly reduced our reliance on commercial paper to fund our operations, and have developed plans that would enable us to further reduce, or if necessary eliminate, our commercial paper borrowings by accessing other sources of liquidity.
The following table sets forth Prudential Financial’s and Prudential Funding’s outstanding commercial paper borrowings as of the dates indicated.
The daily weighted average outstanding during 2011 and 2010 was $4,651 million and $4,678 million, respectively, for the Financial Services Businesses and $4,301 million and $3,969 million, respectively, for the Closed Block Business.
In addition, as of December 31, 2011, our Closed Block Business had outstanding mortgage dollar rolls under which we are committed to repurchase $860 million of mortgage-backed securities, or “to be announced” (“TBA”) forward contracts. These repurchase agreements do not qualify as secured borrowings and are accounted for as derivatives. These mortgage-backed securities are considered high or highest quality based on NAIC or equivalent rating.
Prudential Insurance is a member of the Federal Home Loan Bank of New York, or FHLBNY. Membership allows Prudential Insurance access to the FHLBNY’s financial services, including the ability to obtain collateralized loans and to issue collateralized funding agreements that can be used as an alternative source of liquidity. FHLBNY borrowings and funding agreements are collateralized by qualifying mortgage-related assets or U.S. Treasury securities, the fair value of which must be maintained at certain specified levels relative to outstanding borrowings, depending on the type of asset pledged. FHLBNY membership requires Prudential Insurance to own member stock, and borrowings require the purchase of activity-based stock in an amount equal to 4.5% of outstanding borrowings. Under FHLBNY guidelines, if Prudential Insurance’s financial strength ratings decline below A/A2/A Stable by S&P/Moody’s/Fitch, respectively, and the FHLBNY does not receive written assurances from NJDOBI regarding Prudential Insurance’s solvency, new borrowings from the FHLBNY would be limited to a term of 90 days or less. Currently there are no restrictions on the term of borrowings from the FHLBNY.
Prudential Retirement Insurance and Annuity Company, or PRIAC, is a member of the Federal Home Loan Bank of Boston, or FHLBB. Membership allows PRIAC access to collateralized advances which will be classified in “Short-term debt” or “Long-term debt,” depending on the maturity date of the obligation. PRIAC’s membership in FHLBB requires the ownership of member stock, and borrowings from FHLBB require the
purchase of activity-based stock in an amount between 3.0% and 4.5% of outstanding borrowings, depending on the maturity date of the obligation. As of December 31, 2011, PRIAC had no advances outstanding under the FHLBB facility.
The principal sources of liquidity for Prudential Insurance and our other domestic insurance subsidiaries are premiums and certain annuity considerations, investment and fee income, and investment maturities and sales associated with our insurance and annuity operations, as well as internal and external borrowings. The principal uses of that liquidity include benefits, claims, dividends paid to policyholders, and payments to policyholders and contractholders in connection with surrenders, withdrawals and net policy loan activity. Other uses of liquidity include commissions, general and administrative expenses, purchases of investments, and payments in connection with financing activities.
Our domestic insurance companies’ liquidity is managed through access to substantial investment portfolios as well as a variety of instruments available for funding and/or managing cash flow mismatches, including from time to time those arising from claim levels in excess of projections. To the extent we need to pay claims in excess of projections, we may borrow temporarily or sell investments sooner than anticipated to pay these claims, which may result in increased borrowing costs or realized investment gains or losses affecting results of operations. For a further discussion of realized investment gains and losses, see “-Realized Investment Gains
In addition to hedging equity market exposure, we also manage certain risks associated with our variable annuity products through our hedging programs. In our living benefits hedging program, we purchase interest rate derivatives and equity options and futures to hedge certain optional 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-perceived risk of our own non-performance, 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 determining the hedge target. Our new hedge target 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 assumptions to remove certain risk margins embedded in the valuation technique used to fair value 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. We evaluate hedge levels versus our hedge target based on the overall capital considerations of the Company and prevailing market conditions. The U.S. GAAP/capital markets valuation framework underlying our hedge target assumes that current interest rate levels remain unchanged for the full projection period with no reversion to longer term averages. Due to the recent low interest rate environment, we decided to temporarily hedge to an amount that differs from our hedge target definition to be consistent with our long-term economic view. Because the hedging decision was based on the overall capital considerations of the Company, the corresponding impact on results is reported within Corporate and Other operations. For the years ended December 31, 2011 and 2010, “Realized investment gains (losses), net, and related adjustments” within Corporate and Other operations includes a pre-tax loss of $1,662 million and a pre-tax gain of $306 million, respectively, resulting from our decision to temporarily hedge to a different target and the decline in interest rates during the year. Through our Capital Protection Framework, we have access to on-balance sheet capital and contingent sources of capital that is available to meet capital needs arising from activities such as the after-tax realized investment losses incurred in 2011 from our living benefits hedging program, including our decision to temporarily hedge to an amount that differs from our hedge target definition. For a full discussion of the results of our living benefits hedging program, see “-Results of Operations for Financial Services Businesses by Segment-U.S. Retirement Solutions and Investment Management Division-Individual Annuities.”
