We own our headquarters building located at 751 Broad Street, Newark, New Jersey. Excluding our headquarters building and properties used by our International Businesses and the international investment operations of PGIM, which are discussed below, as of December 31, 2019, we conduct our business and home office functions in both owned and leased locations throughout the U.S. We also conduct back-office functions in leased properties outside the U.S.
For our International Businesses, as of December 31, 2019, we own and lease home offices located in Japan, Argentina, Brazil, Korea, Mexico, Malaysia and Taiwan. We also conduct our business in owned and leased properties, primarily field offices, located throughout these same countries. For PGIM’s international investment operations, as of December 31, 2019, we lease home offices located in Japan and Taiwan. We also lease principal properties and other branch and field offices in other countries where PGIM does business.
We derived the selected consolidated income statement data for the years ended December 31, 2019, 2018 and 2017 and the selected consolidated balance sheet data as of December 31, 2019 and 2018, from the Consolidated Financial Statements included elsewhere herein. We derived the selected consolidated income statement data for the years ended December 31, 2016 and 2015, and the selected consolidated balance sheet data as of December 31, 2017, 2016 and 2015, from consolidated financial statements not included herein.
Pursuant to the FAST Act Modernization and Simplification of Regulation S-K, discussions related to the results of operations for the year ended December 31, 2018 in comparison to the year ended December 31, 2017 have been omitted. For such omitted discussions, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.
Our principal operations are comprised of PGIM (our global investment management business), our U.S. Businesses (consisting of our U.S. Workplace Solutions, U.S. Individual Solutions, and Assurance IQ divisions), our International Businesses, the Closed Block division, and our Corporate and Other operations. The U.S. Workplace Solutions division consists of our Retirement and Group Insurance businesses, the U.S. Individual Solutions division consists of our Individual Annuities and Individual Life businesses, and the Assurance IQ division consists of our Assurance IQ business. In October 2019, we completed the acquisition of Assurance IQ, Inc. (“Assurance IQ”), a leading consumer solutions platform that offers a range of solutions that help meet consumers’ financial needs (see Note 1 to the Consolidated Financial Statements for additional information). The Closed Block division is accounted for as a divested business that is reported separately from the Divested and Run-off Businesses that are included in Corporate and Other. Our Corporate and Other operations include corporate items and initiatives that are not allocated to business segments and businesses that have been or will be divested or placed in run-off, excluding the Closed Block division. See “Business” for a description of our sources of revenue and details on how our profitability is impacted. In addition, our profitability is impacted by our ability to effectively deploy capital, utilize our tax capacity and manage expenses.
Management expects that results in 2020 will continue to benefit from our differentiated mix of market-leading businesses that complement each other to provide competitive advantages, earnings diversification and capital benefits from a balanced risk profile. While challenges exist in the form of a low interest rate environment (see “Impact of a Low Interest Rate Environment”), fee compression in certain of our businesses and other market factors, we expect that our businesses will produce appropriate returns for the current market environment. We believe we are well-positioned to tap into market opportunities to meet the evolving needs of individual customers, workplace clients, and society at large. Our mix of high-quality protection, retirement and investment management businesses enables us to offer solutions that cover a broad range of financial needs and to engage with our clients through multiple channels. The Assurance IQ acquisition accelerates our ability to sell solutions across a broad socio-economic spectrum. We aim to expand our addressable market, build deeper and longer-lasting relationships with customers and clients, and make a meaningful difference in the financial wellness of their lives.
In order to further increase our competitive advantage, we are working to enhance the experience of our customers and the capabilities of our businesses, which we expect will also help us realize improved margins. In 2019, we announced programs we have launched in pursuit of these objectives that will result in multi-year investments in technology, systems and employee reskilling, as well as severance and related charges. Over the next several years, we will also see significant expense efficiencies resulting from these investments. During 2019, we incurred significant implementation costs related to these programs, which reflected an acceleration of spending that the Company announced in December 2019 that brought forward a portion of the expected implementation costs and is also expected to drive faster realization of projected margin improvement. Implementation costs were approximately $365 million in the fourth quarter of 2019, and approximately $400 million for the full year 2019, including a charge related to the Company’s Voluntary Separation Program offered to certain eligible U.S.-based employees. The voluntary separation program excluded senior executives and employees in certain roles (including employees in our PGIM investment businesses). The employment end dates for the employees that applied to participate in the program and whose applications were accepted by management are expected to occur between February and September of 2020.
We feel confident about our prospects for the future supported by our integrated and complementary businesses. Specific outlook considerations for each of our businesses include the following:
Assurance IQ. In October 2019, we completed the acquisition of Assurance IQ. Launched in 2016, Assurance IQ leverages data science and technology to distribute third-party life, health, Medicare and property and casualty products directly to retail shoppers primarily through its digital and independent agent channels. We expect that the acquisition of Assurance IQ will enhance the growth of our U.S. Businesses and generate cost synergies. We also believe that Assurance IQ has the potential to enhance the growth of our International Businesses over time. See Note 1 to the Consolidated Financial Statements for additional information about the acquisition, including the purchase consideration. See “Business” for a description of the business and “Risk Factors” for a description of the risks associated with the acquisition.
Our U.S. and International Businesses are impacted by financial markets, economic conditions, regulatory oversight, and a variety of trends that affect the industries in which we compete.
U.S. Businesses - As discussed further under “Impact of a Low Interest Rate Environment” below, interest rates in the U.S. remain lower than historical levels, which may continue to negatively impact our portfolio income yields and our net investment spread results among other factors. In addition, we are subject to financial impacts associated with movements in equity markets and the evolution of the credit cycle as discussed in “Segment Results of Operations” where applicable and more broadly in “Risk Factors”.
International Businesses - Japan has an aging population as well as a large pool of household assets invested in low-yielding deposit and savings vehicles. The aging of Japan’s population, along with strains on government pension programs, have led to a growing demand for insurance products with a significant savings element to meet savings and retirement needs as the population prepares for retirement. We are seeing a similar shift to retirement-oriented products across other Asian markets, including Korea and Taiwan, each of which also has an aging population.
See below for discussions related to the current interest rate environments in our two largest markets, the U.S. and Japan; the composition of our insurance liabilities and policyholder account balances; and the hypothetical impacts to our investment results if these interest rate environments are sustained.
For the general account supporting our U.S. Individual Solutions division, U.S. Workplace Solutions division and our Corporate and Other operations, we estimate annual principal payments and prepayments that we would be required to reinvest to be approximately 6.4% of the fixed maturity security and commercial mortgage loan portfolios through 2021. The portion of the general account attributable to these operations has approximately $222 billion of such assets (based on net carrying value) as of December 31, 2019. The average portfolio yield for fixed maturity securities and commercial mortgage loans is approximately 4.2%, as of December 31, 2019.
The $58 billion above relates to contracts with crediting rates that may be adjusted over the life of the contract, subject to guaranteed minimums. Although we may have the ability to lower crediting rates for those contracts above guaranteed minimums, our willingness to do so may be limited by competitive pressures. The following table sets forth the related account values by range of guaranteed minimum crediting rates and the related range of the difference, in basis points (“bps”), between rates being credited to contractholders as of December 31, 2019, and the respective guaranteed minimums.
Includes approximately $0.66 billion related to contracts that impose a market value adjustment if the invested amount is not held to maturity.
In order to mitigate the unfavorable impact that a low interest rate environment has on our net interest margins, we employ a proactive asset/liability management program, which includes strategic asset allocation and hedging strategies within a disciplined risk management framework. These strategies seek to match the characteristics of our products, and to closely approximate the interest rate sensitivity of the assets with the estimated interest rate sensitivity of the product liabilities. Our asset/liability management program also helps manage duration gaps, currency and other risks between assets and liabilities through the use of derivatives. We adjust this dynamic process as products change, as customer behavior changes and as changes in the market environment occur. As a result, our asset/liability management process has permitted us to manage the interest rate risk associated with our products through several market cycles. Our interest rate exposure is also mitigated by our business mix, which includes lines of business for which fee-based and insurance underwriting earnings play a more prominent role in product profitability.
Substantially all of the $60 billion of general account assets in the Closed Block division support obligations and liabilities relating to the Closed Block policies only. See Note 15 to the Consolidated Financial Statements for further information on the Closed Block.
While our international insurance operations have experienced a low interest rate environment for many years, the current reinvestment yields for certain blocks of business in our international insurance operations are generally lower than the current portfolio yield supporting these blocks of business. In recent years, the Bank of Japan’s monetary policy has resulted in even lower and, at times, negative yields for certain tenors of government bonds. Our international insurance operations employ a proactive asset/liability management program in order to mitigate, to the extent possible, the unfavorable impact that the current interest rate environment has on our net interest margins. In conjunction with this program, we have not purchased negative yielding assets to support the portfolio and we continue to purchase long-term bonds with tenors of 30 years or greater. Additionally, our diverse product portfolio in terms of currency mix and premium payment structure allows us to further mitigate the negative impact from this low interest rate environment. We regularly examine our product offerings and their profitability. As a result, we have repriced certain products, adjusted commissions for certain products and have discontinued sales of other products that do not meet our profit expectations. The impact of these actions and the introduction of certain new products, has resulted in an increase in sales
Of the $127 billion above, $126 billion is comprised of long-duration insurance products that have fixed and guaranteed terms, for which underlying assets may have to be reinvested at interest rates that are lower than current portfolio yields. The remaining insurance liabilities and policyholder account balances include $26 billion related to contracts that impose a market value adjustment if the invested amount is not held to maturity and $11 billion related to contracts with crediting rates that may be adjusted over the life of the contract, subject to guaranteed minimums. Most of the current crediting rates on these contracts, however, are at or near contractual minimums. Although we have the ability in some cases to lower crediting rates for those contracts that are above guaranteed minimum crediting rates, the majority of this business has interest crediting rates that are determined by formula.
2019 to 2018 Annual Comparison. The $112 million increase in “Net income (loss) attributable to Prudential Financial, Inc.” reflected the following notable items:
$1,624 million favorable variance, on a pre-tax basis, from adjustments to reserves as well as DAC and other costs, reflecting the impact of our annual reviews and update of assumptions and other refinements. This excludes the impact associated with the variable annuity hedging program discussed below (see “-Results of Operations by Segment-U.S. Businesses-U.S. Individual Solutions Division-Individual Annuities” for additional information);
$954 million favorable variance, on a pre-tax basis, from unrealized gains (losses) from equity securities recorded within “Other income (loss)” for PFI excluding our Divested and Run-off Businesses; and
$642 million net favorable variance, on a pre-tax basis, primarily from income in the current period from our Divested and Run-off Businesses compared to a loss in the prior period, excluding the impact of our annual reviews and update of assumptions and other refinements, as discussed above.
$272 million unfavorable variance, on a pre-tax basis, driven by market experience updates; and
$125 million unfavorable variance from higher income tax expense primarily due to the impact of tax reform and certain other tax matters on the prior year period (see Note 16 to the Consolidated Financial Statements for additional information).
Includes charges that represent the impact of realized investment gains (losses), net, on the amortization of DAC and other costs, and on changes in reserves. Also includes charges resulting from payments related to market value adjustment features of certain of our annuity products and the impact of realized investment gains (losses), net, on the amortization of Unearned Revenue Reserves (“URR”).
Represents the contribution to income (loss) of Divested and Run-off Businesses that have been or will be sold or exited, including businesses that have been placed in wind down, but that did not qualify for “discontinued operations” accounting treatment under U.S. GAAP. See “-Divested and Run-off Businesses” for additional information.
Represents adjustments not included in the above reconciling items. “Other adjustments” include certain components of the consideration for the Assurance IQ acquisition, which are recognized as compensation expense over the requisite service periods, as well as changes in the fair value of contingent consideration. See Note 22 to the Consolidated Financial Statements.
Equity in earnings of operating joint ventures are included in adjusted operating income but excluded from “Income (loss) before income taxes and equity in earnings of operating joint ventures” as they are reflected on an after-tax U.S. GAAP basis as a separate line in the Consolidated Statements of Operations. Earnings attributable to noncontrolling interests are excluded from adjusted operating income but included in “Income (loss) before income taxes and equity in earnings of operating joint ventures” as they are reflected on a U.S. GAAP basis as a separate line in the Consolidated Statements of Operations. Earnings attributable to noncontrolling interests represent the portion of earnings from consolidated entities that relates to the equity interests of minority investors.
Retirement. Results for 2019 increased in comparison to 2018, primarily reflecting a favorable comparative net impact from our annual reviews and update of assumptions and other refinements, and higher net investment spread results. This increase was partially offset by higher expenses and less favorable reserve experience.
Group Insurance. Results for 2019 increased in comparison to 2018, primarily reflecting more favorable underwriting results, higher net investment spread results and lower expenses, partially offset by an unfavorable comparative net impact from our annual reviews and update of assumptions and other refinements.
Closed Block Division. Results for 2019 increased in comparison to 2018, primarily driven by an increase in net realized investment gains and related activity, higher net investment income, and an increase in net insurance activity including dividends to policyholders, partially offset by an increase on the policyholder dividend obligation.
In order to reduce equity volatility from foreign currency exchange rate movements, we primarily utilize a yen hedging strategy that calibrates the hedge level to preserve the relative contribution of our yen-based business to the Company’s overall return on equity on a leverage neutral basis. We implement this hedging strategy utilizing a variety of instruments, including USD-denominated assets, foreign currency derivative contracts, and dual currency and synthetic dual currency investments held locally in our Japanese insurance subsidiaries. The total hedge level may vary based on our periodic assessment of the relative contribution of our yen-based business to the Company’s overall return on equity.
The USD-denominated investments that hedge the impact of foreign currency exchange rate movements on USD-equivalent earnings and shareholder return on equity from our Japanese insurance operations are reported within yen-based entities and, as a result, foreign currency exchange rate movements will impact their value reported within our yen-based Japanese insurance entities. We seek to mitigate the risk that future unfavorable foreign currency exchange rate movements will decrease the value of these USD-denominated investments reported within our yen-based Japanese insurance entities, and therefore negatively impact their equity and regulatory solvency margins, by having our Japanese insurance operations enter into currency hedging transactions. Those hedges are with a subsidiary of Prudential Financial. These hedging strategies have the economic effect of moving the change in value of these USD-denominated investments due to foreign currency exchange rate movements from our Japanese yen-based entities to our USD-based entities.
These USD-denominated investments also pay a coupon which is generally higher than what a similar yen-denominated investment would pay. The incremental impact of this higher yield on our USD-denominated investments, as well as our dual currency and synthetic dual currency investments, will vary over time, and is dependent on the duration of the underlying investments as well as interest rate environments in both the U.S. and Japan at the time of the investments.
The financial results of our International Businesses and PGIM reflect the impact of intercompany arrangements with our Corporate and Other operations pursuant to which certain of these segments’ non-USD-denominated earnings are translated at fixed currency exchange rates. The financial results of our Retirement segment reflected the impact of an intercompany foreign currency exchange arrangement with our Corporate and Other operations in 2017 prior to its termination effective January 1, 2018. This foreign currency exchange risk is now managed within our Retirement segment using a strategy that may include external hedges. Results of our Corporate and Other operations include any differences between the translation adjustments recorded by the segments at the fixed currency exchange rate versus the actual average rate during the period. In addition, specific to our International Businesses segment where we hedge certain currencies, the results of our Corporate and Other operations also include the impact of any gains or losses recorded from the forward currency contracts that settled during the period, which include the impact of any over or under hedging of actual earnings that differ from projected earnings.
As a result of these arrangements, our International Businesses segment’s results for 2019, 2018 and 2017 reflect the impact of translating yen-denominated earnings at fixed currency exchange rates of 105, 111, and 112 yen per USD, respectively, and Korean won-denominated earnings at fixed currency exchange rates of 1,110, 1,150, and 1,130 Korean won per USD, respectively. We expect our 2020 results to reflect the impact of translating yen-denominated earnings at a fixed currency exchange rate of 104 yen per USD and Korean won-denominated earnings at a fixed currency exchange rate of 1,090 won per USD. Since determination of the fixed currency exchange rates for a given year is impacted by changes in foreign currency exchange rates over time, the segment’s future earnings will ultimately be impacted by these changes in exchange rates.
In 2015 we implemented a structure in Gibraltar Life’s operations that disaggregated the USD- and AUD-denominated businesses into separate divisions, each with its own functional currency that aligns with the underlying products and investments. The result of this alignment was to reduce differences in the accounting for changes in the value of these assets and liabilities that arise due to changes in foreign currency exchange rate movements. For the USD- and AUD-denominated assets that were transferred under this structure, the net cumulative unrealized investment gains associated with foreign exchange remeasurement that were recorded in “Accumulated other comprehensive income (loss)” (“AOCI”) totaled $2.7 billion and $3.2 billion as of December 31, 2019 and 2018, respectively, and will be recognized in earnings within “Realized investment gains (losses), net” over time as these assets mature or are sold. Absent the sale of any of these assets prior to their stated maturity, approximately 14% of the $2.7 billion balance as of December 31, 2019 will be recognized in 2020, approximately 12% will be recognized in 2021, and the remaining balance will be recognized from 2022 through 2051.
We capitalize costs that are directly related to the acquisition or renewal of insurance and annuity contracts. These costs primarily include commissions, as well as costs of policy issuance and underwriting and certain other expenses that are directly related to successfully negotiated contracts. We have also deferred costs associated with sales inducements related to our variable and fixed annuity contracts primarily within our Individual Annuities segment. Sales inducements are amounts that are credited to the policyholders’ account balances mainly as an inducement to purchase the contract. For additional information about sales inducements, see Note 13 to the Consolidated Financial Statements. We generally amortize DAC and deferred sales inducements (“DSI”) over the expected lives of the contracts, based on our estimates of the level and timing of gross premiums, gross profits, or gross margins, depending on the type of contract. As described in more detail below, in calculating DAC and DSI amortization, we are required to make assumptions about investment returns, mortality, persistency, and other items that impact our estimates of the level and timing of gross margins, gross profits, or gross premiums. We also periodically evaluate the recoverability of our DAC and DSI. For certain contracts, this evaluation is performed as part of our premium deficiency testing, as discussed further below in “-Insurance Liabilities-Future Policy Benefits.” As of December 31, 2019, DAC and DSI for PFI excluding the Closed Block division were $19.7 billion and $0.9 billion, respectively, and DAC in our Closed Block division was $235 million.
