Management's Discussion and Analysis of Financial Position and Results of Operations - --------------------------------------------------------------------------------
The Company sells interest-sensitive individual life insurance and variable life insurance, term life insurance, individual variable annuities, and a non-participating guaranteed interest contract ("GIC") called Prudential Credit Enhanced ("PACE") primarily through the Prudential Insurance sales force in the United States. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure as the legal barriers, which have historically segregated the markets of the financial services industry, have been changed through both legislative and judicial processes. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels. The Company also marketed individual life insurance through its branch office in Taiwan. The Taiwan branch was transferred to an affiliated Company on January 31, 2001, as described in the Notes to the Financial Statements. Beginning February 1, 2001, all insurance activity of the Taiwan branch has been ceded to the affiliated Company and is not included in the Company's results of operations.
fee income consist mainly of three types, sales charges or loading fees on new sales, mortality and expense charges ("M&E") assessed on fund balances, and mortality and related charges based on total life insurance in-force business. Policyholder fund values are affected by net sales (sales less withdrawals), changes in interest rates and investment returns. The interest spread represents the difference between the investment income earned by the Company on its investment portfolio and the amount of interest credited to the policyholders' accounts. Products that generate spread income primarily include the GIC product, general account life insurance products, fixed annuities and the fixed-rate option of variable annuities.
Policyholder liabilities and deferred policy acquisition costs The liability for "Future policy benefits and other policyholder liabilities" represents 4.8% of total liabilities as of December 31, 2002. Changes in this liability are generally reflected in the "Policyholders' benefits" caption in our statements of operations. This liability is primarily comprised of the present value of estimated future payments to holders of life insurance and annuity products where the timing and amount of payment depends on policyholder mortality or surrender experience. For life insurance and annuity products, 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 loss recognition reserves.
For most life insurance and annuity products that we sell, we defer costs that vary with and are related primarily to the production of new business to the extent these costs are deemed recoverable from future profits, and we record these costs as an asset known as deferred policy acquisition costs or "DAC" "in the statements of financial position. We amortize this DAC asset over the expected lives of the contracts, based on the level and timing of either estimated profits or premiums, depending on the type of contract. For products with amortization based on estimated profits, the amortization rate is periodically updated to reflect current period experience or changes in assumptions that affect future profitability, such as lapse rates, investment returns, mortality experience, expense margins and surrender charges. However, for products with amortization based on future premiums, the amortization rate is locked-in when the product is sold.
The FASB is currently discussing the accounting related to certain modified coinsurance ("modco") and funds withheld reinsurance agreements. More specifically, the discussions relate to whether modco and funds withheld reinsurance agreements that provide for a total return on a pool of fixed income securities contain embedded derivatives that would require bifurcation under SFAS No. 133. The FASB plans to address this issue by combining it with a portion of the tentative guidance in SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives-Bifurcation of Embedded Credit."
During the year, liabilities decreased by $953 million from $20.442 billion to $19.489 billion. Corresponding with the asset change, separate account liabilities decreased by $2.224 billion primarily from market value declines of $2.094 billion, and policy charges and other disbursements of $446 million offset by net sales of $316 million. Current year net sales of $316 million consist of $1.639 billion of contributions and policy credit transfers less $1.323 billion of surrenders, withdrawals and transfers.
Policyholder account balances increased by $908 million primarily from positive net sales (sales less withdrawals) of annuity products with fixed rate options and the PACE product. A higher level of securities lending activity increased liabilities by $355 million. Future policy benefits increased $126 million mainly due to increases in reserves for the transferred Taiwan business and for domestic life term and extended term insurance.
From December 31, 2000 to December 31, 2001 there was a decrease of $966 million in total assets from $23.059 billion to $22.093 billion, the majority of which relates to a $1.310 billion decrease in separate accounts primarily from stock market declines, as described below. The fixed maturity portfolio increased $139 million resulting from unrealized appreciation from declining interest rates and from positive cash inflows. The transfer of the Company's Taiwan branch accounted for using coinsurance accounting required the establishment of reinsurance recoverable of $260.6 million, and the inclusion of the Taiwan branch future policy reserve liabilities on the Company's balance sheet. The Company also reclassified held-to-maturity securities, amounting to $324.5 million at January 1, 2001 to the available-for-sale category.
Policyholder account balances increased by $301 million from interest credited and positive cash inflows for the PACE product and the general account life and annuity products. Future policy benefit liabilities increased by $105 million resulting from sales of term insurance, additional extended term insurance, and increases to Taiwan branch reserves. Other liabilities increased by $108 million as a result of policy credits granted to separate account qualified annuity contract holders related to the demutualization.
products offset by a $17.2 million decrease for annuity products. Mortality and sales based loading charges for life products increased as a result of growth of the in-force business. The life insurance in-force (excluding term insurance) grew to $65.5 billion at December 31, 2002 from $58.7 billion at December 31, 2001. Policy charges from life products were also positively impacted by $12 million in policy fees from a sale to Prudential Insurance in December 2002 of Corporate Owned Life Insurance ("COLI").
