We own our headquarters building located at 751 Broad Street, Newark, New Jersey. Our headquarters is approximately one half million square feet. In addition, we own other properties that we use for home office functions. Excluding properties used for the International division and Prudential Securities' operations, we own 14 and lease 21 properties. Our insurance operations use approximately 500 other locations throughout the United States, most of which are leased.
For our International Insurance operations, we lease nine home offices located in Argentina, Brazil, China, Italy, Japan, The Philippines, Poland and Taiwan and own a home office in Korea. In addition, we have purchased an 80% beneficial interest in a 38-story office, residential and retail development that is currently
under construction in central Tokyo and that will become the home office of our Japan operations when completed, which is expected late in 2002. In connection with the development of this property, we have paid approximately (Yen)42.3 billion (approximately $323 million at an exchange rate on December 31, 2001 of $1=(Yen)131.06) through December 31, 2001. On completion of the building and full occupancy, we expect that the major portion of our total acquisition and development costs, estimated at (Yen)55.4 billion (approximately $423 million), will be financed through non-recourse borrowings and that our equity investment in this property will be approximately (Yen)17.4 billion (approximately $133 million). We also own 327 field offices and lease approximately 279 other field offices throughout Argentina, Brazil, Italy, Japan, Korea, The Philippines, Poland and Taiwan. For our International Securities and Investments operations, we own one branch office and lease approximately 17 other branch offices throughout Japan, Mexico and Taiwan.
For our securities operations we lease two home offices in New York City, which total approximately 1.8 million square feet. These leases are linked to benefit agreements with the New York City Industrial Development Agency. In addition, we lease approximately 310 other locations throughout the United States and approximately 30 locations outside of the United States for our securities operations.
On December 18, 2001, Prudential Insurance converted from a mutual life insurance company owned by its policyholders to a stock life insurance company and became an indirect, wholly owned subsidiary of Prudential Financial. For a discussion of these transactions, see "Business--Demutualization and Related Transactions" included elsewhere in this Annual Report on Form 10-K. "Demutualization costs and expenses" amounted to $588 million in 2001, $143 million in 2000, $75 million in 1999 and $24 million in 1998. "Demutualization costs and expenses" in 2001 include $340 million of demutualization consideration payable to former Canadian branch policyholders as more fully described in Note 2 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.
- -------- (1) Earnings per share data reflects earnings for the period from December 18, 2001, the date of demutualization, through December 31, 2001 only. Net income during this period was $38 million and $3 million for the Financial Services Businesses and Closed Block Business, respectively. (2) Prepared in accordance with GAAP. Operating results by division and segment for 1997 are neither readily available nor practicable to obtain.
Wind-down businesses that we have not divested remain in adjusted operating income. We exclude our discontinued healthcare operations from income from continuing operations before income taxes, as shown above.
The excluded items are important to an understanding of our overall results of operations. You should not view adjusted operating income as a substitute for net income determined in accordance with GAAP and you should note that our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances the understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability factors of our business. We exclude realized investment gains, net of losses and related charges, from adjusted operating income because the timing of transactions resulting in recognition of gains or losses is largely at our discretion and the amount of these gains or losses is heavily influenced by and fluctuates in part according to the availability of market opportunities. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of our businesses. We exclude sales practices remedies and costs because they relate to a substantial and identifiable non-recurring event. We exclude the gains and losses and contribution to income/loss of divested businesses because, as a result of our decision to dispose of these businesses, these results are not relevant to the profitability of our ongoing operations and could distort the trends associated with our ongoing businesses. We also exclude demutualization costs and expenses because they are directly related to our demutualization and could distort the trends associated with our business operations.
- -------- (1)Revenues by segment exclude (i) realized investment gains, net and (ii) revenues from divested businesses. Revenues for the Closed Block Business exclude realized investment gains, net. (2)Adjusted operating income equals revenues as defined above in footnote (1) less benefits and expenses excluding (i) the impact of net realized investment gains on deferred acquisition cost amortization, reserves and dividends to policyholders; (ii) sales practices remedies and costs; (iii) the benefits and expenses of divested businesses; and (iv) demutualization costs and expenses. (3)Net realized investment gains impact our reserves for future policy benefits, our deferred policy acquisition costs, and our policyholder dividends. We refer to these impacts collectively as the "related charges." Related charges for the Financial Services Businesses consist of the following:
- -------- (1) All periods exclude employees of our discontinued healthcare operations.
On the date of demutualization, Prudential Insurance converted from a mutual life insurance company owned by its policyholders to a stock life insurance company and became an indirect, wholly owned subsidiary of Prudential Financial. On that date, eligible policyholders, as defined in the Plan of Reorganization, received shares of Prudential Financial's Common Stock or the right to receive cash or policy credits, which are increases in policy values or increases in other policy benefits, upon the extinguishment of all membership interests in Prudential Insurance. In the aggregate, eligible policyholders received 457.1 million shares of Common Stock, the right to receive cash totaling $3,487 million, including $340 million to former Canadian branch policyholders, and policy credits totaling $1,042 million in the demutualization. In addition, two closed blocks, as discussed below, were established for the benefit of certain participating individual life insurance policies and annuities issued by Prudential Insurance and its Canadian branch.
The Plan of Reorganization required us to establish and operate a mechanism known as the Closed Block. The Closed Block is designed generally to provide for the reasonable expectations for future policy dividends after demutualization of holders of policies included in the Closed Block by allocating assets that will be used for payment of benefits, including policyholder dividends, on these policies. See Note 9 to the Consolidated Financial Statements for more information on the Closed Block.
On January 22, 2002, Prudential Financial's Board of Directors authorized the repurchase of up to $1 billion of its Common Stock. The timing and amount of any purchases of Common Stock under this authorization will be determined by management based on market conditions and other considerations, and such purchases may be effected by market or negotiated transactions, including programs adopted under Rule 10b5-1 of the Securities Exchange Act of 1934.
We refer to the businesses in our four operating divisions and our Corporate and Other operations, collectively, as our Financial Services Businesses. The U.S. Consumer division consists of our Individual Life Insurance, Private Client Group, Retail Investments and Property and Casualty Insurance segments. The Employee Benefits division consists of our Group Insurance and Other Employee Benefits segments. The International division consists of our International Insurance and International Securities and Investments segments. The Asset Management division consists of our Investment Management and Advisory Services and Other Asset Management segments. We also have Corporate and Other operations, which contain corporate items and initiatives that are not allocated to the business segments. Corporate and Other operations also include businesses that we have divested or placed in wind-down status (other than our divested healthcare business, which is treated as a discontinued operation). The principal corporate items are the expense of corporate management and earnings on equity not allocated to our businesses.
We earn our revenues principally from insurance premiums; mortality, expense, and asset management fees from insurance and investment products; commissions and other revenues from securities brokerage transactions; and investment of general account and other funds. We earn premiums primarily from the sale of individual life insurance, group life and disability insurance and automobile and homeowners insurance. We earn mortality, expense, and asset management fees from the sale and servicing of separate account products including variable life insurance and variable annuities. We also earn asset management and administrative fees from the sale and servicing of mutual funds, retirement products and other asset management products and services. Our operating expenses principally consist of insurance benefits provided, general business expenses, dividends to policyholders, commissions and other costs of selling and servicing the various products we sell and interest credited on general account liabilities.
. our ability to price our insurance products at a level that enables us to earn a margin over the cost of providing benefits and the expense of acquiring customers and administering those products;
. our returns on invested assets, net of the amounts we credit to policyholders' accounts;
. the amount of our assets under management and changes in their fair value, which affect the amount of asset management fees we receive;
. our ability to generate commissions and fees from securities activities at a level that enables us to earn a margin over the expenses of providing such services; and
. our ability to generate favorable investment results through asset-liability management and strategic and tactical asset allocation.
Historically, the participating products included in the Closed Block have yielded lower returns on capital invested than many of our other businesses. Following the demutualization, we expect that the proportion of the traditional participating products in our in force business will gradually diminish as these older policies age and we grow other businesses. However, the relatively lower returns to us on this existing block of business will continue to affect our consolidated results of operations for many years. Our Common Stock reflects the performance of our Financial Services Businesses, but there can be no assurance that the market value of the Common Stock will reflect solely the performance of these businesses. The Financial Services Businesses include the capital previously included in the Traditional Participating Products segment in excess of the amount necessary to support the Closed Block Business. The Financial Services Businesses also includes other traditional insurance products previously included in the Traditional Participating Products segment but which are not included in the Closed Block. The Class B Stock reflects the financial performance of our Closed Block Business.
In February 1998, we announced our intention to seek legislation that would permit our demutualization. The publicity about our possible demutualization may have contributed to improvements in our sales, our persistency experience or both in a number of product lines since that time, although we cannot be certain of this.
"Commercial loans" are carried at unpaid principal balances, net of unamortized discounts and an allowance for losses. This allowance includes a loan specific portion as well as a portfolio reserve for 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. 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.
Business, the mortality and interest rate assumptions we apply are those used to calculate the policies' guaranteed cash surrender values. For life insurance and annuity products of our Financial Services Businesses, 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 us to provide for expected future losses on a product by establishing premium deficiency reserves. For example, in 2000 we restructured the portfolio that supports the structured settlement products within our Other Employee Benefits segment to reduce the emphasis on equity investments, which in turn lowered our expected future investment returns. As a result, we recorded a charge to establish a premium deficiency reserve for these products.
establishment of these reserves reflected management's best estimate of the ultimate costs. Our results for subsequent periods reflected changes in these estimates to the extent that the actual costs of carrying out the plans were different from our original estimates.
In managing our business, we analyze our operating performance by separately considering our Financial Services Businesses and our Closed Block Business. In addition, within the Financial Services Businesses, we analyze our operating performance using a non-GAAP measure we call "adjusted operating income". Prior to the date of demutualization, we also analyzed results of our Traditional Participating Products segment based on this non-GAAP measure. We calculate adjusted operating income by adjusting our income from continuing operations before income taxes to exclude certain items. The items excluded are:
. the gains, losses and contribution to income/loss of divested businesses that we have sold but that do not qualify for "discontinued operations" accounting treatment under GAAP; and
The excluded items are important to an understanding of our overall results of operations. You should not view adjusted operating income as a substitute for net income determined in accordance with GAAP, and you should note that our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances the understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability of our businesses. We exclude realized investment gains, net of losses and related charges, from adjusted operating income, because the timing of transactions resulting in recognition of gains or losses is largely at our discretion and the amount of these gains or losses is heavily influenced by and fluctuates in part according to the availability of market opportunities. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of our businesses. We exclude sales practices remedies and costs because they relate to a substantial and identifiable non-recurring event. We exclude the gains and losses and contribution to income/loss of divested businesses because, as a result of our decision to dispose of these businesses, these results are not relevant to the profitability of our ongoing operations and could distort the trends associated with our ongoing operations. We also exclude demutualization costs and expenses because they are directly related to our demutualization and could distort the trends associated with our business operations.
2001 to 2000 Annual Comparison. On a consolidated basis net income decreased $552 million from income of $398 million in 2000 to a loss of $154 million in 2001. The decrease reflects a $954 million decrease in income from continuing operations before income taxes, partially offset by a $463 million decrease in the related provision for income taxes as discussed below under "--Taxes." Our $154 million net loss in 2001 included a net loss of $506 million for the fourth quarter of 2001. The $506 million net loss reflects a loss from continuing operations before income taxes of $609 million, including net realized investment losses of $435 million, demutualization costs and expenses of $389 million, and adjusted operating income of $320 million.
The $954 million decrease in income from continuing operations before income taxes resulted from a $142 million decrease from the Financial Services Businesses and a $812 million decrease from the Closed Block Business. The $142 million decrease from the Financial Services Businesses came primarily from a $534 million decline from our U.S. Consumer division, a $244 million decline from our Employee Benefits division, and an $66 million decline from our Asset Management division, partially offset by an increase of $159 million from our International division and a $543 million reduction in losses from Corporate and Other operations.
The $534 million decline from our U.S. Consumer division, the $244 million decline from our Employee Benefits division and the $66 million decline from our Asset Management division came primarily from decreases in adjusted operating income. The $159 million increase from our International division came from an increase in adjusted operating income. Results for our International division include the results of Gibraltar Life Insurance Company, Ltd. ("Gibraltar Life"), which we acquired in April 2001, from April 2, 2001 through November 30, 2001. The $543 million reduction in losses from Corporate and Other operations came primarily from a $467 million increase in realized investment gains, net of losses, and a $489 million decrease in losses from divested businesses which were partially offset by a $445 million increase in demutualization costs and expenses and a $32 million improvement in adjusted operating income.
Net income on an equivalent share basis assumes that shares issued in the demutualization and the initial public offering were outstanding for all periods and does not reflect adjustments to earnings for demutualization or related transactions. Net income per equivalent share of Common Stock, which reflects the performance of the Financial Services Businesses, decreased to 52 cents per equivalent Common Share for the year ended December 31, 2001, from 53 cents per equivalent Common Share for the year ended December 31, 2000. Also on an equivalent share basis, net income per equivalent share of the Class B Stock, which reflects the performance of the Closed Block Business, decreased to a loss of $228.00 per equivalent share of Class B Stock for the year ended December 31, 2001, from income of $43.50 per equivalent share of Class B Stock for the year ended December 31, 2000. The decrease in net income per equivalent share of the Common Stock and Class B Stock from 2000 to 2001 reflects the decline in net income of the Financial Services Businesses and Closed Block Business as discussed above.
Our losses from insurance claims arising in connection with the September 11, 2001 terrorist attacks, after release of existing reserves and reinsurance recoveries, had a negative effect on adjusted operating income and income from continuing operations before income taxes of approximately $37 million, and on net income of approximately $23 million, for 2001. These insurance losses are based on gross losses of approximately $172 million from group life, individual life, and property and casualty insurance claims. Approximately $27 million of the negative impact on adjusted operating income and income from continuing operations before income taxes related to the Financial Services Businesses, primarily in the Individual Life Insurance segment. The remainder of the losses related to the Closed Block Business.
2000 to 1999 Annual Comparison. Net income decreased $415 million, or 51%, from $813 million in 1999 to $398 million in 2000. This decrease reflects a $1.528 billion decrease in income from continuing operations before income taxes, partially offset by a $636 million decrease in the related provision for income taxes as discussed below under "--Taxes." Additionally, net income for 2000 included $77 million of income resulting from a reduction in our loss on disposal of our discontinued healthcare operations, while 1999 net income included a $400 million increase in our loss on disposal of these operations, as discussed below under "--Discontinued Operations."
The $1.528 billion decrease in income from continuing operations before income taxes resulted from a $1.377 billion decrease from the Financial Services Businesses and a $151 million decrease from the Closed Block Business. The $1.377 billion decrease from the Financial Services Businesses came primarily from a $1.335 billion decline from Corporate and Other operations and a $216 million decline from our Employee Benefits division, partially offset by an $85 million increase from our U.S. Consumer division and a $65 million increase from our International division. The $1.335 billion decline from Corporate and Other operations came primarily from a $637 million decline in realized investment gains, net of losses, and from a $643 million decline from the former lead-managed underwriting and institutional fixed income businesses of Prudential Securities, which we include in "divested businesses." The $216 million decline from our Employee Benefits division came primarily from a $203 million decline in realized investment gains, net of losses and related charges. The $85 million increase from our U.S. Consumer division came primarily from a $73 million increase in adjusted operating income. The $65 million increase from our International division reflected an $89 million increase in adjusted operating income.
Adjusted operating income of our Financial Services Businesses decreased $458 million, or 27%, from 2000 to 2001. The decrease came primarily from decreases of $430 million from our U.S. Consumer division and $204 million from our Employee Benefits division, partially offset by a $201 million increase in adjusted operating income from our International division, including the $262 million contribution of Gibraltar Life in 2001.
The $430 million decrease in adjusted operating income from our U.S. Consumer division came primarily from a $476 million decrease from the Private Client Group segment. The $204 million decrease in adjusted operating income from our Employee Benefits division came from declines in both segments in the division.
Adjusted operating income of the Closed Block Business decreased $111 million, or 20%, from 2000 to 2001, primarily from a $144 million reserve for unreported death claims and related expenses and a decline in net investment income resulting from the transfer of assets previously associated with our Traditional Participating Products segment to the Financial Services Businesses in connection with the establishment of the Closed Block Business on the date of demutualization. These declines were partially offset by a reduction in the charge for policyholder dividends, which excludes the portion of the dividend related to net realized investment gains, a reduction in amortization of deferred policy acquisition costs and a decline in operating expenses.
In addition, we require most issuers of private fixed maturity securities to pay us make-whole yield maintenance payments when they prepay the securities. Prepayment levels are also driven by the interest rate environment and other factors not within our control. The prepayment of private fixed maturities we held contributed realized investment gains of $155 million in the year ended December 31, 2001, $74 million in 2000 and $155 million in 1999.