Gross Margins. DAC associated with the traditional participating products of our Closed Block is amortized over the expected lives of these contracts in proportion to total gross margins. Total gross margins are defined as: i) amounts received from premiums, earned from investment of policyholder balances and other assessments, less ii) benefits paid, costs for contract administration, changes in the net level premium reserve for death and endowment benefits, annual policyholder dividends and other credits. We evaluate our estimates of future gross margins and adjust the related DAC balance with a corresponding charge or credit to current period earnings for the effects of actual gross margins and changes in our expected future gross margins. DAC adjustments for these participating products generally have not created significant volatility in our results of operations since many of the factors that affect gross margins are also included in the determination of our dividends to these policyholders and, during most years, the Closed Block has recognized a cumulative policyholder dividend obligation expense in “Policyholders’ dividends,” for the excess of actual cumulative earnings over expected cumulative earnings as determined at the time of demutualization. However, if actual cumulative earnings fall below expected cumulative earnings in future periods, thereby eliminating the cumulative policyholder dividend obligation expense, changes in gross margins and DAC amortization would result in a net impact to the Closed Block results of operations. As of December 31, 2019, the excess of actual cumulative earnings over the expected cumulative earnings was $2,816 million.
The amortization methodologies for products not discussed above primarily relate to less significant DAC and DSI balances associated with products in our Group Insurance and Retirement segments, which comprised approximately 2% of the Company’s total DAC and DSI balances as of December 31, 2019.
With regard to interest rate assumptions used in evaluating DAC and DSI, we update the long-term and near-term future rates used to project fixed income returns annually and quarterly, respectively. As a result of our 2019 annual reviews and update
We establish reserves for future policy benefits to, or on behalf of, policyholders using methodologies prescribed by U.S. GAAP. The reserving methodologies used include the following:
For certain contract features, such as those related to guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”) and no-lapse guarantees, a liability is established when associated assessments (which include all policy charges including charges for administration, mortality, expense, surrender, and other, regardless of how characterized) are recognized. This liability is established using current best estimate assumptions and is based on the ratio of the present value of total expected excess payments (e.g., payments in excess of account value) over the life of the contract divided by the present value of total expected assessments (i.e., benefit ratio). The liability equals the current benefit ratio multiplied by cumulative assessments recognized to date, plus interest, less cumulative excess payments to date. The result of the benefit ratio method is that the liability at any point in time represents an accumulation of the portion of assessments received to date expected to be needed to fund future excess payments, less any excess payments already paid. The liability does not necessarily reflect the full policyholder obligation the Company expects to pay at the
International Businesses. The reserves for future policy benefits of our International Businesses, which as of December 31, 2019, represented 45% of our total future policy benefit reserves, primarily relate to non-participating whole life and term life products and endowment contracts, and are generally calculated using the net premium valuation methodology, as described above. The primary assumptions used in determining expected future benefits and expenses include mortality, lapse, morbidity, investment yield and maintenance expense assumptions. Reserves also include claims reported but not yet paid, and claims incurred but not yet reported. In addition, future policy benefit reserves for certain contracts also include amounts related to our deferred profit liability, as described above.
The reserves for certain optional living benefit features, including GMAB, GMWB and GMIWB are accounted for as embedded derivatives at fair value, as described above. This methodology could result in either a liability or contra-liability balance, given changing capital market conditions and various actuarial assumptions. Since there is no observable active market for the transfer of these obligations, the valuations are calculated using internally-developed models with option pricing techniques. The models are based on a risk neutral valuation framework and incorporate premiums for risks inherent in valuation techniques, inputs, and the general uncertainty around the timing and amount of future cash flows. The significant inputs to the valuation models for these embedded derivatives include capital market assumptions, such as interest rate levels and volatility assumptions,
the Company’s market-perceived risk of its own non-performance risk (“NPR”), as well as actuarially determined assumptions, including mortality rates and contractholder behavior, such as lapse rates, benefit utilization rates and withdrawal rates. Capital market inputs and actual contractholders’ account values are updated each quarter based on capital market conditions as of the end of the quarter, including interest rates, equity markets and volatility. In the risk neutral valuation, the initial swap curve drives the total returns used to grow the contractholders’ account values. The Company’s discount rate assumption is based on the London Inter-Bank Offered Rate swap curve adjusted for an additional spread, which includes an estimate of NPR. Actuarial assumptions, including contractholder behavior and mortality, are reviewed at least annually, and updated based upon emerging experience, future expectations and other data, including any observable market data, such as available industry studies or market transactions such as acquisitions and reinsurance transactions. For additional information regarding the valuation of these optional living benefit features, see Note 6 to the Consolidated Financial Statements.
Group Insurance. The reserves for future policy benefits of our Group Insurance segment, which as of December 31, 2019, represented 2% of our total future policy benefit reserves, primarily relate to reserves for group life and disability benefits. For short-duration contracts, a liability is established when the claim is incurred. The reserves for group life and disability benefits also include a liability for unpaid claims and claim adjustment expenses, which relates primarily to the group long-term disability product. This liability represents our estimate of future disability claim payments and expenses as well as estimates of claims that have been incurred, but have not yet been reported, as of the balance sheet date. The liability is determined as the present value of expected future claim payments and expenses. The primary assumptions used in determining expected future claim payments are claim termination factors, an assumed interest rate and expected Social Security offsets. The remaining reserves for future policy benefits for group life and disability benefits relate primarily to our group life business, and include reserves for Waiver of Premium, Claims In Course of Settlement and Claims Incurred But Not Reported. The Waiver of Premium reserve is calculated as the present value of future benefits and utilizes assumptions such as expected mortality and recovery rates. The Claims In Course of Settlement reserve is based on the inventory of claims that have been reported but not yet paid. The Claims Incurred But Not Reported reserve is estimated using expected patterns of claims reporting.
Closed Block Division. The future policy benefit reserves for the traditional participating life insurance products of the Closed Block division, which as of December 31, 2019, represented 16% of our total future policy benefit reserves are determined using the net premium valuation methodology, as described above. Under this method, the future policy benefit reserves are accrued as a level proportion of the premium paid by the policyholder. In applying this method, we use mortality assumptions to determine our expected future benefits and expected future premiums, and apply an interest rate to determine the present value of both of these amounts. The mortality assumptions are based on standard industry mortality tables that were used to determine the cash surrender value of the policies, and the interest rates used are the interest rates used to calculate the cash surrender value of the policies.
In certain instances, the policyholder liability for a particular line of business may not be deficient in the aggregate to trigger loss recognition, but the pattern of earnings may be such that profits are expected to be recognized in earlier years followed by losses in later years. In these situations, accounting standards require that an additional liability (Profits Followed by Losses or “PFL” liability) be recognized by an amount necessary to sufficiently offset the losses that would be recognized in later years. The PFL liability is based on our current estimate of the present value of the amount necessary to offset losses anticipated in future
The following table summarizes the impact that could result on each of the listed financial statement balances for the specified businesses from changes in certain key assumptions. The information below is for illustrative purposes and includes only the hypothetical direct impact on December 31, 2019 balances of changes in a single assumption and not changes in any combination of assumptions. The figures below are presented in aggregate for those businesses that are expected to experience a significant positive or negative impact as a result of the corresponding assumption change. Changes in current assumptions and the related impact that could result in the listed financial statement balances that are in excess of the amounts illustrated may occur in future periods. A description of the estimates and assumptions used in the preparation of each of these financial statement balances is provided further above. For traditional long duration and limited payment contracts, U.S. GAAP requires the original assumptions used when the contracts are issued to be locked-in and that those assumptions be used in all future liability calculations as long as the resulting liabilities are adequate to provide for the future benefits and expenses (i.e., there is no premium deficiency). Therefore, these products are not reflected in the sensitivity table below unless the hypothetical change in assumption would result in an adverse impact that would cause a premium deficiency. Similarly, the impact of any favorable change in assumptions for traditional long-duration and limited-payment contracts is not reflected in the table below given that the current assumption is required to remain locked-in, and instead the positive impacts would be recognized into net income over the life of the policies in force.
The impacts of our Long-Term Care business, a component of our Divested and Run-off Businesses within our Corporate and Other operations. Long-Term Care business sensitivities are presented separately in the immediately following table (see “-Sensitivities for the Long-Term Care business within our Corporate and Other operations”). While the accounting for long-term care products primarily follows the locked-in assumptions model described above, as a result of our 2018 annual review and update of assumptions this business recognized a premium deficiency and unlocked and updated the previously locked-in assumptions used in the valuation model. Sensitivities are presented separately in order to provide stand-alone and supplementary information.
Represents the impact of an increase or decrease in lapse rates for the Individual Annuities and Individual Life businesses.
The following table summarizes certain significant assumptions made in establishing reserves for long-term care products and the net impact that could result from changes in these assumptions should they occur. Under U.S. GAAP, reserves for long-term care products are primarily calculated using the locked-in assumptions concept described above. As such, the adverse hypothetical impacts illustrated in the table below are those that would increase our best estimate reserves and, when compared to our GAAP reserves, may cause a premium deficiency that would require us to unlock and update our assumptions and record a charge to net income. The favorable hypothetical impacts in the table below would decrease our best estimate reserves but they would not result in an immediate decrease to our GAAP reserves (given that we would be required to leave the current assumptions locked-in) and instead the positive impacts would be recognized into net income over the life of the policies in force.
Investment rate reflects the expected investment yield over the life of the block of business, and is derived from the portfolio yield, current reinvestment rates and our intermediate and long-term assumption for investment yields.
As of December 31, 2019, our goodwill balance of $3,013 million is primarily reflected in the following reporting units: $2,128 million for Assurance IQ, $455 million for Retirement’s Full Service business, $254 million for PGIM, $156 million for Gibraltar Life and Other, and $10 million for Life Planner.
In Retirement’s Full Service business, the quantitative impairment analysis was completed using a discounted cash flow approach. This approach calculates the value of a business by applying a discount rate reflecting a market expected rate of return of the reporting unit to its projected future cash flows. These projected future cash flows were based on our internal forecasts, an expected growth rate and a terminal value. The reporting unit expected rate of return represents the required rate of return on its total capitalization. The process of deriving reporting unit specific required rates of return begins with the calculation of an overall Company Weighted Average Cost of Capital, which includes the calculation of the required return on equity using a Capital Asset Pricing Model (“CAPM”). The CAPM is a generally accepted method for estimating an equity investor’s return requirement, and hence a company’s cost of equity capital. The calculation using the CAPM begins with the long-term risk-free rate of return, then applies a market risk premium for large company common stock, as well as company specific adjustments to address volatility versus the market. The Company then determines reporting unit specific required rates of return based on their relative volatilities, benchmarks results against reporting unit comparable companies, and ensures that the sum of the reporting unit required returns (after considering the impact of unallocated Corporate costs and capital) add up to the overall Company required return. This
process results in reporting unit specific discount rates which are then applied to the expected future cash flows of Retirement’s Full Service business to estimate fair value.
After completion of the first step of the quantitative tests, the fair values exceeded the carrying amounts for each of the four reporting units tested and we concluded there was no impairment as of December 31, 2019. PGIM, Life Planner, Gibraltar Life and Other, and Retirement’s Full Service business had estimated fair values that exceeded their carrying amounts by a weighted average of 223%. Completion of the second step of the quantitative analysis is therefore not necessary.
We determine our expected rate of return on plan assets based upon a building block approach that considers plan asset mix, risk free rates, inflation, real return, term premium, credit spreads, equity risk premium and capital appreciation as well as expenses, the effect of active management and the effect of rebalancing for the equity, debt and real estate asset mix applied on a weighted average basis to our pension asset portfolio. See Note 18 to the Consolidated Financial Statements for our actual asset allocations by asset category and the asset allocation ranges prescribed by our investment policy guidelines for both our pension and other
postretirement benefit plans. Our assumed long-term rate of return for 2019 was 6.25% for our domestic pension plans and 7.00% for our other postretirement benefit plans. Given the amount of plan assets as of December 31, 2018, the beginning of the measurement year, if we had assumed an expected rate of return for both our domestic pension and other domestic postretirement benefit plans that was 100 bps higher or 100 bps lower than the rates we assumed, the change in our net periodic costs would have been as shown in the table below. The information provided in the table below considers only changes in our assumed long-term rate of return given the level and mix of invested assets at the beginning of the measurement year, without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed long-term rate of return.
For a discussion of our expected rate of return on plan assets and discount rate for our qualified pension plan in 2019, see “-Results of Operations by Segment-Corporate and Other.”
For purposes of calculating pension income from our own qualified pension plan for the year ended December 31, 2020, we will decrease the discount rate to 3.30% from 4.30% in 2019. The expected rate of return on plan assets will decrease to 6.00% in 2020 from 6.50% in 2019, and the assumed rate of increase in compensation will remain unchanged at 4.5%.
At December 31, 2019, the sensitivity of our domestic and foreign pension and postretirement obligations to a 100 basis point change in discount rate was as follows:
In December 2017, Securities and Exchange Commission (“SEC”) staff issued “Staff Accounting Bulletin 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act” (“SAB 118”), which allowed the registrants to record provisional amounts during a ‘measurement period’ not to extend beyond one year. Under the relief provided by SAB 118, a company could recognize provisional amounts when it did not have the necessary information available, prepared or analyzed in reasonable detail to complete its accounting for the change in tax law. See Note 16 to the Consolidated Financial Statements for a discussion of provisional amounts related to The United States Tax Cuts and Jobs Act of 2017 (“Tax Act of 2017”) included in “Total income tax expense (benefit) before equity in earnings of operating joint ventures” in 2017 and adjustments to provisional amounts recorded in 2018.
For digital insurance brokerage placement services, the Company earns both initial and renewal commissions as compensation for the placement of insurance policies with insurance carriers. At the effective date of the policy, the Company records within “Other income” the expected lifetime revenue for the initial and renewal commissions considering estimates of the timing of future policy cancelations. These estimates are reassessed each reporting period and any changes in estimates are reflected in the current period.
In the first quarter of 2019, we completed the acquisition of Wadhwani Asset Management LLP, a London-based quantitative macro-focused investment management firm, and renamed the firm QMA Wadhwani LLP, which now operates as part of our QMA business with an independent investment platform.
In the third quarter of 2019, we completed the acquisition of our joint venture partner’s share of our India-based asset management joint venture, DHFL Pramerica Asset Managers, and re-named the business PGIM India Asset Management.
Includes payments from Wells Fargo under an agreement dated as of July 30, 2004, implementing arrangements with respect to money market mutual funds in connection with the combination of our retail securities brokerage and clearing operations with those of Wells Fargo. The agreement extended for ten years from the Wachovia Securities joint venture termination date of December 31, 2009 to December 31, 2019. The revenue from Wells Fargo under this agreement was $60 million, $70 million and $80 million for the years ended December 31, 2019, 2018 and 2017, respectively.
2019 to 2018 Annual Comparison. Revenues increased $295 million. Asset management fees increased primarily reflecting an increase in average assets under management as a result of market appreciation and fixed income flows. Other related revenues increased primarily driven by higher gross performance-based incentive fees and higher strategic investing results due to favorable investment performance. These increases were partially offset by charges associated with a joint venture.
These amounts primarily include certain assets related to annuity and variable life products in our U.S. Individual Solutions division, retirement and group life products in our U.S. Workplace Solutions division, and certain general account assets of our International Businesses. These assets are not directly managed by PGIM, but rather are invested in non-proprietary funds or are managed by either the divisions themselves or our Chief Investment Officer Organization.
2019 to 2018 Annual Comparison. PGIM’s assets under management increased $147 billion to $1.308 trillion in 2019, primarily reflecting market appreciation and higher fixed income flows driven by strong retail sales and institutional flows.
Represents adjustments not included in the above reconciling items. “Other adjustments” include certain components of the consideration for the Assurance IQ acquisition, which are recognized as compensation expense over the requisite service periods, as well as changes in the fair value of contingent consideration. See Note 22 to the Consolidated Financial Statements for additional information.
Higher net investment spread results driven by continued business growth and higher income on non-coupon investments and higher prepayment fee income;
A favorable comparative net impact from our annual reviews and update of assumptions and other refinements.
Higher expenses, including costs associated with business growth and business initiatives;
2019 to 2018 Annual Comparison. Adjusted operating income increased $252 million. Results for 2019 included a net benefit of $154 million from our annual reviews and update of assumptions and other refinements primarily driven by a reduction in expected benefit payments, while results for 2018 included a net charge of $68 million from these updates, primarily driven by updates to our assumptions for benefit payments. Excluding these impacts, adjusted operating income increased $30 million, primarily driven by higher net investment spread results, partially offset by higher expenses and less favorable reserve experience. The increase in net investment spread results primarily reflected higher income on non-coupon investments, higher prepayment fee income and higher asset balances within our pension risk transfer business, partially offset by the impact from higher crediting rates on full service account values. The increase in expenses was primarily driven by higher costs supporting business growth initiatives. The lower contribution from reserve experience primarily reflected lower mortality gains on a comparative basis within our pension risk transfer business.
2019 to 2018 Annual Comparison. Revenues decreased $1,761 million. Excluding the impact of our annual reviews and update of assumptions and other refinements, as discussed above, revenues decreased $1,755 million. This decrease primarily reflected lower funded pension risk transfer premiums with corresponding offsets in policyholders’ benefits, as discussed below. The decrease was partially offset by higher net investment income, primarily reflecting higher income on non-coupon investments, higher prepayment fee income and higher asset balances within our pension risk transfer business.