We reinsure variable annuity living benefit guarantees from certain of our life insurance companies to a captive reinsurance company, Pruco Reinsurance, Ltd. (“Pruco Re”). The variable annuity living benefit hedging program described above is primarily executed within Pruco Re. Effective as of July 1, 2011, Pruco Re re-domiciled from Bermuda to Arizona. As a result, beginning in the third quarter of 2011, our Arizona domiciled life insurance company, Pruco Life Insurance Company, is able to claim reinsurance reserve credit for business ceded to Pruco Re without any need for Pruco Re to collateralize its obligations under the reinsurance arrangement. However, for business ceded to Pruco Re by Prudential Annuities Life Assurance Corporation (“PALAC”) and Pruco Life Insurance Company of New Jersey (“PLNJ”), we must continue to collateralize Pruco Re’s obligations under the reinsurance arrangement in order for PALAC and PLNJ to claim reinsurance reserve credit for their business ceded. We satisfy this requirement by depositing assets into statutory reserve credit trusts for Pruco Re. Funding needs for the statutory reserve credit trusts are separate and distinct from the capital needs of the captive reinsurance company. However, assets pledged to the statutory reserve credit trusts may include assets supporting the capital of the captive reinsurance company provided that they meet eligibility requirements prescribed by the relevant insurance regulators.
Effective January 1, 2012, the Star and Edison entities merged with Gibraltar Life. We believe the solvency margin ratio of the merged entity will continue to be in excess of our solvency margin targets.
In our international insurance operations, liquidity is provided through operating cash flows from ongoing operations as well as portfolios of liquid assets. In managing the liquidity and the interest rate and credit risk profiles of our international insurance portfolios, we employ a discipline similar to the discipline employed for domestic insurance subsidiaries. We monitor liquidity through the use of internal liquidity measures, taking into account the liquidity of the asset portfolios. We also 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 international insurance operations’ liquidity under stress scenarios. We believe that ongoing operations and the liquidity profile of our international insurance assets provide sufficient liquidity under reasonably foreseeable stress scenarios.
The following table sets forth our international insurance subsidiaries portfolio of liquid assets, including cash and short-term investments, and fixed maturity investments, other than those designated as held-to-maturity, by NAIC or equivalent rating as of the dates indicated.
As with our domestic operations, in managing the liquidity of these operations, we consider the risk of policyholder and contractholder withdrawals of funds earlier than our assumptions in selecting assets to support these contractual obligations. The following table sets forth the total general account insurance-related liabilities (other than dividends payable to policyholders) of our international insurance subsidiaries, as of the dates indicated.
We believe that the solvency margins of our Japanese insurance subsidiaries, under the new method, will continue to satisfy regulatory and other requirements and will not negatively impact our competitive positioning. The capital requirements in Korea and Taiwan are also undergoing change. Korean insurance regulators have refined their RBC calculation effective June 2011 with the most significant change related to the interest rate risk charge. The RBC ratio for Prudential of Korea, or POK, will be lower under the new calculation reflective of the long duration of its liabilities and high policy persistency. Nevertheless, we expect that POK’s RBC ratio under the new calculation will remain one of the highest in the industry and will continue to exceed a level consistent
with our “AA” ratings target. Additionally, Taiwanese regulators recently made slight refinements to their RBC calculation effective as of January 2011. The new calculation resulted in a modest increase in the interest rate risk charge and resulted in only a slight decline in Prudential of Taiwan’s RBC ratio with no expected corresponding competitive impact.