Realized investment gains, net of losses, also includes impairments on fixed income and equity assets, which we recognize on an ongoing basis. The level of impairments generally reflects economic conditions, and is expected to increase when economic conditions worsen and to decrease when economic conditions improve.
The comparisons below discuss realized investment gains net of losses and related charges. These charges relate to policyholder dividends, DAC, and reserves for future policy benefits. Net realized investment gains is one of the elements that we consider in establishing the domestic dividend scale and in providing for dividends to Gibraltar Life policyholders, and the related charge for dividends to policyholders represents the estimated portion of our expense charge for policyholder dividends that is attributable to net realized investment gains that we consider in determining our dividend scale and the Gibraltar Life dividends. See "--Results of Operations for Financial Services Businesses by Division and Closed Block Business" below. We amortize deferred policy acquisition costs for interest sensitive products based on estimated gross profits, which include net realized investment gains on the underlying invested assets, and the related charge for amortization of deferred policy acquisition costs represents the amortization related to net realized investment gains. We adjust the reserves for some of our policies when cash flows related to these policies are affected by net realized investment gains, and the related charge for reserves for future policy benefits represents that adjustment. The changes in these related charges from one period to another may be disproportionate to the changes in realized investment gains, net of
losses, because the indicated reserve adjustments relate to realized investment gains, but not losses, evaluated over several periods, and because realized investment gains and losses are reflected in the dividend scale over a number of years.
2001 to 2000 Annual Comparison. For the Financial Services Businesses, realized investment gains, net of losses and related charges, increased $272 million, from a net loss of $408 million in 2000 to a net loss of $136 million in 2001. The net realized investment loss of the Financial Services Businesses for 2001 reflected impairments recognized of $557 million, and $196 million of losses on disposal of substantially all of the Enron holdings of the Financial Services Businesses. For the Closed Block Business, realized investment gains, net of losses and related charges, declined $701 million, from a net loss of $354 million in 2000 to a net loss of $1.055 billion in 2001. The net realized investment loss of the Closed Block Business for 2001 reflected impairments recognized of $475 million, and $160 million of losses on disposal of substantially all of the Enron holdings of the Closed Block Business.
On a consolidated basis, realized investment gains, net of losses and related charges, declined $429 million, from a net loss of $762 million in 2000 to a net loss of $1.191 billion in 2001. Realized investment losses, net of gains but excluding related charges, declined $417 million, from a net loss of $288 million in 2000 to a net loss of $705 million in 2001. Charges related to net realized investment gains and losses amounted to $474 million in 2000 and $486 million in 2001. These charges did not change proportionately with the change in realized investment gains, net of losses, from 2000 to 2001 for the reasons described above.
On a consolidated basis, we realized net losses of $639 million on fixed maturity investments in 2001, compared to net losses of $ 1.066 billion in 2000. During 2001, we recognized impairments on fixed maturities totaling $777 million and realized additional losses of $356 million on the sale of substantially all of our Enron holdings. These impairments and losses were partially offset by realized gains of $494 million primarily from sales and prepayments of fixed maturities in an environment of lower interest rates than when the securities were purchased. The net losses in 2000 came primarily from fixed maturity investment sales in an environment of higher interest rates than those when the securities were purchased as well as impairments we recorded on fixed maturity investments totaling $540 million. The effect of economic and market conditions is uncertain and could result in additional impairments. We realized net losses on equity securities of $245 million in 2001, compared to net gains of $450 million in 2000, as we benefited in 2000 from more favorable equity market conditions, particularly during the early part of the year, and we disposed of appreciated equity securities as part of a portfolio rebalancing program. We recorded net investment gains on derivatives of $126 million in 2001 and $165 million in 2000.
2000 to 1999 Annual Comparison. For the Financial Services Businesses, realized investment gains, net of losses and related charges, declined $852 million from a net gain of $444 million in 1999 to a net loss of $408 million in 2000. For the Closed Block Business, realized investment gains, net of losses and related charges, declined $382 million, from a net gain of $28 million in 1999 to a net loss of $354 million in 2000.
of $540 million in 2000, primarily on publicly traded high yield and other corporate bonds, compared to $266 million in 1999. We realized net gains on sales of equity securities of $450 million in 2000, compared to $223 million in 1999. We realized net gains from disposals of direct real estate and real estate related joint ventures of $149 million in 2000 compared to $703 million in 1999, reflecting several major transactions that closed in 1999. We recorded net investment gains of $165 million on derivatives during 2000, compared to net gains of $305 million in 1999.
Charges associated with the cost of remedying policyholder claims and additional sales practices costs have been adjusted from year to year, beginning in 1996. No additional net charges have been recorded since 1999. The charges from year to year primarily reflected the increased availability over time of more specific information about the number of policyholder claims received and remedied, the accrued interest associated with claim relief, other factors affecting both the cost of remedies and the cost to us of administering the remediation program, and the cost of resolving "opt out" litigation as described above. See Note 21 to the Consolidated Financial Statements for a further description of these charges.
The charges related to our estimated costs of sales practices remedies and additional sales practices costs and the related liability balances at the dates indicated are shown below.
While a portion of the sales practices remedies have been in the form of policy credits or enhancements, the major portion of the total cost for sales practices remedies and additional sales practices costs have resulted in cash disbursements. The cash outflows from these disbursements have reduced our invested assets and consequently have reduced our investment income. We included the investment income from the assets used to satisfy the sales practices remedies and additional sales practices costs prior to their disbursement in our adjusted operating income for Corporate and Other operations. The $4.4 billion of cash disbursements do not include the cash flow from surrenders associated with the implementation of the sales practices remediation program, which are discussed under "--Results of Operations for Financial Services Businesses by Division and Closed Block Business--Closed Block Business--Policy Surrender Experience."
We incurred costs and expenses related to demutualization totaling $588 million in the year ended December 31, 2001, including $340 million of demutualization consideration paid to our former Canadian branch policyholders, $143 million in 2000, and $75 million in 1999. These costs and expenses are reported separately in our consolidated income statements within income from continuing operations before income taxes. Demutualization expenses consist primarily of the costs of engaging independent accounting, actuarial, investment banking, legal and other consultants to advise us and insurance regulators in the demutualization process and related matters as well as printing and postage for communication with policyholders.
We recorded a net income tax benefit of $57 million in 2001 and an income tax provision of $406 million in 2000. The income tax benefit in 2001 represented 25% of our loss from continuing operations before income taxes, while the income tax provision in 2000 represented 56% of that year's income from continuing operations before income taxes. The net income tax benefit in 2001 was primarily due to a $200 million reduction of the estimated liability for the mutual life insurance company tax, while the income tax provision in 2000 reflected a $100 million provision for this tax. The disparity between our effective tax rates in 2001 and 2000 and the application of the corporate income tax rate of 35% to our income or loss from continuing operations before income taxes is primarily a result of the mutual life insurance company tax and the inclusion of demutualization costs and expenses within income or loss from continuing operations before income taxes.
Our income tax provisions amounted to $406 million for 2000 and $1.042 billion for 1999. The income tax provisions represented 56% of income from continuing operations before income taxes in 2000 and 46% of income from continuing operations before income taxes in 1999. This increase in the effective rate was due primarily to the mutual life insurance company tax discussed above and an increase in demutualization expenses.
Results of Operations for Financial Services Businesses by Division and Closed Block Business
- -------- (1) Revenues exclude realized investment gains, net of losses, and revenues from divested businesses. (2) Amounts shown for the Closed Block Business represent results of the Traditional Participating Products segment for periods prior to the date of demutualization. (3) Adjusted operating income equals revenues as defined above in footnote (1) less benefits and expenses excluding (i) the impact of net realized investment gains on deferred acquisition cost amortization, reserves and dividends to policyholders; (ii) sales practices remedies and costs; (iii) the benefits and expenses from divested businesses; and (iv) demutualization costs and expenses. (4) Assets of our International division at December 31, 2001 include assets of Gibraltar Life, which we acquired in April 2001, amounting to $30.238 billion.
The U.S. Consumer division generates income from premiums, as well as fee-based revenues and spread income, through the Individual Life Insurance, Retail Investments and Property and Casualty Insurance segments. Premiums and investment income are received by the Individual Life Insurance and Property and Casualty Insurance segments on insurance products and by the Retail Investments segment on some of its annuity products. Products and services that generate fee-based revenue include mutual funds, variable annuities, variable life insurance and wrap-fee products. The latter fee-based revenues consist primarily of asset management fees, account servicing fees and risk charges. The Retail Investments segment receives fees and investment income from retail investment products. Additionally, the securities brokerage operations that account for the major portion of revenues of the Private Client Group segment generate revenues from client commissions, asset management and portfolio service fees, and net interest revenues derived primarily from margin lending to customers, as well as sales credits related to transactions with retail customers associated with equity and fixed income sales and trading operations. We also earn trading revenues from our fixed income trading operations which are incidental to our retail operations. We include fee-based revenues in the line captioned "Commissions and other income" or "Policy charges and fee income" in our consolidated statements of operations. The Private Client Group segment also includes our consumer banking operations.
The Individual Life Insurance and Private Client Group segments pay the expenses of their own proprietary sales forces for distribution of products. Additionally, the Retail Investments segment pays the Individual Life Insurance and Private Client Group segments for distribution of its products by Prudential Agents and Financial Advisors. The Individual Life Insurance, Retail Investments and Property and Casualty Insurance segments also pay our Investment Management and Advisory Services segment for management of proprietary assets which include the general account investments that support our Individual Life Insurance, Retail Investments and Property and Casualty Insurance segments, as well as most of the assets supporting our separate account life insurance and annuity products such as variable life insurance and annuities. These fees result in expenses to the segments of the U.S. Consumer division and revenues to the Asset Management division. We reflect all of the intra-company asset management services at rates that we determine with reference to market rates.
In recent years, sales in our individual life insurance business, as measured by both number of policies and premiums, have generally declined or not grown significantly. This trend is due in part to a continuing decline in the number of Prudential Agents. We believe that the decline in Prudential Agents results, in part, from our implementation of higher productivity standards associated with measures we have taken to reduce the cost structure of our proprietary distribution channel. This trend in sales has had an adverse impact on premiums, primarily from new business, and adjusted operating income. We are seeking to improve performance by taking steps to refocus the Prudential Agent sales force on the mass affluent market and to continue to improve productivity of the proprietary distribution channel, and to expand third-party distribution of our products. However, we cannot predict whether these steps will succeed or have the desired effects.
Prior to 2001, we experienced net redemptions in our proprietary retail investment products due in substantial part to turnover among experienced Financial Advisors and our focus on the value style of investment management in our equity mutual funds. The impact of these outflows was partially offset by higher revenues resulting from market appreciation of remaining assets, which produced increases in assets under management in 1999 and 2000. Over the last several years, we began to diversify the focus of our investment products and we have been building investment manager choice into most of our Retail Investments products. This advised choice approach allows us to offer customers investment alternatives advised by third parties in our products and asset management styles that we might not otherwise offer. Our Retail Investments wrap-fee assets increased to $19.6 billion at December 31, 2000, from $16.7 billion a year earlier and $11.5 billion at December 31, 1998. We believe these increases reflect increased marketplace emphasis on products that provide customers a broader
choice of investments. At December 31, 2001, wrap-fee assets decreased to $18.0 billion, reflecting market value declines during 2001. We believe the continuing turnover among domestic Financial Advisors is due in part to the lack of a stock-based compensation program. In 1999 this turnover increased due in part to greater industry competition for productive Financial Advisors. We have taken actions to stabilize the Financial Advisor force, including our implementation, effective January 1, 2000, of an equity-market-linked, voluntary long-term deferred compensation plan, and our introduction of an aggressive recruiting effort targeting experienced Financial Advisors, including recruiting and retention incentives. We expect that these programs will contribute to improvement of our turnover rates over time, although there can be no assurance of this.
The following table and discussion present the U.S. Consumer division's results based on our definition of adjusted operating income, which is a non-GAAP measure, as well as income from continuing operations before income taxes, which is prepared in accordance with GAAP. As shown below, adjusted operating income excludes realized investment gains, net of losses and related charges. The excluded items are important to an understanding of our overall results of operations. You should not view adjusted operating income as a substitute for income from continuing operations determined in accordance with GAAP, and you should note that our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances the understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability factors of our businesses. We exclude realized investment gains, net of losses and related charges, from adjusted operating income because the timing of transactions resulting in recognition of gains or losses is largely at our discretion and the amount of these gains or losses is heavily influenced by and fluctuates in part according to the availability of market opportunities. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of our businesses.
2000 to 1999 Annual Comparison. Adjusted operating income of our U.S. Consumer division increased $73 million, or 11%, in 2000 from 1999. The increase came primarily from an increase in adjusted operating income from our Retail Investments segment. Income from continuing operations before income taxes increased $85 million, or 13%, primarily as a result of the increase in adjusted operating income.
The following table sets forth the Individual Life Insurance segment's operating results for the periods indicated.
- -------- (1) Revenues exclude realized investment gains, net of losses.
2001 to 2000 Annual Comparison. Adjusted operating income increased $159 million in 2001 from 2000. The increase came primarily from a $183 million decrease in operating expenses. The decrease in operating expenses came primarily from savings that we have begun to realize from our field management and agency restructuring program as described above and lower program implementation costs, which amounted to $90 million in 2001 and $107 million in 2000. Implementation costs for this program were substantially completed in 2001. Additionally, in 2000 we recorded a $23 million one-time increase in reserves related to a portion of our variable life insurance business in force. However, amortization of deferred policy acquisition costs increased $60 million in 2001 from 2000, and we recorded net losses of $25 million from insurance claims arising from the September 11, 2001 terrorist attacks on the United States.
Premiums increased $117 million, or 43%, from $270 million in 2000 to $387 million in 2001, due to increased premiums on term insurance we issued, under policy provisions, to customers who previously had lapsing variable life insurance with us.
Net investment income increased $17 million, or 5%, from $374 million in 2000 to $391 million in 2001, primarily from an increase in the base of general account invested assets.
Operating expenses decreased $183 million, from $761 million in 2000 to $578 million in 2001, primarily as a result of savings we began to realize from our program to restructure our field management and agency structure as described above and lower program implementation costs which amounted to $90 million in 2001 and $107 million in 2000. The implementation costs for this program were substantially completed in 2001. While there can be no assurance, based on our evaluation of results through 2001 we believe that these initiatives will reduce operating expenses below 2000 levels by approximately $120 million on an annual basis in 2002, including a reduction of about $30 million below the level of 2001, and that reduced expenses resulting from these initiatives will benefit results thereafter. In addition, we expect these initiatives to eliminate approximately $50 million of costs that would have been capitalized.
2000 to 1999 Annual Comparison. Benefits and expenses increased $128 million, or 8%, in 2000 from 1999. The increase came primarily from an increase in policyholder benefits and related changes in reserves of $121 million, from $507 million in 1999 to $628 million in 2000, as a result of growth in the base of term insurance in force and aging of policies in force as well as the reserve increase related to a portion of our variable life insurance business as noted above amounting to $23 million. Operating expenses, including distribution costs that we charge to expense, were essentially unchanged in 2000 from 1999.
The following table sets forth the Individual Life Insurance segment's sales, as measured by statutory first year premiums and deposits for the periods indicated. These amounts do not correspond to revenues under GAAP. In managing our individual life insurance business, we analyze statutory first year premiums and deposits as well as revenues because statutory first year premiums and deposits measure the current sales performance of
- -------- (1)Statutory first year premiums and deposits. (2)Includes universal life insurance products.
2001 to 2000 Annual Comparison. Sales of new life insurance, as measured by statutory first year premiums, increased $83 million, or 21%, in 2001 from 2000. The increase came from a $157 million increase in the segment's sales of corporate-owned life insurance products, substantially all of which is sold by the PruSelect third-party distribution channel. Inclusive of these corporate-owned life insurance sales, which totaled $199 million for 2001 including a single $100 million sale, PruSelect accounted for 54% of the Individual Life Insurance segment's sales in 2001, compared to 33% in 2000. Sales by the PruSelect channel, other than corporate-owned life insurance, decreased $33 million, or 38%, in 2001 from 2000. We have begun to expand the focus of PruSelect, which has historically served intermediaries who provide insurance solutions in support of estate and wealth transfer planning for affluent individuals and corporate-owned life insurance for businesses, toward the mass affluent market. We believe the 2001 sales results for the PruSelect channel for products other than corporate-owned life insurance reflected both a reduced level of market demand for individual variable life insurance products during 2001 and our transition to the new focus, which included changes in our underwriting classifications and a reduction in our maximum insurance coverage on a single life. Additionally, we repriced certain term insurance products and introduced two new universal life insurance products in late 2001 to be offered by both the PruSelect distribution channel and Prudential Agents. While there can be no assurance, we believe these actions will result in more favorable risk adjusted return on business written and an opportunity to enhance sales in our selected markets.
