The Company has sold 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.
Beginning in March 2010, the Company ceased offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product in each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company within the Prudential Annuities business unit of Prudential Financial). In general, the new product line offers the same optional living benefits and optional death benefits as offered by the Company’s existing variable annuities. However, subject to applicable contractual provisions and administrative rules, the Company will continue to accept subsequent purchase payments on inforce contracts under existing annuity products. These initiatives were implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. In addition, by limiting its variable annuity offerings to a single product line sold through one insurer (and its affiliate, for New York sales), the Prudential Annuities business unit of Prudential Financial expects to convey a more focused, cohesive brand in the marketplace.
In addition to policy charges and fee income, the Company earns revenues from asset administration fees calculated on the average separate account fund balances. The Company’s operating expenses principally consist of insurance benefits provided, general business expenses, commissions and other costs of selling and servicing the various products it sold.
our ability to manage and control our operating expenses, including overhead;
In addition, factors such as regulation, competition, interest rates, taxes, market fluctuations and general economic, market and political conditions affect the Company’s profitability. See “Risk Factors” for a discussion of risks that have affected and may affect in the future our business, results of operations or financial condition, or cause our actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.
The following sections discuss the accounting policies applied in preparing our financial statements that management believes are most dependent on the application of estimates and assumptions and require management’s most difficult, subjective, or complex judgements.
We update the projected future rate 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. As of December 31, 2010, our expected rate of return for the next four years across all asset types is 6.1% per annum. These rates represent a weighted average of our expected rates of return across all contract groups. For some contract groups, our expected rate of return for the next four years equals our current maximum future rates of return, as the near-term projected future rate of return under the reversion to the mean approach is greater than our maximum future rate of return. For certain contract groups relating to variable annuities issued in 2009 and 2010, the expected rate of return over the next four years is under 6.1% per annum, reflecting the impact of more favorable markets in 2009 and 2010 and the reversion to the mean approach.
direct effect of changes in our future rate of return on the DAC and DSI balances and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC. 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.
For a discussion of our actual DAC and DSI adjustments for the years ended December 31, 2010 and 2009 , see “-Results of Operations”
In addition to DAC and DSI, we also recognize an asset for valuation of business acquired (“VOBA”). As of December 31, 2010, VOBA balance was $32.5 million. VOBA represents the present value of future profits embedded in acquired businesses, and is determined by estimating the net present value of future cash flows from the contracts in force at the date of acquisition. VOBA is amortized over the effective life of the acquired contracts. For additional information about VOBA including its bases for amortization, see Note 5 of the financial statements. VOBA is also subject to recoverability testing at the end of each reporting period to ensure that balance does not exceed the present value of total anticipated gross profits.
For a discussion of adjustments to the reserves for guaranteed minimum death and income benefits for the years ended December 31, 2010 and 2009 , see “-Results of Operations”.
or capital; (3) in which tax jurisdictions they were generated and the timing of their reversal; (4) taxable income in prior carryback years as well as projected taxable earnings exclusive of reversing temporary differences and carryforwards; (5) the length of time that carryovers can be utilized in the various taxing jurisdictions; (6) any unique tax rules that would impact the utilization of the deferred tax assets; and (7) any tax planning strategies that we would employ to avoid a tax benefit from expiring unused. Although realization is not assured, management believes it is more likely than not that the deferred tax assets, net of valuation allowances, will be realized.
Our accounting represents management’s best estimate of future events that can be appropriately reflected in the accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate. For example, the dividends received deduction, or DRD, reduces the amount of dividend income subject to tax and 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 U.S. Treasury Department and the Internal Revenue Service, or IRS, intend to address through regulations the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. On February 14, 2011, the Obama Administration released the “General Explanations of the Administration’s Revenue Proposals.” Although the Administration has not released proposed statutory language, one proposal would change the method used to determine the amount of the DRD. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulation or legislation, could increase our actual tax expense and reduce our net income.