Benefits and Expenses Policyholder benefits increased by $19.2 million, which consists of increases in death benefits of $16.1 million and reserve increases of $3.1 million. The primary reason for the higher death benefits is the increase in guaranteed minimum death benefits for annuity products, as described below. Guaranteed minimum death benefits increased from $13.6 million in 2001 to $33.8 million in 2002. Death benefits associated with our life insurance products decreased by $2.4 million despite an increase in the in-force business and unfavorable mortality experience due to two factors, which were favorable when compared to the prior year. The prior year policyholder benefits included the impact of September 11th claims of $11.6 million, net of reinsurance. In addition, the current year benefited from reinsurance recoveries from Prudential Insurance and other insurance carriers. In particular, two large death claims totaling $30 million were reinsured by Prudential Insurance.
The guaranteed minimum death benefit feature provides annuity contract holders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically the greatest of these values, depending on features offered in various contracts and elected by the contract holders. These contracts generally require payment of additional charges for guarantees other than those based on net deposits paid into the contract. To the extent that the guaranteed minimum death benefit is higher than the current account value at the time of death, the Company incurs a cost. This results in increased annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. Current accounting literature does not prescribe advance recognition of the expected future net costs associated with these guarantees, and accordingly we currently do not record a liability corresponding to these projected future obligations for death benefits in excess of annuity account values. However, we consider the expected net costs associated with these guarantees in our calculations of expected gross profits on variable annuity business, on which our periodic evaluations of unamortized policy acquisition costs are based. A proposed AICPA Statement of Position, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" (the "Proposed SOP"), would require recording of a liability for the expected net costs associated with these guarantees under certain circumstances, if adopted as proposed. We are currently evaluating the impact of the Proposed SOP. As of December 31, 2002, the death benefit coverage in force (representing the amount we would have to pay if all annuitants had died on that date) was approximately $3.0 billion. The death benefit coverage in force represents the excess of the guaranteed benefit amount over the fair value of the underlying mutual fund investments.
Reserve increases were $3.2 million higher than the prior year primarily from increases to term insurance reserves of $23.6 million due to sales and renewals of the Term Essential and Term Elite products. Partially offsetting this, were
decreases to reserves resulting from lower extended term premiums and increased surrenders of reduced paid up policies. The change in Taiwan reserves was $5.4 million lower in 2002 due to the transfer of the branch as of January 31, 2001, and the subsequent ceding of the business.
Interest credited to policyholder account balances increased by $8.8 million as a result of growth in policyholder account balances of approximately $900 million. Interest credited increased by $7.0 million for PACE guaranteed investment contracts and $3.5 million for life funds. Annuity interest credited declined by $1.7 million despite growth of approximately $600 million in policyholder account balances due to a reduction in annuity interest rates. Annuity interest crediting rates were reduced in reaction to the declining investment portfolio yields. Overall net interest spread revenue has declined from last year as investment income and yields on general account assets have declined as described above.
General, administrative, and other expenses increased $127.0 million from the prior year, primarily the result of increased DAC amortization of $112.3 million. The majority of the DAC amortization increase, $75.3 million, was related to our annuity products. These charges reflect our lower estimates of future gross profits from greater expected costs from minimum death benefit guarantees and lower expected fees under these contracts due to declines in asset values and decreased future asset returns. The remaining increase in DAC amortization is associated with our life products and is primarily due to the growth of the in-force, less favorable market performance, and the reduction in prior year amortization due to claims from the September 11th terrorist attack on the United States. In addition, general, administrative, and other expenses increased by $14.7 million as a result of the growth of the business.
Revenues Consolidated revenues decreased by $110.6 million, from $987.7 million to $877.1 million. As discussed above, the elimination of PSF asset management fees reduced revenues by $63.3 million. Premiums decreased by $31.0 million from the prior year. The ceding of premiums pursuant to the transfer of the Company's Taiwan branch caused an $80.6 million decline in premiums. This was partially offset by higher term insurance sales of the Term Essential and Term Elite products, and an increase in premiums related to extended term policy conversions.