2001 to 2000 Annual Comparison. The total cash value of surrenders and the level of surrenders as a percentage of mean future policy benefit reserves, policyholders' account balances and separate account balances were relatively constant from 2000 to 2001.
2000 to 1999 Annual Comparison. The total cash value of surrenders increased $44 million, or 7%, in 2000 from 1999. The level of surrenders as a percentage of mean future policy benefits, policyholders' account balances and separate account balances remained constant from 1999 to 2000.
The following table sets forth the Private Client Group segment's operating results for the periods indicated.
2000 to 1999 Annual Comparison. Adjusted operating income increased $13 million, or 6%, from 1999 to 2000. Adjusted operating income from our consumer banking operations increased $27 million, primarily as a
result of the sale of a major portion of the consumer bank's credit card receivables in 2000. Adjusted operating income from our domestic securities brokerage operations decreased $14 million, from $204 million in 1999 to $190 million in 2000.
2001 to 2000 Annual Comparison. Total revenues, net of interest expense, as shown in the table above under "--Operating Results," decreased $551 million, or 20%, from 2000 to 2001. The decrease came primarily from a $498 million decline in revenues from our domestic securities brokerage operations, from $2.675 billion in 2000 to $2.177 billion in 2001.
Commission revenues decreased $406 million, or 26%, from 2000 to 2001. The decrease came primarily from a $375 million decline in commissions from over-the-counter and listed equity securities transactions. Commission revenues were negatively affected in 2001 by less active securities markets and reduced retail transaction volume, and benefited in 2000 from exceptionally active over-the-counter equity markets and related retail transaction volume in the first four months of the year. Commission revenues accounted for 59% of total segment non-interest revenues for 2001. Accordingly, we expect that a continuation of the level of securities market activity experienced in 2001, or a further downtrend in this activity, would continue to have a negative impact on our revenues and on the segment's adjusted operating income, partially offset by planned expense reductions.
The number of domestic retail Financial Advisors was 5,383 at December 31, 2001, a decrease of 9% from 5,906 at December 31, 2000. Approximately 90% of the decline came from Financial Advisors with less than 4
years' industry experience with us, and reflected a decrease in our recruiting of inexperienced Financial Advisors to be trained by us. In response to recruiting efforts by our competitors, we introduced an aggressive recruiting effort targeting experienced Financial Advisors, including recruiting and retention incentives, and, as discussed above, an equity-market-linked voluntary long-term deferred compensation plan to seek to enhance our Financial Advisor recruitment and retention efforts.
Fee revenues, comprised of asset management and account service fees, increased $177 million, or 31%, from 1999 to 2000. This increase resulted primarily from a $5.2 billion increase in wrap-fee and managed account assets under management to $31.9 billion at December 31, 2000 from $26.7 billion a year earlier.
Assets under management and client assets decreased $16 billion to $272 billion at December 31, 2000 from $288 billion a year earlier, primarily as a result of overall market value declines.
2001 to 2000 Annual Comparison. Total non-interest expenses, as shown in the table above under "--Operating Results," decreased $75 million from 2000 to 2001. Employee compensation and benefits at our domestic securities brokerage operation decreased due to the lower level of revenues and earnings in 2001, but the decrease was not proportional to the revenue decline largely due to the recruiting and retention incentives as described above as well as $41 million in employee termination costs associated with staff reductions in 2001. These recruiting and retention incentives will continue to be applicable and to adversely affect expense levels in future periods. The decrease in employee compensation and benefits was further offset by $24 million of costs we incurred to consolidate and close several retail branch and other locations during 2001.
- -------- (1) Revenues exclude realized investment gains, net of losses. (2) Benefits and expenses exclude the impact of net realized investment gains on deferred acquisition cost amortization and reserves.
The remainder of the increase in adjusted operating income came from our mutual funds and wrap-fee products business. Asset-based and transaction-based fees increased as a result of continued growth in our proprietary mutual fund assets under management and expansion of our wrap-fee products.
2000 to 1999 Annual Comparison. Revenues increased $80 million, or 5%, from 1999 to 2000. Fee-based revenues increased $74 million, from $1.007 billion in 1999 to $1.081 billion in 2000. The increase came primarily from our mutual funds and wrap-fee products, as well as our variable annuity products, reflecting growth in our average assets under management for these products. In addition, premiums increased by $19 million as a result of increased conversions of deferred annuities by our customers to income-paying status. Net investment income declined $13 million, from $491 million in 1999 to $478 million in 2000, as a result of reductions in our base of fixed annuity business due to withdrawals and scheduled benefit payments.
2000 to 1999 Annual Comparison. Benefits and expenses remained relatively unchanged from 1999 to 2000. Benefits and expenses for 2000 includes a $21 million reduction in amortization of deferred policy acquisition costs from the refinements noted above. Excluding the impact of this change, benefits and expenses increased $36 million, or 3%. Changes in reserves, net of benefit payments, increased $34 million, from $118 million in 1999 to $152 million in 2000, as a result of customers converting deferred annuities to income-paying status and a $12 million charge to increase annuity reserves due to investment portfolio restructuring as noted above. During 2000, we recorded $20 million of additional amortization of deferred policy acquisition costs, to reflect a decrease in expected future gross profits on our annuity products primarily due to declines in market values of the underlying assets on which our fees are based. However, this increased charge was essentially offset by reduced amortization resulting from our termination, in the second quarter of 2000, of the annuity exchange program we commenced in 1997. Other general expenses were flat in 2000 from 1999, as a decrease in administrative expenses reflecting our expense management efforts was largely offset by a $30 million increase in sub-advisory expense resulting from growth in assets under management of our mutual funds and wrap-fee products and our variable annuity products.
- -------- (1) Mutual funds and variable annuities include only those sold as retail investment products. Investments through defined contribution plan products are included with such products. (2) Wrap-fee product assets include proprietary assets of $3.1 billion at December 31, 2001, $3.4 billion at December 31, 2000, and $3.5 billion at December 31, 1999. (3) Excludes wrap-fee products. (4) Includes maintenance and insurance charges assessed, net bonus payments credited to contract holder accounts, annuity benefits and other adjustments. (5) Includes increases to policyholder account values as a result of policyholder credits issued in 2001 in connection with Prudential's demutalization, amounting to $429 million for variable annuities and $157 million for fixed annuities.
Mutual fund assets under management were essentially unchanged at December 31, 2001 from a year earlier, as declines in market values of existing customer accounts were essentially offset by our $1.4 billion net money market sales and net mutual fund sales, other than money market funds, of $576 million. We believe our
net money market sales, both in 2001 and 2000, reflect customer response to the unfavorable performance of the equity securities markets subsequent to the early part of 2000. The $759 million increase in net mutual fund sales other than money market funds reflected increased gross sales that came primarily from third-party distribution of our mutual funds resulting from our participation in competitors' products and distribution and a lower level of redemptions than that of 2000. Net sales of mutual funds from sub-advised relationships, which commenced in 2000, amounted to $1.2 billion in 2001 and $472 million in 2000.
Wrap-fee assets increased $2.9 billion, or 17%, from $16.7 billion at December 31, 1999 to $19.6 billion at December 31, 2000. The increase came from net sales during 2000 of $4.8 billion of wrap-fee products, in which we offer customers a choice of proprietary and non-proprietary mutual funds as well as managed accounts, which was partially offset by declines in market values. We believe these net sales reflect increased marketplace emphasis on products that provide customers with a broader choice of investment options.
Total account values for fixed and variable annuities amounted to $24.0 billion at December 31, 2000, a decrease of $1.6 billion, or 6%, from December 31, 1999. The decrease resulted from market value declines and greater net redemptions. Net redemptions of variable annuities were $699 million for 2000, an increase of $694 million compared to 1999. This increase resulted from an increase in surrenders, other than those related to exchange activity, consistent with maturation of the business, as a larger percentage of the business is no longer subject to surrender charges.
2000 to 1999 Annual Comparison. Adjusted operating income was essentially unchanged from 1999 to 2000. Results in 2000 reflect an $80 million recovery from a stop-loss reinsurance contract based on current accident-year results during that year and a $15 million greater benefit from prior accident year development. We released reserves of $165 million in 2000 and $150 million in 1999 because our automobile casualty claims experience for prior accident years was more favorable than we previously estimated in establishing reserves for these accident years. However, these favorable developments were largely offset by a $53 million increase in operating expenses, other than expenses of the specialty automobile business we acquired in 2000 as discussed below. The increase in operating expenses was primarily due to increases in expenses to expand our distribution capabilities in direct, affinity group, property and casualty agent and independent agent channels, and a provision for refunds or credits to certain New Jersey automobile policyholders under insurance regulations based on profits generated from that business, as noted above.
While, as discussed under "--Revenues" below, our acquisition in May 2000 of a business which writes non-standard automobile insurance had an effect on the comparison of revenues for 2000 to 1999, it did not have a material impact on adjusted operating income.
The following table sets forth the Property and Casualty Insurance segment's earned premiums, which are net of reinsurance ceded, for the periods indicated.
2001 to 2000 Annual Comparison. Revenues, as shown in the table above under "--Operating Results," increased $251 million, or 14%, from 2000 to 2001. The $251 million increase included an increase of $96 million in revenues from the subsidiary we acquired in May 2000 that specializes in non-standard automobile business, which is included in 2000 results only from the date of acquisition. The remaining revenue increase of $155 million, from our existing business, came primarily from a $196 million increase in earned premiums from automobile and homeowners' insurance, partially offset by a $41 million decline in investment income.
Homeowners earned premiums increased $35 million, or 8%, from 2000 to 2001 due to lower reinsurance premiums ceded, as the number of policies in force was relatively unchanged. This stabilization of our policies in force represents an improvement compared with declines in prior years, which reflects intense rate competition that attracted customers to other companies.
Losses that we ceded through reinsurance, including stop-loss reinsurance, resulted in decreases in the total combined ratio of 7.3 percentage points for 2001 and 8.3 percentage points for 2000.
Losses that we ceded through reinsurance resulted in a decrease in the total combined ratio of 8.3 percentage points for 2000 and, as a result of changes in recoverable amounts previously recorded, an increase of 2.6 percentage points for 1999.
Our overall expense ratio for 2000 increased in comparison to 1999 mainly because of the impact of increased operating expenses as discussed above.
The Employee Benefits division generates income from premiums, as well as fee-based revenues and spread income, through the Group Insurance and Other Employee Benefits segments. Premiums and investment income from group life and disability insurance, as well as fee-based revenues from products like group variable universal life insurance, are the primary sources of revenues for the Group Insurance segment. The Other Employee Benefits segment also receives premiums and investment income, as well as fee-based revenues. Products and services for defined contribution and defined benefit retirement plans, as well as real estate and relocation services, generate the major portion of the Other Employee Benefits segment's fee-based revenues. We include these fee-based revenues in the line captioned "Commissions and other income" or "Policy charges and fee income" in our consolidated statements of operations.
The following table and discussion present the Employee Benefits division's results based on our definition of adjusted operating income, which is a non-GAAP measure, as well as income from continuing operations before income taxes, which is prepared in accordance with GAAP. As shown below, adjusted operating income excludes realized investment gains, net of losses and related charges. The excluded items are important to an understanding of our overall results of operations. You should not view adjusted operating income as a substitute for income from continuing operations determined in accordance with GAAP, and you should note that our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances the understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability factors of our businesses. We exclude realized investment gains, net of losses and related charges, from adjusted operating income because the timing of transactions resulting in recognition of gains or losses is largely at our discretion and the amount of these gains or losses is heavily influenced by and fluctuates in part according to the availability of market opportunities. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of our business.
- -------- (1) Revenues exclude realized investment gains, net of losses. (2)Benefits and expenses exclude the impact of net realized investment gains on reserves and deferred acquisition cost amortization. (3)Related charges consist of the following:
2001 to 2000 Annual Comparison. Adjusted operating income of our Employee Benefits division decreased $204 million, or 53%, from 2000 to 2001 as a result of a $116 million decrease in adjusted operating income from our Other Employee Benefits segment and an $88 million decrease from our Group Insurance segment. Income from continuing operations before income taxes decreased $244 million, or 91%, from 2000 to 2001, reflecting the decrease in adjusted operating income as well as a $40 million increase in realized investment losses, net of related charges. For a discussion of realized investment gains and losses and charges related to realized investment gains and losses, see "--Consolidated Results of Operations--Realized Investment Gains."
2001 to 2000 Annual Comparison. Revenues, as shown in the table above under "--Operating Results," increased by $447 million, or 16%, from 2000 to 2001. Group life insurance premiums increased by $350 million, or 21%, to $2.005 billion primarily due to growth in business in force resulting from new sales, as described below, and continued strong persistency, which increased from 95% in 2000 to 97% in 2001. Group disability premiums, which include long-term care products, increased by $43 million, also reflecting the growth in business in force. Persistency decreased from 91% in 2000 to 89% in 2001, primarily due to the cancellation of a large case. Net investment income increased $62 million, or 13%, primarily due to a larger base of invested assets.
2000 to 1999 Annual Comparison. Revenues increased by $373 million, or 15%, from 1999 to 2000. Group life insurance premiums increased by $189 million, or 13%, to $1.655 billion primarily due to growth in business in force resulting from new sales, which increased in 2000. Persistency increased from 94% in 1999 to 95% in 2000. Group disability premiums, which include long-term care products, increased by $71 million, or 18%, also reflecting the growth in business in force resulting from new sales, which increased in 2000. Persistency increased from 88% in 1999 to 91% in 2000. The remainder of the increase in revenues came primarily from higher fees on products sold to employers for funding of employee benefit programs and retirement arrangements, reflecting growth of this business in 2000. Net investment income was $485 million in 2000, relatively unchanged from $470 million in 1999.
The following table sets forth the Group Insurance segment's benefits and administrative operating expense ratios for the periods indicated.
2001 to 2000 Annual Comparison. Benefits and expenses, as shown in the table above under "--Operating Results," increased by $535 million, or 20%, from 2000 to 2001. The increase resulted in large part from an increase of $448 million, or 22%, in policyholders' benefits, including the change in policy reserves. This increase reflected less favorable group life insurance claims experience in 2001, which included an increase in our estimate of incurred but not reported claims, as well as the growth of business in force. Based on our evaluation of mortality experience during 2001, we have reviewed our pricing policies to determine whether our pricing structure provides for adequate margins and returns on all of our group insurance products. As a result of this review, we have commenced pricing adjustments, when contractually permitted, which consider the recent deterioration of the benefits ratio on our group life insurance products. During 2002, we expect to implement pricing adjustments on group life insurance business representing about half of our 2001 premiums in force, including business representing approximately 26% of our 2001 premium in force for which pricing adjustments were implemented upon renewal in January 2002. While there can be no assurance, we expect these actions to result, over time, in a return to benefits ratios consistent with those experienced on this business prior to 2001. However, we expect that the implementation of these actions, given the competitive marketplace for our products, may result in a decline in persistency on our group life insurance business in force and some slowing of our sales. As a result of our reinsurance coverages, insurance losses resulting from the September 11, 2001 terrorist attacks on the United States did not have a material impact on our results. An increase of $64 million, or 16%, in operating expenses also contributed to the increase in benefits and expenses. The increase in operating
- -------- (1) Amounts do not include excess premiums, which are premiums that build cash value but do not purchase face amounts of group universal life insurance. (2) Includes long-term care products.
2000 to 1999 Annual Comparison. Total new annualized premiums increased $116 million, or 32%, from 1999 to 2000, with increases of $59 million in group life sales and $57 million in group disability sales. Sales for 1999 benefited from annualized premiums of $40 million from one sale. We believe the sales increase reflected improved competitiveness of our products as well as sales opportunities resulting from the well-publicized financial difficulties of a competitor.
The following table sets forth the Other Employee Benefits segment's operating results for the periods indicated.
- -------- (1) Revenues exclude realized investment gains, net of losses. (2) Benefits and expenses exclude the impact of net realized investment gains on reserves and deferred acquisition cost amortization.
2001 to 2000 Annual Comparison. Adjusted operating income decreased $116 million, or 51%, in 2001 from 2000. Adjusted operating income benefited $64 million in 2000 primarily from refinements in our annuity reserves. Excluding this change, adjusted operating income decreased $52 million, or 32%. The $52 million decrease came from decreases in adjusted operating income of $42 million from our real estate and relocation business and $23 million from our guaranteed products business, partially offset by a $13 million reduction in losses from our full service defined contribution business.