Benefits and expenses decreased $2,013 million. Excluding the impact of our annual reviews and update of assumptions and other refinements, as discussed above, benefits and expenses decreased $1,785 million. Policyholders’ benefits, including the change in policy reserves, decreased primarily related to the decrease in premiums discussed above, driven by lower comparative funded pension risk transfer premiums. The decrease was partially offset by an increase in interest credited to policyholders’ account balances, including the impact of higher crediting rates on experience-rated account balances and higher account values.
Account values are a significant driver of our operating results, and are primarily driven by net additions (withdrawals) and the impact of market changes. The income we earn on most of our fee-based products varies with the level of fee-based account values, since many policy fees are determined by these values. The investment income and interest we credit to policyholders on
Additions primarily include: group annuities calculated based on premiums received; longevity reinsurance contracts calculated as the present value of future projected benefits; and investment-only stable value contracts calculated as the fair value of customers’ funds held in a client-owned trust.
The increase in institutional investment products account values primarily reflected net additions from funded pension risk transfer transactions and the favorable changes in the market value of account assets.
The following table sets forth Group Insurance’s operating results and benefits and administrative operating expense ratios for the periods indicated.
Benefits ratios reflect the impacts of our annual reviews and update of assumptions and other refinements. Excluding these impacts, the group life, group disability and total Group Insurance benefits ratios were 87.0%, 77.7% and 84.9% for 2019, respectively, 87.4%, 77.8% and 85.5% for 2018, respectively, and 88.7%, 78.9% and 86.9% for 2017, respectively.
2019 to 2018 Annual Comparison. Adjusted operating income increased $56 million, including an unfavorable comparative net impact from our annual reviews and update of assumptions and other refinements. Results for both 2019 and 2018 included a net benefit from this update of $9 million and $31 million, respectively. Excluding this item, adjusted operating income increased $78 million, primarily driven by more favorable underwriting results in our group disability and group life businesses, higher net investment spread results driven by higher income on non-coupon investments, and lower expenses driven by the absence of costs related to the termination of a third-party underwriting service provider contract in 2018. The more favorable underwriting results were driven by favorable claim experience on long-term products in our group disability business and favorable claim experience on non-experience rated contracts in our group life business.
2019 to 2018 Annual Comparison. Total annualized new business premiums decreased $146 million compared to 2018, primarily driven by large life client sales in the prior year period.
Our Individual Annuities business includes both fixed and variable annuities which may include optional guaranteed living benefits riders (e.g., GMIB, GMAB, GMWB and GMIWB), and/or optional death benefit riders (e.g., GMDB). We also offer fixed annuities that provide a guarantee of principal and interest credited at rates we determine (subject to certain contractual minimums) or at rates based upon the performance of an index (subject to caps or participation rates). The drivers of our business results are generally included in adjusted operating income, with exceptions related to certain guarantees, as discussed below.
Fee income, net of distribution expenses and other associated costs, declined due to certain products reaching contractual milestones for fee tier reduction, unfavorable impacts from our living benefit guarantees as a result of declining interest rates, lower average account values resulting from net outflows which were partially offset by market appreciation, and higher capital hedge costs reflecting the impacts of equity market performance. The increase in expenses was primarily driven by initiatives to generate business growth. The increase in net investment income was primarily due to a higher level of invested assets. The unfavorable impact on the estimates of profitability in the prior period was driven by market conditions, and beginning with the second quarter of 2019, this activity is excluded from adjusted operating income (see Note 22 to the Consolidated Financial Statements for further information).
Includes gross variable and fixed annuities sold as retail investment products. Investments sold through defined contribution plan products are included with such products within our Retirement business. Variable annuity account values were $164.9 billion, $147.3 billion and $165.1 billion as of December 31, 2019, 2018 and 2017, respectively. Fixed annuity account values were $4.8 billion, $3.7 billion and $3.5 billion as of December 31, 2019, 2018 and 2017, respectively.
2019 to 2018 Annual Comparison. The increase in account values during 2019 was primarily driven by favorable changes in the market value of contractholder funds, partially offset by net outflows and policy charges.
Fixed Annuity Risks and Risk Mitigants. The primary risk exposure of our fixed annuity products relates to investment risks we bear for providing customers a minimum guaranteed interest rate required to be credited to the customer’s account value, interest rate fluctuations and/or sustained periods of low interest rates, and credit risk related to the underlying investments. We manage these risk exposures primarily through a combination of product design features and external reinsurance. Our product design features include rate resetting subject to the guaranteed interest rate as well as surrender charges applied during the early years of the policy that help to provide protection for premature withdrawals. In addition, a portion our fixed products have a market value adjustment provision that provides protection of lapse in the case of rising interest rates. For information on our external reinsurance agreements, refer to the “Business” section.
A portion of the variable annuity contracts that we offer include an automatic rebalancing feature, also referred to as an asset transfer feature. This feature is implemented at the contract level, and transfers assets between certain variable investment sub-accounts selected by the annuity contractholder and, depending on the benefit feature, a fixed-rate account in the general account or a bond fund sub-account within the separate accounts. The automatic rebalancing feature associated with currently-sold variable annuity products with the highest daily benefit uses a designated bond fund sub-account within the separate accounts. The transfers are based on a static mathematical formula used with the particular benefit which considers a number of factors, including, but not limited to, the impact of investment performance on the contractholder’s total account value. The objective of the automatic rebalancing feature is to reduce our exposure to equity market risk and market volatility. Other product design features we utilize include, among others, asset allocation restrictions, minimum issuance age requirements and certain limitations on the amount of contractholder deposits, as well as a required minimum allocation to our general account for certain of our products. We continue to introduce products that diversify our risk profile and have incorporated provisions in product design allowing frequent revisions of key pricing elements for certain of our products. In addition, there is diversity in our fee arrangements, as certain fees are primarily based on the benefit guarantee amount, the contractholder account value and/or premiums, which helps preserve certain revenue streams when market fluctuations cause account values to decline.
Under our ALM strategy, adjusted operating income includes the fees earned that are in excess of the estimated portion of fees required to cover expected claims and hedge costs for the economic liability. The portion of fees required to cover such costs is updated quarterly to reflect revised estimates and actual experience. The effectiveness of our hedging program is measured by comparing the change in value of our hedging assets to the change in value of the liability we are attempting to hedge and is reflected in adjusted operating income over time through the inclusion of actual hedge costs. Expected costs are updated periodically along with our expectation of claims. For adjusted operating income purposes, DAC and other costs are fully amortized over the life of the contracts proportional to our actual and estimated gross profits under the adjusted operating income framework described above.
The following table provides a reconciliation between the liability reported under U.S. GAAP and the economic liability we manage through our ALM strategy as of the periods indicated.
As of December 31, 2019, our fixed income instruments and derivative assets exceed the economic liability within the entities in which the risks reside.
The following table illustrates the net impact to our Consolidated Statements of Operations from changes in the U.S. GAAP embedded derivative liability and hedge positions under the ALM strategy, and the related amortization of DAC and other costs, that are excluded from adjusted operating income for the periods indicated:
Represents risk margins and valuation methodology differences between the economic liability managed by the ALM strategy and the U.S. GAAP liability.
For 2018, the loss of $84 million primarily reflected the impact of a $173 million charge from our annual review and update of assumptions, driven by modifications to both our actuarial assumptions, including updates to expected withdrawal rates, as well as to economic assumptions. These charges were largely offset by changes in the U.S. GAAP embedded derivative and hedge positions as a result of credit spreads widening, partially offset by declining interest rates and unfavorable equity market performance.
For information regarding the Risk Appetite Framework (“RAF”) we use to evaluate and support the risks of the ALM strategy, see “-Liquidity and Capital Resources-Capital.”
We employ a capital hedge program to hedge equity market impacts. The program is intended to protect a portion of the overall capital position of the variable annuities business against its exposure to the equity markets. The capital hedge program is conducted using equity derivatives which include equity call and put options, total return swaps and futures contracts. The changes in value of these derivatives are recognized in adjusted operating income over the expected duration of the capital hedge program.
The majority of our variable annuity contracts with living benefits guarantees, and all new contracts sold with our highest daily living benefits feature, include risk mitigants in the form of an automatic rebalancing feature and/or inclusion in our ALM strategy. We may also utilize external reinsurance as a form of additional risk mitigation. The risks associated with the guaranteed benefits of certain legacy products that were sold prior to our development of the automatic rebalancing feature are also managed through our ALM strategy. Certain legacy GMAB products include the automatic rebalancing feature but are not included in the ALM strategy.
For our GMDBs, we provide a benefit payable in the event of death. Our base GMDB is generally equal to a return of cumulative deposits adjusted for any partial withdrawals. Certain products include an optional enhanced GMDB based on the greater of a minimum return on the contract value or an enhanced value. We have retained the risk that the total amount of death benefit payable may be greater than the contractholder account value; however, a substantial portion of the account values associated with GMDBs are subject to an automatic rebalancing feature because the contractholder also selected a living benefit guarantee which includes an automatic rebalancing feature. All of the variable annuity account values with living benefit guarantees also contain GMDBs. The living and death benefit features for these contracts cover the same insured life and, consequently, we have insured both the longevity and mortality risk on these contracts.
All contracts with living benefit guarantees also contain GMDB features, which cover the same insured contract.
The following table sets forth Individual Life’s operating results for the periods indicated.
2019 to 2018 Annual Comparison. Revenues increased $284 million. Excluding the impact of our annual reviews and update of assumptions and other refinements, as discussed above, revenues increased $321 million. This increase was primarily driven by an increase in net investment income from higher average invested assets resulting from business growth, higher income on non-coupon investments and higher prepayment fee income, and higher investment income from unaffiliated reserve financing activity that resulted in a corresponding increase in interest expense, as discussed below. Also contributing to the increase was higher policy charges and fee income driven by business growth and equity market appreciation.
The following table sets forth Individual Life’s annualized new business premiums, as defined under “-Results of Operations-Segment Measures” above, by distribution channel and product, for the periods indicated.
The results of our International Businesses’ operations are translated on the basis of weighted average monthly exchange rates, inclusive of the effects of the intercompany arrangement discussed in “-Results of Operations-Impact of Foreign Currency Exchange Rates” above. To provide a better understanding of operating performance within International Businesses, where indicated below, we have analyzed our results of operations excluding the effect of the year over year change in foreign currency exchange rates. Our results of operations, excluding the effect of foreign currency fluctuations, were derived by translating foreign currencies to USD at uniform exchange rates for all periods presented, including for constant dollar information discussed below. The exchange rates used were Japanese yen at a rate of 105 yen per USD and Korean won at a rate of 1,110 won per USD, both of which were determined in connection with the foreign currency income hedging program discussed in “-Results of Operations-Impact of Foreign Currency Exchange Rates” above. In addition, for constant dollar information discussed below, activity denominated in USD is generally reported based on the amounts as transacted in USD. Annualized new business premiums presented on a constant exchange rate basis in the “Sales Results” section below reflect translation based on these same uniform exchange rates.
The following table sets forth International Businesses’ operating results for the periods indicated.
Represents the immediate impacts in current period results from changes in current market conditions on estimates of profitability, which are excluded from adjusted operating income beginning with the second quarter of 2019. The Company had historically recognized these impacts in adjusted operating income. See Note 22 to the Consolidated Financial Statements for additional information.
Adjusted operating income from our Gibraltar Life and Other operations increased $3 million including a net favorable impact of $14 million from currency fluctuations, inclusive of the currency hedging program discussed above. Both periods also include the impact of our annual reviews and update of assumptions and other refinements, which resulted in a $7 million net benefit in 2019 compared to a $32 million net charge in 2018. The net benefit in 2019 reflected a net positive impact primarily related to updates to lapse assumptions. The net charge in 2018 was primarily driven by the impact from unfavorable economic assumption updates driven by a lower long-term interest rate assumption in Japan, as well as other refinements.
Benefits and expenses from our Life Planner operations increased $598 million including a net favorable impact of $117 million from currency fluctuations and a net benefit of $66 million from our annual review and update of assumptions and other refinements. Excluding these items, benefits and expenses increased $781 million, primarily reflecting higher policyholders’ benefits, including changes in reserves, driven by business growth, and higher expenses driven by updates to legal reserves, as well as higher costs including those related to business growth and business initiatives.
Revenues from our Gibraltar Life and Other operations increased $273 million, including a net favorable impact of $30 million from currency fluctuations. Excluding this item, revenues increased $243 million, primarily reflecting higher net investment results driven by higher income on non-coupon investments and higher prepayment fee income, and higher other income driven by a favorable impact from our joint venture investments.
2019 to 2018 Comparison. The number of Life Planners increased by 449, driven by an increase of 173 in Japan as a result of recruiting efforts and fewer terminations. Life Planners increased by 276 in other operations, primarily due to increases in Brazil and Korea as a result of recruiting efforts. The number of Gibraltar Life Consultants decreased by 561, primarily reflecting more selective recruiting efforts and retention standards.
In 2020, pension and other postretirement benefit service costs related to active employees will continue to be allocated to our business segments. For further information regarding our pension and postretirement plans, see Note 18 to the Consolidated Financial Statements.
Each year, the Board of Directors of The Prudential Insurance Company of America (“PICA”) determines the dividends payable on participating policies for the following year based on the experience of the Closed Block, including investment income, net realized and unrealized investment gains (losses), mortality experience and other factors. Although Closed Block experience for dividend action decisions is based upon statutory results, at the time the Closed Block was established, we developed, as required by U.S. GAAP, an actuarial calculation of the timing of the maximum future earnings from the policies included in the Closed Block. If actual cumulative earnings in any given period are greater than the cumulative earnings we expected, we 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 we originally expected. The policyholder dividends we charge to expense within the Closed Block division will include any change in our policyholder dividend obligation that we recognize for the excess of actual cumulative earnings in any given period over the cumulative earnings we expected in addition to the actual policyholder dividends declared by the Board of Directors of PICA.
As of December 31, 2019, the excess of actual cumulative earnings over the expected cumulative earnings was $2,816 million, which was recorded as a policyholder dividend obligation. Actual cumulative earnings, as required by U.S. GAAP, reflect the recognition of realized investment gains and losses in the current period, as well as changes in assets and related liabilities that support the Closed Block policies. Additionally, the accumulation of net unrealized investment gains that have arisen subsequent to the establishment of the Closed Block has been reflected as a policyholder dividend obligation of $3,332 million at December 31, 2019, to be paid to Closed Block policyholders unless offset by future experience, with a corresponding amount reported in AOCI.
2019 to 2018 Annual Comparison. Income (loss) before income taxes and equity in earnings of operating joint ventures increased $98 million. Results for 2019 primarily reflected an increase in net realized investment gains and related activity primarily driven by gains from sales of fixed maturities and favorable changes in the value of equity securities. Net investment income increased primarily due to higher income on non-coupon investments and higher prepayment fee income, partially offset by lower income on fixed income investments. Net insurance activity results increased primarily as a result of a decrease in the 2020 dividend scale, partially offset by a decrease in premiums as a result of runoff of policies in force and higher benefit payments. As a result of the above and other variances, a $564 million increase in the policyholder dividend obligation was recorded in 2019, compared to a $508 million reduction in 2018. If actual cumulative earnings fall below expected cumulative earnings in future periods, earnings volatility in the Closed Block division, which is primarily due to changes in investment results, may not be offset by changes in the cumulative earnings policyholder dividend obligation. For a discussion of the Closed Block division’s realized investment gains (losses), net, see “-General Account Investments.”
2019 to 2018 Annual Comparison. Revenues increased $964 million primarily driven by an increase in net realized investment gains and related activity, and net investment income, as discussed above.
Benefits and expenses increased $866 million, primarily driven by an increase in dividends to policyholders, reflecting an increase in the policyholder dividend obligation expense due to changes in cumulative earnings, as discussed above.
The effective tax rate is the ratio of “Total income tax expense (benefit)” divided by “Income before income taxes and equity in earnings of operating joint ventures.” Our effective tax rate for fiscal years 2019, 2018 and 2017 was 18.6%, 17.0%, and (22.2)%, respectively. For a detailed description of the nature of each significant reconciling item, see Note 16 to the Consolidated Financial Statements. The increase in the effective tax rate from (22.2)% in 2017 to 17.0% in 2018, and to 18.6% in 2019 was primarily driven by the impacts of the Tax Act of 2017 in 2017 and 2018.
The Company’s liability for income taxes includes the liability for unrecognized tax benefits and interest that relate to tax years still subject to review by the Internal Revenue Service or other taxing authorities. The completion of review or the expiration of the Federal statute of limitations for a given audit period could result in an adjustment to the liability for income taxes. The total unrecognized benefit as of December 31, 2019, 2018 and 2017 was $18 million, $20 million and $45 million, respectively. We do not anticipate any significant changes within the next twelve months to our total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.
Our Retirement segment has two types of experience-rated products that are supported by assets supporting experience-rated contractholder liabilities and other related investments. Fully participating products are those for which the entire return on underlying investments is passed back to the policyholders through a corresponding adjustment to the related liability, primarily classified in the Consolidated Statements of Financial Position as “Policyholders’ account balances.” The adjustment to the liability is based on changes in the fair value of all of the related assets, including commercial mortgage and other loans, which are carried at amortized cost, less any valuation allowance. Partially participating products are those for which only a portion of the return on underlying investments is passed back to the policyholders over time through changes to the contractual crediting rates. The crediting rates are typically reset semiannually, often subject to a minimum crediting rate, and returns are required to be passed back within ten years.
In our International Businesses, the experience-rated products are fully participating. As a result, the entire return on the underlying investments is passed back to policyholders through a corresponding adjustment to the related liability.
Prior period amounts have been reclassified to conform to current period presentation.
The table below presents the balances of assets and liabilities measured at fair value on a recurring basis, as of the periods indicated, and the portion of such assets and liabilities that are classified in Level 3 of the valuation hierarchy. The table also provides details about these assets and liabilities excluding those held in the Closed Block division. We believe the amounts excluding the Closed Block division are most relevant to an understanding of our operations that are pertinent to investors in Prudential Financial because substantially all Closed Block division assets support obligations and liabilities relating to the Closed Block policies only. See Note 15 to the Consolidated Financial Statements for further information on the Closed Block.
