This Management’s narrative addresses the financial condition of Prudential Annuities Life Assurance Corporation (“PALAC”), formerly known as American Skandia Life Assurance Corporation as of December 31, 2009, compared with December 31, 2008, and its results of operations for the years ended December 31, 2009 and 2008.
The Company’s profitability depends principally on its ability to price and manage risk on insurance products, to attract and retain customer assets, and to manage expenses. Specific drivers of our profitability include:
We present our investments classified as available for sale, including fixed maturity and equity securities, our investments classified as trading, and derivatives, and our embedded derivatives at fair value in the statements of financial position. For additional information regarding the key estimates and assumptions surrounding the determination of fair value of fixed maturity and equity securities, as well as derivative instruments, embedded derivatives and other investments, see Note 10 to the Financial Statements.
For our investments classified as available for sale, the impact of changes in fair value is recorded as an unrealized gain or loss in “Accumulated other comprehensive income (loss), net,” a separate component of equity. For our investments classified as trading, the impact
Commercial mortgage and other loans are carried primarily at unpaid principal balances, net of unamortized premiums or discounts and a valuation allowance for losses. For a discussion of our policies regarding the valuation allowance for commercial mortgage and other loans see Note 2 to the Financial Statements.
In establishing reserves for guaranteed minimum death and income benefits related to variable annuity policies, we must make estimates and assumptions about the timing of annuitization, contract lapses and contractholder mortality, as well as interest rates and equity market returns. Assumptions relating to contractholder behavior, such as the timing of annuitization and contract lapses, are based on our experience by contract group, and vary by product type and year of issuance. Our dynamic lapse rate assumption applies a different lapse rate on a contract by contract basis based on a comparison of the guaranteed minimum death or income benefit and the current policyholder account value as well as other factors such as the applicability of any surrender charges. In-the-money contracts are those with a guaranteed minimum benefit in excess of the current policyholder account value. Since in-the-money contracts are less likely to lapse, we apply a lower lapse rate assumption to these contracts. As an example, the lapse rate assumptions for contracts that are not in-the-money and out of their surrender charge period average between 11% and 15% per year. This lapse rate assumption would be reduced for similar in-the-money contracts, based on the extent of the excess described above and the age of the contract. Mortality assumptions are generally based on our historical experience or standard industry tables, and also vary by contract group. Unless a material change in behavior or mortality experience is observed in an interim period, we generally update assumptions related to contractholder behavior and mortality in the third quarter of each year by considering the actual results that have occurred during the period from the most recent update to the expected amounts. Generally, we do not expect our actual 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.
Tax regulations require items to be included in the tax return at different times from the items reflected in the financial statements. As a result, the effective tax rate reflected in the financial statements is different than the actual rate applied on the tax return. Some of these differences are permanent such as expenses that are not deductible in our tax return, and some differences are temporary, reversing over time, such as valuation of insurance reserves. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet recognized in our financial statements.
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. For example, the dividends received deduction, or DRD, reduces the amount of dividend income subject to tax and is a significant component of the difference between our actual tax expense and the expected amount determined using the federal statutory tax rate of 35%. The U.S. Treasury Department and the Internal Revenue Service, or IRS, intend to address through regulations the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. On February 1, 2010, the Obama Administration released the “General Explanations of the Administration’s Revenue Proposals.” Although the Administration has not released proposed statutory language, one proposal would change the method used to determine the amount of the DRD. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulations or legislation, could increase our actual tax expense and reduce our net income.
On January 1, 2007, we adopted the revised authoritative guidance for Income Tax Uncertainties which prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that a company has taken or expects to take on a tax return. The application of this guidance is a two-step process, the first step being recognition. We determine whether it is more likely than not, based on the technical merits, that the tax position will be sustained upon examination. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. We measure the tax position as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate resolution with a taxing authority that has full knowledge of all relevant information. This measurement considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement using the facts, circumstances, and information available at the reporting date.