Our guaranteed products business reported adjusted operating income of $153 million in 2001, a decrease of $23 million from 2000 adjusted operating income, excluding the impact of the annuity reserve refinement noted above. Results from this business in 2000 were negatively affected by a $56 million charge we recorded to increase reserves for our structured settlement products as a result of our restructuring of the investment portfolio supporting these products to reduce the emphasis on equity investments, and we also recorded charges amounting to $26 million during that year to establish reserves for guaranteed benefits on several separate account contracts. However, the impact of the foregoing items was largely offset by less favorable mortality experience in 2001, and, during the first nine months of 2001, we recorded approximately $29 million of increased estimates of policy liabilities relating to prior periods. Additionally, this business continues to be adversely affected by the gradual runoff of our general account products, including general account guaranteed investment contract ("GIC"), business, that we have experienced over the past several years. We expect to continue to have low sales of general account GICs unless and until our ratings improve.
The following table shows the changes in the account values and net sales of Other Employee Benefits segment products for the periods indicated. Net sales are total sales minus withdrawals or withdrawals and benefits, as applicable. As noted above under "--U.S. Consumer Division--Retail Investments--Sales Results and Assets Under Management," neither sales nor net sales are revenues under GAAP.
- -------- (1) Includes an increase to policyholder account values as a result of policyholder credits issued in 2001 in connection with Prudential's demutualization, amounting to $433 million. (2) Prudential's retirement plan accounted for 29% of sales in the year ended December 31, 2001, 27% of sales for 2000, and 28% for 1999. Ending total account value includes assets of Prudential's retirement plan of $9.1 billion at December 31, 2001, $8.2 billion at December 31, 2000, and $8.2 billion at December 31, 1999. (3) Represents changes in asset balances for externally managed accounts. Additionally, in 2001, includes an increase to policyholder account values of $181 million representing cumulative conversions of client balances to products currently included in this business and a further increase of $2 million as a result of policyholder credits issued in connection with Prudential's demutualization.
Assets under management for guaranteed products amounted to $39.8 billion at December 31, 2001, a decrease of $1.8 billion, or 4%, from December 31, 2000. The decrease from December 31, 2000 is primarily due to a decrease in separate account annuity assets that reflected approximately $1.4 billion of annuity benefits.
Our international operations conduct their business primarily in local currencies and, accordingly, fluctuations in foreign currency exchange rates, net of the impact of our hedging strategies, affect the profitability of these operations in our Consolidated Financial Statements. For a discussion of our currency hedging strategies, see "Quantitative and Qualitative Disclosures About Market Risk--Risk Management, Market Risk and Derivative Instruments--Other Than Trading Activities--Market Risk Related to Foreign Currency Exchange Rates."
In addition, we must manage our risk in connection with principal transactions associated with the international and futures operations of the International Securities and Investments segment. The liquidity of markets and transactional volume, the level and volatility of interest rates, security and currency valuations, competitive conditions and other factors also affect our revenues and profitability. See "--Overview--Profitability."
2001 to 2000 Annual Comparison. Adjusted operating income of our International division increased $201 million, or 62%, in 2001 from 2000. The increase came from an increase of $315 million in adjusted operating income from our International Insurance segment, including $262 million from Gibraltar Life which we acquired in 2001, as discussed below. This increase was partially offset by a $114 million decline in adjusted operating income from our International Securities and Investments segment. Income from continuing operations before income taxes increased by $159 million, or 52%, in 2001 from 2000 as a result of the increase in adjusted operating income, which was partially offset by a $42 million increase in realized investment losses. For a discussion of realized investment gains and losses, and charges related to realized investment gains and losses, see "--Consolidated Results of Operations--Realized Investment Gains."
Our international insurance operations are subject to currency fluctuations that can materially impact the U.S. dollar results of our international insurance operations from period to period even if results on a local currency basis are relatively constant. Exchange rates fluctuated significantly in the three years ended December 31, 2001. The financial results of our International Insurance segment reflect the impact of our currency hedging strategies including internal hedges, whereby some currency fluctuation exposure is assumed in our Corporate and Other operations. Unless otherwise stated, we have translated all information in this section on the basis of exchange rates in accordance with GAAP. To achieve a better understanding of local operating performance, where indicated below, we analyze results both on the basis of GAAP translated results and on the basis of local results translated at a constant exchange rate. When we discuss constant exchange rate information below, we translated on the basis of the average exchange rates for the year ended December 31, 2001.
The following table sets forth the International Insurance segment's operating results for the periods indicated.
2001 to 2000 Annual Comparison. Adjusted operating income increased $315 million from 2000 to 2001. Results of Gibraltar Life, which we include in our results from April 2, 2001, the date of the reorganization, through November 30, 2001, contributed $262 million to the increase in adjusted operating income. The International Insurance segment reported adjusted operating income of $172 million for the fourth quarter of 2001, including $77 million from Gibraltar Life.
The segment's increase in adjusted operating income includes the unfavorable effect of year over year fluctuations in currency exchange rates as well as the impact of our hedging at expected exchange rates. On a constant exchange rate basis and excluding the impact of currency hedging, adjusted operating income, including results of Gibraltar Life, increased $333 million.
2000 to 1999 Annual Comparison. Adjusted operating income increased $78 million, or 36%, from 1999 to 2000. The increase resulted from continuing improved results from our Japanese insurance operations, from $240 million in 1999 to $315 million in 2000, which experienced continued growth in insurance in force due to strong persistency and new sales. Our operations in countries other than Japan resulted in operating losses of $19 million in 2000 and $22 million in 1999, as improved operating income from our Korean insurance operations was partially offset by increased costs associated with our expansion into additional countries. The segment's increase in adjusted operating income includes the favorable effect of year over year fluctuations in currency exchange rates as well as the impact of our hedging at expected exchange rates. On a constant exchange rate basis and excluding the impact of currency hedging, adjusted operating income increased $37 million, or 18%.
In managing our international insurance business, we analyze new annualized premiums, which do not correspond to revenues under GAAP, as well as revenues, because new annualized premiums measure the current sales performance of the business unit, while revenues reflect the renewal persistency and aging of in force policies written in prior years and net investment income in addition to current sales.
2000 to 1999 Annual Comparison. Adjusted operating income increased $11 million from 1999 to 2000. Adjusted operating income from our international securities operations, including our futures operations, increased $30 million in 2000 from 1999, including a $21 million gain in 2000 from our interest in the conversion of stock exchange seats as discussed above. Our international securities operations benefited from continued active U.S. equity markets, particularly during the early part of 2000. An $11 million decline in adjusted operating income from our futures operations due to reduced volatility in the global commodity and foreign exchange markets in 2000 was a partial offset. Losses from our international investments operations increased $19 million, from $32 million in 1999 to $51 million in 2000, reflecting increased expenses from the expansion of this developing business.
2001 to 2000 Annual Comparison. Revenues, as shown in the table above under "--Operating Results," decreased $156 million, or 22%, from 2000 to 2001. The decrease came from a $177 million decrease in revenues from our international securities operations, which include our futures operations. The $177 million decrease came primarily from lower commission revenues associated with reduced transaction volume, reflecting the less active equity markets in comparison to 2000 which benefited from exceptionally active equity markets in the early part of the year. In addition, revenues for 2000 included the $21 million gain from our interest in the conversion of stock exchange seats as noted above. Revenues from our international investments operations increased $21 million, primarily from asset management fees and commissions earned by recently acquired units.
2000 to 1999 Annual Comparison. Expenses increased $113 million, or 20%, from 1999 to 2000. Expenses of our international securities operations increased $76 million, primarily as a result of increased compensation paid to Financial Advisors on higher commission revenues, increased formula-based and incentive compensation on higher revenues and earnings, increased expenses from a London-based broker and asset manager that we acquired in 1999 and costs to expand our securities operations in Asia and Latin America. Expenses of our international investment operations increased $37 million, reflecting expenses from the development of this business.
efforts are attractive to issuers and lead underwriters, engages in equity securities sales and trading, manages our hedge portfolios. We include the division's asset-based management fees in the line captioned "Commissions and other income" in our consolidated statements of operations.
2000 to 1999 Annual Comparison. Adjusted operating income was flat from 1999 to 2000. Although revenues increased, the increase was essentially offset primarily by expenses related to the consolidation of substantially all of our public equity management capabilities into our Jennison unit.
2001 to 2000 Annual Comparison. Revenues, as shown in the table above under "--Operating Results," decreased $39 million, or 4%, from 2000 to 2001. The decrease came primarily from declines of $34 million, or 14%, in revenues from management of retail customer assets and $26 million, or 6%, in revenues from management of institutional customer assets. The decrease in revenues from management of retail customer assets came primarily from market value declines on publicly traded equity securities which resulted in a lower level of average assets under management. The decrease in revenues from management of institutional customer assets reflected a $25 million performance incentive fee earned in 2000. Revenues from management of general account assets increased $21 million, reflecting increased market values on fixed income securities.
2000 to 1999 Annual Comparison. Revenues increased $106 million, or 14%, from 1999 to 2000. The increase was principally a result of an $87 million increase in revenues from management of institutional customer assets, which included $32 million of mortgage origination and servicing revenues from a subsidiary we acquired in 2000. The remainder of the increase came primarily from a $25 million performance incentive fee as well as increased revenue from our real estate and private equity advisory businesses.
2001 to 2000 Annual Comparison. Expenses, as shown in the table above under "--Operating Results," were essentially unchanged from 2000 to 2001, as our 2001 results included expenses for the entire year relating to the mortgage origination and servicing activities of a subsidiary that we acquired in June 2000, while our 2000 results included approximately $40 million of expenses related to the consolidation of substantially all of our public equity management capabilities into our Jennison unit.
The following table sets forth the Other Asset Management segment's operating results for the periods indicated.
2001 to 2000 Annual Comparison. Adjusted operating income decreased $8 million, or 7%, in 2001 from 2000. The decrease came from a $25 million decline in adjusted operating income from our equity sales and trading operations, partially offset by a $17 million increase from our commercial mortgage securitization operations and hedge portfolios. Adjusted operating income from our equity sales and trading operations in 2001 included $20 million that Prudential Securities earned as co-manager in the initial public offering of our Common Stock during the fourth quarter of 2001, which is offset by a corresponding charge in our Corporate and Other results. Absent this item, adjusted operating income from our equity sales and trading operations in 2001 was $35 million, a decrease of $45 million or 56% from 2000. This decrease reflected a decline in our revenues from principal trading activities supporting retail and institutional customers as well as increased costs from employee terminations associated with staff reductions and facilities consolidations.
Adjusted operating income from our commercial mortgage securitization operations and hedge portfolios increased $17 million to $59 million in 2001 from $42 million in 2000. The increase came primarily from our mortgage securitization operations, which benefited from changes in market value of financial instruments held pending securitizations. As of December 31, 2001, the hedge portfolios held assets, including both principal positions and securities financing positions, of approximately $3.9 billion, compared to $7.9 billion at December 31, 2000.
2001 to 2000 Annual Comparison. Revenues, as shown in the table above under "--Operating Results," decreased $33 million, or 7%, from 2000 to 2001. The decrease came from a decline in revenues from our equity sales and trading operations, from $404 million in 2000 to $347 million in 2001, which included revenues of $22 million that Prudential Securities received as co-manager in the initial public offering of our Common Stock. Excluding this item, revenues from our equity sales and trading operations declined $79 million, or 20%, in 2001 from 2000. Revenues in 2001 were negatively affected by reduced revenues from principal trading supporting retail and institutional customers, while 2000 revenues benefited from exceptionally active equity securities markets during the first four months of the year. The reduced principal trading revenues we experienced in 2001 reflected lower transaction volume in the equity securities markets resulting from decreased individual investor trading activity, as well as reduced securities trading spreads.
2000 to 1999 Annual Comparison. Revenues increased $97 million, or 26%, from 1999 to 2000. The increase came from a $102 million increase in revenues from our equity sales and trading operations, from $302 million in 1999 to $404 million in 2000. The equity sales and trading operations benefited from increased volume from retail activity associated with the strength of the technology sector early in 2000, as well as increased transaction volume from institutional clients.
Corporate and Other operations includes corporate-level activities that we do not allocate to our business segments. It also consists of international ventures, divested businesses and businesses that we have placed in wind-down status, but that we have not divested. The latter businesses include individual health insurance, group credit insurance and Canadian life insurance. The divested businesses include the lead-managed equity underwriting for corporate issuers and institutional fixed income businesses of Prudential Securities, Gibraltar Casualty Company, a Canadian life insurance subsidiary, and our divested residential first mortgage banking business. As previously discussed, we exclude the gains, losses and contributions to income/loss of the divested businesses from adjusted operating income.
The following table and discussion present results of these activities based on our definition of adjusted operating income, which is a non-GAAP measure, as well as income from continuing operations before income taxes, which is prepared in accordance with GAAP. As shown below, in addition to the gains, losses and contributions to income/loss of divested businesses, adjusted operating income excludes realized investment gains, net of losses, sales practices remedies and costs and demutualization costs and expenses.
Income from our own qualified pension plan amounted to $540 million in 2001, compared to $415 million in 2000. The $125 million increase came primarily from increased income on pension assets and amortization of deferred gains. This income is partially offset in our consolidated results by charges for our other retirement plans allocated both to Corporate and Other operations and our business segments. On a consolidated basis, our net pension credit related to continuing operations amounted to $457 million in 2001 and $362 million in 2000. The contribution to adjusted operating income from income from our own qualified pension plan has increased during recent periods. We expect that income from our own qualified pension plan will continue to contribute to adjusted operating income in 2002 at a level about 10% below that of 2001. Hedging losses retained at the corporate level decreased $22 million, from $26 million in 2000 to $4 million in 2001. The increase in income from our own qualified pension plan and decrease in hedging losses were partially offset by reductions in investment income from our debt-financed investment portfolio and from invested assets that we held pending disbursement for sales practices remedies and costs. Investment income from the debt-financed investment portfolio, net of interest expense, contributed $38 million to adjusted operating income for 2001 compared to $98 million for 2000, as a result of a decline in the assets in the portfolio to approximately $223 million at December 31, 2001 from $3.7 billion a year earlier. We have taken actions to reduce this portfolio and repay the related borrowings, and expect that we will continue to do so. Accordingly, we expect that the contribution to adjusted operating income from this debt-financed portfolio will decline in future periods. Income from invested assets related to sales practices remedies and costs declined $25 million as disbursements were made to satisfy these liabilities. Investment income for 2001 included about $15 million relating to assets initially invested within our Corporate and Other operations as a result of transactions relating to our demutualization, effective as of December 18, 2001. About half of this investment income represents earnings on assets corresponding to cash payments in January 2002 for demutualization consideration in lieu of Common Stock.
Income from continuing operations before income taxes amounted to a loss of $520 million in 2001, compared to a loss of $1.063 billion in 2000. The $543 million decrease in the loss came primarily from a $489 million decrease in losses from divested businesses which included, in 2000, charges of $476 million associated with the termination and wind-down of Prudential Securities' former lead-managed equity underwriting for corporate issuers and institutional fixed income businesses, and from $187 million of realized investment gains in 2001 compared to $280 million of realized investment losses in 2000. However, we incurred demutualization costs and expenses of $588 million in 2001, including a charge of $340 million for demutualization consideration to former Canadian branch policyholders, compared to $143 million of demutualization expenses in 2000.
liabilities for our own employee benefits that we recorded in 1999 due to a clarification of law that led us to take into account previously unrecognized assets in that amount. Corporate-level activities benefited from income related to our own qualified pension plan amounting to $415 million in 2000 compared to $197 million in 1999, an increase of $218 million. This income is partially offset in our consolidated results by charges for our other retirement plans allocated both to Corporate and Other operations and our business segments. On a consolidated basis, our net pension credit related to continuing operations amounted to $362 million in 2000 and $201 million in 1999. The increase in pension plan income came primarily from a reduction in the number of plan participants due to the sale of our healthcare operations in 1999, increased income on pension assets and amortization of deferred gains. Amendments to our pension and postretirement plans in 2000 did not have a material effect on our results of operations. The $218 million increase in qualified pension plan income was offset by an increase in general and administrative expenses, and a reduction of investment income net of interest expense at the corporate level. General and administrative expenses at the corporate level, on a gross basis before qualified pension income, were $687 million in 2000 compared to $576 million in 1999. The $111 million increase came primarily from costs incurred during 2000 for company-wide technology development including enhancement of our Internet capabilities. The decrease in investment income net of interest expense, from $386 million in 1999 to $303 million in 2000, resulted primarily from a reduction in invested assets related to sales practices remedies and costs as disbursements were made to satisfy these liabilities.
Income from continuing operations before income taxes declined $1.335 billion, from $272 million in 1999 to a loss of $1.063 billion in 2000. The increase in losses came primarily from a $637 million decline in realized investment gains, net of losses, and from the former lead-managed underwriting and institutional fixed income businesses of Prudential Securities, as well as the $141 million decline in adjusted operating income and a $68 million increase in demutualization expenses.
