Management’s Discussion and Analysis of Financial Condition and Results of Operations, or “MD&A,” is omitted pursuant to General Instruction I (2) (a) of Form 10-K. The management narrative for Pruco Life Insurance Company that follows should be read in conjunction with the Forward-looking Statements included below the Table of Contents, “Risk Factors”, and the Financial Statements and related notes included in this Annual Report on Form 10-K.
Management’s narrative addresses the financial condition of Pruco Life Insurance Company as of December 31, 2008, compared with December 31, 2007, and its results of operations for the years ended December 31, 2008 and 2007.
account products including universal and variable life insurance and variable annuities. 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 we sell and interest credited on general account liabilities.
The Company’s profitability depends principally on its ability and Prudential Insurance’s ability to price and manage risk on insurance products, to attract and retain customer assets, and to manage expenses. Specific drivers of our profitability include:
and takes into account, among other things, the credit quality of the issuer and the reduced liquidity associated with private placements. In determining the fair value of certain securities, the discounted cash flow model may also use unobservable inputs, which reflect our own assumptions about the inputs market participants would use in pricing the asset.
We capitalize costs that vary with and are related primarily to the acquisition of new and renewal insurance and annuity contracts. These costs include primarily commissions, costs of policy issuance and underwriting, and variable field office expenses. We amortize these deferred policy acquisition costs, over the expected life of the contracts, based on the level and timing of either gross profits, or gross premiums, depending on the type of contract. As of December 31, 2008, DAC in our life business was $1.796 billion and DAC in our annuity business was $806 million.
Tax regulations require items to be included in the tax return at different times from the items reflected in the financial statements. As a result, the effective tax rate reflected in the financial statements is different than the actual rate applied on the tax return. Some of these differences are permanent such as expenses that are not deductible in our tax return, and some differences are temporary, reversing over time, such as valuation of insurance reserves. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit
in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet recognized in our financial statements.
Our liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the IRS or other taxing authorities. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards, or tax attributes, the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to our liability for income taxes. The statute of limitations for the 2002 and 2003 U.S. Federal tax years is set to expire in 2009. The Company does not anticipate any significant changes to it’s unrecognized tax benefit during the next 12 months. U.S. Federal tax years 2004 through 2008 are still open for IRS examination.
On January 26, 2006, the IRS officially closed the audit of our consolidated federal income tax returns for the 1997 to 2001 periods. The statute of limitations has closed for these tax years; however, there were tax attributes which were utilized in subsequent tax years for which the statute of limitations remains open.
In December 2006, the IRS completed all fieldwork with regards to its examination of the consolidated U.S. federal income tax returns for tax years 2002 and 2003. The final report was initially submitted to the Joint Committee on Taxation for their review in April 2007. The final report was resubmitted in March 2008 and again in April 2008. The Joint Committee returned the report to the IRS for additional review of an industry issue regarding the methodology for calculating the DRD related to variable life insurance and annuity contracts. The IRS completed its review of the issue and proposed an adjustment with respect to the calculation of the DRD. In order to
Total assets decreased by $4.362 billion, from $35.358 billion at December 31, 2007 to $30.996 billion at December 31, 2008. The largest decrease was in separate account assets, which decreased $7.034 billion, from $24.609 billion at December 31, 2007 to $17.575 billion at December 31, 2008, primarily driven by equity market depreciation during the current year. This decline is partially offset by the items discussed below.
Commercial loans increased $137 million, from $745 million at December 31, 2007, to $882 million at December 31, 2008, due to continued investing in commercial loans.
Fixed maturities increased by $34 million, from $4.510 billion at December 31, 2007 to $4.544 billion at December 31, 2008. This increase was primarily driven by transfers from our separate account to our general account due to an automatic rebalancing element in certain of our living benefit features on our annuity products. Also contributing to the increase was continued reinvestment of cash flows from business operations and reinvestment of investment income in our life business primarily due to continued growth. This increase was partially offset by increased unrealized losses in 2008 of $321 million driven by market depreciation.
Deferred policy acquisition costs “DAC” increased by $428 million from $2.174 billion at December 31, 2007, to $2.602 billion at December 31, 2008, primarily driven by $472 million of capitalization of acquisition costs from the continued growth of sales in life and annuity products, partially offset by net amortization of $309 million. DAC increased $265 million related to unrealized capital losses.
Additional Paid in Capital increased $360 million due to a contribution from Prudential Insurance Company of America, the parent company in 2008.
Consolidated net income of $249 million for 2008 increased $2 million from $247 million in 2007. Net income for 2008 included net charges of $241 million before taxes reflecting the impact of the annual reviews in the third quarter of our estimate of total gross profits for life and annuities as well as market performance adjustments to our estimate of total gross profits on our annuity products in the fourth quarter. Net income for 2007 included a $22 million benefit before taxes resulting from the annual review in the third quarter, primarily related to lower benefits expected under guaranteed income benefit features on variable annuity products. Absent the impacts of the annual reviews conducted in the third quarter and market performance adjustments in the fourth quarter, consolidated net income was $265 million higher than the prior year mainly due to higher realized gains of $227 million primarily driven by the change in the value of an embedded derivative associated with the no lapse feature on our universal life business that is reinsured with “UPARC” (See Note 13 to Consolidated Financial Statements). The current period net income also benefited from lower reinsurance ceded premiums due to an adjustment of an overpayment to an affiliate in prior periods of $32 million after tax, higher product margins in our term and universal life in force and lower general and administrative expenses primarily driven by lower bonus costs. These increases were partially offset by lower asset based fees due to lower separate account balances reflecting the unfavorable equity markets and lower investment spreads driven by the payment of a $300 million dividend to parent in third quarter of 2007 and losses on our capital investment in the real property separate account fund.