The determination of fair value, which for certain assets and liabilities is dependent on the application of estimates and assumptions, can have a significant impact on our results of operations and may require the application of a greater degree of judgment depending on market conditions, as the ability to value assets and liabilities can be significantly impacted by a decrease in market activity or a lack of transactions executed in an orderly manner.
those assets classified as “Separate account assets” on our balance sheet.
The general account portfolios are managed pursuant to the distinct objectives and investment policy statements of PFI excluding the Closed Block division and of the Closed Block division. The primary investment objectives of PFI excluding the Closed Block division include:
The following tables set forth the composition of our general account investment portfolio apportioned between PFI excluding the Closed Block division and the Closed Block division, as of the dates indicated:
The increase in general account investments attributable to PFI excluding the Closed Block division in 2019 was primarily due to market appreciation from a decrease in U.S. and Japan interest rates and tighter credit spreads, the reinvestment of net investment income and net business inflows. For information regarding the methodology used in determining the fair value of our fixed maturities, see Note 6 to the Consolidated Financial Statements.
As of December 31, 2019 and 2018, 42% and 43%, respectively, of our general account investments attributable to PFI excluding the Closed Block division related to our Japanese insurance operations. The following table sets forth the composition of the investments of our Japanese insurance operations’ general account, as of the dates indicated:
The increase in general account investments related to our Japanese insurance operations in 2019 was primarily attributable to market appreciation from a decrease in U.S. and Japan interest rates and tighter credit spreads, the reinvestment of net investment income and net business inflows.
As of December 31, 2019, our Japanese insurance operations had $77.1 billion, at carrying value, of investments denominated in U.S. dollars, including $2.1 billion that were hedged to yen through third-party derivative contracts and $62.4 billion that support liabilities denominated in U.S. dollars, with the remainder hedging our foreign currency exchange rate exposure on U.S. dollar-equivalent equity. As of December 31, 2018, our Japanese insurance operations had $64.9 billion, at carrying value, of investments denominated in U.S. dollars, including $2.5 billion that were hedged to yen through third-party derivative contracts and $50.0 billion that support liabilities denominated in U.S. dollars, with the remainder hedging our foreign currency exchange rate exposure on U.S. dollar-equivalent equity. The $12.2 billion increase in the carrying value of U.S. dollar-denominated investments from December 31, 2018 was primarily attributable to the impact of the decrease in the U.S. treasury bond rates and credit rate spreads, portfolio growth as a result of net business inflows and the reinvestment of net investment income.
under U.S. GAAP and as such do not include certain interest-related items, such as settlements of duration management swaps which are included in “Realized investment gains (losses), net.”
Other invested assets consist of investments in LPs/LLCs, investment real estate held through direct ownership, derivative instruments, fixed maturities classified as trading and other miscellaneous investments.
The total yield was 3.81%, 3.77% and 3.68% for the years ended December 31, 2019, 2018 and 2017, respectively.
The decrease in investment income after investment expenses yield attributable to the Japanese insurance operations’ portfolio for 2019 compared to 2018 was primarily the result of lower reinvestment rates.
The following table sets forth “Realized investment gains (losses), net” of our general account apportioned between PFI excluding Closed Block division and the Closed Block division by investment type as well as related charges and adjustments, for the periods indicated:
Represents circumstances where we believe credit events or other adverse conditions of the respective issuers have caused or will lead to a deficiency in the contractual cash flows related to the investment. The amount of the impairment recorded in earnings is the difference between the amortized cost of the debt security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment.
Excludes the portion of OTTI recorded in OCI, representing any difference between the fair value of the impaired debt security and the net present value of its projected future cash flows at the time of impairment.
Net gains on sales and maturities of fixed maturity securities were $867 million and $504 million for the years ended December 31, 2019 and 2018, respectively, primarily driven by the impact of foreign currency exchange rate movements of U.S. and Australian dollar-denominated securities that matured or were sold within our International Businesses segment.
$2,677 million of losses on product-related embedded derivatives and related hedge positions associated with certain variable annuity contracts; and
$1,070 million of losses on capital hedges due to increases in equity indices.
$378 million of gains on foreign currency hedges due to U.S. dollar appreciation versus the euro;
$124 million of gains on credit default swaps primarily due to spreads tightening.
Related adjustments include the portions of “Realized investment gains (losses), net” that are included in adjusted operating income and the portions of “Other income (loss)” and “Net investment income” that are excluded from adjusted operating income. These adjustments are made to arrive at “Realized investment gains (losses), net, and related adjustments” which are excluded from adjusted operating income. Results for the years ended December 31, 2019 and 2018 reflected related adjustments of net positive of $216 million and net negative $1,381 million, respectively. Both periods’ results reflected settlements and changes in values related to interest rate and currency derivatives, as well as changes in fair value of equity securities recorded in “Other income (loss).”
The level of OTTI generally reflects economic conditions and is expected to increase when economic conditions worsen and to decrease when economic conditions improve. Historically, the causes of OTTI have been specific to each individual issuer and have not directly resulted in impairments to other securities within the same industry or geographic region. We may also realize additional credit and interest rate-related losses through sales of investments pursuant to our credit risk and portfolio management objectives.
We maintain separate monitoring processes for public and private fixed maturities and create watch lists to highlight securities that require special scrutiny and management. For private placements, our credit and portfolio management processes help ensure prudent controls over valuation and management. 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. Our public and private fixed maturity investment managers formally review all public and private fixed maturity holdings on a quarterly basis and more frequently when necessary to identify potential credit deterioration whether due to ratings downgrades, unexpected price variances and/or company or industry-specific concerns.
As of December 31, 2019 and 2018, based on amortized cost, 77% and 76%, respectively, represent Japanese government bonds held by our Japanese insurance operations with no other individual country representing more than 11% of the balance.
As of both December 31, 2019 and 2018, based on amortized cost, more than 99% were rated A or higher.
Excluded from the table above are securities held outside the general account in other entities and operations. For additional information regarding investments held outside the general account, see “-Invested Assets of Other Entities and Operations” below.
The increase in net unrealized gains from December 31, 2018 to December 31, 2019 was primarily due to a decrease in U.S. and Japan interest rates and credit spread tightening.
The following table sets forth our fixed maturity portfolio by NAIC Designation or equivalent rating attributable to PFI excluding the Closed Block division, as of the dates indicated:
Includes, as of December 31, 2019 and 2018, 796 securities with amortized cost of $3,073 million (fair value, $3,130 million) and 1,744 securities with amortized cost of $9,079 million (fair value, $9,135 million), respectively, that have been categorized based on expected NAIC Designations pending receipt of SVO ratings.
On an amortized cost basis, as of December 31, 2019, securities considered below investment grade based on lowest of external rating agency ratings total $17,527 million, or approximately 6% of the total fixed maturities, and include securities considered high or highest quality by the NAIC based on the rules described above.
Includes collateralized loan obligations (“CLOs”), credit-tranched securities collateralized by auto loans, education loans, credit cards and other asset types.
Included in “Asset-backed securities” above are investments in CLOs. The following table sets forth information pertaining to these investments in CLOs within our fixed maturity available-for-sale portfolio attributable to PFI excluding the Closed Block division, as of the dates indicated:
We originate commercial mortgage and agricultural property loans using a dedicated sales and underwriting staff through our various regional offices in the U.S. and international offices primarily in London and Tokyo. All loans are underwritten consistently to our standards using a proprietary quality rating system that has been developed from our industry experience in real estate and mortgage lending.
As of December 31, 2019, our commercial mortgage and agricultural property loans attributable to PFI excluding the Closed Block division had a weighted-average debt service coverage ratio of 2.46 times and a weighted-average loan-to-value ratio of 56%. As of December 31, 2019, 95% of commercial mortgage and agricultural property loans were fixed rate loans. For those commercial mortgage and agricultural property loans that were originated in 2019, the weighted-average debt service coverage ratio was 2.68 times, and the weighted-average loan-to-value ratio was 63%.
The values utilized in calculating these loan-to-value ratios are developed as part of our periodic review of the commercial mortgage and agricultural property loan portfolio, which includes an internal evaluation of the underlying collateral value. Our periodic review also includes a quality re-rating process, whereby we update the internal quality rating originally assigned at underwriting based on the proprietary quality rating system mentioned above. As discussed below, the internal quality rating is a key input in determining our allowance for credit losses.
For loans with collateral under construction, renovation or lease-up, a stabilized value and projected net operating income are used in the calculation of the loan-to-value and debt service coverage ratios. Our commercial mortgage and agricultural property loan portfolio included $1.8 billion and approximately $0.7 billion of such loans as of December 31, 2019 and 2018, respectively. All else being equal, these loans are inherently riskier than those collateralized by properties that have already stabilized. As of December 31, 2019, there were no loan-specific reserves related to these loans. In addition, these unstabilized loans are included in the calculation of our portfolio reserve, as discussed below.
The commercial mortgage and other loans portfolio is monitored on an ongoing basis. If certain criteria are met, loans are assigned to either of the following “watch list” categories:
(1) “Closely Monitored,” which includes a variety of considerations, such as when loan metrics fall below acceptable levels, the borrower is not cooperative or has requested a material modification, or the portfolio manager has directed a change in category; or
We establish an allowance for credit losses to provide for the risk of credit losses inherent in the lending process. The allowance includes loan-specific reserves for loans that are determined to be impaired as a result of our loan review process and a portfolio reserve for probable incurred but not specifically identified losses for loans which are not on the watch list. We define an impaired loan as a loan for which we estimate it is probable that amounts due according to the contractual terms of the loan agreement will not be collected. The loan-specific portion of the allowance for credit losses is based on our assessment as to ultimate collectability of loan principal and interest. An allowance for credit losses for an impaired loan is recorded based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or based on the fair value of the collateral if the loan is collateral dependent. The portfolio reserve for incurred but not specifically identified losses considers the current credit composition of the portfolio based on the internal quality ratings mentioned above. The portfolio reserves are determined using past loan experience, including historical credit migration, loss probability and loss severity factors by property type. These factors are reviewed and updated as appropriate. The allowance for credit losses for commercial mortgage and other loans can increase or decrease from period to period based on these factors.
Amounts presented exclude investments in private equity and hedge funds and other investments which are reported in “Other invested assets.”
The net change in unrealized gains (losses) from equity securities attributable to PFI excluding Closed Block division still held at period end, recorded within “Other income (loss),” was $586 million and $(569) million during the year ended December 31, 2019 and 2018, respectively.
Primarily includes leveraged leases and member and activity stock held in the Federal Home Loan Banks of New York and Boston. For additional information regarding our holdings in the Federal Home Loan Banks of New York and Boston, see Note 17 to the Consolidated Financial Statements.
During 2019, we took the following significant actions that impacted our liquidity and capital position:
We repurchased $2.5 billion of shares of Prudential Financial’s Common Stock in accordance with our 2019 share repurchase authorization and declared aggregate Common Stock dividends of $1.6 billion;
In October 2019, we completed the acquisition of Assurance IQ. See Note 1 to the Consolidated Financial Statements for additional information about the acquisition, including the purchase consideration;
On September 30, 2019, we entered into a ¥100 billion five-year credit facility with a syndicate of lenders, with terms similar to the prior three-year syndicated credit facility expiring on that date. There were no borrowings under the facility as of December 31, 2019;
The primary components of the Company’s capitalization consist of equity and outstanding capital debt, including junior subordinated debt. As shown in the table below, as of December 31, 2019, the Company had $53.7 billion in capital, all of which was available to support the aggregate capital requirements of its businesses and its Corporate and Other operations. Based on our assessment of these businesses and operations, we believe this level of capital is consistent with our ratings targets.
We manage PICA, The Prudential Life Insurance Company, Ltd. (“Prudential of Japan”), Gibraltar Life, and other significant insurance subsidiaries to regulatory capital levels consistent with our “AA” ratings targets. We utilize the RBC ratio as a primary
The table below presents the RBC ratios of our most significant domestic insurance subsidiaries as of December 31, 2018, the most recent statutory fiscal year-end for these subsidiaries for which RBC information has been filed.
Although not yet filed, we expect our RBC ratios as of December 31, 2019 to be above our “AA” financial strength target levels.
Although not yet filed, we expect the solvency margin ratio for each of these subsidiaries to be greater than 700% (3.5 times the regulatory required minimums) as of December 31, 2019.
We manage our capital consistent with our RAF to determine the amount of capital the Company needs to hold given its risk profile. The RAF is designed to ensure that all risks taken across the Company align with our capacity and willingness to take those risks. It allows for a cohesive assessment of risk and available resources and supports management’s decision-making. The RAF is supported by our comprehensive stress testing framework to provide a dynamic assessment of stress impacts and the resources available to absorb those impacts under stress scenarios. It incorporates the objectives of what we previously referred to as our Capital Protection Framework.
In December 2018, our Board of Directors (the “Board”) authorized the Company to repurchase at management’s discretion up to $2.0 billion of its outstanding Common Stock during the period from January 1, 2019 through December 31, 2019. In September 2019, the Board authorized a $500 million increase to the authorization for calendar year 2019. As a result, the Company’s aggregate share repurchase authorization for calendar year 2019 was $2.5 billion. In December 2019, the Board authorized the Company to repurchase at management’s discretion up to $2.0 billion of its outstanding Common Stock during the period from January 1, 2020 through December 31, 2020.
We seek to mitigate the risk of having limited or no access to financing due to stressed market conditions by generally pre-funding debt in advance of maturity. We mitigate the refinancing risk associated with our debt that is used to fund operating needs by matching the term of debt with the assets financed. To ensure adequate liquidity in stress scenarios, stress testing is performed for our major operating subsidiaries. We seek to further mitigate liquidity risk by maintaining our access to alternative sources of liquidity, as discussed below.
The primary uses of funds at Prudential Financial include servicing debt, making capital contributions and loans to subsidiaries, making acquisitions, paying declared shareholder dividends and repurchasing outstanding shares of Common Stock executed under authority from the Board.
As of December 31, 2019, Prudential Financial had highly liquid assets with a carrying value totaling $5,104 million, a decrease of $1,095 million from December 31, 2018. Highly liquid assets predominantly include cash, short-term investments, U.S. Treasury securities, obligations of other U.S. government authorities and agencies, and/or foreign government bonds. We maintain an intercompany liquidity account that is designed to optimize the use of cash by facilitating the lending and borrowing of funds between Prudential Financial and its subsidiaries on a daily basis. Excluding net borrowings from this intercompany liquidity account, Prudential Financial had highly liquid assets of $4,061 million as of December 31, 2019, a decrease of $1,487 million from December 31, 2018.
See “Item 15 - Schedule II-Notes to Condensed Financial Information of Registrant-Dividends and Returns of Capital” for dividends and returns of capital by subsidiary.
Affiliated loans/(borrowings) - (capital activities) represent the investment and deployment of capital to and from our businesses in the form of loans. 2019 includes net receipts of $818 million from international insurance subsidiaries. 2018 includes lending of $623 million to international subsidiaries.
Includes $1,758 million of purchase consideration and $73 million related to compensation expense which is recognized over the requisite service periods. See Note 1 to the Consolidated Financial Statements for additional information.
International insurance subsidiaries. During 2019, Prudential Financial received dividends of $1,065 million from its international insurance subsidiaries. In addition to paying Common Stock dividends, our international insurance operations may return capital to Prudential Financial through or facilitated by other means, such as the repayment of preferred stock obligations held by Prudential Financial or other affiliates, affiliated lending, affiliated derivatives and reinsurance with U.S.- and Bermuda-based affiliates. In 2019, our Japan insurance operations entered into reinsurance agreements with Gibraltar Re, our Bermuda-based reinsurance affiliate, to reinsure the mortality and morbidity risk associated with a portion of the in-force contracts as well as newly-issued contracts for certain products. We expect these transactions will allow us to more efficiently manage our capital and risk profile.
Gross account withdrawals for our domestic insurance operations’ products in 2019 were generally consistent with our assumptions in asset/liability management, and the associated cash outflows did not have a material adverse impact on our overall liquidity.
The following table sets forth the fair value of our international insurance operations’ portfolio of liquid assets, as of the dates indicated.
As of December 31, 2019, $122.2 billion, or 78%, were invested in government or government agency bonds.
Income Hedges-We hedge a portion of our prospective yen-based earnings streams by entering into external forward currency derivative contracts that effectively fix the currency exchange rates for that portion of earnings, thereby reducing volatility from foreign currency exchange rate movements. As of December 31, 2019, we have hedged 100%, 72% and 28% of expected yen-based earnings for 2020, 2021 and 2022, respectively.
Includes non-yen related cash settlements of $41 million, primarily denominated in Australian dollar, Korean won, and Brazilian real and $(11) million, primarily denominated in Korean won, for the year ended December 31, 2019 and 2018, respectively.
Includes Korean won related cash settlements of $17 million and $2 million for the year ended December 31, 2019 and 2018, respectively.
Includes Korean won related assets of $1 million and liabilities of $(2) million as of December 31, 2019 and 2018, respectively.
As of December 31, 2019, approximately $331 million, $332 million and $(115) million of the net market values are scheduled to settle in 2020, 2021 and thereafter, respectively. The net market value of the assets (liabilities) will vary with changing market conditions to the extent there are no corresponding offsetting positions.
The principal sources of liquidity for our fee-based PGIM businesses include asset management fees and commercial mortgage origination and servicing fees. The principal uses of liquidity include general and administrative expenses, facilitating our commercial mortgage loan business, and distributions of dividends and returns of capital to Prudential Financial. The primary liquidity risks for our fee-based PGIM businesses relate to their profitability, which is impacted by market conditions and our investment management performance. We believe the cash flows from our fee-based PGIM businesses are adequate to satisfy the current liquidity requirements of these operations, as well as requirements that could arise under reasonably foreseeable stress scenarios, which are monitored through the use of internal measures.
include the inability to sell assets in a timely manner, declines in the value of assets and credit defaults. There have been no material changes to the liquidity position of our PGIM operations since December 31, 2019.
