This Management’s narrative addresses the financial condition of Prudential Annuities Life Assurance Corporation (“PALAC”), formerly known as American Skandia Life Assurance Corporation as of December 31, 2008, compared with December 31, 2007, and its results of operations for the years ended December 31, 2008 and 2007.
The Company offers a wide array of annuities, including (1) deferred and immediate variable annuities that are registered with the SEC, including fixed interest rate allocation options that are offered in certain of our variable annuities and are registered because of their market value adjustment feature and (2) fixed rate allocation options in certain of our variable and fixed annuities that are not registered with the SEC. In addition, the Company has in force a relatively small block of variable life insurance policies, but it no longer actively sells such policies. The markets in which the Company operates are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure as the legal barriers that have historically segregated the markets of the financial services industry, have been changed through both legislative and judicial processes. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels.
Our cost of administering insurance contracts and providing asset management products and services;
As prescribed by GAAP, we present our investments classified as available for sale, including fixed maturity and equity securities, and our investments classified as trading, at fair value in the statements of financial position. The fair values for our public fixed maturity securities and our public equity securities are generally based on quoted market prices or estimates from independent pricing services, which we validate for reasonability. However, for our investments in private securities such as private placement fixed maturity securities, which comprise 6% of our investments as of December 31, 2008, this information is generally not available. For these private investments, fair value is determined typically by using a discounted cash flow model, which utilizes a discount rate based upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions and takes into account, among other factors, the credit quality and industry sector of the issuer and the reduced liquidity associated with private placements. Historically, changes in estimated future cash flows or the assessment of an issuer’s credit quality have been the more significant factors in determining fair values. In determining the fair value of certain securities, the discounted cash flow model may use unobservable inputs, which reflect our own assumptions about the inputs market participants would use in pricing the asset.
For fixed maturities 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. Adjustments to the costs of fixed maturities of other-than-temporary impairments are included in “Realized investment gains (losses), net.” In evaluating whether a decline in value is other-than-temporary, we consistently consider several factors including, but not limited to, the following: the extent and duration of the decline; the reasons for the decline in value (credit event interest related, including credit spread widening); our ability and intent to hold the investment for a period of time to allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When we determine that is an other than temporary impairment, we write down the value of the security to its fair value, with a corresponding charge to earnings. In addition, for its impairment review of asset-backed fixed maturity securities with a credit rating below AA, the Company forecasts its best estimate of the prospective future cash flows of the security to determine if the present value of those cash flows, discounted using the effective yield of the most recent interest accrual rate, has decreased from the previous reporting period. When a decrease from the prior reporting period has occurred and the security’s fair value is less than its carrying value, an other-than-temporary impairment is recognized by writing the security is down to its fair value, with a corresponding charge to earnings. In both cases, this corresponding charge is referred to as impairment and is reflected in “Realized investment gains (losses), net” in the statements of operations. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. In periods subsequent to the recognition of an other-than-temporary impairment, the impaired security is accounted for as if it had been purchased on the measurement date of the impairment. Accordingly, the discount (or reduced premium) based on the new cost basis is accreted into net investment income in future periods based upon the amount and timing of expected future cash flows of the security, if the recoverable value of the investment based upon cash flows we can reasonably estimate, is greater than the carrying value of the investment after the impairment. The level of impairment losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
Given recent market conditions and liquidity concerns, beginning in the third quarter of 2008, our determinations of whether a decline in value of fixed maturity securities is other-than-temporary have placed greater emphasis on our internal analysis of the underlying credit and our ability and intent to hold the investment for a period of time to allow for a recovery of value, versus the extent and duration of a decline in fair value.
The Company’s liability for future policy benefits is primarily comprised of the present value of estimated future payments to or on behalf of policyholders, where the timing and amount of payment depends on policyholder mortality, less the present value of future net premiums. Expected mortality is generally based on the Company’s historical experience or standard industry tables. Interest rate assumptions are based
on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are “locked-in” upon the issuance of new insurance or annuity business with fixed and guaranteed terms, significant changes in experience or assumptions may require the Company to provide for expected future losses on a product by establishing premium deficiency reserves. The Company’s liability for future policy benefits is also inclusive of liabilities for guarantee benefits related to certain nontraditional long-duration life and annuity contracts, which are discussed more fully in Note 6.
DAC is amortized over the expected life of the policy in proportion to gross profits. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and the cost of contract minimum guarantees net of, where applicable, the impact of any capital markets hedging activities related to these guarantees. We regularly evaluate and adjust the related DAC balance with a corresponding charge or credit to current period earnings for the effects of our actual gross profits and changes in our assumptions regarding estimated future gross profits. Adjustments to the DAC balance include our quarterly adjustments for current period experience and market performance related adjustments, as discussed below, and the impact of the annual reviews of our estimate of total gross profits. We also perform recoverability testing at the end of each reporting period to ensure the DAC balance does not exceed the present value of total estimated gross profits.
