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, 2005, compared with December 31, 2004, and its consolidated results of operations for the years ended December 31, 2005 and 2004.
You should read the following analysis of the Company’s consolidated financial condition and results of operations in conjunction with the Forward-Looking Statements included below the Table of Contents, “Risk Factors,” and Consolidated Financial Statements included in this Annual Report on Form 10-K
The Company sells interest-sensitive individual life insurance and variable life insurance, term life insurance and individual variable annuities. These markets 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, which 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. The Company also marketed individual life insurance through its branch office in Taiwan. The Taiwan branch was transferred to an affiliated Company on January 31, 2001, as described in the Notes to the Financial Statements. Beginning February 1, 2001, all insurance activity of the Taiwan branch has been ceded to the affiliated Company.
The future policy benefit reserves at December 31, 2005 represented 5% of our total liabilities and relate primarily to term life, variable, and universal products and 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 and conduct full actuarial studies every three years. 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 variable annuity contracts, DAC is more sensitive to the effects of changes in our estimates of gross profits due primarily to the significant portion of gross profits that is dependent upon the total rate of return on assets held in separate account investment options, and the shorter average life of the contracts. This rate of return influences the fees we earn, costs we incur associated with minimum death benefit and other contractual guarantees specific to our variable annuity contracts, as well as other sources of profit. This is also true, to a lesser degree, for our variable life policies; however, the variable life policies derive a significant portion of their gross profits from margins in the cost of insurance charge.
Future rate of return assumptions used in evaluating DAC for our domestic 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 project returns for the future period so that the assets grow at the expected rate of return for the entire period. If the projected future rate of return is greater than our maximum future rate of return, we use our maximum reasonable future rate of return. As part of our approach for variable annuity contracts, if the estimated gross profits under the previously projected rate of returns are greater than or less than a range of estimated gross profits determined by statistically generated rates of return, we change our future assumption to reflect the result of the reversion to the mean approach. For variable annuities products, our expected rate of return is 8% per annum, which reflects an expected rate of return of 8.9% per annum for equity type assets. The future equity rate of return used varies by product, but was under 8.9% per annum for all of our variable annuity products for our evaluation of deferred policy acquisition costs as of December 31, 2005.
An increase or decrease in our effective tax rate by one percent of income from operations before income taxes and cumulative effect of accounting change, would have resulted in a decline or increase in consolidated income from continuing operations before cumulative effect of accounting change in 2005 of $2.5 million.
Fixed maturities decreased by $150 million, from $6.339 billion at December 31, 2004 to $6.189 billion at December 31, 2005. The decrease was primarily driven by scheduled withdrawals and maturities within the GIC business, re-investment in commercial loans, mentioned above, and a decline in the level of unrealized gains resulting from an increasing interest rate environment, partly offset by investing positive cash flows and reinvestment of investment income.
Deferred policy acquisition costs increased by $234 million from $1.429 billion at December 31, 2004, to $1.663 billion at December 31, 2005, primarily driven by an $103 million increase in the shadow DAC adjustment from lower unrealized gains and $340 million in net capitalization of acquisition expenses, partially offset by $209 million of amortization. Capitalization and amortization in the life
business reflected a reduction in net capitalization net of amortization of $51 million related to ceded costs due to cost reimbursements under the coinsurance agreement with Prudential Arizona Reinsurance Captive Company or, “PARCC.” (See Note 13 to the Consolidated Financial Statements)
Reinsurance recoverable increased by $168 million, from $765 million at December 31, 2004 to $933 million at December 31, 2005, largely as a result of increased ceded reserves held under the PARCC agreement (see Note 13 to the Consolidated Financial Statements) and increased recoverables for the Taiwan business.
Total liabilities increased by $1.612 billion, from $25.996 billion at December 31, 2004 to $27.608 billion at December 31, 2005. Corresponding with the asset change, separate account liabilities increased by $1.767 billion, as described above. Policyholder account balances decreased by $414 million, primarily due to continued maturities and surrenders of guaranteed investment contracts in 2005. Future policy benefits increased by $206 million, due to increased reserves for the Taiwan business and increases to life reserves as a result of sales and renewals of term life products. The Company had short-term borrowings from an affiliate of $106 million at December 31, 2005 to provide short-term working capital. There were no such borrowings outstanding at December 31, 2004. Total securities lending activity decreased by $30 million. The relative amounts of cash collateral for loaned securities and securities sold under agreements to repurchase decreased $21 million and $9 million, respectively.
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, decreased by $48 million, from $612 million in 2004 to $564 million in 2005. The decrease was the result of a $75 million decrease for individual life products and a $27 million increase for annuity products. Policy charges for life products decreased as a result of the new reinsurance agreement (see Note 13 to the Consolidated Financial Statements) entered into during the fourth quarter of 2004, resulting in higher ceded variable and universal life policy charges, partly offset by growth in the in force business, the favorable impact of increases in the market value of variable life insurance assets, and the sale of newer interest-sensitive products that generally carry higher expense charges in the first few years of the contract. The gross variable life in force business grew by 6% from $77.1 billion at December 31, 2004 to $82.1 billion at December 31, 2005. Annuity fees are mainly asset-based fees, which are dependent on fund balances that are affected by net sales as well as asset depreciation or appreciation on the underlying investment funds in which customers may invest. Average annuity separate account fund balances are nearly 12% higher than in the prior year as a result of favorable market performance and positive net sales.
Realized investment gains (losses) decreased by $5 million, from realized gains of $5 million in 2004 to realized losses of less than $1 million in 2005, due to losses associated with increased trading activity in 2005.
Stockholder’s equity increased by $175 million, from $1.891 billion at December 31, 2004, to $2.066 billion at December 31, 2005, primarily as a result of net income, partly offset by a decrease in unrealized gains in the fixed maturity portfolios, mentioned above.
Total benefits and expenses decreased $161 million, from $944 million in 2004 to $783 million in 2005, driven by a $136 million decrease in policyholders’ benefits, including changes in reserves, in 2005. Policyholder benefits, including changes in reserves, decreased $127 million and $9 million in the life business and annuity business, respectively.
Policyholders’ benefits, excluding changes in reserves, for life insurance products decreased by $125 million, from $169 million in 2004, driven by lower net death benefits of $125 million. While net term death benefits increased by $6 million from the prior year, net variable and universal death benefits combined were $131 million lower than the prior year, due to an increase in the ceded in force improved and mortality for these products as a result of the new excess reinsurance agreement entered into during the fourth quarter of 2004 (see Note 13 to the Consolidated Financial Statements). Annuity policyholders’ benefits of $25 million in 2005 were $7 million lower than in the prior year, primarily due to lower guaranteed minimum death benefits on variable annuities driven by higher average fund values in the current year as a result of market appreciation.
The net change in reserves for life insurance products in 2005 decreased $2 million from $27 million in 2004. Changes in reserves resulting from variable and universal life products, were $6 million lower primarily due to the new excess of loss reinsurance agreement discussed above, offset by an $8 million increase in the GMDB reserve due to updated assumptions and a $4 million increase in net term reserves due growth in the term book of business. The change in reserves for annuity products decreased $2 million in 2005, as a result of a decrease in reserves for our guaranteed minimum death benefit feature of our variable annuity products due to decreased costs of actual and expected death claims. The GMDB feature provides annuity contractholders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount as described above.