In addition to asset-based financing as discussed below, Prudential Financial and certain subsidiaries have access to other sources of liquidity, including syndicated, unsecured committed credit facilities, membership in the Federal Home Loan Banks, commercial paper programs, and a put option agreement. See Note 17 to the Consolidated Financial Statements for more information on these sources of liquidity.
The daily weighted average outstanding balance for the year ended December 31, 2019 and 2018 was $10,524 million and $9,653 million, respectively, for PFI excluding the Closed Block division, and $4,152 million and $4,343 million, respectively, for the Closed Block division.
Excludes securities that may be returned to the Company overnight. “N/A” reflects that all outstanding balances may be returned to the Company overnight.
As of December 31, 2019, our domestic insurance entities had assets eligible for the asset-based or secured financing programs of $123.0 billion, of which $13.9 billion were on loan. Taking into account market conditions and outstanding loan balances as of December 31, 2019, we believe approximately $17.4 billion of the remaining eligible assets are readily lendable, including approximately $12.4 billion relating to PFI excluding the Closed Block division, of which $4.0 billion relates to certain separate accounts and may only be used for financing activities related to those accounts, and the remaining $4.9 billion relating to the Closed Block division.
Amounts are net of assets under set-off arrangements of $9,749 million and $9,095 million as of December 31, 2019 and 2018, respectively.
As of December 31, 2019 and 2018, we were in compliance with all debt covenants related to the borrowings in the table above. For further information on our short- and long-term debt obligations, see Note 17 to the Consolidated Financial Statements.
Based on the use of proceeds, we classify our borrowings as capital debt and operating debt. Capital debt, which is debt utilized to meet the capital requirements of our businesses, was $14.6 billion and $13.4 billion as of December 31, 2019 and 2018, respectively. Operating debt of $5.2 billion and $5.7 billion as of December 31, 2019 and 2018, respectively, consists of debt issued to finance specific investment assets or portfolios of investment assets, the proceeds from which will service the debt. Specifically, this includes institutional spread lending investment portfolios, assets supporting reserve requirements under Regulation XXX and Guideline AXXX as described below, as well as funding for institutional and insurance company portfolio cash flow timing differences. Operating debt is also utilized for business funding to meet specific purposes, which may include funding new business acquisition costs associated with our individual annuities business, operating needs associated with hedging our individual annuities products as discussed above and activities associated with our PGIM business.
million in debt maturities, a $239 million decrease in mortgage debt, and a $203 million decrease in commercial paper outstanding, primarily offset by a $300 million draw on a credit facility and a $13 million increase in short-term debt.
We have entered into agreements with external counterparties providing for the issuance of surplus notes by our captive reinsurers in return for the receipt of credit-linked notes (“Credit-Linked Note Structures”). As of December 31, 2019, we had Credit-Linked Note Structures with an aggregate issuance capacity of $13,700 million, of which $12,009 million was outstanding, as compared to an aggregate issuance capacity of $13,750 million, of which $11,445 million was outstanding, as of December 31, 2018. Under the agreements, the captive receives in exchange for the surplus notes one or more credit-linked notes issued by a special-purpose affiliate of the Company with an aggregate principal amount equal to the surplus notes outstanding. The captive holds the credit-linked notes as assets supporting Regulation XXX or Guideline AXXX non-economic reserves, as applicable. The captive can redeem the principal amount of the outstanding credit-linked notes for cash upon the occurrence of, and in an amount necessary to remedy, a specified liquidity stress event affecting the captive. Under the agreements, the external counterparties have agreed to fund any such payments under the credit-linked notes in return for the receipt of fees. Under certain of the transactions, Prudential Financial has agreed to make capital contributions to the captive to reimburse it for investment losses in excess of specified amounts and/or has agreed to reimburse the external counterparties for any payments made under the credit-linked notes. To date, no such payments under the credit-linked notes have been required. Under these transactions, because valid rights of set-off exist, interest and principal payments on the surplus notes and on the credit-linked notes are settled on a net basis, and the surplus notes are reflected in the Company’s total consolidated borrowings on a net basis.
The following table summarizes our Credit-Linked Note Structures, which are reported on a net basis, as of December 31, 2019.
The $2.36 billion of surplus notes represents an intercompany transaction that eliminates upon consolidation. Prudential Financial has agreed to reimburse amounts paid under credit-linked notes issued in this structure up to $1.0 billion.
The Company has introduced updated versions of its products in phases over the course of the principle-based reserving implementation period and has transitioned all products by January 1, 2020. These updated products support the principle-based statutory reserve level without the need for captive reserve financing. The Company is continuing to assess the impact of this new reserving approach on projected statutory reserve levels and product pricing for its entire portfolio of individual life product offerings. Certain elements of the implementation of principle-based reserving are yet to be finalized by the NAIC and may have a material impact on statutory reserves.
Fitch Ratings Inc., which we refer to as Fitch, financial strength ratings range from “AAA (exceptionally strong)” to “C (distressed)”. A rating of AA- is the fourth highest of twenty-one rating categories. Fitch long-term credit ratings range from “AAA (highest credit quality)”, which denotes exceptionally strong capacity for timely payment of financial commitments, to “D (default)”. Short-term ratings range from “F1+ (highest credit quality)” to “D (default)”.
Rating agencies use an “outlook” statement for both industry sectors and individual companies. For an industry sector, a stable outlook generally implies that over the next 12 to 18 months the rating agency expects ratings to remain unchanged among companies in the sector. In 2019, Fitch revised the Rating Outlook on the U.S. life insurance industry from Stable to Negative. A.M. Best, Moody’s, and S&P maintained their outlook for the U.S. life insurance sector at Stable. For a particular company, an outlook generally indicates a medium- or long-term trend (generally six months to two years) in credit fundamentals, which if continued, may lead to a rating change. These indicators are not necessarily a precursor of a rating change nor do they preclude a rating agency from changing a rating at any time without notice. A.M. Best, Fitch, S&P and Moody’s have the Company’s ratings on Stable outlook.
On May 9, 2019, Moody’s Investors Service upgraded the financial strength rating of PICA, Pruco Life and PRIAC to ‘Aa3’ from ‘A1’with a Stable outlook. Moody’s also upgraded Prudential Financial’s long-term senior debt rating to ‘A3’ from ‘Baa1’ with a Stable outlook.
Requirements to post collateral or make other payments because of ratings downgrades under certain agreements, including derivative agreements, can be satisfied in cash or by posting permissible securities held by the subsidiaries subject to the agreements. In addition, a ratings downgrade by A.M. Best to “A-” for our domestic life insurance companies would require PICA to either post collateral or a letter of credit in the amount of approximately $1.3 billion, based on the level of statutory reserves related to the variable annuity business acquired from Allstate. We believe that the posting of such collateral would not be a material liquidity event for PICA.
As discussed in Note 23 to the Consolidated Financial Statements, we have commitments to purchase or fund investments, some of which are contingent upon events or circumstances not under our control, including those at the discretion of our counterparties. The timing of the fulfillment of certain of these commitments cannot be estimated, therefore the settlements of these obligations are reflected in estimated payments due in less than one year. Commitments to purchase or fund investments include $49 million that we anticipate will ultimately be funded from our separate accounts.
The estimated payments due by period for other liabilities includes securities sold under agreements to repurchase, cash collateral for loaned securities, liabilities for unrecognized tax benefits, bank customer liabilities, and other miscellaneous liabilities. Amounts presented in the table also exclude $1,274 million of notes issued by consolidated VIE’s which recourse for these obligations is limited to the assets of the respective VIE and do not have recourse to the general credit of the company.
We employ a risk governance structure, overseen by senior management and our Board and managed by Enterprise Risk Management (“ERM”), to provide a common framework for evaluating the risks embedded in and across our businesses and corporate centers, developing risk appetites, managing these risks and identifying current and future risk challenges and opportunities. For a discussion of the risks of our businesses, see “Risk Factors”.
Audit Committee: oversees insurance risk and operational risks, including model risk, as well as risks related to financial controls, legal, regulatory and compliance risks, and the overall risk management governance structure and risk management function.
Finance Committee: oversees liquidity risk, including risks involving our capital and liquidity management, the incurrence and repayment of borrowings, the capital structure, the funding of benefit plans and statutory insurance reserves. The Finance Committee oversees our capital plan and receives regular updates on the sources and uses of capital relative to plan, as well as on our RAF.
Our primary risk management committee is the Enterprise Risk Committee (“ERC”). Currently, the ERC is chaired by our Chief Risk Officer and otherwise comprised of the Vice Chairman, Head of U.S. Businesses, Head of International Businesses, General Counsel, Chief Financial Officer, Chief Investment Officer and Chief Actuary. Our Chief Auditor also attends meetings of the ERC. The ERC is charged with facilitating the Company’s ability to identify, assess, monitor and manage risk. The primary focus of the Committee is the critical analysis of significant risks and the appropriateness and alignment to the defined risk appetite of the Company.
The ERC is supported by six Risk Oversight Committees aligned with our tactical risks, each of which is comprised of subject matter experts and dedicated to one of the following risk types: investment, market, insurance, operational, model and liquidity. Significant matters or matters where there are unresolved points of view are reviewed by the ERC. The Risk Oversight Committees provide an opportunity to evaluate complex issues by subject matter experts within the various risk areas. They evaluate the adequacy and effectiveness of risk mitigation options, identify stakeholders of risks and issues, review material assumptions for reasonability and consistency across the Company and, working with the different risk areas, develop recommendations for risk limits, among other responsibilities.
Each of our businesses and certain corporate centers maintains its own risk committee. The risk committees serve as a forum for leaders within each business or corporate center to identify, assess and monitor risk and exposure issues and to review new business activities and initiatives, prior to being reviewed by the Risk Oversight Committees and/or the ERC as appropriate.
ERM manages the risk management framework. It operates independently and is responsible for recommending policies, limits and standards for all risks. ERM oversees these risks under the guidance of the ERC and Risk Oversight Committees. Additionally, ERM works with our businesses and corporate areas to identify, monitor and manage risks that we may face. The ERM infrastructure is generally aligned by risk type, with certain groups within ERM working across risk types.
Businesses: Each business area has a risk committee that meets periodically to allow senior leaders to discuss and evaluate current, new, and emerging risks in their own operations. Businesses are required to develop and maintain documented risk inventories which facilitate the identification of current risk exposures.
Our Risk Appetite Framework (“RAF”) is a comprehensive process designed to reasonably ensure that all risks taken across the Company align with the Company’s capacity and willingness to take those risks. Using common metrics allows for a cohesive assessment of risk, resources and strategy, and supports management and the Board in making well-informed business decisions. The Company has a comprehensive stress testing framework, which serves as the foundation for the RAF. The RAF evaluates the Company’s exposure under various stress metrics and stress severities. The RAF provides a dynamic assessment of stress impacts and resources available to absorb these impacts under comprehensive stress scenarios. The Company’s capital management framework is integrated with the RAF to determine the amount of capital the Company needs to hold given the risks taken.
Management of Prudential Financial, Inc. (together with its consolidated subsidiaries, the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. Management conducted an assessment of the effectiveness, as of December 31, 2019, of the Company’s internal control over financial reporting, based on the framework established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment under that framework, which excluded the controls for Assurance IQ discussed further below, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2019.
We have excluded Assurance IQ, acquired on October 10, 2019, from management’s assessment of internal control over financial reporting. Assurance IQ total assets and total revenues represented less than 1% of the related consolidated financial statement amounts as of and for the year ended December 31, 2019.
We have audited the accompanying consolidated statements of financial position of Prudential Financial, Inc. and its subsidiaries (the “Company”) as of December 31, 2019 and 2018, and the related consolidated statements of operations, comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2019, including the related notes and financial statement schedules listed in the index appearing under Item 15.2 (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
As described in Management’s Annual Report on Internal Control over Financial Reporting, management has excluded Assurance IQ, Inc. (“Assurance IQ”) from its assessment of internal control over financial reporting as of December 31, 2019, because it was acquired by the Company in a purchase business combination during 2019. We have also excluded Assurance IQ from our audit of internal control over financial reporting. Assurance IQ is a wholly-owned subsidiary whose total assets and total revenues excluded from management’s assessment and our audit of internal control over financial reporting represent less than 1% of the related consolidated financial statement amounts as of and for the year ended December 31, 2019.
As described in Notes 2, 6, 12 and 13 to the consolidated financial statements, the Company issues certain variable annuity contracts which contain guaranteed benefit features. Certain of the guarantees associated with these contracts are accounted for as embedded derivatives and recorded at fair value. As of December 31, 2019, the fair value of the obligations associated with these guarantees was $12.8 billion. As there is no observable active market for the transfer of these obligations, the valuations are calculated by management using internally-developed models with option pricing techniques. The models are based on a risk neutral valuation framework and incorporate premiums for risks inherent in valuation techniques, inputs, and the general uncertainty around the timing and amount of future cash flows. The significant inputs to the valuation models for these embedded derivatives include capital market assumptions, such as interest rate levels and volatility assumptions, the risk of the Company’s non-performance under the contract, as well as actuarially determined assumptions, including mortality rates, lapse rates, benefit utilization rates and withdrawal rates. Additional policyholder liabilities are also established for certain life insurance and annuity products that include certain contract features, including guaranteed minimum death benefits (GMDB) and no-lapse guarantees. The liability for no-lapse guarantee features is grouped with GMDB features in Note 13. For these contract features, a liability is established when associated assessments are recognized. As of December 31, 2019, the additional liability for these contract features included in the liability for future policy benefits was $8.4 billion. This liability is established using current best estimate assumptions, including lapse, withdrawal, mortality, and premium pattern rates, as well as interest rate and equity market return assumptions, and is based on the ratio of the present value of total expected excess payments (e.g., payments in excess of account value) over the life of the contract divided by the present value of total expected assessments (i.e., benefit ratio). The liability equals the current benefit ratio multiplied by cumulative assessments recognized to date, plus interest, less cumulative excess payments to date.
The principal considerations for our determination that performing procedures relating to the valuation of guaranteed benefit features associated with certain life and annuity products included in the liability for future policy benefits is a critical audit matter are there was significant judgment by management to determine i) the valuation model for the benefit features accounted for as embedded derivatives given the lack of an observable market for these guarantees and ii) the aforementioned assumptions for the benefit features described above. This in turn led to a high degree of auditor judgment, subjectivity and effort in performing procedures and evaluating the audit evidence relating to the model for embedded derivatives recorded at fair value and the aforementioned assumptions used in the valuation of the liabilities for all guaranteed benefit features described above. Also, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing procedures and evaluating the audit evidence obtained.
As described in Notes 2, 7 and 13 to the consolidated financial statements, as of December 31, 2019, a significant portion of the $19.9 billion deferred policy acquisition costs (DAC) are associated with certain universal and variable life products and fixed and variable deferred annuity products, and a significant portion of the $935 million deferred sales inducements (DSI) are associated with certain fixed and variable deferred annuity products. Acquisition costs that relate directly to the successful acquisition of new and renewal insurance and annuity business are deferred to the extent such costs are deemed recoverable from future profits. DAC related to universal and variable life products and fixed and variable deferred annuity products is generally amortized over the expected life of the policies in proportion to gross profits arising principally from investment margins, mortality and expense margins, and surrender charges. These margins are updated periodically based on historical and anticipated future experience. The Company also offers various types of sales inducements to policyholders related to fixed and variable deferred annuity contracts. Sales inducements are amortized over the expected life of the policies using the same methodology and assumptions used to amortize DAC. DAC and DSI balances are regularly adjusted with a corresponding charge or credit to current period earnings for the impact of actual gross profits and changes in management’s projections of estimated future gross profits. DAC and DSI are subject to periodic recoverability testing.
As described in Note 12 to the consolidated financial statements, as of December 31, 2019, a portion of the liability for future policy benefits is associated with benefits that will become payable on long-term care policies. This liability is determined by management using the net premium valuation methodology and, is accrued when premium revenue is recognized. The liability, which represents the present value of future benefits to be paid to or on behalf of policyholders and related expenses less the present value of future net premiums, is estimated using assumptions applicable at the time the insurance contracts are written, with provisions for the risk of adverse deviation, as appropriate. The original assumptions continue to be used in subsequent accounting periods unless a premium deficiency exists. Premium deficiency reserves are established by management, if necessary,
when the liability for future policy benefits plus the present value of expected future gross premiums are determined to be insufficient to provide for expected future policy benefits and expenses. Most contracts have recorded a premium deficiency reserve, for which assumptions as of the most recent premium deficiency reserve establishment are used. The primary assumptions used in establishing these reserves include interest rate, morbidity, mortality, lapse, premium rate increase and maintenance expenses.
As described in Note 1 to the consolidated financial statements, on October 10, 2019, the Company completed the acquisition of Assurance IQ for $2.2 billion paid at closing, plus the fair value of additional contingent payments of up to $1.2 billion payable in 2023 upon the achievement of certain financial targets. A portion of the contingent payments will be accounted for as compensation expense.
Years Ended December 31, 2019, 2018 and 2017 (in millions, except per share amounts)
(1)Includes the impact from the adoption of ASU 2017-08 and 2017-12. See Note 2.
The total purchase consideration included $2,212 million paid at closing, and $100 million of contingent consideration (see “Contingent Consideration Liability” below). The amount paid at closing was comprised of $1,758 million in cash and $454 million in shares of restricted Prudential Financial Common Stock and other equity awards. In addition to the purchase consideration, the Company also granted approximately$160 million of cash and equity awards to Assurance IQ employees which are recognized
If Variable Profits are greater than $1,300 million, an additional amount of $1,150 million is payable.
If Variable Profits are greater than $900 million but less than or equal to $1,300 million, an additional amount is payable equal to the product of (i) the quotient of (A) an amount equal to (1) Variable Profits achieved minus (2) $900 million divided by (B) $400 million and (ii) $1,150 million.