An increase or decrease in our effective tax rate by one percent would have resulted in an increase or decrease in consolidated income from continuing operations in 2010 of $5.4 million.
See Note 2 to the Financial Statements for a discussion of adopted and newly issued accounting pronouncements.
Total assets increased by $5.3 billion, from $51.9 billion at December 31, 2009 to $57.2 billion at December 31, 2010. Separate account assets increased by $6.8 billion, primarily driven by market appreciation, positive net flows and transfers of balances from the general account to the separate accounts primarily as a result of transfers from a customer elected dollar cost averaging (“DCA”) program and the asset transfer feature embedded, in some of our optional living benefit features, as discussed above. Additionally, reinsurance recoverables increased by $146.5 million driven by an increase in the reinsured liability for living benefit embedded derivatives primarily driven by an increase in the present value of future expected benefit payments driven by lower interest rates as well as a updates of the inputs used in the valuation of the embedded derivatives. The reinsured liability increased related to an update to reduce expected lapse rate assumption based on evolving experience, partially offset by updates to the market perceived risk of our non-performance resulting from the increase in the fair value of embedded derivative liabilities. Also contributing to the increase in total assets was an increase in deferred policy acquisition costs (“DAC”) of $128.5 million mainly due to capitalized costs on new business sales, partially offset by amortization on current year gross profits. Partially offsetting the above increases in total assets were decreases in fixed maturities and short term investments of $1.0 billion and $477.5 million, respectively, driven by lower general account balances due to the aforementioned transfers related to the DCA program and the asset transfer feature. Also serving as a partial offset was lower income tax receivable of $230.4 million.
The increase in income from operations before taxes was driven by an increase in fee income, net of higher distribution costs, due to higher average variable annuity asset balances invested in separate accounts. The increase in average separate account asset balances was due to positive net flows, net market appreciation, and net transfers of balances from the general account to the separate accounts during 2010. The transfer of balances from the general account were approximately $1.4 billion, primarily related to both transfers from the DCA program and net transfers from the asset transfer feature, in some of our optional living benefit features. The asset transfer feature is part of the overall product design, and as a result of market improvements, transferred balances out of the fixed-rate account in our general account to the separate accounts during 2010. Also included within the increase was an $80.3 million favorable variance in the mark-to-market on derivative positions associated with our capital hedging program. Results for 2009 included $76.1 million of mark-to-market losses on these capital hedges driven by favorable market conditions during the year. Results for 2010 included $4.2 million of mark-to-market gains on these capital hedges. During the second quarter of 2010, we terminated the capital hedge program in lieu of a new program managed at the Prudential Financial level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial as a whole and its subsidiaries, under stress scenarios. Additionally, the above increase in income from operation before income taxes included a favorable variance from lower amortization of deferred policy acquisition and other costs, and more favorable adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, as discussed in more detail below.
Included in the favorable variance from lower amortization of deferred policy acquisition and other costs mentioned above, was a $137.8 million favorable variance in amortization related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions. This impact primarily relates to updates to the inputs used in the valuation of the reinsured liability for living benefit embedded derivatives, primarily due to reductions in the expected lapse rate assumption based on actual experience in 2010. Also contributing to lower deferred policy acquisition and other costs amortization is the impact of a change in our market-perceived non-performance risk (“NPR”), and lower amortization rates used as a basis for amortizing deferred policy acquisition and other costs, as discussed below. We incorporate the market-perceived risk of non-performance of our affiliates’ in the valuation of the embedded derivatives associated with our living benefit features on our variable annuity contracts. Beginning in the first quarter of 2009, in light of developments including rating agency downgrades to the financial strength ratings of the Company, we incorporated an additional spread over LIBOR into
(1) Amounts reflect (charges) or benefits for (increases) or decreases, respectively, in the amortization of deferred policy acquisition, or DAC, and other costs.