Total assets increased by $12.3 billion, from $39.6 billion at December 31, 2008 to $51.9 billion at December 31, 2009. Separate account assets increased by $17.2 billion, primarily driven by positive net flows, market appreciation during the current year and transfers out of the fixed income investments backed by our general account as a result of the automatic rebalancing element in certain of our optional living benefit features. Partially offsetting the above increase was a decrease in fixed maturities of $3.4 billion driven by lower general account balances due to the aforementioned automatic rebalancing element. Additionally, reinsurance recoverables decreased by $2.1 billion driven by a decrease in the reinsured liability for living benefit embedded derivatives resulting from a decrease in the underlying base reserve due to an increase in LIBOR. Also contributing to the decrease were updates of inputs used in the valuation of the embedded derivatives under the authoritative guidance for fair value measurements and disclosures. Under this guidance we are required to incorporate our own risk of non-performance in the valuation of the embedded derivatives associated with our living benefit features. In light of recent developments, including rating agency downgrades to the claims-paying ratings of the Company, beginning in the first quarter of 2009, we incorporated an additional spread over LIBOR into the discount rate used in the valuation of the embedded derivative liabilities to reflect an increase in our market perceived non-performance risk, thereby reducing the value of the embedded derivative liabilities.
During the period, total liabilities increased by $12.2 billion, from $37.9 billion at December 31, 2008 to $50.1 billion at December 31, 2009. Separate account liabilities increased by $17.2 billion driven by positive net flows, market appreciation during the current year and transfers out of the fixed income investments backed by our general account as a result of the automatic rebalancing element. In addition, borrowings increased by $463.8 million in order to fund the costs associated with new business sales. Partially offsetting the above increases was a decrease in policyholders’ account balances of $3.4 billion driven by transfers of customer account values to the separate account variable investment options from the fixed income investments backed by our general account due to the automatic rebalancing element in certain of our optional living benefit riders. Additionally, future policy benefits and other policyholder liabilities decreased by $2.2 billion from $2.5 billion at December 31, 2008 to $0.3 billion at December 31, 2009 driven by a decrease in the liability for living benefit embedded derivatives resulting from a decrease in the underlying base reserve primarily due to an increase in LIBOR and improving equity markets conditions. Also contributing to the decrease, as discussed above, were updates of inputs used in the valuation of the embedded derivatives under the authoritative guidance for fair value measurements and disclosures.
changes in our capital position resulting from market driven changes in certain living and death benefit features of our variable annuity products. In 2009, favorable market conditions resulted in an overall improvement in our capital position, which was partially offset by mark-to-market losses on the capital hedges.
The $134.8 million of benefits in 2009 relating to the quarterly market performance adjustments shown in the table above are attributable to changes to our estimate of total gross profits to reflect actual fund performance in 2009. The following table shows the actual quarterly rate of return on variable annuity account values for each of the quarters in 2009 compared to our previously expected quarterly rate of return used in our estimate of total gross profits.
As shown in the table above, results for both periods include the impact of the annual reviews of the assumptions used in the reserve for the guaranteed minimum death and income benefit features of our variable annuity products and in our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs. The year ended December 31, 2009 included $4.5 million of charges from these annual reviews, primarily related to reductions in the future rate of return assumptions applied to the underlying assets associated with our variable annuity products. Partially offsetting the impact of the updated future rate of return assumptions were benefits related to the impact of lower mortality and higher investment spread assumptions. Income from operations for 2008 included $81.2 million of charges from these annual reviews, primarily reflecting increased cost of expected income and death benefit claims due to lower expected lapse rates for policies where the current policyholder account value is below the guaranteed minimum death benefit.
As mentioned above, we derive our near-term future rate of return assumptions using a reversion to the mean approach, a common industry practice. Under this approach, we consider actual returns over a period of time and initially adjust future projected returns over a four year period so that the assets grow at the long-term expected rate of return for the entire period. However, beginning in the fourth quarter of 2008 and continuing through 2009, the projected future annual rate of return calculated using the reversion to the mean approach for most contract groups was greater than our maximum future rate of return assumption across all asset types. In those cases, we utilize the maximum future rate of return over the four year period, thereby limiting the impact of the reversion to the mean on our estimate of total gross profits. As discussed above, the near-term maximum future rate of return under the reversion to the mean approach was reduced in 2009 from 10.5% to 9.5% as part of our annual reviews. Included in this revised blended maximum future rate are assumptions for returns on various asset classes, including a 13% annual maximum rate of return on equity investments. Further or continued market volatility could result in additional market value changes within our separate account assets and corresponding changes to our gross profits, as well as additional adjustments to the amortization of deferred policy acquisition and other costs, and the costs relating to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products. Given that the estimates of future gross profits are based upon our maximum future rate of return assumption for most contract groups, all else being equal, future rates of return higher or lower than 2.3% per quarter, or 9.5% per annum, will result in decreases or increases in the amortization of deferred policy acquisition and other costs, and the costs relating to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products. Including the offsetting impact of certain contract groups relating to business issued in 2009, our weighted average expected rate of return across all contract groups is 7.2% per annum as of December 31, 2009.