Fixed maturities, trading, at fair value consists of fixed maturities with embedded features and assets contained within consolidated variable interest entities. Realized and unrealized gains and losses on these investments are reported in “Other income (loss),” and interest and dividend income from these investments is reported in “Net investment income.”
Effective January 1, 2018, the Company adopted ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Liabilities using a modified retrospective method. Adoption of this ASU impacted the Company’s accounting and presentation related to equity investments. The most significant impact is that the changes in fair value of equity securities previously classified as “available-for-sale” are reported in net income within “Other income (loss)” in the Consolidated Statements of Operations. Prior to this, the changes in fair value on equity securities classified as “available-for-sale” were reported in AOCI. The impact of this standard resulted in an increase to retained earnings of $904 million, a reduction to AOCI of $847 million, and an increase to equity of $57 million upon adoption on January 1, 2018.
Realized investment gains (losses) are computed using the specific identification method with the exception of some of the Company’s International Businesses portfolios, where the average cost method is used. Realized investment gains and losses are generated from numerous sources, including the sales of fixed maturity securities, investments in joint ventures and limited partnerships and other types of investments, as well as adjustments to the cost basis of investments for net OTTI recognized in earnings. Realized investment gains and losses also reflect changes in the allowance for losses on commercial mortgage and other loans, fair value changes on commercial mortgage loans carried at fair value, and fair value changes on embedded derivatives and free-standing derivatives that do not qualify for hedge accounting treatment. See “Derivative Financial Instruments” below for additional information regarding the accounting for derivatives.
Cash and cash equivalents include cash on hand, amounts due from banks, certain money market investments, funds managed similar to regulated money market funds, other debt instruments with maturities of three months or less when purchased, other than cash equivalents that are included in “Assets supporting experience-rated contractholder liabilities, at fair value,” and receivables related to securities purchased under agreements to resell (see also “Securities sold under agreements to repurchase” below). These assets are generally carried at fair value or amortized cost which approximates fair value.
Deferred policy acquisition costs are costs directly related to the successful acquisition of new and renewal insurance and annuity business that have been deferred to the extent such costs are deemed recoverable from future profits. Such DAC primarily includes commissions, costs of policy issuance and underwriting, and certain other expenses that are directly related to successfully negotiated contracts. In each reporting period, capitalized DAC is amortized to “Amortization of DAC,” net of the accrual of imputed interest on DAC balances. DAC is subject to periodic recoverability testing. DAC, for applicable products, is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges included in AOCI.
For traditional participating life insurance which are included in the Closed Block, DAC is amortized over the expected life of the contracts in proportion to gross margins based on historical and anticipated future experience, which is evaluated regularly. The effect of changes in estimated gross margins on unamortized DAC is reflected in the period such estimated gross margins are revised on a retrospective basis. DAC related to non-participating traditional individual life insurance and longevity reinsurance contracts is amortized in proportion to gross premiums.
For some products, policyholders can elect to modify product benefits, features, rights or coverages by exchanging a contract for a new contract or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. These transactions are known as internal replacements. If policyholders surrender traditional life insurance policies in exchange for life insurance policies that do not have fixed and guaranteed terms, the Company immediately charges to expense the remaining unamortized DAC on the surrendered policies. For other internal replacement transactions, except those that involve the addition of a nonintegrated contract feature that does not change the existing base contract, the unamortized DAC is immediately charged to expense if the terms of the new policies are not substantially similar to those of the former policies. If the new terms are substantially similar to those of the earlier policies, the DAC is retained with respect to the new policies and amortized over the expected life of the new policies. See Note 7 for additional information regarding DAC.
Value of business acquired represents identifiable intangible assets to which a portion of the purchase price in a business acquisition is attributed under the application of purchase accounting. VOBA represents an adjustment to the stated value of in-force insurance contract liabilities to present them at fair value, determined as of the acquisition date. VOBA balances are subject to recoverability testing, in the manner in which they were acquired. The Company has established a VOBA asset primarily for its acquired life insurance products, accident and health products with fixed benefits, deferred annuity contracts, and defined contribution and defined benefit businesses. As of December 31, 2019, the majority of the VOBA balance relates to the 2011 acquisition of AIG Star Life Insurance Co., Ltd, AIG Edison Life Insurance Company, and AIG Financial Assurance Japan K.K. and AIG Edison Service Co., Ltd. (collectively, the “Star and Edison Businesses”.) The Company amortizes VOBA over the anticipated life of the acquired contracts using the same methodology and assumptions used to amortize DAC. The Company records amortization of VOBA in “General and administrative expenses.” VOBA, for applicable products, is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges included in AOCI. See Note 8 for additional information regarding VOBA.
The Company tests goodwill for impairment annually as of December 31 and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Accounting guidance provides for an optional qualitative assessment for testing goodwill impairment that may allow companies to skip the quantitative two-step test. The Company performed the qualitative assessment for Assurance IQ which was acquired in October 2019. All other reporting units elected the quantitative two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit’s fair value to its carrying value including goodwill. If the fair value of a reporting unit exceeds its carrying value, the applicable goodwill is considered not to be impaired. If the carrying value exceeds fair value, there is an indication of a potential impairment and the second step of the test is performed to measure the amount of impairment.
Policyholders’ account balances liability represents the contract value that has accrued to the benefit of the policyholder as of the balance sheet date. This liability is primarily associated with the accumulated account deposits, plus interest credited, less policyholder withdrawals and other charges assessed against the account balance, as applicable. These policyholders’ account balances also include provision for benefits under non-life contingent payout annuities and certain unearned revenues. See Note 12 for additional information regarding policyholders’ account balances.
Securities sold under agreements to repurchase represent liabilities associated with securities repurchase agreements which are used primarily to earn spread income. As part of securities repurchase agreements, the Company transfers U.S. government and government agency securities to a third-party, and receives cash as collateral. For securities repurchase agreements, the cash received is typically invested in cash equivalents, short-term investments or fixed maturities. Receivables associated with securities purchased under agreements to resell are generally reflected as cash equivalents (see also “Cash and cash equivalents” above). As part of securities resale agreements, the Company invests cash and receives as collateral U.S. government securities or other debt securities.
Cash collateral for loaned securities represent liabilities to return cash proceeds from security lending transactions. Securities lending transactions are used primarily to earn spread income. As part of securities lending transactions, the Company transfers U.S. and foreign debt and equity securities, as well as U.S. government and government agency securities, and receives cash as collateral. Cash proceeds from securities lending transactions are primarily used to earn spread income, and are typically invested in cash equivalents, short-term investments or fixed maturities. Securities lending transactions are treated as financing arrangements and are recorded at the amount of cash received. 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 the securities loaned on a daily basis with additional collateral obtained as necessary. Substantially all of the Company’s securities lending transactions are with large brokerage firms and large banks. Income and expenses associated with securities lending transactions used to earn spread income are reported as “Net investment income.”
The U.S. Tax Cuts and Jobs Act of 2017 (“Tax Act of 2017”) includes two new tax provisions that could impact the Company’s effective tax rate and cash tax payments in future periods. The Base Erosion and Anti-Abuse Tax (“BEAT”) taxes modified taxable income at a rate of 10% in 2019 increasing to 12.5% in 2026 and is due if the calculated BEAT amount that is determined without the benefit of foreign and certain tax credits is greater than the regular corporate tax in any given year. In general, modified taxable income is calculated by adding back to a taxpayer’s regular taxable income the amount of certain “base erosion tax benefits” with respect to payments to foreign affiliates, as well as the “base erosion percentage” of any net operating loss deductions. Final Regulations confirmed that benefit and claim payments made by our U.S. insurance business to our foreign affiliates on reinsurance assumed by the U.S. affiliates are not base erosion payments. The Global Intangible Low-Taxed Income (“GILTI”) provision applies a minimum U.S. tax to earnings of consolidated foreign subsidiaries in excess of a 10% deemed return on tangible assets of foreign subsidiaries by imposing the U.S. tax rate to 50% of earnings of such foreign affiliates and provides for a partial foreign tax credit for foreign income taxes. The amount of tax in any period on GILTI can depend on annual differences between U.S. taxable income recognition rules and taxable income recognition rules in the country of operations and the overall taxable income of U.S. operations, as well as U.S. expense allocation rules which limit the amount of foreign tax credits that can be applied to reduce the U.S. tax on the GILTI provision. Under certain circumstances the taxable income of U.S. operations may cause more than 50% of earnings of foreign affiliates to be subject to the GILTI provision. In years that the PFI consolidated federal income tax return reports a net operating loss or has a loss attributable to U.S. sources of operations, the GILTI provision would operate to cause a loss of U.S. tax benefits for some or all of those losses, effectively increasing the tax on foreign earnings. The Company accounts for the effects of the BEAT and GILTI provisions as a period cost if and when incurred.
The Company’s liability for income taxes includes a liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the Internal Revenue Service (“IRS”) or other taxing jurisdictions. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards (“tax attributes”), the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the liability for income taxes. The Company classifies all interest and penalties related to tax uncertainties as income tax expense. See Note 16 for additional information regarding income taxes.
Effective January 1, 2018, the Company adopted ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (Loss), which allowed a reclassification from AOCI to retained earnings for stranded effects resulting from the Tax Act of 2017. The Company elected to apply the ASU subsequent to recording the adoption impacts of ASU 2016-01 as described above. As a result, the Company reclassified stranded effects resulting from the Tax Act of 2017 by increasing AOCI and decreasing retained earnings, each by $1,653 million upon adoption on January 1, 2018. Stranded effects unrelated to the Tax Act of 2017 are generally released from AOCI when an entire portfolio of the type of item related to the stranded effect is liquidated, sold or extinguished (i.e., portfolio approach).
The Company applies the fair value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. Excess tax benefits (deficits) are recorded in earnings and represent the cumulative difference between the actual tax benefit realized and the amount of deferred tax assets recorded attributable to shared-based payment transactions.
The Company accounts for non-employee stock options using the fair value method in accordance with authoritative guidance and related interpretations on accounting for equity instruments that are issued to other than employees for acquiring, or in conjunction with selling, goods or services.
Earnings per share of Common Stock for 2019, 2018 and 2017 reflects the consolidated earnings of Prudential Financial. Basic earnings per share is computed by dividing available income attributable to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share includes the effect of all dilutive potential common shares that were outstanding during the period. See Note 20 for additional information.
There are two distinct processes for expressing these foreign transactions and balances in the Company’s financial statements: foreign currency measurement and foreign currency translation. Foreign currency measurement is the process by which transactions in foreign currencies are expressed in the functional currency. Gains and losses resulting from foreign currency measurement are reported in current earnings in “Other income (loss).” Foreign currency translation is the process of expressing a foreign entity’s functional currency financial statements in the reporting currency. Assets and liabilities of foreign operations and subsidiaries reported in currencies 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 operations and financial position of non-U.S. entities with functional currencies other than the U.S. dollar are included, net of related qualifying hedge gains and losses and income taxes, in “Foreign currency translation adjustment,” a component of AOCI.
If a derivative does not qualify for hedge accounting, all changes in its fair value, including net receipts and payments, are included in “Realized investment gains (losses), net” without considering changes in the fair value of the economically associated assets or liabilities.
For each of its reinsurance contracts, the Company determines if the contract provides indemnification against loss or liability relating to insurance risk in accordance with applicable accounting standards. The Company reviews all contractual features, particularly those that may limit the amount of insurance risk to which the reinsurer is subject or features that delay the timely reimbursement of claims.
In 2017, the Company recognized a charge of $237 million in the Individual Life segment, reflecting a change to a preferable accounting method for estimating reinsurance cash flows associated with universal life products and reflecting these cash flows in the financial statements. Under the previous method of accounting, with the exception of recoveries pertaining to no lapse guarantees, reinsurance cash flows (e.g., premiums and recoveries) were generally recognized as they occurred. Under the new method, the expected reinsurance cash flows are recognized more ratably over the life of the underlying reinsured policies. In conjunction with this change, the way in which reinsurance is reflected in estimated gross profits used for the amortization of unearned revenue reserves, DAC and VOBA was also revised. The change represents a change in accounting estimate effected by
Changes to U.S. GAAP are established by the Financial Accounting Standards Board (“FASB”) in the form of Accounting Standards Updates (“ASUs”) to the FASB Accounting Standards Codification (“ASC”). The Company considers the applicability and impact of all ASUs. ASUs listed below include those that have been adopted during the current fiscal year and/or those that have been issued but not yet adopted as of December 31, 2019, and as of the date of this filing. ASUs not listed below were assessed and determined to be either not applicable or not material.
ASU issued but not yet adopted as of December 31, 2019- ASU 2018-12
Includes collateralized loan obligations, auto loans, education loans, home equity and other asset types.
Excludes notes with amortized cost of $4,998 million (fair value, $5,401 million), which have been offset with the associated debt under a netting agreement.
As of December 31, 2018, there was $13 million of fair value and less than $1 million of gross unrealized losses, which are not reflected in AOCI, on securities classified as held-to-maturity.
Excludes the portion of OTTI amounts remaining in OCI, representing any difference between the fair value of the impaired debt security and the net present value of its projected future cash flows at the time of impairment.
As a percentage of amortized cost, 94% and 93% of the portfolio was considered high or highest quality based on NAIC or equivalent ratings, as of December 31, 2019 and 2018, respectively.
As of the dates indicated, the Company’s exposure to concentrations of credit risk of single issuers greater than 10% of the Company’s equity included securities of the U.S. government and certain U.S. government agencies and securities guaranteed by the U.S. government, as well as the securities disclosed below:
The following tables set forth certain key credit quality indicators based upon the recorded investment gross of allowance for credit losses, as of the date indicated:
In certain investment structures, the Company’s investment management business invests with other co-investors in an investment fund referred to as a feeder fund. In these structures, the invested capital of several feeder funds is pooled together and used to purchase ownership interests in another fund, referred to as a master fund. The master fund utilizes this invested capital and, in certain cases, other debt financing, to purchase various classes of assets on behalf of its investors. Specialized industry accounting for investment companies calls for the feeder fund to reflect its investment in the master fund as a single net asset equal to its proportionate share of the net assets of the master fund, regardless of its level of interest in the master fund. In cases where the Company consolidates the feeder fund, it retains the feeder fund’s net asset presentation and reports the consolidated feeder fund’s proportionate share of the net assets of the master fund in “Other invested assets,” with any unaffiliated investors’ non-controlling interest in the feeder fund reported in “Other liabilities” or “Noncontrolling interests.” The consolidated feeder funds’ investments in these master funds, reflected on this net asset basis, totaled $428 million and $349 million as of December 31, 2019 and 2018, respectively. There was $230 million and $199 million of unaffiliated interest in the consolidated feeder funds as of December 31, 2019 and 2018, respectively, and the master funds had gross assets of $89,313 million and $122,376 million, respectively, and gross liabilities of $86,471 million and $119,697 million, respectively, which are not included on the Company’s balance sheet.
As of December 31, 2019, there were no net unrealized losses on held-to-maturity securities that were previously transferred from available-for-sale. Includes net unrealized gains on certain joint ventures that are strategic in nature and are included in “Other assets.”
The following table sets forth the carrying amount of the associated liabilities supported by the pledged collateral, as of the dates indicated:
The following table provides assets on deposit, assets held in trust, and securities restricted as to sale, as of the dates indicated:
Includes member and activity stock associated with memberships in the Federal Home Loan Banks of New York and Boston.
In the normal course of its activities, the Company will invest in LPs/LLCs which include hedge funds, private equity funds and real estate-related funds and may or may not be VIEs. The Company’s maximum exposure to loss on these investments, both VIEs and non-VIEs, is limited to the amount of its investment. The Company has determined that it is not required to consolidate these entities because either (1) it does not control them or (2) it does not have the obligation to absorb losses of these entities that could be potentially significant to the entities or the right to receive benefits from the entities that could be potentially significant. The Company classifies these investments as “Other invested assets” and its maximum exposure to loss associated with these entities was $11,157 million and $9,841 million as of December 31, 2019 and 2018, respectively.
In standardized exchange-traded interest rate futures transactions, the Company purchases or sells a specified number of contracts, the values of which are determined by the daily market values of underlying referenced investments. The Company enters into exchange-traded futures with regulated futures commission’s merchants who are members of a trading exchange.
The table below provides a summary of the gross notional amount and fair value of derivatives contracts by the primary underlying risks, excluding embedded derivatives and associated reinsurance recoverables. Many derivative instruments contain multiple underlying risks. The fair value amounts below represent the value of derivative contracts prior to taking into account the netting effects of master netting agreements and cash collateral. This netting impact results in total derivative assets of $867 million and $1,148 million as of December 31, 2019 and 2018, respectively, and total derivative liabilities of $831 million and $127 million as of December 31, 2019 and 2018, respectively, reflected in the Consolidated Statements of Financial Position.
Excludes embedded derivatives and associated reinsurance recoverables which contain multiple underlying risks. The fair value of these embedded derivatives was a net liability of $14,035 million and $8,959 million as of December 31, 2019, and 2018, respectively, primarily included in “Future policy benefits.”
The primary derivative instruments used by the Company in its fair value, cash flow and net investment hedge accounting relationships are interest rate swaps, currency swaps and currency forwards. These instruments are only designated for hedge accounting in instances where the appropriate criteria are met. The Company does not use futures, options, credit, and equity derivatives in any of its fair value, cash flow or net investment hedge accounting relationships.
The changes in fair value of cash flow hedges are deferred in AOCI and are included in “Net unrealized investment gains (losses)” in the Consolidated Statements of Comprehensive Income; these amounts are then reclassified to earnings when the hedged item affects earnings. Using December 31, 2019 values, it is estimated that a pre-tax gain of approximately $261 million is expected to be reclassified from AOCI to earnings during the subsequent twelve months ending December 31, 2020.
For effective net investment hedges, the amounts, before applicable taxes, recorded in the cumulative translation adjustment within AOCI were $536 million as of 2019, $532 million as of 2018, and $526 million as of 2017.