As shown in the table above, results for both periods include the impact of the annual reviews of the assumptions used in the reserve for the guaranteed minimum death and income benefit features of our variable annuity products and in our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs. The year ended December 31, 2010 included a $108.2 million of benefits from these annual reviews, primarily related to reductions in lapse rate assumptions and more favorable assumptions relating to fee income. The year ended December 31, 2009 included $4.5 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 $134.8 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, which are detailed further below.
business. In those cases, we utilize the maximum future rate of return over the four year period, thereby limiting the impact of the reversion to the mean on our estimate of total gross profits. The near-term blended maximum future rate of return, for these impacted contract groups, under the reversion to the mean approach is 9.3% at the end of 2010. Included in the blended maximum future rate are assumptions for returns on various asset classes, including a 5.7% annual weighted average rate of return on fixed income investments and a 13% annual maximum rate of return on equity investments.
The $11.6 million benefit for the year ended December 31, 2010 and the $1.8 million benefit for the year ended December 31, 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 guaranteed minimum death and income benefit 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 the year ended December 31, 2010 reflect an increase in amortization due to less favorable than expected gross profits, resulting primarily from the charges related to the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features. The adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in the year ended December 31, 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 the year ended December 31, 2009 reflect an increase in amortization due to lower than expected realized gains activity. The adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in the year ended December 31, 2009 primarily reflects higher than expected fee income due to market value increases, partially offset by higher than expected contract guaranteed claims due to lower than expected lapses.
Revenues increased $438.5 million, from $1,136.5 million for the year ended December 31, 2009 to $1,574.0 million for the year ended December 31, 2010. Premiums increased $16.0 million, from $13.4 million for the year ended December 31, 2009 to $29.4 million for the year ended December 31, 2010, reflecting an increase in funds from customers electing to enter into the payout phase of their annuity contracts.
Policy charges and fee income increased $348.4 million, from $392.8 million for the year ended December 31, 2009 to $741.2 million for the year ended December 31, 2010 driven by higher fee income primarily driven by an increase in average variable annuity asset balances invested in separate accounts. The increase in average separate account asset balances was due to positive net flows, net market appreciation, and net transfers of balances from the fixed-rate option in the general account to the separate accounts over the past twelve months relating to both a customer elected dollar cost averaging program and an asset transfer feature in some of our optional living benefit features. The increase in optional benefit charges was primarily offset in realized investment gains, net as these features are reinsured with affiliates. Also included in the above increases was a $27.0 million benefit in the year ended December 31, 2010 from refinements based on review and settlement of reinsurance contracts and $40.8 million of lower charges from market value adjustments related to the Company’s MVA option driven by market conditions and transfer of assets to the separate account primarily due to the asset transfer feature.
Asset administration fees and other income increased $92.5 million, from $197.7 million for the year ended December 31, 2009 to $290.2 million for the year ended December 31, 2010 as a result of higher average variable annuity asset balances invested in separate accounts, as discussed above.
Realized investment gains, net, increased by $99.0 million from $37.0 million for the year ended December 31, 2009 to $136.0 million for the year ended December 31, 2010. This increase was driven by an increase in net realized investment gains on fixed maturities primarily in our MVA and general account portfolios, driven by the sale of assets in a low interest rate environment. Also contributing to above increase was a favorable variance primarily related to mark-to-market losses in 2009 on derivative positions associated with our capital hedging program. This variance was partially offset by an unfavorable variance in the mark-to-market of embedded derivatives and related hedge positions associated with our non-reinsured living benefit features of our variable annuity products, including the impact of our market-perceived non-performance risk.
Interest credited to policyholders’ account balances decreased $37.3 million, from $409.1 million for the year ended December 31, 2009 to $371.8 million for the year ended December 31, 2010, due to lower interest credited to policyholders’ account balances of $94.6 driven by
Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long term financial resources available to support the operation of our business, fund business growth, and provide a cushion to withstand adverse circumstances. The ability to generate and maintain sufficient liquidity and capital depends on the profitability of our business, general economic conditions and our access to the capital markets through our affiliates as described herein.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, could result in the imposition of new capital, liquidity and other requirements on Prudential Financial and the Company. See Item 1. Business -”Regulatory Environment” for information regarding the potential effects of the Dodd-Frank Act on the Company and its affiliates.