In addition to DAC, we also recognize assets for deferred sales inducements and valuation of business acquired (“VOBA”). The deferred sales inducements are amortized over the anticipated life of the policy using the same methodology and assumptions used to amortize
An increase or decrease in our effective tax rate by one percent of income (loss) from operations before income taxes would have resulted in an increase or decrease in the loss from operations in 2008 of $.2 million.
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under U.S. GAAP, reserves for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial reserve reflects management’s best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure. In situations in which the Company is to be indemnified by Skandia, there will be no financial impact on the Statements of Operations and Comprehensive Income. See Note 12 to the Financial Statements for a further discussion of indemnification provisions of the Agreement.
Net income decreased $274.6 million, from $294.6 million for the year ended December 31, 2007 to $20.0 million for the year ended December 31, 2008. Net income for 2008 included charges of $363.8 million reflecting the impact of the annual reviews of, and market performance adjustment to, the reserve for the guaranteed minimum death and income benefit features of our variable annuity products and our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs. The total charge of $363.8 million in 2008 included $208.9 million of charges from the annual reviews, which were completed in the third quarter of 2008, and $154.8 million of charges relating to additional market performance adjustments in the fourth quarter of 2008. Net income for 2007 included $40.6 million of benefits from the annual reviews.
The charges from the annual reviews of $208.9 million in 2008, included $134.9 million relating to reserve increases for the guaranteed minimum death and income benefit features of our variable annuity products and $74.0 million related to increased amortization of deferred policy acquisition and other costs. The charge relating to increased amortization of deferred policy acquisition and other costs primarily reflects the impact on gross profits of market value decreases in the underlying assets associated with our variable annuity products. The reserve increases for the guaranteed minimum death and income benefit features of our variable annuity products also reflects this impact, as well as increased cost of expected income and death benefit claims due to lower expected lapse rates for policies where the current policyholder account value is below the guaranteed minimum death benefit. Net income for 2007 included $40.6 million of benefits from the annual reviews, reflecting market value increases in the underlying assets associated with our variable annuity products, and decreased cost of actual and expected death claims.
As discussed above, results for 2008 also include $154.8 million of charges associated with market performance related adjustments to our estimate of total gross profits to reflect actual fund market performance in the fourth quarter of 2008 and corresponding changes to the future rate of return assumptions. This adjustment for market performance included $72.2 million relating to increased amortization of deferred policy acquisition and other costs and $82.6 million relating to reserve increases for the guaranteed minimum death and income benefit features of our variable annuity products, and reflects additional market value decreases in the underlying assets associated with our variable annuity products. In light of recent market conditions, beginning in the fourth quarter of 2008, we determined that adjustments to our estimate of total gross profits to reflect actual fund market performance and any corresponding changes to the future rate of return assumptions should no longer be dependent on a comparison to a statistically generated range of estimated gross profits. Instead, for purposes of evaluating deferred policy acquisition and other costs and the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, total estimated gross profits are updated for these items each quarter. Market value declines in the fourth quarter of 2008 decreased our estimates of total gross profits by establishing a new, lower starting point for the variable annuity account values used in estimating gross profits for future periods. The decrease in our estimate of total gross profits results in a higher required rate
of amortization and a higher rate to build reserve provisions, which is applied to all prior periods’ gross profits. The resulting cumulative adjustment to prior amortization and reserve balances is recognized in the current period. In addition, the higher rate of amortization and reserves will also be applied to future gross profits in calculating amortization in future periods which, all else being equal, will result in lower net profits in future periods.
We continue to derive our future rate of return assumptions 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 so that the assets grow at the expected rate of return for the entire period. However, beginning in the second half of 2008, the projected future rate of return calculated using the reversion to the mean approach for most contact groups was greater than 10.5%, our maximum future rate of return assumption across all asset types for this business. In those cases we utilized the maximum future rate of return, thereby limiting the impact of the reversion to the mean, and further decreasing our estimate of total gross profits. Further or continued market declines could result in additional market depreciation within our separate account assets and corresponding decreases in our gross profits, as well as additional adjustments to the amortization of deferred policy acquisition and other costs, and the costs relating to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products. Given that the estimates of future gross profits for most contract groups are already based upon our maximum future rate of return assumption as discussed above, all else being equal, further market movements could have a greater impact on the amortization of deferred policy acquisition and other costs, and the costs relating to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, in comparison to prior periods.