Credit derivatives, where the Company has written credit protection on a single name reference, had outstanding notional amounts of $100 million and $110 million as of December 31, 2019 and 2018, respectively. These credit derivatives are reported at fair value as an asset of $1 million as of both December 31, 2019 and 2018. As of December 31, 2019, the notional amount of these credit derivatives had the following NAIC ratings: $36 million in NAIC 1; $60 million in NAIC 2; and $4 million in NAIC 3. The Company has also written credit protection on certain index references with notional amounts of $692 million and $4,953 million, reported at fair value as an asset of $20 million and $10 million as of December 31, 2019 and 2018, respectively. As of December 31, 2019, the notional amount of these credit derivatives had the following NAIC ratings: $50 million in NAIC 1; $570 million in NAIC 3; and $72 million in NAIC 6. NAIC designations are based on the lowest rated single name reference included in the index.
The Company’s maximum amount at risk under these credit derivatives equals the aforementioned notional amounts and assumes the value of the underlying referenced securities become worthless. These credit derivatives have maturities of less than 1 year and less than 28 years for single name and index references, respectively.
Substantially all of the Company’s derivative agreements have zero thresholds which require daily full collateralization by the party in a liability position. In addition, certain of the Company’s derivative agreements contain credit-risk related contingent features; if the credit rating of one of the parties to the derivative agreement is to fall below a certain level, the party with positive fair value could request termination at the then fair value or demand immediate full collateralization from the party whose credit rating fell and is in a net liability position.
“Netting” amounts represent cash collateral of $6,814 million and $4,050 million as of December 31, 2019 and 2018, respectively.
Excludes notes with fair value of $4,757 million (carrying amount of $4,751 million) and $4,216 million (carrying amount of $4,216 million) as of December 31, 2019 and 2018, respectively, which have been offset with the associated payables under a netting agreement.
As of December 31, 2019, the net embedded derivative liability position of $12.8 billion includes $0.7 billion of embedded derivatives in an asset position and $13.5 billion of embedded derivatives in a liability position. As of December 31, 2018, the net embedded derivative liability position of $8.9 billion includes $0.7 billion of embedded derivatives in an asset position and $9.6 billion of embedded derivatives in a liability position.
Internally-developed valuations or indicative broker quotes are also used to determine fair value in circumstances where vendor pricing is not available, or where the Company ultimately concludes that pricing information received from the independent pricing services is not reflective of market activity. If the Company concludes the values from both pricing services and brokers are not reflective of market activity, it may override the information with an internally-developed valuation. As of December 31, 2019 and 2018, overrides on a net basis were not material. Pricing service overrides, internally-developed valuations and indicative broker quotes are generally included in Level 3 in the fair value hierarchy.
Other Invested Assets-Other invested assets primarily include investments in LPs/LLCs, derivatives and certain limited partnerships which are consolidated because the Company is either deemed to exercise control or considered the primary beneficiary of a variable interest entity. These entities are primarily investment companies and follow specialized industry accounting whereby their assets are carried at fair value. The investments held by these entities include various feeder fund investments in underlying master funds (whose underlying holdings generally include public fixed maturities, equity securities and mutual funds), as well as wholly-owned real estate held within other investment funds. For the unconsolidated fund investments, the fair value is primarily determined by the fund managers and is measured at net asset value (“NAV”) as a practical expedient.
The majority of the Company’s derivative positions are traded in the OTC derivative market and are classified within Level 2 in the fair value hierarchy. OTC derivatives classified within Level 2 are valued using models that utilize actively quoted or observable market input values from external market data providers, third-party pricing vendors and/or recent trading activity. The Company’s policy is to use mid-market pricing in determining its best estimate of fair value. The fair values of most OTC derivatives, including interest rate and cross-currency swaps, currency forward contracts, commodity swaps, commodity forward contracts, single name credit default swaps, loan commitments held for sale and TBA forward contracts on highly rated mortgage-backed securities issued by U.S. government sponsored entities are determined using discounted cash flow models. The fair values of European style option contracts are determined using Black-Scholes option pricing models. These models’ key inputs include the contractual terms of the respective contract, along with significant observable inputs, including interest rates, currency rates, credit spreads, equity prices, index dividend yields, NPR, volatility and other factors.
Other Liabilities-Other liabilities include certain derivative instruments and the contingent consideration liability associated with the acquisition of Assurance IQ. The fair values of derivative instruments are primarily determined consistent with those described above under “Derivative Instruments.” For the contingent consideration liability, see Note 1 for additional information.
Includes certain investments where enterprise value is less than the amount needed to support senior and subordinated claims. These investments typically use a range of discount rates (10% to 20%), therefore presenting a range, rather than a weighted average, is a more meaningful representation of the unobservable inputs used in the valuation.
Policyholders’ account balances primarily represent general account liabilities for the index-linked interest credited on certain of the Company’s life and annuity products that are accounted for as embedded derivatives. Since the valuation methodology for these liabilities uses a range of inputs that vary at the contract level over the cash flow projection period, presenting a range, rather than a weighted average, is a more meaningful representation of the unobservable inputs used in the valuation.
The spread over the London Inter-Bank Offered Rate (“LIBOR”) swap curve represents the premium added to the proxy for the risk-free rate (LIBOR) to reflect the Company’s estimates of rates that a market participant would use to value the living benefits in both the accumulation and payout phases and index-linked interest crediting guarantees. This spread includes an estimate of NPR, which is the risk that the obligation will not be fulfilled by the Company. NPR is primarily estimated by utilizing the credit spreads associated with issuing funding agreements, adjusted for any illiquidity risk premium. In order to reflect the financial strength ratings of the Company, credit spreads associated with funding agreements, as opposed to credit spread associated with debt, are utilized in developing this estimate because funding agreements, living benefit guarantees, and index-linked interest crediting guarantees are insurance liabilities and are therefore senior to debt.
The utilization rate assumption estimates the percentage of contracts that will utilize the benefit during the contract duration, and begin lifetime withdrawals at various time intervals from contract inception. The remaining contractholders are assumed to either begin lifetime withdrawals immediately or never utilize the benefit. Utilization assumptions may vary by product type, tax status, and age. The impact of changes in these assumptions is highly dependent on the product type, the age of the contractholder at the time of the sale, and the timing of the first lifetime income withdrawal. Range reflects the utilization rate for the vast majority of business with living benefits.
The following tables summarize the portion of changes in fair values of Level 3 assets and liabilities included in earnings and OCI for the year ended December 31, 2017, as well as the portion of gains or losses included in income attributable to unrealized gains or losses related to those assets and liabilities still held as of December 31, 2017.
Changes in Level 3 derivative assets and liabilities-The following tables provide a summary of the changes in fair value of Level 3 derivative assets and liabilities as of the dates indicated, as well as the portion of gains or losses included in income attributable to unrealized gains or losses related to those assets and liabilities still held at the end of their respective periods.
Related to warrants received in restructuring a certain asset that resulted in reclassification of reporting category.
Nonrecurring Fair Value Measurements-The following tables represent information for assets measured at fair value on a nonrecurring basis. The fair value measurement is nonrecurring as these assets are measured at fair value only when there is a triggering event (e.g., an evidence of impairment). Assets included in the table are those that were impaired during the respective reporting periods and that are still held as of the reporting date. The estimated fair values for these amounts were determined using significant unobservable inputs (Level 3).
Carrying values presented herein differ from those in the Company’s Consolidated Statements of Financial Position because certain items within the respective financial statement captions are not considered financial instruments or out of scope under authoritative guidance relating to disclosures of the fair value of financial instruments.
Excludes notes with fair value of $5,401 million (carrying amount of $4,998 million) and $4,879 million (carrying amount of $4,879 million) as of December 31, 2019 and 2018, respectively, which have been offset with the associated payables under a netting agreement.
The fair value of short-term and long-term debt, as well as notes issued by consolidated VIEs, is generally determined by either prices obtained from independent pricing services, which are validated by the Company, or discounted cash flow models. With the exception of the notes issued by consolidated VIEs for which recourse is limited to the assets of the respective VIE and does not extend to the general credit of the Company, the fair values of these instruments consider the Company’s NPR. Discounted cash flow models predominately use market observable inputs such as the borrowing rates currently available to the Company for debt and financial instruments with similar terms and remaining maturities. For commercial paper issuances and other debt with a maturity of less than 90 days, the carrying value approximates fair value.
Only the portion of separate account liabilities related to products that are investment contracts are reflected in the table above. Separate account liabilities are recorded at the amount credited to the contractholder, which reflects the change in fair value of the corresponding separate account assets including contractholder deposits less withdrawals and fees; therefore, carrying value approximates fair value.
“Other” for 2019 primarily represents the impact related to the sale of the Company’s Pramerica of Italy subsidiary of $(46) million and DAC ceded to a third-party reinsurer of $(14) million. “Other” for 2018 represents the impact related to the sale of the Company’s Pramerica of Poland subsidiary of $(38) million and the impact of the elimination of Gibraltar Life’s one-month reporting lag of $20 million.
The fair values of net mortgage servicing rights were $287 million and $295 million at December 31, 2019 and 2018, respectively. Amortization expense for other intangibles was $65 million, $61 million and $51 million for the years ending December 31, 2019, 2018 and 2017, respectively. The amortization expense amounts for 2019, 2018 and 2017 do not include impairments recorded for mortgage servicing rights or other intangibles. See the nonrecurring fair value measurements section of Note 6 for more information regarding these impairments.
The following table provides estimated future amortization for the periods indicated.
Lease expense is included in “General and administrative expenses.” The expense was comprised of operating lease costs and short-term lease costs of $138 million and $101 million for the twelve months ended December 31, 2019, respectively. Short-term lease costs relate to those leases with terms of twelve months or less that do not include an option to purchase the underlying asset that is reasonably certain of exercise.
Future policy benefits for other contract liabilities are generally equal to the present value of expected future payments based on the Company’s experience, except for example, certain group insurance coverages for which future policy benefits are equal to gross unearned premium reserves. The interest rates used in the determination of the present values range from 0.8% to 7.0%.
Policyholders’ account balances primarily represent an accumulation of account deposits plus credited interest less withdrawals, expense charges and mortality charges, if applicable. These policyholders’ account balances also include provisions for benefits under non-life contingent payout annuities. Included in “Funding agreements” at December 31, 2019 and 2018 are $4,104 million and $3,755 million, respectively, related to the Company’s Funding Agreement Notes Issuance Program (“FANIP”). Under this program, which has a maximum authorized amount of $15 billion of medium-term notes and $3 billion of commercial paper, Delaware statutory trusts issue short-term commercial paper and/or medium-term notes to investors that are secured by funding agreements issued to the trusts by PICA. The outstanding commercial paper and notes have fixed or floating interest rates that range from 0.0% to 3.5% and original maturities ranging from two months to five years. Included in the amounts at December 31, 2019 and 2018 is the medium-term note liability, which is carried at amortized cost, of $2,414 million and $2,764 million, respectively and short-term note liability of $1,697 million and $997 million, respectively.
For guarantees of benefits that are payable at withdrawal, the net amount at risk is generally defined as the present value of the minimum guaranteed withdrawal payments available to the contractholder determined in accordance with the terms of the contract in excess of the current account balance. For guarantees of accumulation balances, the net amount at risk is generally defined as the guaranteed minimum accumulation balance minus the current account balance. The Company’s primary risk exposures for these contracts relates to actual deviations from, or changes to, the assumptions used in the original pricing of these products, including equity market returns, interest rates, market volatility and contractholder behavior.
In addition to the amounts invested in separate account investment options above, $7,781 million at December 31, 2019, and $8,104 million at December 31, 2018, of account balances of variable annuity contracts with guarantees, inclusive of contracts with MVA features, were invested in general account investment options. For the years ended December 31, 2019, 2018 and 2017, there were no transfers of assets, other than cash, from the general account to any separate account, and accordingly no gains or losses recorded.
The table below summarizes the changes in general account liabilities for guarantees. The liabilities for GMDB and GMIB are included in “Future policy benefits” and the related changes in the liabilities are included in “Policyholders’ benefits.” GMAB, GMWB and GMIWB are accounted for as embedded derivatives and are recorded at fair value within “Future policy benefits.” Changes in the fair value of these derivatives, including changes in the Company’s own risk of non-performance, along with any fees attributed or payments made relating to the derivative, are recorded in “Realized investment gains (losses), net.” See Note 6 for additional information regarding the methodology used in determining the fair value of these embedded derivatives. The Company maintains a portfolio of derivative investments that serve as a partial hedge of the risks associated with these products, for which the changes in fair value are also recorded in “Realized investment gains (losses), net.” This portfolio of derivative investments does not qualify for hedge accounting treatment under U.S. GAAP. Additionally, the Company externally reinsures the guaranteed benefit features associated with certain contracts. See Note 14 for further information regarding the external reinsurance arrangement.
Since 2011, the Company has entered into several reinsurance agreements to assume pension liabilities in the United Kingdom. Under these arrangements, the Company assumes the longevity risk associated with the pension benefits of certain specified beneficiaries.
In 2006, the Company acquired the variable annuity business of The Allstate Corporation (“Allstate”) through a reinsurance transaction. The reinsurance arrangements with Allstate include a coinsurance arrangement associated with the general account liabilities assumed and a modified coinsurance arrangement associated with the separate account liabilities assumed. The reinsurance payable, which represents the Company’s obligation under the modified coinsurance arrangement, is netted with the reinsurance receivable in the Consolidated Statements of Financial Position.
On December 18, 2001, the date of demutualization, PICA established a closed block for certain in-force participating insurance policies and annuity products, along with corresponding assets used for the payment of benefits and policyholders’ dividends on these products, (collectively the “Closed Block”), and ceased offering these participating products. The recorded assets and liabilities were allocated to the Closed Block at their historical carrying amounts. The Closed Block forms the principal component of the Closed Block division. See Note 22 for financial information on the Closed Block division. The insurance policies and annuity contracts comprising the Closed Block are managed in accordance with the Plan of Reorganization approved by the New Jersey Department of Banking and Insurance (“NJDOBI”) on December 18, 2001, and PICA is directly obligated for the insurance policies and annuity contracts in the Closed Block.
The excess of Closed Block liabilities over Closed Block assets at the date of the demutualization (adjusted to eliminate the impact of related amounts in AOCI) represented the estimated maximum future earnings at that date from the Closed Block expected to result from operations attributed to the Closed Block after income taxes. In establishing the Closed Block, the Company developed an actuarial calculation of the timing of such maximum future earnings. If actual cumulative earnings of the Closed Block from inception through the end of 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, which are recorded as a policyholder dividend obligation. The policyholder dividend obligation represents amounts 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. If the actual cumulative earnings of the Closed Block from its inception through the end of any given period are less than the expected cumulative earnings of the Closed Block, the Company will recognize only the actual earnings in income.
As of December 31, 2019 and 2018, the Company recognized a policyholder dividend obligation of $2,816 million and $2,252 million, respectively, to Closed Block policyholders for the excess of actual cumulative earnings over the expected cumulative earnings. Additionally, accumulated net unrealized investment gains that have arisen subsequent to the establishment of the Closed Block have been reflected as a policyholder dividend obligation of $3,332 million and $899 million at December 31, 2019 and 2018, respectively, to be paid to Closed Block policyholders unless offset by future experience, with a corresponding amount reported in AOCI.
Amounts for 2018 U.S. and foreign deferred tax expense have been revised to correct previously reported amounts.
Tax Act of 2017 - On December 22, 2017, the Tax Act of 2017 was enacted into U.S. law. As a result, the Company recognized a $2,880 million tax benefit in “Total income tax expense (benefit)” in the Company’s Consolidated Statements of Operations for the year ended December 31, 2017. In accordance with SEC Staff Accounting Bulletin 118, in 2017 the Company recorded the effects of the Tax Act of 2017 using reasonable estimates due to the need for further analysis of the provisions within the Tax Act of 2017 and collection, preparation and analysis of relevant data necessary to complete the accounting. During 2018, the Company completed the collection, preparation and analysis of data relevant to the Tax Act of 2017, and interpreted any additional guidance issued by the IRS, U.S. Department of the Treasury, or other standard-setting organizations, and recognized a $153 million reduction in income tax expense primarily related to refinements of our provisional estimates of earnings of affiliated foreign companies subject to the one-time toll charge.
Non-Taxable Investment Income. The U.S. Dividends Received Deduction (“DRD”) reduces the amount of dividend income subject to U.S. tax and accounts for most of the non-taxable investment income shown in the table above. More specifically, the U.S. DRD constitutes $122 million of the total $270 million of 2019 non-taxable investment income, $127 million of the total $246 million of 2018 non-taxable investment income, and $280 million of the total $369 million of 2017 non-taxable investment income. The DRD for the current period was estimated using information from 2018, current year investment results, and current year’s equity market performance. The actual current year DRD can vary based on factors such as, but not limited to, changes in the amount of dividends received that are eligible for the DRD, changes in the amount of distributions received from fund investments, changes in the account balances of variable life and annuity contracts, and the Company’s taxable income before the DRD.
Foreign Taxes at Other Than U.S. Rates. The statutory income tax rate in the Company’s two largest non-U.S. tax jurisdictions is approximately 28% in Japan and 24.2% in Korea as compared to the U.S. federal income tax rate of 21% applicable for 2019 and 2018 and 35% applicable for 2017.
The following table sets forth the amount and expiration dates of federal, state and foreign operating losses, capital loss and foreign tax credit carryforwards for tax purposes, as of the periods indicated:
$124 million expires between 2021 and 2035 and $79 million has an unlimited carryforward. Prior year balance has been updated to conform with current period presentation.
