You should read the following analysis of the Company’s consolidated financial condition and results of operations in conjunction with the Forward-Looking Statements disclosure included below the Table of Contents, “Risk Factors,” and Consolidated Financial Statements included in this Annual Report on Form 10-K.
See “Risk Factors” for a discussion of risks that could materially affect The Company’s business, results of operations or financial condition, or cause The Company’s actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.
As prescribed by “GAAP”, we present our fixed maturity investments classified as available for sale, at fair value in the statements of financial position. The fair values for our public fixed maturity securities are based on quoted market prices or estimates from independent pricing services. However, for our investments in private securities such as private placement fixed maturity securities, which comprised 16% of our investments as of December 31, 2006, this information is not available. For these private fixed maturities, fair value is determined typically by using a discounted cash flow model, which relies upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions and takes into account, among other things, the credit quality of the issuer and the reduced liquidity associated with private placements.
Commercial loans, which comprised nearly 8% of our investments as of December 31, 2006, are carried primarily at unpaid principal balances, net of unamortized premiums or discounts and an allowance for losses. This allowance includes a loan specific portion as well as a portfolio reserve for probable incurred but not specifically identified losses. The loan specific portion, is based on management’s judgment as to ultimate collectibility of loan principal. The portfolio reserve is based on a number of factors, such as historical experience and portfolio diversification. Adjustments to the allowance are reflected in “Realized investment gains (losses), net,” in our statements of operations. Similar to impairment losses discussed above, the allowance for losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
The future policy benefit reserves at December 31, 2006 represented 6% of our total liabilities and relate primarily to term life are determined in accordance with GAAP as the present value of expected future benefits to or on behalf of policyholders plus the present value of future expenses less the present value of future net premiums. The expected future benefits are based on mortality, lapse, and maintenance expense and interest rate assumptions. Reserves for new business are based on best estimate assumptions as of the date the policy is issued with provisions for the risk of adverse deviation. After our reserves are initially established, we perform premium deficiency tests using best estimate assumptions as of the testing date without provisions for adverse deviation. If reserves determined based on these best estimate assumptions are greater than the GAAP liabilities (i.e., reserves net of any DAC asset), the existing GAAP liabilities are adjusted to the greater amount. Our best estimate mortality assumptions are generally based on the Company’s historical experience or standard industry tables, as applicable; our expense assumptions are based on current levels of maintenance costs, adjusted for the effects of inflation; and our interest rate assumptions are based on current and expected net investment returns. Generally, we do not expect our mortality trends to change significantly in the short-term and to the extent these trends may change we expect such changes to be gradual over the long-term.
We capitalize costs that vary with and are related primarily to the acquisition of new and renewal insurance and annuity contracts. These costs include primarily commissions, costs of policy issuance and underwriting, and variable field office expenses. We amortize these deferred policy acquisition costs, or DAC, over the expected lives of the contracts, based on the level and timing of either gross profits, or gross premiums, depending on the type of contract. As of December 31, 2006, DAC in our life business was $1.385 billion and DAC in our annuity business was $574 million.
Our accounting represents management’s best estimate of future events that can be appropriately reflected in the accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate.
An increase or decrease in our effective tax rate by one percent of income from operations before income taxes and cumulative effect of accounting change, would have resulted in a decline or increase in consolidated income from continuing operations before cumulative effect of accounting change in 2006 of $3.3 million.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service (“the Service”) and other taxing jurisdictions for audits ongoing or not yet commenced. In 2006, the Service completed all fieldwork with regards to its examination of the Company’s federal income tax returns for tax years 2002-2003. The Company anticipates the final report being submitted to the Joint Committee on Taxation for their review during the first quarter of 2007. The statute of limitations for the 2002-2003 tax years expires in 2008. In addition, in January 2007, the Service began an examination of tax years 2004 through 2006.
Deferred policy acquisition costs increased by $296 million from $1.663 billion at December 31, 2005, to $1.959 billion at December 31, 2006, primarily driven by $383 million of capitalization of acquisition costs from the continued growth of sales in life and annuity products, partially offset by net amortization of $76 million primarily driven by an increased estimate of total gross profits used as a basis for amortizing deferred policy acquisitions and other costs. The shadow DAC increased $11 million as a result of increased unrealized losses from a rising interest rate environment.
Reinsurance recoverables increased by $276 million, from $933 million at December 31, 2005 to $1,209 million at December 31, 2006, largely as a result of increased ceded reserves to an affiliated Company primarily reflecting continued growth of the term Life in force (see Note 13 to the Consolidated Financial Statements).
Deferred sales inducements are higher by $44 million, driven by continued sales of annuity products as the Company sells annuity contracts that contain these features.
Consolidated net income of $263 million for 2006 improved $32 million from $231 million earned in 2005. This benefit was primarily driven by a net reduction in amortization of deferred policy acquisition costs. The net reduction in amortization is due to an increased estimate of total gross profits used as a basis for amortizing deferred policy acquisition costs and unearned revenue reserves, based on an annual review. This benefit is partially offset by realized losses from sales of fixed maturities in a rising interest rate environment in 2006. The 2005 results also include a favorable adjustment of $33 million reflecting the resolution of substantially all issues relating to the Internal Revenue Service examination of Prudential’s consolidated federal income tax returns for the 1997 to 2001 periods. Further details regarding the components of revenues and expenses are described in the following paragraphs.
Consolidated revenues decreased by $69 million, from $1.035 billion in 2005 to $966 million in 2006.
Premiums of $44 million increased in 2006 by $6 million, from $38 million in 2005, due to increased sales and growth of the in force net of reinsurance.
Realized investment gains (losses) increased by ($63) million, from realized (losses) of less than ($1) million in 2005 mainly due to sales of fixed maturities in a rising interest rate environment in 2006.
General, administrative, and other expenses decreased by $140 million from $449 million 2005 to $309 million 2006. General, administrative and other expenses, including DAC amortization, decreased $137 million driven by lower DAC amortization from an increased estimate of total gross profits used as a basis for amortizing deferred policy acquisitions and other costs. Net distribution costs increased slightly and were mostly offset by higher reinsurance expense allowance, resulting from the PARCC coinsurance agreement (see Note 13 to the Consolidated Financial Statements).