Management’s Discussion and Analysis of Financial Condition and Results of Operations, or “MD&A,” addresses the consolidated financial condition of Pruco Life Insurance Company as of December 31, 2007, compared with December 31, 2006, and its consolidated results of operations for the years ended December 31, 2007 and 2006.
The Company earns revenues principally from insurance premiums; mortality, expense, and asset management fees from insurance and investment products; and investment of general account and other funds. The Company earns premiums primarily from the sale of term individual life insurance. The Company earns mortality, expense, and asset management fees and servicing of separate 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.
Commercial loans, which comprised nearly 12% of our investments as of December 31, 2007, are carried primarily at unpaid principal balances, net of unamortized premiums or discounts and an allowance for losses. This allowance includes a loan specific portion as well as a portfolio reserve for probable incurred but not specifically identified losses. The loan specific portion, is based on management’s judgment as to ultimate collectibility of loan principal. The portfolio reserve is based on a number of factors, such as historical experience and portfolio diversification. Adjustments to the allowance are reflected in “Realized investment gains (losses), net,” in our statements of operations. Similar to impairment losses discussed above, the allowance for losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
The future policy benefit reserves at December 31, 2007 represented 7% of our total liabilities and relate primarily to term life are determined in accordance with GAAP as the present value of expected future benefits to or on behalf of policyholders plus the present value of future expenses less the present value of future net premiums. The expected future benefits are based on mortality, lapse, and maintenance expense and interest rate assumptions. Reserves for new business are based on best estimate assumptions as of the date the policy is issued with provisions for the risk of adverse deviation. After our reserves are initially established, we perform premium deficiency tests using best estimate assumptions as of the testing date without provisions for adverse deviation. If reserves determined based on these best estimate assumptions are greater than the GAAP liabilities (i.e., reserves net of any DAC asset), the existing GAAP liabilities are adjusted to the greater amount. Our best estimate mortality assumptions are generally based on the Company’s historical experience or standard industry tables, as applicable; 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. We review our mortality assumptions annually. Generally, we do not expect our mortality trends to change significantly in the short term and to the extent these trends may change we expect such changes to be gradual over the long term.
DAC associated with the variable and universal life policies of our domestic individual life insurance and the variable and fixed annuity contracts of our individual annuities business is amortized over the expected life of these policies 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. 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. For the variable and universal life policies 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 experience. Updates to our mortality assumptions in future periods could have a significant adverse or favorable effect on our results of operations.
Fixed maturities decreased by $401 million, from $4.911 billion at December 31, 2006 to $4.510 billion at December 31, 2007. The decrease was primarily driven by the sale of securities to fund the payment of a dividend to the Company’s parent, Prudential Insurance, of $300 million and the movement of contractholder assets from the fixed rate general account options to the variable separate account investment options. Also contributing were scheduled withdrawals and maturities of guaranteed investment contracts or “GIC”, and the re-investment in commercial loans.
Deferred policy acquisition costs increased by $215 million from $1.959 billion at December 31, 2006, to $2.174 billion at December 31, 2007, primarily driven by $490 million of capitalization of acquisition costs from the continued growth of sales in life and annuity products, partially offset by net amortization of $288 million. Shadow DAC increased $13 million from decreased unrealized gains.
Total liabilities increased by $2.917 billion, from $30.168 billion at December 31, 2006 to $33.085 billion at December 31, 2007, primarily due to separate account liabilities growth of $2.657 billion, as described above. Policyholder account balances decreased by $407 million, from $5.484 billion at December 31, 2006 to $5.077 billion at December 31, 2007, primarily due to the movement of contractholder assets from the fixed rate general account option to the variable separate account investment options in annuity products and continued maturities and surrenders of guaranteed investment contracts in 2007. Future policy benefits and other policyholder liabilities increased by $410 million, from $1.765 billion at December 31, 2006 to $2.175 billion at December 31, 2007 primarily due to increases to life reserves as a result of sales and renewals of term products, and increased reserves for the Taiwan business. The Company’s short term debt from affiliates used to provide short term working capital increased by $31 million from $25 million at December 31, 2006 to $56 million at December 31, 2007. Total securities lending activity increased by $267 million from $148 million at December 31, 2006 to $415 million at December 31, 2007. The relative amounts of cash collateral for loaned securities and securities sold under agreements to repurchase increased $8 million and $259 million, respectively.
Consolidated revenues increased by $194 million, from $966 million in 2006 to $1.160 billion in 2007.
Policy charges and fee income, consisting primarily of mortality and expense, loading and other insurance charges assessed on general and separate account policyholders’ fund balances, increased by $140 million, from $548 million in 2006 to $688 million in 2007, including $79 million due to updates in both periods of our assumptions related to the amortization of unearned revenue reserves based on the annual reviews as discussed above. Absent this item, policy charges and fee income increased $61 million in 2007, reflecting growth in universal life insurance in force, higher fees from growth in separate account assets resulting from market appreciation and the sale of a large COLI case to an affiliate.
Net realized investment losses decreased by $42 million, from realized losses of $63 million in 2006 to realized losses of $21 million in 2007, mainly due to higher sales of fixed maturities in a rising interest rate environment in 2006. Also affecting 2007 were losses of
$10 million due to mark to market on embedded derivatives associated with a dollar denominated foreign investment partially offset by a gain of $13 million related to the change in the value of an embedded derivative associated with a no lapse feature related to the universal life business (See Note 13 to Consolidated Financial Statements).
General, administrative, and other expenses increased by $219 million from $309 million 2006 to $528 million 2007. General, administrative, and other expenses in 2006 were primarily driven by the annual review, discussed above, which resulted in a reduction in amortization of deferred acquisition costs of $149 million. In 2007, the annual review resulted in an increase in amortization of deferred acquisition costs of $35 million. Absent the impacts of the annual reviews conducted in both periods, general, administrative, and other expenses increased $35 million in 2007, primarily due to higher new business related expenses, and higher expense charges due to increased policy counts.
Interest credited to policyholders’ account balances decreased by $3 million, from $212 million in 2006 to $209 million in 2007. This was primarily due to lower interest credited on GIC contracts of $11 million due to continued maturities and withdrawals in the current year with no additional sales. Also contributing to this decrease were lower policyholders’ account balances for annuity products driven by movement of contractholder assets from the fixed rate general account option to the variable separate account investment option of $5 million, partially offset by an increase in growth of policyholders’ account balances of life products which increased due to higher policyholder deposits resulting from universal life sales of $13 million.