As discussed under "Overview--Financial Services Businesses and Closed Block Business," we established the Closed Block Business effective at the date of demutualization. The Closed Block Business, which represents results of our Traditional Participating Products segment prior to the demutualization, includes our in force traditional participating life insurance and annuity products, and assets that will be used for the payment of benefits and policyholder dividends on these policies, as well as other assets and equity and related liabilities that support these policies. We have ceased offering these participating policies.
Also concurrently with our demutualization, PHLLC issued the IHC debt. We allocated the majority of the net proceeds from the issuance of the IHC debt to the Financial Services Businesses. However, we expect that the IHC debt will be serviced by the net cash flows of the Closed Block Business over time, and we report results of the Closed Block Business, including interest expense associated with the IHC debt.
At the end of each year, the Board of Directors of Prudential Insurance determines the dividends payable for participating policies for the following year based on its statutory results and past experience, including investment income, net realized gains over a number of years, mortality experience and other factors. As required by generally accepted accounting principles, we developed an actuarial calculation of the timing of the maximum future earnings from the policies included in the Closed Block, and if actual cumulative earnings in any given period are greater than the cumulative earnings we expect, we will record this excess as a policyholder dividend obligation. We will subsequently pay this excess to Closed Block policyholders as an additional dividend unless it is otherwise offset by future Closed Block performance that is less favorable than what we originally expected. The policyholder dividends we charge to expense within the Closed Block Business will include any such policyholder dividend obligations that we recognize in addition to the actual policyholder dividends declared by
the Board of Directors of Prudential Insurance. If cumulative performance is less favorable than we expected, the policyholder dividends we charge to expense within the Closed Block Business will be the actual dividends declared by the Board of Directors. For the portion of the year ended December 31, 2001 subsequent to the date of demutualization, there was no required charge to recognize a policyholder dividend obligation.
The following table sets forth the Closed Block Business's operating results for the periods indicated.
Adjusted Operating Income and Income from Continuing Operations Before Income Taxes
2001 to 2000 Annual Comparison. Adjusted operating income decreased $111 million, or 20%, in 2001 from 2000. The decrease in adjusted operating income reflected $144 million of reserves established in 2001 for death and other benefits due with respect to policies for which we have not received a death claim but where death has occurred. We have made substantial efforts to identify policyholders for whom we lack current information and the $144 million reserve recorded represents a revision to our past estimate of incurred but not reported death claims and related expenses. Upon demutalization $134 million of this reserve became a liability of the Financial Services Businesses, and any subsequent reestimation of the liability (upward or downward) will be included in adjusted operating income of the Financial Services Businesses. Additionally, the effect of aging of policies in force on policyholder benefits and related reserves exceeded the returns on the underlying assets. These developments were partially offset by a $141 million reduction in the charge for policyholder dividends, a $56 million reduction in amortization of deferred policy acquisition costs, and a $26 million decline in operating expenses. The $141 million reduction in the charge for policyholder dividends, which excludes the portion of the dividend related to net realized investment gains, reflects dividend scale changes for 2002. Income from continuing operations before income taxes amounted to a loss of $619 million in 2001, compared to income of $193 million in 2000, with the decline primarily due to a $701 million decrease in realized investment gains, net of losses and related charges. For a discussion of realized investment gains and losses, and charges related to realized investment gains and losses, see "--Consolidated Results of Operations --Realized Investment Gains."
2001 to 2000 Annual Comparison. Revenues, as shown in the table above under "--Operating Results," decreased $367 million, or 4%, in 2001 from 2000. Premiums decreased $105 million, or 2%, from $4.355 billion in 2000 to $4.250 billion in 2001, as an increase in paid-up additions which represent additional insurance purchased with policyholder dividends was more than offset by lower renewal premiums. We expect the decline in premiums for this business to continue as the policies in force mature or terminate over time, as we have discontinued sales of traditional participating products in connection with our demutualization. Net investment income decreased $275 million, or 7%, from $4.172 billion in 2000 to $3.897 billion in 2001. The decrease, which was partially offset by a $118 million decrease in interest expense, as discussed below, reflects a decline in the general account invested assets supporting this business due to a lower level of borrowing activity, and a lower investment yield.
Dividends to policyholders, which excludes the portion of dividends relating to net realized investment gains as discussed under "--Consolidated Results of Operations--Realized Investment Gains" above, amounted to $2.261 billion in 2000, relatively unchanged from $2.246 billion in 1999. There was no adjustment to the dividend scale for 2000 from the scale for 1999. Mortality experience for both 2000 and 1999 was consistent, on an overall basis, with our pricing assumptions.
New statutory premiums from sales of traditional participating individual life insurance products amounted to $36 million for the year ended December 31, 2001, $49 million for 2000, and $61 million for 1999. The limited sales of these products reflect a continuing shift in our sales during recent years away from traditional whole life into variable life insurance products. We ceased sales of traditional participating products in connection with our demutualization.
The following table sets forth policy surrender experience for the Closed Block Business, measured by cash value of surrenders, for the periods indicated. These amounts do not correspond to the income statement impact of surrenders under GAAP. In managing this business, we analyze the cash value of surrenders because it is a measure of the degree to which policyholders are maintaining their in force business with us, a driver of future profitability.
Prudential Financial's principal source of revenues to meet its obligations, including the payment of shareholder dividends, debt service, capital contributions to subsidiaries as may be required, and operating expenses, are dividends and interest income from its direct and indirect subsidiaries. At December 31, 2001, Prudential Financial had substantial excess cash liquidity, including cash and short-term investments of approximately $4.4 billion as a result of $6.0 billion of funds received in the fourth quarter of 2001, less net application of $1.6 billion of funds to our operating businesses. The $6.0 billion of funds received were from the following sources:
. net proceeds from the issuance of the Class B Stock of $167 million, and net proceeds from the IHC debt of $1.218 billion; and
. dividends in late December 2001 from our property and casualty insurance subsidiary of $525 million and from our asset management subsidiary of $40 million.
We anticipate that Prudential Financial will establish several financing programs to satisfy needs for cash and capital at the parent company level and for the destacked subsidiaries and will eventually serve as the primary financing company for the destacked subsidiaries. Prudential Funding, LLC ("Prudential Funding"), a wholly owned subsidiary of Prudential Insurance, has historically served as the primary financing company for Prudential Insurance and its subsidiaries as discussed under "--Financing Activities" below and will continue to provide a limited amount of financing for the destacked subsidiaries. Rating organizations have assigned lower credit ratings to Prudential Financial than Prudential Funding. As a result, we expect that some of our financing costs will increase as we transition existing financing from Prudential Funding to Prudential Financial.
On the date of demutualization, Prudential Financial made a capital contribution of approximately $1.05 billion to Prudential Insurance to replenish the reduction of its capital in that amount which resulted from distribution of demutualization compensation to some policyholders in the form of policy credits rather than Common Stock or cash. The capital contribution was financed with the proceeds from the purchase by Prudential Insurance of a series of notes issued by Prudential Financial with market rates of interest and maturities ranging from nineteen months to three years.
Our insurance, broker-dealer and various other companies are subject to regulatory limitations on the payment of dividends and on other transfers of funds to affiliates. For the reason noted in the following paragraph, the ability of Prudential Insurance to pay stockholder dividends will be constrained in the initial years following demutualization. The principal sources of funds to meet Prudential Financial's obligations, including the payment of dividends to its stockholders, will be the net proceeds, after the foregoing cash payments to eligible policyholders, from the initial public offering of its Common Stock, the offering of the equity security units and the net proceeds from issuances of the Class B Stock and IHC debt, as well as dividends from the destacked subsidiaries, and interest and fee payments from subsidiaries.
New Jersey insurance law provides that, except in the case of extraordinary dividends or distributions, all dividends or distributions paid by Prudential Insurance may be declared or paid only from unassigned surplus, as determined pursuant to statutory accounting principles, less unrealized investment gains and revaluation of assets. Upon demutualization, unassigned surplus was reduced to zero, thereby limiting Prudential Insurance's ability to pay a dividend immediately following demutualization. As of December 31, 2001, Prudential Insurance's unassigned surplus was $228 million, and there were no applicable adjustments for unrealized investment gains or revaluation of assets for purposes of the foregoing law regarding dividends and distributions. Dividendable funds are expected to grow thereafter in the ordinary course of business over time. Prudential Insurance also must notify the New Jersey insurance regulator of its intent to pay a dividend, if the dividend, together with other dividends or distributions made within the preceding twelve months, would exceed a specified statutory limit and obtain a non-disapproval from the New Jersey insurance regulator. The current statutory limitation applicable to New Jersey life insurers generally is the greater of:
(2) the net gain from operations of such insurer, not including realized investment gains, for the 12-month period ending the December 31 next preceding the date of the proposed dividend or distribution,
Other states and foreign jurisdictions have similar regulations to those of New Jersey which affect the ability of our other insurance companies to pay dividends. The laws regulating dividends of the other states and foreign jurisdictions where our other insurance companies are domiciled are similar, but not identical, to New Jersey's. In addition, the net capital rules to which our broker-dealer subsidiaries are subject may limit their ability to pay dividends to Prudential Financial.
We seek to manage our consolidated liquidity position so that we have, on a cost-effective basis, adequate resources to satisfy operating cash requirements and investment objectives, as well as to fund business growth. We also seek to manage our liquidity so that we have adequate sources of funding to support our needs under stress scenarios so that we can meet our obligations without materially disrupting our operating and investing activities.
We borrow money on an ongoing basis to support our business operations and strategies and seek to do so in a manner consistent with maintaining and seeking to improve our current credit ratings. We manage our borrowing according to company-wide, legal entity and business borrowing limits, which are monitored by our
Prudential Insurance and Prudential Funding have unsecured committed lines of credit totaling $4.1 billion, of which $1.5 billion expires in October 2002, $0.1 billion expires during 2003, $1.0 billion expires in May 2004, and the remaining $1.5 billion expires in October 2006. Borrowings under the facility expiring in October 2002 must mature no later than October 2003, and borrowings under the other facilities must mature no later than the respective expiration dates of the facilities. The facility expiring in May 2004 includes 33 financial institutions, many of which are also among the 27 financial institutions participating in the other facilities. Up to $2.5 billion of the amount available under these facilities can be utilized by Prudential Financial. The $2.5 billion consists of $500 million, $1.0 billion and $1.0 billion made available under the facilities expiring in October 2002, May 2004 and October 2006, respectively. We use these facilities primarily as back-up liquidity lines for our commercial paper programs. Our ability to borrow under these facilities is conditioned on our continued satisfaction of customary conditions, including maintenance at all times by Prudential Insurance of total adjusted capital of at least $5.5 billion based on statutory accounting principles prescribed under New Jersey law. Prudential Insurance's total adjusted capital as of December 31, 2001 was $10.0 billion. The ability of Prudential Financial to borrow under these facilities is conditioned on its maintenance of consolidated net worth of at least $12.5 billion, based on GAAP. Prudential Financial's consolidated net worth totaled $20.5 billion as of December 31, 2001. In addition, we have an uncommitted credit facility utilizing a third-party-sponsored, asset-backed commercial paper conduit, under which we can borrow up to $1.0 billion. Our actual ability to borrow under this facility depends on market conditions. This facility expires in June 2002. We also use uncommitted lines of credit from banks and other financial institutions.
Our total borrowings consist of amounts used for general corporate purposes, investment related debt, securities business related debt, and debt related to specified other businesses. Borrowings used for general corporate purposes include those used for cash flow timing mismatches, and investments in equity and debt securities of subsidiaries including amounts needed for regulatory capital purposes. Investment related borrowings consist of debt issued to finance specific investment assets or portfolios of investment assets, including real estate, real estate related investments held in consolidated joint ventures, and institutional spread lending investment portfolios. Securities business related debt consists of debt issued to finance primarily the liquidity of our broker-dealers, and our capital markets and other securities business related operations. Debt related to specified other businesses consists of borrowings associated with consumer banking activities, real estate franchises, and relocation services. Borrowings under which either the holder is entitled to collect only against the assets pledged to the debt as collateral, or has only very limited rights to collect against other assets, have been classified as limited and non-recourse debt.
Our borrowings as of December 31, 2001 and December 31, 2000, categorized by use of proceeds, are summarized below:
Total borrowings and asset-based financing at December 31, 2001 decreased approximately $10.8 billion, or 23%, from December 31, 2000, reflecting a $5.7 billion decrease in short-term debt, a $2.8 billion increase in long-term debt, and a $7.9 billion decrease in asset-based financing. The decline in short-term debt resulted from decreases in our debt-financed investment portfolios, reductions in subsidiary debt in our insurance operations with cash raised at the time of demutualization, and reductions in bank borrowings associated with our broker-dealer operations. Long-term debt increased due to the issuance by PHLLC of $1.75 billion of IHC debt related to the establishment of the Closed Block Business. We have classified this debt as limited and non-recourse. In addition, long-term debt has also increased $599 million due to the acquisition of Gibraltar Life. The decline in asset-based financing relates primarily to reductions in asset-based financed positions in our spread and hedge portfolios.
The ratings assigned by independent rating agencies are an important determinant of the market acceptance and cost of our financing through commercial paper, medium-term notes, surplus notes and other indebtedness.
Gross account withdrawals, including those of Gibraltar Life, which we acquired in April 2001, amounted to $9.014 billion in the year ended December 31, 2001 and $8.165 billion in the year ended December 31, 2000. These withdrawals include contractually scheduled maturities of traditional guaranteed investment contracts totaling $1.671 billion in the year ended December 31, 2001 and $1.785 billion in the year ended December 31, 2000. We experienced these large withdrawals on guaranteed products as a result of contractual expirations of products sold in the late 1980s and early 1990s. Since these contractual withdrawals, as well as the level of surrenders experienced, were consistent with our assumptions in asset liability management, the associated cash outflows did not have an adverse impact on our overall liquidity.
We closely monitor surrenders and withdrawals for our life insurance and annuity contracts. Upon policy surrender, life insurance policyholders are surrendering the life insurance protection in addition to their investment in the contract, which would typically require new underwriting and acquisition costs to replace. Therefore, our exposure to increased surrenders is considerably less for life insurance policies than for annuities. In addition, many of our contracts contain provisions that discourage early surrender. Market value adjustment features in some contracts provide for adjustments of the amount available in the event of surrender to reflect changes in the value of the underlying investments. We deduct policy loans, which we report as assets, from amounts available on surrender. Some contracts impose surrender charges that we deduct in the event of surrender before specified dates.
We sell variable life insurance products that contain both general and separate account components, with the bulk of account balances in separate accounts. The principal product of this type, Variable Appreciable Life, also imposes surrender charges for the first ten years after issuance. In addition to the right to surrender, policyholders may transfer account balances between the general account and the separate account components, subject to limitations on the amount transferred and only within a 30-day period following each anniversary of the policy. As of December 31, 2001 and 2000, general account balances for variable life insurance products other than single-payment life were $1.9 billion and $1.8 billion, respectively, while separate account balances were $13.0 billion and $13.9 billion, respectively. The table above includes as of December 31, 2001, $5.881 billion of annuity reserves and deposit liabilities of Gibraltar Life, which we acquired in April 2001. Gibraltar Life's assets and liabilities were substantially restructured under a reorganization concurrent with our acquisition, which included the imposition of special surrender penalties on existing policies according to the following schedule (for each year ending March 31):
We believe that cash flows from operating and investing activities of our insurance, annuity and guaranteed products operations are adequate to satisfy liquidity requirements of these operations based on our current liability structure and considering a variety of reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors including future securities market conditions, changes in interest rate levels and policyholder perceptions of our financial strength, which could lead to reduced cash inflows or increased cash outflows. As of December 31, 2001 and 2000, we had short-term investments of approximately $4.9 billion and $5.0 billion, respectively, and fixed maturity investments classified as "available for sale" with fair values of $109.9 billion and $83.8 billion at those dates, respectively. At December 31, 2001, the fair value of fixed maturities available for sale included $17.6 billion related to Gibraltar Life. Additionally, the increase in fixed maturities classified as "available for sale" in the 2001 reflects our reclassification, as of January 1, 2001, of $12.1 billion fair value of fixed maturity investments that were previously classified as "held to maturity" concurrently with our adoption of new accounting standards for derivative instruments and hedging activities as required by guidance issued by the Financial Accounting Standards Board. The latter portfolios are comprised primarily of investment grade corporate bonds and United States government obligations, substantially all of which we consider to be highly liquid and can be sold and/or pledged in financing transactions.