Absent the effect of the annual reviews and market performance adjustments discussed above, net income for the year ended December 31, 2008 increased $129.7 million from the year ended December 31, 2007. Contributing to this increase was higher net investment income of $245.5 million due to transfers from the separate account variable investment options into the general account fixed rate investment options. The transfer of balances to our general account relates to an automatic rebalancing element in some of our living benefit features, which as part of the overall product design transferred approximately $9.3 billion of investments in the first year of 2008 out of the separate accounts and into our general account due to equity market declines. Realized investment losses, net, decreased by $87.0 million from losses of $41.0 million for the year ended December 31, 2007 to gains of $46.0 million for the year ended December 31, 2008 driven by increased investment gains on our general account and MVA portfolio due to decrease in interest rates. Also contributing to the increase in net income was a decrease in the amortization of deferred policy acquisition and other costs of $121.8 million, absent the effect of the annual reviews and market performance adjustments discussed above and the quarterly adjustments as discussed below, due to lower levels of actual gross profits driven by unfavorable market performance and embedded derivative breakage.
In addition to the quarterly adjustment, the favorable variances in net income were further offset by higher interest credited to policyholder account balances of $155.6 million due to the aforementioned general account transfers. Additionally, policy charges and fee income and asset administration fees decreased $101.8 million driven by lower average variable annuity asset balances invested in separate accounts. The declines in separate account assets were due to market depreciation and transfers of balances to our general account. Further details regarding the components of revenues and expenses are described below.
Revenues increased $222.5 million, from $993.6 million for the year ended December 31, 2007 to $1,216.1 million for the year ended December 31, 2008. Premiums decreased $7.8 million, from $28.2 million for the year ended December 31, 2007 to $20.4 million for the year ended December 31, 2008, reflecting a decrease in funds from customers electing to enter into the payout phase of their annuity contracts.
Policy charges and fee income decreased $74.9 million, from $707.3 million for the year ended December 31, 2007 to $632.4 million for the year ended December 31, 2008 driven by lower mortality and expense (“M&E”) fees of $83.7 million driven by lower average variable annuity asset balances invested in separate accounts due to market depreciation and the transfer of balances to our general account relating to an automatic rebalancing element in some of our living benefit features, as discussed above partially offset by the change in realized market value adjustments related to the Company’s market value adjusted investment option (the “MVA option”).
Net investment income increased $245.5 million from $74.6 million for the year ended December 31, 2007 to $320.1 million for the year ended December 31, 2008 as a result of higher general account assets as these assets moved from separate account variable investment options into the general account fixed rate investment options due to the automatic rebalancing element, as discussed above.
General, administrative and other expenses increased by $97.1 million, from $529.2 million for the year ended December 31, 2007 to $626.3 million for the year ended December 31, 2008. The increase was primarily driven by $124.0 million from the impact of an annual review of our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, as discussed above, as well as the impact of $62.3 million from the quarterly adjustment for current period experience, as discussed above. Also contributing to the increase was higher general expenses of $21.3 million primarily driven by higher employee benefits. Partially offsetting these increases was a decrease in the amortization of deferred policy acquisition and other costs of $104.4 million due to lower levels of actual gross profits primarily driven by unfavorable market performance. We amortize deferred policy acquisition and other costs over the expected lives of the contracts based on the level and timing of gross profits on the underlying product. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and include profits and losses related to these contracts that are reported in affiliated legal entities other than the Company as a result of, for example, reinsurance agreements with those affiliated entities.
The decline in income tax expense primarily reflects the decline in income from operations before income taxes for the year ended December 31, 2008. The impact of non-taxable investment income on the total tax provision decreased in 2008 as compared to 2007 and 2006, primarily due to a decrease in the dividends received deduction, or DRD. The DRD reduces the amount of dividend income subject to tax and is the primary component of the non-taxable investment income shown in the table above, and, as such, is a significant component of the difference between our actual tax expense and the expected amount determined using the federal statutory tax rate of 35%. The DRD for the current period was estimated using information available from current year results, information from 2007 calculations, and estimates to take into account the current year’s equity market performance. The actual current year DRD can vary from the estimate based on factors such as, but not limited to, changes in the amount of dividends received that are eligible for the DRD, changes in the amount of distributions received from mutual fund investments, changes in the account balances of variable life and annuity contracts, and our taxable income before the DRD.
Management monitors the liquidity of Prudential Financial and the Company on a daily basis and projects borrowing and capital needs over a multi-year time horizon through our quarterly planning process. We believe that cash flows from the sources of funds presently available to us are sufficient to satisfy our current liquidity requirements, including reasonably foreseeable contingencies.
The principal sources of the Company’s liquidity are premiums and annuity considerations, investment and fee income, and investment maturities and sales, as well as internal borrowings. The principal uses of that liquidity include benefits, claims, 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.
The Risk Based Capital, or RBC, ratio is the primary measure by which we evaluate the capital adequacy of the Company. We manage our RBC ratio to a level consistent with an “AA” ratings objective. RBC is determined by statutory formulas that consider risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products, interest rate risks and general business risks. The RBC ratio calculations are intended to assist insurance regulators in measuring the adequacy of an insurer’s statutory capitalization.