The quarterly adjustments for current period experience shown in the table above reflect the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as an update for current and future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products. To the extent each period’s actual experience differs from the previous estimate for that period, the assumed level of total gross profits may change, and a cumulative adjustment to previous periods’ amortization, referred to as an adjustment for current period experience, may be required in the current period. This adjustment to previous periods’ amortization is in addition to the direct impact of actual gross profits on current period amortization and the market performance related adjustment to our estimates of gross profits for future periods. The adjustments for deferred policy acquisition and other costs in 2009 reflect a reduction in amortization due to better than expected gross profits, resulting primarily from the favorable variance in the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features and better than expected contract persistency experience. The adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in 2009 primarily reflects higher than expected fee income due to favorable market performance, partially offset by higher than expected actual contract guarantee claims costs due to lower than expected lapses. Less favorable than expected gross profits in 2008 were primarily due to lower than expected fee income, the unfavorable variance in the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features, and higher actual contract guarantee claims costs in 2008, primarily driven by unfavorable financial market conditions.
Absent the impact of the quarterly adjustments, assumption updates, the capital hedge program, and the change in non-performance risk in the valuation of embedded derivatives under the authoritative guidance for fair value measurements and disclosures, as previously discussed, income from operations before income taxes for the twelve months ended December 31, 2009 decreased $359.4 million from the twelve months ended December 31, 2008, primarily relating to a decrease in policy charges and fee income and asset administration fees and other income of $239.7 million primarily from the market value adjustments related to the Company’s MVA option driven by market conditions and transfer of assets back to the separate account due to the automatic rebalancing element. Additionally, policy charges and fee income and asset administration fees and other income were lower driven by lower average variable annuity asset balances invested in separate accounts. The declines in average separate account assets were due to market depreciation and transfers of balances to fixed income investments backed by our general account. The transfer of balances to fixed income investments backed by our general account relates to an automatic rebalancing element in some of our optional living benefit features, which, as part of the overall product design, transferred approximately $9.5 billion out of the separate accounts and into fixed income investments backed by our general account from January 1, 2008 through March 31, 2009, due to equity market declines. Subsequently in 2009, approximately $3.8 billion of assets was transferred from fixed income investments backed by our general account to the separate accounts by operation of the automatic rebalancing element due to market improvements. Also contributing to the decrease was higher amortization of deferred policy acquisition and other costs of $257.5 million due to higher levels of actual gross profits primarily from positive embedded derivative breakage. Additionally, interest credited to policyholder account balances increased $72.4 million primarily due to the aforementioned general account transfers. Lastly, reserves related to the guaranteed minimum death and income benefit features of our variable annuity products increased by $25.7 million primarily driven by higher actual and expected contract guarantee claim. Partially offsetting the unfavorable variances in pre-tax net income was higher net investment income of $174.6 million primarily due to aforementioned transfers of balances to fixed income investments backed by our general account.
Policy charges and fee income decreased $239.7 million, from $632.4 million for the twelve months ended December 31, 2008 to $392.7 million for the twelve months ended December 31, 2009 driven by a decrease of $210.7 million from market value adjustments related to the Company’s MVA option driven by market conditions and transfer of assets back to the separate account due to the automatic rebalancing element. Additionally, policy charges and fee income decreased from lower mortality and expense (“M&E”) fees of $33.1 million and a decrease in optional benefit charges on our living and death benefit features of $11.1 million, primarily driven by lower average variable annuity asset balances invested in separate accounts. The declines in average separate account assets were due to market depreciation and transfers of balances to fixed income investments backed by our general account, as previously discussed. The decrease in optional benefit charges was primarily offset in realized investment gains, net because these features are reinsured with affiliates.