During the fourth quarter of 2017, in light of and for the period after the Tax Act of 2017, the Company determined that all unremitted earnings of the Company’s foreign operations are not considered indefinitely reinvested for purposes of determining U.S. tax liability, as well as determining whether the unremitted earnings of the Company’s foreign operations are considered indefinitely reinvested for purposes of determining its foreign withholding tax liability, as described above. Prior to the enactment of the Tax Act of 2017, for the Japanese insurance operations, the Company provided for U.S. income taxes on pre-2014 U.S. GAAP earnings, post-2013 realized and unrealized capital gains, and an additional amount from Gibraltar Life and Prudential Gibraltar Financial Life Insurance Co. Ltd. (“PGFL”), not to exceed the deferred tax asset recorded in the Statement of Financial Position as of the acquisition date for PGFL and the Star and Edison Businesses. The Company had no change to its U.S. tax in “Income (loss) before equity in earnings of operating joint ventures” during 2017. During the first and second quarters of 2018,
respectively, the Company determined that the earnings of its Polish and Italian insurance operation would be repatriated to the U.S. Accordingly, earnings of the Polish and Italian insurance operations were not considered indefinitely reinvested, and the Company recognized an income tax expense of $10 million during 2018. During the first and fourth quarters of 2018, the Company determined that a portion of the earnings of its Korean insurance operation would be repatriated to the U.S. Accordingly, a portion of the earnings of the Korean insurance operation were not considered indefinitely reinvested, and the Company recognized an income tax expense of $14 million in “Income (loss) before equity in earnings of operating joint ventures” during 2018. The Company made no changes with respect to its repatriation assumptions in 2019.
The Company participates in the IRS’s Compliance Assurance Program. Under this program, the IRS assigns an examination team to review completed transactions as they occur in order to reach agreement with the Company on how they should be reported in the relevant tax returns. If disagreements arise, accelerated resolutions programs are available to resolve the disagreements in a timely manner.
Includes $13 million drawn on a revolving line of credit held by a subsidiary at December 31, 2019.
NJDOBI permits PICA to pledge collateral to the FHLBNY in an amount of up to 5% of its prior year-end statutory net admitted assets, excluding separate account assets. Based on PICA’s statutory net admitted assets as of December 31, 2018, the 5% limitation equates to a maximum amount of eligible assets of $6.7 billion and an estimated maximum borrowing capacity (after taking into account required collateralization levels) of approximately $5.9 billion. Nevertheless, FHLBNY borrowings are subject to the FHLBNY’s discretion and to the availability of qualifying assets at PICA.
Prudential Retirement Insurance and Annuity Company (“PRIAC”) is a member of the Federal Home Loan Bank of Boston (“FHLBB”). Membership allows PRIAC access to collateralized advances which will be classified in “Short-term debt” or “Long-term debt,” depending on the maturity date of the obligation. PRIAC’s membership in FHLBB requires the ownership of member stock and borrowings from FHLBB require the purchase of activity-based stock in an amount between 3.0% and 4.5% of outstanding borrowings, depending on the maturity date of the obligation. All FHLBB stock purchased by PRIAC is classified as restricted general account investments within “Other invested assets,” and the carrying value of these investments was $6 million and $10 million as of December 31, 2019 and 2018, respectively. As of December 31, 2019, PRIAC had no advances outstanding under the FHLBB facility.
In August 2019, as a result of the note holders’ exercise of the exchange option on $500 million of surplus notes, the Company issued approximately 6.2 million shares of Common Stock at an exchange rate equal to 12.3877 shares of Common Stock per each $1,000 principal amount of surplus notes. The Company’s obligations under the surplus notes are now satisfied.
The ¥100 billion five-year facility was entered into by Prudential Holdings of Japan, Inc. (“PHJ”) in September 2019. This facility also contains customary representations and warranties, covenants, and events of default and borrowings are not contingent on the borrower’s credit ratings nor subject to material adverse change clauses.
In addition to the above credit facilities, the Company had access to $370 million of certain other lines of credit at December 31, 2019, of which $160 million was for the sole use of certain real estate separate accounts. The separate account facilities include loan-to-value ratio requirements and other financial covenants, and recourse on obligations under these facilities is limited to the assets of the applicable separate account. At December 31, 2019, $19 million of these credit facilities were used. The Company also has access to uncommitted lines of credit from financial institutions.
The put option described above will be exercised automatically in full upon the Company’s failure to make certain payments to the trust, such as paying the put option premium or reimbursing the trust for its expenses, if the Company’s failure to pay is not cured within 30 days, and upon an event involving its bankruptcy. The Company is also required to exercise the put option if its consolidated stockholders’ equity, calculated in accordance with U.S. GAAP but excluding AOCI, falls below $7.0 billion, subject to adjustment in certain cases. The Company has a one-time right to unwind a prior voluntary exercise of the put option by repurchasing all of the senior notes then held by the trust in exchange for principal and interest strips of U.S. Treasury securities. Finally, any of the 4.419% senior notes that Prudential Financial issues may be redeemed prior to their maturity at par or, if greater, a make-whole price, following a voluntary exercise in full of the put option.
Includes $53 million and $206 million of debt denominated in foreign currency at December 31, 2019 and 2018, respectively.
Includes Prudential Financial debt of $17,430 million and $16,141 million at December 31, 2019 and 2018, respectively.
At December 31, 2019 and 2018, the Company was in compliance with all debt covenants related to the borrowings in the table above.
The following table presents the contractual maturities of the Company’s long-term debt as of December 31, 2019:
As of December 31, 2019, the Company had $342 million of fixed-rate surplus notes outstanding. These notes are subordinated to other PICA borrowings and policyholder obligations, and the payment of interest and principal may only be made with the prior approval of the NJDOBI. The NJDOBI could prohibit the payment of the interest and principal on the surplus notes if certain statutory capital requirements are not met. At December 31, 2019 and 2018, the Company met these statutory capital requirements.
From 2011 through 2013, a captive reinsurance subsidiary entered into agreements providing for the issuance and sale of up to $2 billion of ten-year fixed-rate surplus notes. The aggregate amount available to be issued under these agreements was reduced to $1.75 billion in 2018. The agreements were restructured in 2019 to provide for financing in the same amount through 2036. Under the agreements, the captive receives in exchange for the surplus notes one or more credit-linked notes issued by a special-purpose subsidiary of the Company in an aggregate principal amount equal to the surplus notes issued. The captive holds the credit-linked notes as assets supporting the non-economic portion of the statutory reserve required to be held by the Company’s domestic insurance subsidiaries under Regulation XXX in connection with the reinsurance of term life insurance policies through the captive. The non-economic portion of the statutory reserve equals the difference between the statutory reserve required under
Another captive reinsurance subsidiary maintains a financing facility with external counterparties, pursuant to which the captive has outstanding $2.36 billion in principal amount of surplus notes and received in return an equal principal amount of credit-linked notes issued by a special-purpose affiliate. The remaining term of the financing is approximately fifteen years. The captive holds the credit-linked notes as assets supporting non-economic reserves required to be held by the Company’s domestic insurance subsidiaries under Regulation XXX. The captive can redeem the credit-linked notes in cash upon the occurrence of, and in an amount necessary to remedy, a liquidity stress event affecting the captive. Current capacity of this financing facility is $2.45 billion. Prudential Financial has agreed to make capital contributions to the captive and to the special-purpose affiliate to reimburse them for investment losses in excess of specified amounts. Prudential Financial has also agreed to reimburse one of the external counterparties for any payments under the credit-linked notes funded by it in an amount of up to $1.0 billion.
In March 2017, a captive reinsurance subsidiary entered into a twenty-year financing facility with external counterparties providing for the issuance and sale of a surplus note for the financing of non-economic reserves required under Guideline AXXX. The initial financing capacity available under the facility was $1.0 billion. In June 2018, the Company amended this captive financing facility by increasing the maximum potential size of the facility to $2.0 billion. The captive receives in exchange for the surplus note one or more credit-linked notes issued by a special-purpose affiliate in an aggregate principal amount equal to the surplus note. The principal amount of the outstanding credit-linked notes is redeemable by the captive in cash upon the occurrence of, and in an amount necessary to remedy, a specified liquidity stress event, and the external counterparties have agreed to fund any such payment. Prudential Financial has no reimbursement obligations to the external counterparties under this facility. As of December 31, 2019, an aggregate of $1.47 billion of surplus notes were outstanding under the facility and no credit-linked note payments have been required.
In March 2018, the Company established a new $1.6 billion captive financing facility to finance non-economic reserves required under Regulation XXX. Similar to the Company’s other captive financing facilities, a captive reinsurance subsidiary issues surplus notes under the facility in exchange for credit-linked notes issued by a special-purpose affiliate that are held to support non-economic reserves. The credit-linked notes are redeemable for cash upon the occurrence of a liquidity stress event affecting the captive and external counterparties have agreed to fund these payments. Prudential Financial has no reimbursement
obligations to the external counterparties under this facility. As of December 31, 2019, $920 million of surplus notes were outstanding under the facility and no credit-linked note payments have been required.
In February 2015, Prudential Legacy Insurance Company of New Jersey (“PLIC”) entered into a twenty-year financing facility with certain external counterparties and a special-purpose affiliate, pursuant to which PLIC may, at its option and subject to the satisfaction of customary conditions, issue and sell to the affiliate up to $4.0 billion in aggregate principal amount of surplus notes, in return for an equal principal amount of credit-linked notes. Upon issuance, PLIC would hold any credit-linked notes as assets to support future statutory surplus needs within PLIC. As of December 31, 2019, an aggregate of $100 million of surplus notes were outstanding under the facility and no credit-linked note payments have been required.
Retail Medium-Term Notes Program. The Company maintains a retail medium-term notes program under its shelf registration statement with an authorized issuance capacity of $5.0 billion. As of December 31, 2019, the outstanding balance of the program was $302 million, of which $29 million is included in current portion of long-term debt.
The weighted average interest rate on outstanding senior notes issued under these programs, including the effect of interest rate hedging activity, was 4.85% and 5.04% for the years ended December 31, 2019 and 2018, respectively, excluding the effect of debt issued to consolidated subsidiaries.
Funding Agreement Notes Issuance Program (“FANIP”). The Company maintains a FANIP in which statutory trusts issue medium-term notes and commercial paper secured by funding agreements issued to the trusts by PICA. These obligations are included in “Policyholders’ account balances” and not included in the foregoing table. See Note 12 for further discussion of these obligations.
Mortgage Debt. As of December 31, 2019, the Company’s subsidiaries had long-term mortgage debt of $537 million that has recourse only to real estate property held for investment by those subsidiaries. This represents a decrease of $239 million from December 31, 2018, primarily due to $288 million of prepayment activity, offset by new borrowings in 2019 of $47 million and foreign exchange fluctuations of $2 million.
Limited Recourse Notes. In 2014, the Company entered into financing transactions pursuant to which it issued $500 million of limited recourse notes and, in return, obtained $500 million of asset-backed notes issued by a designated series of a Delaware master trust. The asset-backed notes mature from 2020 through 2026; however, the maturity date of a portion of the notes may be extended by the Company through 2028, subject to conditions.
The master trust’s payment obligations under each of the asset-backed notes are secured by corresponding payment obligations of a third-party financial institution and a portfolio of specified assets that have an aggregate value at least equal to the principal amount of the applicable asset-backed note. The principal amount of each asset-backed note is payable to PRIAC in cash at any time upon demand by PRIAC or, if not repaid earlier, at maturity. Each of the limited recourse notes obligates Prudential Financial to reimburse the applicable third-party financial institution for any principal payments received on the corresponding asset-backed note, but there is no obligation to reimburse any portion of a principal payment that is needed by PRIAC to pay then current claims to its policyholders. Each limited recourse note bears interest at a rate equal to the rate on the corresponding asset-backed note, plus an amount representing fees payable to the applicable third-party financial institution. As of December 31, 2019, no principal payments have been received or are currently due on the asset-backed notes and, as a result, there was no payment obligation under the limited recourse notes. Accordingly, the notes are not reflected in the Consolidated Financial Statements as of December 31, 2019.
In order to modify exposure to interest rate and currency exchange rate movements, the Company utilizes derivative instruments, primarily interest rate swaps, in conjunction with some of its debt issues. The impact of these derivative instruments is not reflected in the rates presented in the tables above. For those derivative instruments that qualify for hedge accounting treatment, interest expense was less than $1 million, $1 million, and $3 million for the years ended December 31, 2019, 2018 and 2017, respectively. See Note 5 for additional information on the Company’s use of derivative instruments.
Interest expense for short-term and long-term debt was $1,563 million, $1,423 million and $1,334 million for the years ended December 31, 2019, 2018 and 2017, respectively.
Prepaid benefits costs and accrued benefit liabilities 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 December 31, 2019 and 2018 is summarized below:
The Company also maintains a separate rabbi trust for the purpose of holding assets of the Company to be used to satisfy its obligations with respect to certain other non-qualified retirement plans ($76 million and $72 million benefit obligation at December 31, 2019 and 2018, respectively), as well as certain cash-based deferred compensation arrangements. As of December 31, 2019 and 2018, the assets in the trust had a carrying value of $106 million and $102 million, respectively.
Pension benefits for foreign plans comprised 14% and 15% of the ending benefit obligation for both 2019 and 2018, respectively. Foreign pension plans comprised 5% of the ending fair value of plan assets for both 2019 and 2018. There are no material foreign postretirement plans.
There were no purchases of annuity contracts in 2019 and 2018 from PICA. The approximate future annual benefit payment payable by PICA for all annuity contracts was $22 million and $18 million as of December 31, 2019 and 2018, respectively.
For 2019, 2018 and 2017 certain employees were provided special termination benefits under non-qualified plans in the form of unreduced early retirement benefits as a result of their involuntary termination.
The amounts included in AOCI expected to be recognized as components of net periodic (benefit) cost in 2020 are as follows:
The pension and postretirement expected long-term rates of return on plan assets for 2019 were determined based upon an approach that considered the allocation of plan assets as of December 31, 2018. Expected returns are estimated by asset class as noted in the discussion of investment policies and strategies below. Expected returns on asset classes are developed using a building-block approach that is forward looking and are not strictly based upon historical returns. The building blocks for equity returns include inflation, real return, a term premium, an equity risk premium, capital appreciation, expenses, the effect of active management and the effect of rebalancing. The building blocks for fixed maturity returns include inflation, real return, a term premium, credit spread, capital appreciation, effect of active management, expenses and the effect of rebalancing.
The plan fiduciaries for the Company’s pension and postretirement plans have developed guidelines for asset allocations reflecting a percentage of total assets by asset class, which are reviewed on an annual basis. Asset allocation targets as of December 31, 2019 are as follows:
Assets held with PICA are in either pooled separate accounts or single client separate accounts. Pooled separate accounts hold assets for multiple investors. Each investor owns a “unit of account.” Single client separate accounts hold assets for only one investor, the domestic qualified pension plan, and each security in the fund is treated as individually owned. Assets held with a bank are either in common/collective trusts or single client trusts. Common or collective trusts hold assets for more than one investor. Each investor owns a “unit of account.” Single client trusts hold assets for only one investor, the domestic qualified pension plan, and each security in the fund is treated as individually owned.
There were no investments in Prudential Financial Common Stock as of December 31, 2019 and December 31, 2018 for either the pension or postretirement plans.
Variable Life Insurance Policies-These assets are held in group and individual variable life insurance policies issued by PICA. Group policies are invested in Insurance Company Pooled Separate Accounts. Individual policies are invested in Registered Investment Companies (Mutual Funds). The value of interest in these policies is the cash surrender value of the policies based on the underlying investments.
This category mainly consists of a global equity fund, primarily focused on new market leaders with sustainable competitive advantage.
The contractual net value of the investment of securities lending collateral invested primarily in short-term bond funds is $135 million and $157 million and the liability for securities lending collateral is $135 million and $157 million for the years ended December 31, 2019 and 2018, respectively.
The Company accrues postemployment benefits for income continuance and health and life benefits provided to former or inactive employees who are not retirees. The net accumulated liability for these benefits at December 31, 2019 and 2018 was $1 million and is included in “Other liabilities.”
The Company sponsors voluntary savings plans for employees (401(k) plans). The plans provide for salary reduction contributions by employees and matching contributions by the Company of up to 4% of annual salary. The matching contributions by the Company included in “General and administrative expenses” were $84 million, $89 million and $74 million for the years ended December 31, 2019, 2018 and 2017, respectively.
As of December 31, 2019, 2018 and 2017, the Company had 10,000,000 shares of preferred stock authorized but none issued or outstanding.
In October 2019, the Company issued approximately 5.5 million shares of restricted Common Stock as part of consideration paid for the Assurance IQ acquisition. For additional information about the acquisition, see Note 1.
The following table summarizes share repurchases for each of the past three years as well as the share repurchase authorization for 2020 which was approved by the Board of Directors in December 2019.
Includes cash flow hedges. See Note 5 for information on cash flow hedges.
U.S. Insurance Subsidiaries - Restrictions on Payment of Dividends to Prudential Financial, the Parent Holding Company
With respect to PICA, a New Jersey domiciled insurance subsidiary which is also the Company’s primary domestic insurance subsidiary, New Jersey insurance law provides that, except in the case of extraordinary dividends (as described below), all dividends or other distributions paid by PICA may be paid only from unassigned surplus, as determined pursuant to statutory accounting principles, less cumulative unrealized investment gains and losses and revaluation of assets as of the prior calendar year-end. As of December 31, 2019, PICA’s unassigned surplus less applicable adjustments for cumulative unrealized investment gains was $7,511 million. PICA must give prior notification to the NJDOBI of its intent to pay any such dividend or distribution. Also, if any dividend, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of statutory capital and surplus as of the preceding December 31 or (ii) its statutory net gain from operations excluding realized investment gains and losses for the twelve-month period ending on the preceding December 31, the dividend is considered to be an “extraordinary dividend” and requires the prior approval of the NJDOBI. Under New Jersey insurance law, PICA is permitted to pay an ordinary dividend of up to $1,148 million in 2020, without prior approval of the NJDOBI.
All of the Company’s domestic and international insurance subsidiaries have capital and surplus levels that exceed their respective regulatory minimum requirements, and none utilized prescribed or permitted practices that vary materially from the practices prescribed by the NAIC or equivalent regulatory bodies for results reported as of December 31, 2019 and 2018, respectively, or for the years ended December 31, 2019, 2018 and 2017, respectively.