As mentioned above, results for 2008 also included $192 million of charges associated with market performance related adjustments to our estimate of total gross profits to reflect actual fund performance in the fourth quarter of 2008 and corresponding changes to the future rate of return assumptions on our annuity products and life products. This adjustment for market performance included $81 million relating to increased amortization of deferred policy acquisition and other costs and $111 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 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 resulted in a higher required rate of amortization and a higher rate to build reserve provisions, which was applied to all prior periods’ gross profits. The resulting cumulative adjustment to prior amortization and reserve balances was 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.
Consolidated revenues increased by $227 million, from $1.160 billion in 2007 to $1.387 billion in 2008.
Net investment income decreased by $17 million from $381 million in 2007 to $364 million in 2008, primarily due to lower invested assets resulting from a dividend payment to Prudential Insurance Company of America of $300 million during third quarter of 2007, the final run-off of our guaranteed interest contract or “GIC” in-force in 2007 and losses due to individual lifes capital investment in real property separate account fund. This was partially offset by continued growth in the portfolio due to positive cash flows from business operations and reinvestment of net investment income in 2008.
General, administrative, and other expenses decreased by $8 million from $528 million in 2007 to $520 million in 2008. The current year benefited $28 million due to the result of annual reviews in the third quarter discussed above. The prior year increased $35 million from the annual review conducted in the third quarter of 2007. Fourth quarter 2008 expenses included an $81 million increase in amortization of deferred policy acquisition costs due to market and reversion to the mean assumptions on our variable annuity and life business. Absent the impacts of the annual reviews conducted in both periods and reversion to the mean assumptions, general,
administrative, and other expenses decreased $27 million in 2008, primarily driven by driven by lower bonus costs and higher net reinsurance expense allowances resulting from growth in the term business. This decrease was partially offset by higher amortization of deferred acquisition costs due to unfavorable separate account fund performance.
Interest credited to policyholders’ account balances increased by $4 million, from $209 million in 2007 to $213 million in 2008. This was primarily due to an increase in growth of policyholders’ account balances on life products which increased due to higher policyholder deposits resulting from universal life sales. This was partially offset by the final run-off of “GIC” in-force in 2007.
We adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” an Interpretation of FASB Statement No. 109 on January 1, 2007. For additional information regarding the adoption of this guidance, see Note 7 of the Consolidated Financial Statements.
In December 2006, the IRS completed all fieldwork with regards to its examination of the consolidated federal income tax returns for tax years 2002 and 2003. The final report was initially submitted to the Joint Committee on Taxation for their review in April 2007. The final report was resubmitted in March 2008 and again in April 2008. The Joint Committee returned the report to the IRS for additional review of the industry issue regarding the methodology for calculating the DRD related to variable life insurance and annuity contracts. The IRS completed its review of the issue and proposed an adjustment with respect to the calculation of the DRD. In order to expedite receipt of an income tax refund related to the 2002 and 2003 years, we have agreed to such adjustment. Nevertheless, we believe that our return position is technically correct. Therefore, we intend to file a protective refund claim to recover the taxes associated with the agreed upon adjustment and to pursue such other actions as appropriate. The report, with the adjustment, was submitted to the Joint Committee on Taxation in October 2008. We were advised on January 2, 2009 that the Joint Committee completed its consideration of the report and has taken no exception to the conclusions reached by the IRS. Accordingly, the final report was processed and a refund was received. The statute of limitations for these years will close on December 31, 2009. These activities had no impact on our 2007 or 2008 results.
During the fourth quarter of 2008, the volatility and disruptions in the credit and capital markets reached unprecedented levels, adversely affecting the global economy, particularly in the financial services industry. The U.S. federal government has taken or is considering taking actions in order to address this financial market dislocation.
Liquid assets include cash, cash equivalents, short-term investments, fixed maturities and public equity securities. As of December 31, 2008 and December 31, 2007, our insurance operations had liquid assets of $5.232 billion and $4.753 billion, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $671.2 million and $212.6 million as of December 31, 2008 and December 31, 2007, respectively. As of December 31, 2008, $4.082 billion, or 90%, of the fixed maturity investments company general account portfolios were rated investment grade. The remaining $462 million, or 10%, of these fixed maturity investments were rated non-investment grade. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures in order to evaluate the adequacy of our insurance operations’ liquidity under a variety of stress scenarios. We believe that the liquidity profile of our assets is sufficient to satisfy current liquidity requirements, including under foreseeable stress scenarios.
As discussed above, market conditions during 2008 negatively impacted the level of our capital. In order to address these impacts on our capital, Prudential Financial undertook various initiatives to redeploy certain assets to its insurance subsidiaries from its non-insurance subsidiaries.