Prudential Securities Group Inc. maintains a highly liquid balance sheet with substantially all of its assets consisting of securities purchased under agreements to resell, short-term collateralized receivables from clients and broker-dealers arising from securities transactions, marketable securities, securities borrowed and cash equivalents. Prudential Securities Group's assets totaled $22.8 billion at December 31, 2001 and $25.8 billion at December 31, 2000. Prudential Securities Group's total capitalization, including equity, subordinated debt and long-term debt, was $3.3 billion at December 31, 2001 and $3.4 billion at December 31, 2000. In October 2000, we announced that we would terminate our institutional fixed income activities which constituted the major portion of the debt capital markets operations of Prudential Securities Group. As indicated above, our termination of institutional fixed income activities resulted in a reduced level of asset-based financing at Prudential Securities Group and on a consolidated basis. At December 31, 2001, Prudential Securities Group had remaining assets amounting to approximately $1.7 billion related to its institutional fixed income activities, as compared to $2.0 billion at December 31, 2000 and $17 billion at December 31, 1999. Substantially all of these assets were financed by means of asset-based borrowings.
Prudential Securities Group finances its balance sheet through asset-backed financing, including repurchase transactions, securities lending arrangements and free credit balances in customers' accounts, as well as internal short-term and long-term borrowings from Prudential Funding, uncommitted lines of credit from banks and other financial institutions and the asset-backed commercial paper market.
Our Asset Management division includes our hedge portfolios, the commercial mortgage securitization operation and proprietary investments and syndications. The hedge portfolios are financed through securities repurchase agreements and other securities financing activity and to a lesser extent unsecured borrowing. The underlying securities are government securities or corporate bonds and are generally liquid. The commercial mortgage securitization operation is financed by loans from Prudential Funding and by pledging assets to a third-party asset-backed commercial paper conduit. We generally finance the mortgages until a portfolio accumulates that is large enough to securitize and sell, which currently takes approximately 180 to 270 days, a period that we expect will shorten when we have a more fully developed process for accumulating mortgages. The commercial mortgage securitization operation's portfolio is less liquid than publicly traded securities. To mitigate those risks in this portfolio we use an alternative asset-backed commercial paper conduit and maintain a higher proportion of long-term financing to support these activities. In addition, we acquire public and private debt and equity investments, including controlling interests, of domestic and international companies, with the intention of selling them to institutional investors, including Prudential's general account. We acquire the investments with equity or short- or long-term debt depending on the liquidity and anticipated time for selling the investment.
During the normal course of our business, we utilize financial instruments with off-balance sheet credit risk such as commitments, financial guarantees and letters of credit. Commitments include commitments to purchase and sell mortgage loans, the underfunded portion of commitments to fund investments in private placement securities and unused credit card and home equity lines.
In connection with our consumer banking business, loan commitments for credit cards, home equity lines of credit and other lines of credit include agreements to lend up to specified limits to customers. It is anticipated that commitment amounts will only be partially drawn down based on overall customer usage patterns and, therefore, do not necessarily represent future cash requirements. We evaluate each credit decision on such commitments at least annually and have the ability to cancel or suspend such lines at our option. The total available lines of credit card, home equity and other commitments were $1.415 billion, of which $569 million remains available at December 31, 2001.
We utilize special purpose entities ("SPE's") for several business purposes. Our principal use of SPE's has been in connection with our existing commercial mortgage securitization business. The institutional fixed income business of Prudential Securities, which we exited in 2000, also conducted securitization activities. In those securitizations, mortgage loans or other receivables are sold to an SPE that issues debt and residual interests backed by the cash flows of the SPE's assets. In many of these transactions, we have no further continuing involvement in the assets or activities of the SPE except for retained servicing. In others, we may retain subordinated debt or a non-controlling portion of the equity of the SPE or may provide asset management services to the SPE. Our position as asset manager is controlled by third party investors in the SPE, who have the ability to terminate our services. We have also used SPE's in connection with the sale of investments, primarily real estate. In these transactions, at the time of sale, the investment is transferred to the SPE and is no longer included on our balance sheet. In other instances in which we utilize SPE's, such as structured financings and acquisitions, the SPE's are fully consolidated in our financial statements. We do not have any transactions, arrangements or other relationships with unconsolidated entities or other persons that are reasonably likely to have a material effect on our liquidity or our access to or requirements for capital resources. In addition, we do not have relationships with any unconsolidated entities that are contractually limited to narrow activities that facilitate our transfer of or access to assets.
To the Board of Directors and Stockholders of Prudential Financial, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Prudential Financial, Inc. and its subsidiaries at December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 14 (a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Consolidated Statements of Financial Position December 31, 2001 and 2000 (in Millions)
Consolidated Statements of Operations Years Ended December 31, 2001, 2000 and 1999 (in Millions, Except Per Share Amounts)
Consolidated Statements of Cash Flows Years Ended December 31, 2001, 2000 and 1999 (in Millions)
On the date of demutualization, policyholder membership interests in Prudential Insurance were extinguished and eligible policyholders collectively received 457.1 million shares of Common Stock, the rights to receive cash totaling $3,487 million (included in "Other liabilities" at December 31, 2001), including $340 million to certain former Canadian branch policyholders, and increases to their policy values in the form of policy credits totaling $1,042 million. The demutualization was accounted for as a reorganization. Accordingly, the Company's retained earnings on the date of demutualization, net of the aforementioned cash payments other than those to former Canadian policyholders and policy credits which were charged directly to retained earnings, were reclassified to "Common Stock" and "Additional paid-in capital."
Concurrent with the demutualization, Prudential Insurance completed a corporate reorganization whereby various subsidiaries (and certain related assets and liabilities) of Prudential Insurance were dividended so that they became wholly owned subsidiaries of Prudential Financial rather than of Prudential Insurance. The subsidiaries distributed by Prudential Insurance to Prudential Financial included its property and casualty insurance companies, its principal securities brokerage companies, its international insurance companies, its principal asset management operations, its international securities and investments operations, its domestic banking operations and its residential real estate brokerage franchise and relocation services operations.
On the date of demutualization, Prudential Financial completed an initial public offering of 110.0 million shares of Common Stock at a price of $27.50 per share and, on December 21, 2001, Prudential Financial issued an additional 16.5 million shares of Common Stock as a result of the exercise of the over-allotment option granted to underwriters in the initial public offering. Also on the date of demutualization, Prudential Financial completed the sale, through a private placement, of 2.0 million shares of Class B Stock, a separate class of common stock, at a price of $87.50 per share. The Common Stock reflects the performance of the Financial Services Businesses and the Class B Stock reflects the performance of the Closed Block Business. In addition to the issuances of Common Stock and Class B Stock, on the date of demutualization, Prudential Financial issued 13.8 million 6.75% equity security units at a price of $50 per unit (see Note 12) and Prudential Holdings, LLC, a wholly owned subsidiary of Prudential Financial, issued $1.75 billion in senior secured notes (see Note 11).
As discussed in Note 1 under "Demutualization and Initial Public Offering," the Company has outstanding two separate classes of common stock. Basic earnings per share are computed by dividing available income attributable to each of the two groups of common shareholders for the period subsequent to the demutualization by the respective weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised.
Fixed maturities classified as "available for sale" are carried at estimated fair value. Fixed maturities that the Company has both the positive intent and ability to hold to maturity are stated at amortized cost and classified as "held to maturity." See Note 19 for a discussion of the Company's reclassificiation of "held to maturity" securities to "available for sale" in connection with the implementation of new accounting standards for derivatives. The amortized cost of fixed maturities is written down to estimated fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairment adjustments. Unrealized gains and losses on fixed maturities "available for sale," net of income tax and the effect on deferred policy acquisition costs and future policy benefits that would result from the realization of unrealized gains and losses, are included in a separate component of equity, "Accumulated other comprehensive income (loss)."
Trading account assets and securities sold but not yet purchased are carried at estimated fair value. Realized and unrealized gains and losses on trading account assets and securities sold but not yet purchased are included in "Commissions and other income."
Equity securities, available for sale, are comprised of common and non-redeemable preferred stock and are carried at estimated fair value. The associated unrealized gains and losses, net of income tax and the effect on deferred policy acquisition costs and future policy benefits that would result from the realization of unrealized gains and losses, are included in "Accumulated other comprehensive income (loss)." See the discussion below on realized investment gains and losses for a description of the accounting for impairment adjustments.
Securities purchased under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing arrangements and are carried at the amounts at which the securities will be subsequently resold or reacquired, including accrued interest, as specified in the respective agreements. The Company's policy is to take possession or control of securities purchased under agreements to resell and to value the securities daily. Assets to be repurchased are the same, or substantially the same, as the assets transferred. The market value of securities to be repurchased or resold is monitored, and additional collateral is obtained, where appropriate, to protect against credit exposure.
Securities borrowed and securities loaned are treated as financing arrangements and are recorded at the amount of cash advanced or received. With respect to securities loaned, the Company obtains collateral in an amount equal to 102% and 105% of the fair value of the domestic and foreign securities, respectively. The Company monitors the market value of securities borrowed and loaned on a daily basis with additional collateral obtained as necessary. Substantially all of the Company's securities borrowed transactions are with brokers and dealers, commercial banks and institutional clients. Substantially all of the Company's securities loaned transactions are with large brokerage firms.
Securities repurchase and resale agreements and securities borrowed and loaned transactions are used to generate net investment income and facilitate trading activity. These instruments are short-term in nature (usually 30 days or less) and are collateralized principally by U.S. Government and mortgage-backed securities. The carrying amounts of these instruments approximate fair value because of the relatively short period of time between the origination of the instruments and their expected realization.
Company's interest is so minor that it exercises virtually no influence over operating and financial policies. In such instances, the Company applies the cost method of accounting. The Company's net income from investments in joint ventures and partnerships is generally included in "Net investment income." However, for certain real estate joint ventures, Prudential's interest is liquidated by means of one or more transactions that result in the sale of the underlying invested assets to third parties and the ultimate distribution of the proceeds to Prudential and other joint venture partners in exchange for and settlement of the respective joint venture interests. These transactions are accounted for as disposals of Prudential's joint venture interests and the resulting gains and losses are included in "Realized investment gains (losses), net."
Realized investment gains (losses), net are computed using the specific identification method. Costs of fixed maturities and equity securities are adjusted for impairments considered to be other than temporary. Impairment adjustments are included in "Realized investment gains (losses), net." Factors considered in evaluating whether a decline in value is other than temporary are: 1) whether the decline is substantial; 2) the Company's ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; 3) the duration and extent to which the market value has been less than cost; and 4) the financial condition and near-term prospects of the issuer. Provisions for losses on commercial loans are included in "Realized investment gains (losses), net." Decreases in the carrying value of investment real estate held for disposal or for the production of income are recorded in "Realized investment gains (losses), net."
For participating life insurance, DAC is amortized over the expected life of the contracts (up to 45 years) in proportion to estimated gross margins based on historical and anticipated future experience, which is updated
periodically. The average rate of assumed future investment yield used in estimating expected gross margins was 7.28% at December 31, 2001 and gradually increases to 8.06% for periods after December 31, 2031. The effect of changes in estimated gross margins on unamortized deferred acquisition costs is reflected in "General and administrative expenses" in the period such estimated gross margins are revised. Policy acquisition costs related to interest-sensitive and variable life products and certain investment-type products are deferred and amortized over the expected life of the contracts (periods ranging from 7 to 30 years) in proportion to estimated gross profits arising principally from investment results, mortality and expense margins, and surrender charges based on historical and anticipated future experience, which is updated periodically. The effect of changes to estimated gross profits on unamortized deferred acquisition costs is reflected in "General and administrative expenses" in the period such estimated gross profits are revised. DAC related to non-participating term insurance is amortized over the expected life of the contracts in proportion to premiums.
For property and casualty insurance contracts, DAC is amortized over the period in which related premiums are earned. Future investment income is considered in determining the recoverability of DAC.
Premiums from non-participating group annuities with life contingencies are recognized when earned. For single premium immediate annuities and structured settlements with life contingencies, premiums are recognized when earned in a constant relationship to the amount of expected future benefit payments.
Assets and liabilities of foreign operations and subsidiaries reported in other than U.S. dollars are translated at the exchange rate in effect at the end of the period. Revenues, benefits and other expenses are translated at the average rate prevailing during the period. The effects of translating the statements of financial position of non-U.S. entities with functional currencies other than the U.S. dollar are included, net of related hedge gains and losses and income taxes, in "Accumulated other comprehensive income (loss)."
The Company and its domestic subsidiaries file a consolidated federal income tax return. The Internal Revenue Code (the "Code") limits the amount of non-life insurance losses that may offset life insurance company taxable income. The Code also imposes an "equity tax" on mutual life insurance companies which, in effect, imputes an additional tax to the Company based on a formula that calculates the difference between stock and mutual life insurance companies' earnings. Effective for the year ended December 31, 2001, the Company, as a stock company, is no longer subject to the equity tax. The provision for income taxes includes an estimate for changes in the total equity tax to be paid for prior years. Subsidiaries operating outside the United States are taxed under applicable foreign statutes.
In September 2000, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities--a replacement of FASB Statement No. 125." The Company has adopted the provisions of SFAS No. 140 relating to transfers and extinguishments of liabilities which are effective for periods occurring after March 31, 2001. The adoption did not have a material effect on the results of operations of the Company.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 eliminated the requirement that discontinued operations be measured at net realizable value or that entities include losses that have not yet occurred. SFAS No. 144 eliminated the exception to consolidation for a subsidiary for which control is likely to be temporary. SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. An impairment for assets that are not to be disposed of is recognized only if the carrying amounts of long-lived assets are not recoverable and exceed their fair values. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations and cash flows that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. At the date of adoption of this standard, the impact on results of operations of the Company is not material.
The Company retained all liabilities associated with litigation that existed at August 6, 1999 or commenced within two years of that date with respect to claims that were incurred prior to August 6, 1999. The loss on disposal includes management's best estimate of the cost of the ultimate resolution of such litigation as well as the cost of resolving certain matters pertaining to contractual and regulatory requirements. It is possible that additional adjustments to this estimate may be necessary which might be material to future results of operations of a particular quarterly or annual period.
The loss on disposal was increased in 1999 by $400 million, net of taxes, primarily as a result of higher than anticipated healthcare operating losses prior to the August 6, 1999 closing date and an increase in the Company's estimated obligation under the MLR Agreement. Actual pretax losses of $370 million during that period exceeded the original estimate of $160 million. In 2000, upon the completion of the period covered by the MLR Agreement and taking into consideration other costs incurred compared with those estimated in 1998 and 1999, the Company reduced the loss on disposal by $77 million, net of taxes. In 2001, upon the final settlement of the MLR Agreement, the Company reduced the loss on disposal by an additional $16 million, net of taxes.
In the fourth quarter of 2000, Prudential Securities Group Inc. exited the lead-managed equity underwriting for corporate issuers and institutional fixed income businesses. Exiting these businesses resulted in staff reductions of approximately 700 positions, 350 of which were eliminated in 2000 and the remainder in 2001. The positions eliminated included investment bankers, traders, analysts and other professional and support staff. Results for 2000 include a pretax charge of $476 million in connection with the restructuring, which is presented as "Capital markets restructuring." The charge includes $213 million for employee related costs, consisting largely of severance and termination benefits. The charge also includes the write-off of $140 million of goodwill previously recorded in connection with investment banking acquisitions. Remaining charges of $123 million consist of lease termination payments and other facility exit costs, including office equipment and leasehold improvements write-downs, and other related costs. As of December 31, 2001, remaining reserves for capital markets restructuring costs were $28 million. See Note 20 for information pertaining to the operating results of these exited businesses.
On October 20, 2000, Gibraltar Life filed for reorganization under the Reorganization Law of Japan. The Reorganization Law, similar to Chapter 11 of the U.S. Bankruptcy Code, is intended to provide a mechanism for restructuring financially troubled companies by permitting the adjustment of the interests of creditors, shareholders and other interested parties. On October 20, 2000, the Tokyo District Court issued an order generally freezing Gibraltar Life's assets and appointed an interim Trustee who, on October 23, 2000, was appointed as sole Trustee.
On April 2, 2001, the Tokyo District Court issued its official recognition order approving the Reorganization Plan, which was submitted by the Trustee and approved by Gibraltar Life's creditors. The Reorganization Plan became effective immediately upon the issuance of the recognition order, and is binding upon Gibraltar Life, its creditors, including policyholders, its shareholders and other interested parties, whether or not they submitted claims or voted for or against the plan. The Reorganization Plan included the extinguishment of all existing stock for no consideration and the issuance of 1.0 million new shares of common stock. Pursuant to the Reorganization Plan, on April 19, 2001 the Company contributed (Yen)50 billion ($395 million) in cash to Gibraltar Life's capital and on April 20, 2001 received 100% of Gibraltar Life's newly issued common stock. The Company also provided (Yen)98 billion ($775 million) to Gibraltar Life in the form of a subordinated loan. On April 23, 2001, the Tokyo District Court declared the reorganization proceedings concluded and dismissed the Trustee. Under the Reorganization Plan, Gibraltar Life was restructured as follows:
. Gibraltar Life's in force insurance policies, except for group life, collective term and reinsurance policies, were restructured as follows:
-- The guaranteed interest rate on in force policies was reduced to 1.75%.
-- Except for individual annuities, cash surrender values before surrender charges were reduced by an average of approximately 11%, and maturity values were reduced by 8%. Annuities will be subject to reductions only if they are surrendered.
. In years four and eight following the recognition of the Reorganization Plan by the Tokyo District Court, a special dividend to certain Gibraltar Life policyholders will be payable based on 70% of net realized investment gains, if any, over the Trustee's valuation of real estate and loans, net of transaction costs and taxes. As of December 31, 2001, a liability of $678 million is included in "Policyholders' dividends" for amounts expected to be distributed. The liability is based on the difference between the current estimated fair values of loans and real estate at the date of the Consolidated Statements of Financial Position and the value of such assets included in the Reorganization Plan. The liability will be adjusted as purchase
discounts and premiums on loans are accreted and amortized and as changes occur in estimates of fair value of loans and real estate that are expected to have an effect on the ultimate amount to be paid.
For purposes of inclusion in the Company's consolidated financial statements, Gibraltar Life has adopted a November 30 fiscal year end; therefore, the December 31, 2001 consolidated financial statements include Gibraltar Life's assets and liabilities as of November 30, 2001, and Gibraltar Life's results of operations for the period April 2, 2001 through November 30, 2001. The Company's December 31, 2001 consolidated financial statements include assets and liabilities for Gibraltar Life of $30,238 million and $29,012 million, respectively, and income from continuing operations before income taxes for Gibraltar Life of $238 million. Pro forma information to reflect the acquisition of Gibraltar Life as if it had occurred as of an earlier date has been omitted, as the lack of continuity of operations of Gibraltar Life resulting from the implementation of the Reorganization Plan would render such pro forma information not meaningful.
The amortized cost and estimated fair value of fixed maturities by contractual maturities at December 31, 2001, is shown below:
Proceeds from the repayment of held to maturity fixed maturities during 2001, 2000 and 1999 were $139 million, $3,266 million, and $4,957 million, respectively. Gross gains of $0 million, $8 million, and $73 million were realized on prepayment of held to maturity fixed maturities during 2001, 2000 and 1999, respectively.
Proceeds from the sale of available for sale fixed maturities during 2001, 2000 and 1999 were $84,629 million, $93,653 million and $117,685 million, respectively. Proceeds from the maturity of available for
sale fixed maturities during 2001, 2000 and 1999 were $13,521 million, $6,318 million and $5,105 million, respectively. Gross gains of $1,270 million, $909 million and $884 million, and gross losses of $1,136 million, $1,408 million and $1,231 million were realized on sales and prepayments of available for sale fixed maturities during 2001, 2000 and 1999, respectively. Realized losses included $356 million in 2001 resulting from the sale of substantially all of the Company's Enron Corp. holdings.
Write-downs for impairments which were deemed to be other than temporary for fixed maturities were $777 million, $540 million and $266 million, and for equity securities were $238 million, $34 million and $205 million for the years ended 2001, 2000 and 1999, respectively.
The Company's "Other long-term investments" include investments in joint ventures and limited partnerships of $2,108 million and $2,391 million at December 31, 2001 and 2000, respectively. These investments include $959 million and $1,363 million in real estate related interests and $1,149 million and $1,028 million in non-real estate related interests at December 31, 2001 and 2000, respectively. The Company's share of net income from such entities was $84 million, $187 million and $217 million for the years ended 2001, 2000 and 1999, respectively, and is reported in "Net investment income."
Summarized combined financial information for joint ventures and limited partnership interests accounted for under the equity method, in which the Company has an investment of $10 million or greater and an equity interest of 10% or greater, is as follows:
"Other long-term investments" also includes investments in the Company's separate accounts of $975 million and $1,077 million, investment real estate of $1,072 million and $239 million which is held through direct ownership and other miscellaneous investments of $1,263 million and $752 million at December 31, 2001 and 2000, respectively. Of the Company's real estate, $146 million and $181 million consist of commercial and agricultural assets held for disposal at December 31, 2001 and 2000, respectively. Impairment losses were $7 million, $0 million and $3 million for the years ended December 31, 2001, 2000 and 1999, respectively, and are included in "Realized investment gains (losses), net."
Based on the carrying value, assets categorized as "non-income producing" at December 31, 2001 included in fixed maturities, equity securities, commercial loans and other long-term investments totaled $47 million, $6 million, $19 million and $33 million, respectively.
The "joint ventures and limited partnerships" category includes net realized investment gains relating to real estate joint ventures' and partnerships' sales of their underlying invested assets, as described more fully in Note 2, "Investments," amounting to $0 million, $91 million and $114 million for the years ended 2001, 2000 and 1999, respectively.
The table below presents unrealized gains (losses) on investments by asset class:
In the normal course of its business activities, the Company accepts collateral that can be sold or repledged. The primary sources of this collateral are securities in customer accounts, securities purchased under agreements to resell and securities borrowed transactions. At December 31, 2001, the fair value of this collateral was approximately $18,163 million versus $19,329 million in 2000 of which $13,933 million versus $13,099 million in 2000 had either been sold or repledged.
The balances of and changes in deferred policy acquisition costs as of and for the years ended December 31, are as follows:
- -------- (a) Mortality assumptions for life insurance policies and individual annuities relating to Gibraltar Life are established at policy issue based on current Japanese industry tables with certain modifications based on company experience. Reserves for life insurance policies and individual annuities relating to Gibraltar Life are estimated based on the net level premium method and the present value of expected future payments based on historical experience, respectively. (b) Interest rates used in establishing such reserves relating to Gibraltar Life range from 1.3% to 1.9% for both life insurance and individual annuity liabilities.
- -------- (a) The 2001 accident and health increase relates to the acquisition of Gibraltar Life. The reduction in the 2000 property and casualty balance is primarily attributable to the sale of Gibraltar Casualty Company; the 1999 accident and health reduction relates to the sale of Prudential's healthcare business.
The unpaid claims and claim adjustment expenses presented above include estimates for liabilities associated with reported claims and for incurred but not reported claims based, in part, on the Company's experience. Changes in the estimated cost to settle unpaid claims are charged or credited to the Consolidated Statements of Operations periodically as the estimates are revised. Accident and health unpaid claims liabilities are discounted using interest rates ranging from 3.5% to 7.5%.
The amounts incurred for claims and claim adjustment expenses for property and casualty related to prior years were primarily driven by lower than anticipated losses for the auto line of business. The amounts incurred for claims and claim adjustment expenses for accident and health related to prior years were primarily due to improved long-term disability claim termination experience.
On the date of demutualization, Prudential Insurance established a Closed Block for certain individual life insurance policies and annuities issued by Prudential Insurance in the United States. The Closed Block forms the principal component of the Closed Block Business. For a discussion of the Closed Block Business see Note 20. The Company established a separate closed block for participating individual life insurance policies issued by the Canadian branch of Prudential Insurance. Because of the substantially smaller number of outstanding Canadian policies, this separate closed block is insignificant in size and is not included in the information presented below.
The policies included in the Closed Block are specified individual life insurance policies and individual annuity contracts that were in force on the effective date of the Plan of Reorganization and for which Prudential Insurance is currently paying or expects to pay experience-based policy dividends. Assets have been allocated to the Closed Block in an amount that has been determined to produce cash flows which, together with revenues from policies included in the Closed Block, are expected to be sufficient to support obligations and liabilities relating to these policies, including provision for payment of benefits, certain expenses, and taxes and to provide for continuation of the policyholder dividend scales in effect in 2000, assuming experience underlying such scales continues. To the extent that, over time, cash flows from the assets allocated to the Closed Block and claims and other experience related to the Closed Block are, in the aggregate, more or less favorable than what was assumed when the Closed Block was established, total dividends paid to Closed Block policyholders in the future may be greater than or less than the total dividends that would have been paid to these policyholders if the policyholder dividend scales in effect in 2000 had been continued. Any cash flows in excess of amounts assumed will be available for distribution over time to Closed Block policyholders and will not be available to
The recorded assets and liabilities were allocated to the Closed Block at their historical carrying amounts. The excess of Closed Block Liabilities over Closed Block Assets at the effective date of the demutualization (adjusted to eliminate the impact of related amounts in "Accumulated other comprehensive income (loss)") represents the estimated maximum future earnings from the Closed Block expected to result from operations attributed to the Closed Block after income taxes. As required by SOP 00-3, the Company developed an actuarial calculation of the timing of such maximum future earnings. If actual cumulative earnings in any given period are greater than the expected cumulative earnings, only the expected earnings will be recognized in income. Any excess of actual cumulative earnings over expected cumulative earnings will represent undistributed accumulated earnings attributable to policyholders and will be recorded as a policyholder dividend obligation to be paid to Closed Block policyholders as an additional policyholder dividend unless otherwise offset by future Closed Block performance that is less favorable than originally expected. As of December 31, 2001, no such additional policyholder dividends were recorded. If over such period, the actual cumulative earnings of the Closed Block are less than the expected cumulative earnings of the Closed Block, the Company will recognize only the actual earnings in income. However, the Company may change policyholder dividend scales in the future, which would be intended to increase future actual earnings until the actual cumulative earnings equal the expected cumulative earnings.
Closed Block Liabilities and Assets designated to the Closed Block at December 31, 2001, as well as maximum future earnings to be recognized from Closed Block Liabilities and Closed Block Assets, are as follows:
Closed Block revenues and benefits and expenses for the period from the date of demutualization through December 31, 2001 were as follows:
Reinsurance recoverables, included in "Other assets" at December 31, were as follows:
- -------- (a) Annual scheduled repayments of principal for the Series A and Series C notes begin in 2013. Annual scheduled repayments of principal for the Series B notes begin in 2018. (b) The interest rate on the Series A notes is a floating rate equal to LIBOR plus 0.875% per year. The interest rate in 2001 was 2.74%. (c) The interest rate on the Japanese Yen denominated fixed rate note is 2.2% through 2008 at which time it becomes a floating rate note. (d) The interest rates on the U.S. dollar denominated FRNs are generally based on rates such as LIBOR, Constant Maturity Treasury and the Federal Funds Rate. Interest rates on the U.S. dollar denominated FRNs ranged from 2.07% to 9.42% in 2001 and 5.99% to 7.08% in 2000. The 2000 interest rate range excludes a $29 million S&P 500 index linked note which had an interest rate range of 0.10% to 0.46%. (e) The interest rate on the Canadian Dollar denominated FRN is based on the Canadian Bankers Acceptances Rate (CADBA) less 0.30%. This note has a contractual floor of 6.00% with a contractual cap of 9.125%. This rate ranged from 6.00% to 6.84% and 6.12% to 6.84% in 2001 and 2000, respectively. (f) The interest rate on the Japanese Yen denominated FRN is based on the Yen LIBOR plus 1.20%. The interest rate in 2001 was 1.32%. (g) The interest rate on the Great Britain Pound denominated FRN was based on the three month Sterling LIBOR plus 0.10% per year. This rate ranged from 6.22% to 6.89% in 2000.
Payment of interest and principal on the surplus notes issued after 1993, of which $690 million and $689 million were outstanding at December 31, 2001 and 2000, respectively, may be made only with the prior approval of the Commissioner of Banking and Insurance of the State of New Jersey ("the Commissioner"). The Commissioner could prohibit the payment of the interest and principal on the surplus notes if certain statutory capital requirements are not met. At December 31, 2001, the Company has met these statutory capital requirements.
Summarized consolidated financial data for Prudential Holdings, LLC is presented below. Amounts include results of operations and cash flows of Prudential Insurance prior to the date of demutualization.
Prudential Financial is a holding company and is a legal entity separate and distinct from its subsidiaries. The rights of Prudential Financial to participate in any distribution of assets of any subsidiary, including upon its liquidation or reorganization, are subject to the prior claims of creditors of that subsidiary, except to the extent that Prudential Financial may itself be a creditor of that subsidiary and its claims are recognized. PHLLC and its subsidiaries have entered into covenants and arrangements in connection with the issuance of the IHC debt which are intended to confirm their separate, "bankruptcy-remote" status, by assuring that the assets of PHLLC and its subsidiaries are not available to creditors of Prudential Financial or its other subsidiaries, except and to the extent that Prudential Financial and its other subsidiaries are, as shareholders or creditors of PHLLC and its subsidiaries, entitled to those assets.
At December 31, 2001, the Company was in compliance with all IHC debt covenants.
On January 22, 2002, Prudential Financial's Board of Directors authorized the repurchase of up to $1 billion of the outstanding Common Stock over an unspecified period of time.
New Jersey insurance law provides that dividends or distributions may be declared or paid by Prudential Insurance without prior regulatory approval only from unassigned surplus, as determined pursuant to statutory accounting principles, less unrealized capital gains and certain other adjustments. In connection with the demutualization, unassigned surplus was reduced to zero, thereby limiting Prudential Insurance's ability to pay a dividend in 2002 primarily to the amount of its statutory net gain from operations, not including realized investment gains, for the period from December 18, 2001 through December 31, 2001. In addition, Prudential Insurance must obtain prior non-disapproval from the New Jersey insurance regulator before paying a dividend if the dividend, together with other dividends or distributions made within the preceding twelve months, would exceed the greater of 10% of Prudential Insurance's surplus as of the preceding December 31 or its net gain from operations for the twelve month period ending on the preceding December 31.
The laws regulating dividends of Prudential Financial's other insurance subsidiaries domiciled in other states are similar, but not identical, to New Jersey's. In addition, the net capital rules to which the broker-dealer subsidiaries are subject may limit their ability to pay dividends to Prudential Financial. The laws of foreign countries may also limit the ability of our insurance and other subsidiaries organized in those countries to pay dividends to Prudential Financial.
The declaration and payment of dividends on the Class B Stock depends upon the financial performance of the Closed Block Business and, as the Closed Block matures, the holders of the Class B Stock will receive the surplus of the Closed Block Business no longer required to support the Closed Block for regulatory purposes. Dividends on the Class B Stock are payable in an aggregate amount per year at least equal to the lesser of (1) a Target Dividend Amount of $19.25 million or (2) the CB Distributable Cash Flow for such year, which is a measure of the net cash flows of the Closed Block Business. Notwithstanding this formula, as with any common stock, Prudential Financial will retain the flexibility to suspend dividends on the Class B Stock; however, if CB Distributable Cash Flow exists and Prudential Financial chooses not to pay dividends on the Class B Stock in an aggregate amount at least equal to the lesser of the CB Distributable Cash Flow or the Target Dividend Amount for that period, then cash dividends cannot be paid on the Common Stock with respect to such period.
Holders of Class B Stock will be permitted to convert their shares of Class B Stock into such number of shares of Common Stock as have an aggregate average market value equal to 100% of the appraised fair market value of the outstanding shares of Class B Stock (1) in the holder's sole discretion, beginning in the year 2016, and (2) at any time in the event that (a) the Class B Stock will no longer be treated as equity of Prudential Financial for federal income tax purposes or (b) the New Jersey Department of Banking and Insurance amends, alters, changes or modifies the regulation of the Closed Block, the Closed Block Business, the Class B Stock or the IHC debt in a manner that materially adversely affects the CB Distributable Cash Flow; provided, however, that in no event may a holder of Class B Stock convert shares of Class B Stock to the extent such holder immediately upon such conversion, together with its affiliates, would be the beneficial owner (as defined under the Securities Exchange Act of 1934) of in excess of 9.9% of the total outstanding voting power of Prudential Financial's voting securities. In the event a holder of shares of Class B Stock requests to convert shares pursuant to clause (2)(a) in the preceding sentence, Prudential Financial may elect, instead of effecting such conversion, to increase the Target Dividend Amount to $12.6875 per share per annum retroactively from the time of issuance of the Class B Stock.
The income attributable to the Closed Block Business and available to holders of Class B Stock for the period December 18, 2001 through December 31, 2001 amounted to $3 million. The weighted average number of shares of Class B Stock used in the calculation of basic earnings per share amounted to 2,000,000 shares. Diluted earnings per share is not presented as there are no potentially dilutive shares associated with the Class B Stock.
A summary of the status of the Company's employee stock option grants at December 31, and changes during the year ended is presented below:
Employee options granted and their related grant date weighted average fair value is isolated in further detail in the schedule below:
The fair value of each option is estimated on the balance sheet date for non-vested options and on the vesting date for vested options using a Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2001:
The following table summarizes information about the non-employee stock options outstanding at December 31, 2001:
The Company has funded non-contributory defined benefit pension plans which cover substantially all of its employees. The Company also has several non-funded non-contributory defined benefit plans covering certain executives. For some employees, benefits are based on final average earnings and length of service, while other employees are based on an account balance that takes into consideration age, service and salary during their career. The Company's funding policy is to contribute annually an amount necessary to satisfy the Internal Revenue Code contribution guidelines.
The Company has elected to amortize its transition obligation for other postretirement benefits over 20 years.