On November 23, 2010, the Company paid an ordinary dividend of $330 million and an extraordinary dividend of $140 million to Prudential Financial.
Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of our operations. We segment our investment portfolios and employ an asset/liability management approach specific to the requirements of our product lines. This enhances the discipline applied in managing the liquidity, as well as the interest rate and credit risk profiles, of each portfolio in a manner consistent with the unique characteristics of the product liabilities. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact of Prudential Funding, LLC’s financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company.
The principal sources of the Company’s liquidity are 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. As discussed above, in March 2010, the Company ceased offering its existing variable annuity products to new investors upon the launch of a new product by certain affiliates. Therefore, the Company expects its overall level of cash flows to decrease going forward.
We believe that the cash flows from our operations are adequate to satisfy our current liquidity requirements including under reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors such as future securities market conditions, changes in interest rate levels, policyholder perceptions of our financial strength, and the relative safety of competing products, each of which could lead to reduced cash inflows or increased cash outflows. In addition, market volatility can impact the level of capital required to support our businesses. Our cash flows from investment activities result from repayments of principal, proceeds from maturities and sales of invested assets, net of amounts reinvested. The primary liquidity risks with respect to these cash flows are the risk of default by debtors or bond insurers, our counterparties’ willingness to extend repurchase and/or securities lending arrangements, commitments to invest and market volatility. We closely manage these risks through our credit risk management process and regular monitoring of our liquidity position.
Prudential Funding, LLC, or Prudential Funding, a wholly owned subsidiary of Prudential Insurance, serves as an additional source of financing to meet our working capital needs up to limits established with the applicable insurance regulators. Prudential Funding borrows funds in the capital markets primarily through the direct issuance of commercial paper.
Prudential Financial recently changed the focus of its capital hedge program from the equity price risk associated with the annuities business to a broader view of equity market exposure of the statutory capital of Prudential Financial and its subsidiaries, as a whole. In the second quarter of 2010, the capital hedge program was terminated as described under “-Results of Operations” and equity index-linked derivative transactions were entered into that are designed to mitigate the overall impact on statutory capital of a severe equity market stress event on Prudential Financial and its subsidiaries, as whole. A portion of the derivatives related to the new program were purchased by the Company. The program now focuses on tail risk rather than general equity market declines in order to protect statutory capital in a more cost-effective manner under stress scenarios. Prudential Financial assesses the composition of the hedging program on an ongoing basis and may change it from time to time based on an evaluation of its risk position or other factors.
Certain of the Company’s statutory reserves are ceded to an affiliated offshore captive reinsurance company. A reinsurance trust is established by the affiliated offshore captive reinsurance company to satisfy reinsurance reserve credit requirements. These reserve credits allow the Company to reduce the level of statutory capital it is required to hold. Reinsurance credit reserve requirements can move materially in either direction due to changes in equity markets and interest rates, actuarial assumptions and other factors. Higher reinsurance credit reserve requirements would necessitate depositing additional assets in the statutory reserve credit trusts, while lower reinsurance credit reserve requirements would allow assets to be removed from the statutory reserve credit trusts. We expect Prudential Financial would satisfy those additional needs through a combination of funding the reinsurance credit trusts with available cash, certain hedge assets or collateral associated with the hedge positions, and loans from Prudential Financial and/or affiliates. Prudential Financial also continues to evaluate other options to address reserve credit needs such as obtaining letters of credit. Funding was provided to the captive reinsurance trusts of $178 million for the second quarter of 2010 to meet increased reserve credit requirements due to unfavorable equity market conditions and lower interest rates, and an additional $334 million was provided for the third quarter of 2010 due to an update of actuarial assumptions based on an annual review, most notably a decrease in expected future lapse rates, partially offset by favorable equity market conditions. Due to favorable equity market conditions and higher interest rates in the fourth quarter of 2010, our need to fund the captive reinsurance trusts has declined by $907 million.