These decreases were partially offset by increases in policy charges and fee income and net investment income. Policy charges and fee income increased by $15.3 million. The increase was a result of a $29.0 million increase for domestic individual life products offset by a $13.7 million decrease for annuity products. Mortality and sales based loading charges for life products increased as a result of growth in the in-force business and higher new sales. The in-force business grew from $53.2 billion at December 31, 2000 to $58.7 billion at December 31, 2001, an increase of 10.3%. In contrast, annuity fees which are mainly asset-based fees, have declined as a result of unfavorable valuation changes in the securities market and lower sales due to the discontinuation of the Exchange program.
Benefits and Expenses Policyholder benefits increased by $8.0 million from increases in domestic individual life product reserves, death benefits, and surrender benefits; offset by decreases in Taiwan's policyholder benefits. Death benefits increased $29.0 million due mainly to the increased in-force business, with $11.6 million of the increase specifically related to the September 11 terrorist attacks. Domestic individual life reserves increased $32.6 million as a result of sales of term insurance and extended term premiums. There were also increased benefits paid on surrenders of reduced paid up policies of $8.3 million. Offsetting these were decreases in reserve provisions and benefits for the Company's Taiwan branch of $61.6 million.
The overall income yield on our invested assets after investment expenses, excluding realized investment gains (losses), was 6.26% for the year ended December 31, 2002 and 6.88% for 2001. The decline in yield on the portfolio in 2002 from 2001 is primarily attributable to reinvestment activities over the last two years in a declining interest rate environment.
We use our private placement and asset-backed portfolios to enhance the diversification and yield of our overall fixed maturity portfolio. Our investment staff directly originates approximately half of all of our private placements. Our origination capability offers the opportunity to lead transactions and gives us the opportunity for better terms, including covenants and call protection, and to take advantage of innovative deal structures.
U.S. Government, and 10% services sector as of December 31, 2001. Nearly 100% of the mortgage-backed securities were publicly traded agency pass-through securities. Collateralized mortgage obligations represented less than 1% of total mortgage-backed securities.
The NAIC evaluates the investments of insurers for regulatory reporting purposes and assigns fixed maturity securities to one of six categories called "NAIC Designations." NAIC designations of "1" or "2" include fixed maturities considered investment grade, which include securities rated Baa3 or higher by Moody's or BBB- or higher by S&P. NAIC Designations of "3" through "6" are referred to as below investment grade, which include securities rated Ba1 or lower by Moody's and BB+ or lower by S&P. The fixed maturity securities designated as NAIC 6 include securities that are not rated.
The amortized cost of our public and private below-investment grade fixed maturities totaled $526.8 million, or 11%, of the total fixed maturities as of December 31, 2002, compared to $318.7 million, or 8%, of total fixed maturities as of December 31, 2001. The increase in the amount of below-investment grade fixed maturities at December 31, 2002 from a year earlier came primarily from negative credit migration over the period.
The following table sets forth our public fixed maturity portfolios by NAIC rating as of the dates indicated.
The following table sets forth our private fixed maturity portfolios by NAIC rating as of the dates indicated. As of December 31,
Our credit and portfolio management processes help ensure prudent controls over valuation and management of the private portfolio. We have separate pricing and authorization processes to establish "checks and balances" for new investments. We apply consistent standards of credit analysis and due diligence for all transactions, whether they originate through our own in-house origination staff or through agents. Our regional offices closely monitor the portfolios in their regions. We set all valuation standards centrally, and we assess the fair value of all investments quarterly.
When we determine that there is an other-than-temporary impairment, we record a writedown to estimated fair value which reduces the cost basis. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. Estimated fair values for fixed maturities, other than private placement securities are based on quoted market prices or prices obtained from independent pricing services. Estimated fair values for private placement fixed maturities are determined primarily by using a discounted cash flow model which considers the current market spreads between the U.S. Treasury yield curve and corporate bond yield curve, adjusted for type of issue, its current credit quality and its remaining average life. The estimated fair value of certain non-performing private placement fixed maturities is based on amounts estimated by management.
Impairments of fixed maturity securities totaled $27.8 million in 2002 and $53.5 million in 2001.
We manage our liquidity and capital resources on a company-wide basis, as well as by legal entity and business, recognizing regulatory restrictions on transfers of funds among entities engaged in the insurance and other businesses.
Gross account withdrawals, amounted to $1,015 million in the year ended December 31, 2002 and $1,313 million in the year ended December 31, 2001. These withdrawals include contractually scheduled maturities of traditional guaranteed investment contracts totaling $183 million in the year ended December 31, 2002 and $171 million in the year ended December 31, 2001. 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.
As of December 31, ---------------------- 2002 2001 ---------- ---------- Borrowings: (in millions) General obligations $ - $ - Total asset-based financing 626 271 ---------- ---------- Total borrowings and asset-based financings $ 626 $ 271 ========== ==========
As of December 31, 2002, the Company has a commitment to fund private placement fixed maturities in the amount of $10.7 million.