Prepaid and accrued benefits costs are included in "Other assets" and "Other liabilities," respectively, in the Company's Consolidated Statements of Financial Position. The status of these plans as of September 30, adjusted for fourth-quarter activity, is summarized below:
In 2001, the pension plan purchased a variable annuity contract for $232 million from Prudential Insurance. The approximate future annual benefit payment for the variable annuity contract was $14 million.
The benefit obligation for pensions decreased by $6 million in the year 2001 for miscellaneous changes related to the cash balance formula. The benefit obligation for pensions decreased by a net $112 million in the year 2000 for the effect of a Cost of Living Adjustment ("COLA") and the introduction of the cash balance formula of ($134) million and $246 million, respectively. The COLA was effective as of July 1, 2000 and increased benefits, subject to a maximum, to retirees based upon their year of retirement. The introduction of the cash balance formula was a feature of the substantive plan as of the measurement date and is effective January 1, 2001 for new employees and January 1, 2002 for existing employees.
The assumptions at September 30, used by the Company to calculate the benefit obligations as of that date and to determine the benefit cost in the subsequent year are as follows:
The Company's actual income tax expense (benefit) for the years ended December 31, differs from the expected amount computed by applying the statutory federal income tax rate of 35% to income from continuing operations before income taxes for the following reasons:
The Internal Revenue Service (the "Service") has completed all examinations of the consolidated federal income tax returns through 1992. The Service has examined the years 1993 through 1995. Discussions are being held with the Service with respect to proposed adjustments. Management, however, believes there are adequate defenses against, or sufficient reserves to provide for such adjustments. The Service has completed its examination of 1996 and has begun its examination of 1997 through 2000.
The estimated fair values presented below have been determined by using available market information and by applying valuation methodologies. Considerable judgment is applied in interpreting data to develop the estimates of fair value. Estimated fair values may not be realized in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair values. The methods and assumptions discussed below were used in calculating the estimated fair values of the instruments. See Note 19 for a discussion of derivative instruments.
The estimated fair value of policy loans is calculated using a discounted cash flow model based upon current U.S. Treasury rates and historical loan repayment patterns.
The estimated fair value of short-term and long-term debt is derived by using discount rates based on the borrowing rates currently available to the Company for debt with similar terms and remaining maturities.
The following table discloses the carrying amounts and estimated fair values of the Company's financial instruments at December 31,
Derivatives held for trading purposes are used in the Company's securities operations to meet the needs of customers by structuring transactions that allow customers to manage their exposure to interest rates, foreign exchange rates, indices or prices of securities and commodities. Trading derivatives are also utilized in a limited-purpose subsidiary primarily through the operation of hedge portfolios and in the Company's commercial mortgage securitization business. Trading derivative positions are carried at estimated fair value, generally by obtaining quoted market prices or through the use of pricing models. Values are affected by changes in interest rates, currency exchange rates, credit spreads, market volatility and liquidity.
Derivatives held for purposes other than trading are recognized on the Consolidated Statements of Financial Position at their fair value. On the date the derivative contract is entered into, the Company designates the derivative as either (1) a hedge of the fair value of a recognized asset or liability or unrecognized firm commitment ("fair value" hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability ("cash flow" hedge), (3) a foreign-currency fair value or cash flow hedge ("foreign currency" hedge), (4) a hedge of a net investment in a foreign operation, or (5) a derivative entered into as an economic hedge that does not qualify for hedge accounting.
To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated risk of the hedged item. Effectiveness of the hedge is formally assessed at inception and throughout the life of the
The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives designated as fair value, cash flow, or foreign currency hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions.
Presented below is a roll forward of current period cash flow hedges in "Accumulated other comprehensive income (loss)" before taxes .
As discussed above, if an interest rate swap does not qualify for hedge accounting, changes in its fair value are included in "Realized investment gains (losses), net" without considering changes in fair value of the hedged assets or liabilities. During the period that interest rate swaps are outstanding, net receipts or payments are included in "Net investment income." Net interest receipts (payments) were $(29) million in 2001, $11 million in 2000 and $(4) million in 1999.
Treasury futures typically are used to hedge duration mismatches between assets and liabilities by replicating Treasury performance. Treasury futures move substantially in value as interest rates change and can be used to either modify or hedge existing interest rate risk. This strategy protects against the risk that cash flow requirements may necessitate liquidation of investments at unfavorable prices resulting from increases in interest rates. This strategy can be a more cost effective way of temporarily reducing the Company's exposure to a market decline than selling fixed income securities and purchasing a similar portfolio when such a decline is believed to be over.
When the Company anticipates a significant decline in the stock market that will correspondingly affect its diversified portfolio, it may purchase put index options where the basket of securities in the index is appropriate to provide a hedge against a decrease in the value of the Company's equity portfolio or a portion thereof. This strategy effects an orderly sale of hedged securities. When the Company has large cash flows which it has allocated for investment in equity securities, it may purchase call index options as a temporary hedge against an increase in the price of the securities it intends to purchase. This hedge is intended to permit such investment transactions to be executed with less adverse market impact.
Under currency forwards, the Company agrees with other parties upon delivery of a specified amount of an identified currency at a specified future date. Typically, the price is agreed upon at the time of the contract and payment for such a contract is made at the specified future date. In addition to managing the risks noted above,
The Company is exposed to credit-related losses in the event of nonperformance by counterparties to derivative financial instruments. Generally, the current credit exposure of the Company's derivative contracts is limited to the fair value at the reporting date. The credit exposure of the Company's swaps transactions is represented by the fair value (market value) of contracts with a positive fair value (market value) at the reporting date. Because exchange-traded futures and options are effected through regulated exchanges, and positions are marked to market on a daily basis, the Company has little exposure to credit-related losses in the event of nonperformance by counterparties to such financial instruments. The credit exposure of exchange-traded instruments is represented by the negative change, if any, in the fair value (market value) of contracts from the fair value (market value) at the reporting date. The credit exposure of currency forwards is represented by the difference, if any, between the exchange rate specified in the contract and the exchange rate for the same currency at the reporting date.
The Company has organized its principal operations into the Financial Services Businesses and the Closed Block Business. Within the Financial Services Businesses, the Company operates through four divisions which, together, encompass ten reportable segments. The four operating divisions within the Financial Services Businesses are: U.S. Consumer, Employee Benefits, International and Asset Management. Businesses that are not sufficiently material to warrant separate disclosure are included in Corporate and Other operations. Collectively, the businesses that comprise the four operating divisions and Corporate and Other are referred to as the Financial Services Businesses. The segments within the Financial Services Businesses as well as the Closed Block Business correspond to businesses for which discrete financial information is available and reviewed by management.
The Employee Benefits division consists of the Group Insurance and Other Employee Benefits segments. The Group Insurance segment manufactures and distributes group life, disability and related insurance products in connection with employee and member benefit plans. The Other Employee Benefits segment manufactures, services and delivers products and services for defined contribution and other retirement plans as well as guaranteed investment contracts, group annuities and relocation services to employers. The Other Employee Benefits segment also markets real estate brokerage franchises to regional and local real estate brokers.
The International division consists of the International Insurance and International Securities and Investments segments. The International Insurance segment manufactures and distributes principally individual life insurance products to the affluent retail market in Japan, as well as Korea and Taiwan, and has commenced operations in selected Asian, Latin American and European countries. The International Securities and Investments segment offers brokerage services, primarily in U.S. securities, asset management and financial advisory services to retail and institutional clients outside of the United States.
Corporate and Other includes financial services businesses that are not included in other reportable segments as well as corporate-level activities. These businesses include international ventures, divested businesses and businesses that have not been divested but have been placed in wind-down status. The latter includes individual health insurance, group credit insurance and Canadian life insurance. The divested businesses include the results of the lead-managed equity underwriting for corporate issuers and institutional fixed income businesses of Prudential Securities Group Inc. (see Note 4), Gibraltar Casualty (see Note 21), residential first mortgage banking and certain Canadian businesses. Corporate-level activities include corporate-level income and expenses not allocated to any business segments, including the cost of company-wide initiatives, investment returns on unallocated equity, returns from a debt-financed investment portfolio, transactions with other segments and consolidating adjustments.
For periods prior to the date of demutualization, the results of the Closed Block Business are those of the Traditional Participating Products segment, which historically sold primarily participating insurance and annuity products that the Company ceased offering in connection with demutualization. Upon the establishment of the Closed Block Business, $5.6 billion of net assets previously associated with the Traditional Participating Products segment was transferred to the Financial Services Businesses. Consequently, the results of the Closed Block Business after demutualization do not include returns on these assets. A minor portion of the Traditional Participating Products segment consisted of other traditional insurance products that are now included in the Financial Services Businesses and not in the Closed Block.
- -------- (a) 2001 includes $340 million of demutualization consideration payable to former Canadian branch policyholders as described in Note 2.
The accounting policies of the segments are the same as those described in Note 2, "Summary of Significant Accounting Policies."
In managing its business, the Company analyzes the operating performance of each segment using "adjusted operating income," which is a non-GAAP measure. "Adjusted operating income" is calculated by adjusting income from continuing operations before income taxes to exclude certain items. The items excluded are realized investment gains, net of losses and related charges; sales practices remedies and costs; demutualization costs and expenses; and the gains, losses and contribution to income/loss of divested businesses which have been sold but do not qualify for "discontinued operations" treatment under GAAP. Businesses that the Company has placed in wind-down status but are not divested remain in "adjusted operating income." The Company's discontinued healthcare operations are excluded from "Income (loss) from continuing operations before income taxes."
The Company excludes realized investment gains, net of losses and related charges, from "adjusted operating income" because the timing of transactions resulting in recognition of gains or losses is largely at the Company's discretion and the amount of these gains or losses is heavily influenced by and fluctuates in part according to the availability of market opportunities. Including the fluctuating effects of these transactions could distort trends in the underlying profitability of the businesses. The Company excludes sales practices remedies and costs because they relate to a substantial and identifiable non-recurring event. The Company excludes demutualization costs and expenses as they are directly related to demutualization and could distort the trends associated with our business operations. The Company excludes the gains and losses and contribution to income/ loss of divested businesses and related runoff operations because, as a result of the decision to dispose of these businesses, these results are not relevant to the profitability of the Company's ongoing operations and could distort the trends associated with ongoing businesses.
The related charges offset against net realized investment gains and losses relates to policyholder dividends, amortization of deferred policy acquisition costs, and reserves for future policy benefits. Net realized investment
gains is one of the elements that the Company considers in establishing the dividend scale, and the related policyholder dividend charge represents the estimated portion of the Company's expense charge for policyholder dividends that is attributed to net realized investment gains that the Company considers in determining the dividend scale. Deferred policy acquisition costs for certain investment-type products are amortized based on estimated gross profits, which include net realized investment gains and losses on the underlying invested assets, and the related charge for amortization of deferred policy acquisition costs represents the portion of this amortization associated with net realized investment gains and losses. The reserves for certain policies are adjusted when cash flows related to these policies are affected by net realized investment gains and losses, and the related charge for reserves for future policy benefits represents that adjustment.
The Investment Management and Advisory Services segment revenues include intersegment revenues of $418 million, $404 million and $381 million for the years ended 2001, 2000 and 1999, respectively, which primarily consist of asset-based management fees from the businesses of the U.S. Consumer and Employee Benefits divisions and the Closed Block Business. Management has determined the intersegment fees for the various asset classes with reference to market rates. These fees are eliminated in consolidation.
The summary below presents certain financial information for the Company's reportable segments:
The summary below presents total assets for the Company's reportable segments at December 31,
The Company occupies leased office space in many locations under various long-term leases and has entered into numerous leases covering the long-term use of computers and other equipment. Rental expense incurred for the years ended December 31, 2001, 2000 and 1999 was $520 million, $498 million and $456 million, respectively, excluding expenses relating to the Company's healthcare business.
During the normal course of its business, the Company utilizes financial instruments with off-balance sheet credit risk such as commitments, financial guarantees and letters of credit. Commitments include commitments to purchase and sell mortgage loans, the underfunded portion of commitments to fund investments in private placement securities and unused credit card and home equity lines.
The Company's property and casualty operations are subject to rate and other laws and regulations covering a range of trade and claim settlement practices. State insurance regulatory authorities have broad discretion in approving an insurer's proposed rates. A significant portion of the Company's automobile insurance is written in the state of New Jersey. Under certain circumstances, New Jersey insurance laws require an insurer to provide a refund or credit to policyholders based upon the profits earned on automobile insurance.
It is possible that the results of operations or the cash flow of the Company in a particular quarterly or annual period could be materially affected as a result of payments in connection with the matters discussed above depending, in part, upon the results of operations or cash flow for such period. Management believes, however, that ultimate payments in connection with these matters should not have a material adverse effect on the Company's financial position.
In 1996, the Company recorded in its Consolidated Statement of Operations the cost of $410 million before taxes as a guaranteed minimum remediation expense pursuant to the settlement agreement. Management had no better information available at that time upon which to make a reasonable estimate of the losses associated with the settlement. Charges were also recorded in 1996 for estimated additional sales practices costs totaling $715 million before taxes.
In 1999, the Company recorded an increase of $199 million of the estimate of total additional sales practices costs. This increase was partially offset by a $99 million release of the previously recorded liability relative to remedy costs reflecting a decrease in the estimate of the total costs of remedying policyholder claims.
date, with respect to claims relating to events that occurred prior to the closing date. This litigation includes purported class actions and individual suits involving various issues, including payment of claims, denial of benefits, vicarious liability for malpractice claims, and contract disputes with provider groups and former policyholders. Some of the purported class actions challenge practices of the Company's former managed care operations and assert nationwide classes. On October 23, 2000, by Order of the Judicial Panel on Multi-district Litigation, a number of these class actions were consolidated for pre-trial purposes, along with lawsuits pending against other managed health care companies, in the United States District Court for the Southern District of Florida in a consolidated proceeding captioned In Re Managed Care Litigation. Some of these class actions allege, among other things, misrepresentation of the level of services and quality of care, failure to disclose financial incentive agreements with physicians, interference with the physician-patient relationship, breach of contract and fiduciary duty, violations of ERISA, violations of and conspiracy to violate RICO, deprivation of plaintiffs' rights to the delivery of honest medical services and industry-wide conspiracy to defraud physicians by failing to pay under provider agreements and by unlawfully coercing providers to enter into agreements with unfair and unreasonable terms. The remedies sought include unspecified damages, restitution, disgorgement of profits, treble damages, punitive damages and injunctive relief. Motions to dismiss certain of the amended complaints and plaintiff's motions to certify nationwide classes in the consolidated proceedings are pending. In one of the consolidated actions the court granted our motion to dismiss, in part.
A joint venture in which an affiliate of Prudential Securities Group Inc. is a participant brought an arbitration claim against Kyocera Corporation alleging, among other things, claims of breach of contract relating to the manufacture and distribution of computer disk drives. The arbitration panel decided in favor of the claimants. The Company's share of damages, with interest, would exceed $250 million. A federal district court in the Northern District of California has confirmed the award and entered judgment in favor of the claimants. Kyocera Corporation has appealed the decision to the United States Court of Appeals for the Ninth Circuit. As with any litigation, the outcome remains uncertain until all appeals have been concluded or the time to appeal has expired and, accordingly, the Company has not included the award in its results of operations.
The unaudited quarterly results of operations for the years ended December 31, 2001 and 2000 are summarized in the table below:
- -------- (a) Income from continuing operations and net income after the date of demutualization is $41 million. (b) Earnings per share data reflects earnings for the period commencing with the date of demutualization only.
On the date of demutualization, the Company issued two classes of common stock. The Common Stock reflects the performance of the Financial Services Businesses while the Class B Stock reflects the performance of the Closed Block Business. Upon the establishment of the Closed Block Business, $5.6 billion of net assets previously associated with the Traditional Participating Products segment were transferred to the Financial Services Businesses. Concurrent with the demutualization, Prudential Holdings, LLC, a wholly owned subsidiary of Prudential Financial, Inc., issued $1.75 billion in senior secured notes (the "IHC debt"), of which net proceeds of $1.66 billion were allocated to the Financial Services Businesses. The IHC debt is serviced by the cash flows of the Closed Block Business and the results of the Closed Block Business reflect interest expenses associated with the IHC debt.
This supplemental combining financial information reflects the assets, liabilities, revenues and expenses directly attributable to the Financial Services Businesses and the Closed Block Business, as well as allocations
General corporate overhead not directly attributable to a specific business but which has been incurred in connection with the generation of the businesses revenues is generally allocated based on each businesses' historical general and administrative expenses as a percentage of the total for the Company.
The Company has outstanding two separate classes of common stock. The Common Stock reflects the performance of the Financial Services Businesses, while the Class B Stock reflects the performance of the Closed Block Business. Accordingly, earnings per share is calculated separately for each of these two classes of common stock. Earnings per share amounts are based on the earnings available to common stockholders for the period subsequent to the date of demutualization.