Realized investment gains, net, decreased by $9.1 million from $46.0 million for the twelve months ended December 31, 2008 to $36.9 million for the twelve months ended December 31, 2009. This decrease was driven by $76.1 million of mark-to-market losses related to derivative positions associated with our capital hedging program, as previously discussed. This was partially offset by increased investment gains on our MVA and general account portfolios of $37.5 million primarily driven by dispositions to fund outflows in a declining rate environment and an increase in embedded derivative breakage of $29.5 million driven by increasing interest rates in 2009. This represents the embedded derivative breakage on non-reinsured living benefit liabilities
Benefits and expenses decreased $131.9 million, from $1,235.3 million for the twelve months ended December 31, 2008 to $1,103.4 million for the twelve months ended December 31, 2009.
Amortization of deferred policy acquisition costs (“DAC”) increased by $91.0 million, from $228.8 million for the twelve months ended December 31, 2008 to $319.8 million for the twelve months ended December 31, 2009 primarily due to an increase in DAC amortization of $292.7 million driven by higher level of actual gross profits and the impact of the change in non-performance risk in the valuation of embedded derivatives under the authoritative guidance for fair value measurements and disclosures, as previously discussed. Partially offsetting the above increases was a benefit of $201.8 million from the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing DAC, as previously discussed.
The impact of non-taxable investment income on the total tax provision decreased in 2009 as compared to 2008 and 2007, primarily due to an increase in the dividends received deduction, or DRD.
Prudential Financial and the Company continue to operate with significant cash and short-term investments on the balance sheet and have access to alternate sources of liquidity. However, should the recent improvements in the capital markets prove temporary and the severity of prior markets return, such market disruptions could potentially adversely affect our ability to access sources of liquidity, as well as threaten to reduce our capital below a level that is consistent with our existing credit ratings objectives. We may take additional actions, especially in the event of such disruptions, which may include but are not limited to: (1) further access external sources of capital, including the debt or equity markets; (2) limit or curtail sales of certain products and/or restructure existing products; and (3) seek temporary or permanent changes to regulatory rules. Certain of these actions may require regulatory approval and/or agreement of counterparties which are outside of our control or have economic costs associated with them. In the event that market conditions were to deteriorate, Prudential Financial may also be required to make further capital contributions to its regulated domestic or international subsidiaries, including the Company.
We believe that the cash flows from our operations are adequate to satisfy the current liquidity requirements of these operations, including under reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors such as future securities market conditions, changes in interest rate levels, policyholder perceptions of our financial strength, and the relative safety of competing products (including those with enhancements under government-sponsored programs), each of which could lead to reduced cash inflows or increased cash outflows. In addition, market volatility can impact the level of capital required to support our businesses. Our cash flows from investment activities result from repayments of principal, proceeds from maturities and sales of invested assets, net of amounts reinvested. The primary liquidity risks with respect to these cash flows are the risk of default by debtors or bond insurers, our counterparties’ willingness to extend repurchase and/or securities lending arrangements, commitments to invest and market volatility. We closely manage these risks through our credit risk management process and regular monitoring of our liquidity position.
Prudential Funding, LLC, or Prudential Funding, a wholly owned subsidiary of Prudential Insurance, serves as an additional source of financing to meet our working capital needs up to limits established with the Connecticut Insurance Department. Prudential Funding borrows funds in the capital markets primarily through the direct issuance of commercial paper.
The Risk Based Capital, or RBC, ratio is a primary measure by which we evaluate the capital adequacy of the Company. Prudential Financial manages its domestic insurance subsidiaries’ RBC ratio to a level consistent with an “AA” ratings target for those subsidiaries, and in excess of the minimum levels required by applicable insurance regulations. RBC is determined by statutory guidelines and formulas that consider, among other things, risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products, interest rate risks and general business risks. The RBC ratio calculations are intended to assist insurance regulators in measuring the adequacy of an insurer’s statutory capitalization. The reporting of RBC measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities.