On August 30, 2013, the Company received approval from the Arizona and Connecticut Departments of Insurance to redomesticate the Company from Connecticut to Arizona effective August 31, 2013. As a result of the redomestication, the Company is now an Arizona insurance company and its principal insurance regulatory authority is the Arizona Department of Insurance. See Note 1 to the Financial Statements for additional information.
On July 18, 2013, the FSB, consisting of representatives of national financial authorities of the G20 nations, identified Prudential Financial as a G-SII. U.S. financial regulators are thereby expected to enhance their regulation of Prudential Financial to achieve a number of regulatory objectives, including enhanced group-wide supervision, enhanced capital standards (including basic capital and higher loss absorption capacity requirements), and development of a risk management plan (expected to be completed within 12 months of G-SII designation) and recovery and resolution plans (“RRP plans”; expected to be developed and agreed by the end of 2014). Higher loss absorption capacity requirements are expected to begin to be implemented in 2019.
At the direction of the FSB, the IAIS is developing a ComFrame for the supervision of IAIGs that contemplates “group wide supervision” across national boundaries. Prudential Financial qualifies as an IAIG. In October 2013, the IAIS announced that it expects to develop a risk-based global insurance capital standard by 2016 applicable to IAIGs, with full implementation scheduled to begin in 2019. In addition, the IAIS seeks to promote the financial stability of IAIGs by endorsing: uniform standards for insurer corporate governance and enterprise risk management; group-wide supervision of IAIGs; a framework for group capital adequacy assessment that accounts for group-wide risks; additional regulatory and disclosure requirements for insurance groups; and the establishment of ongoing supervisory colleges. In October 2013 several of Prudential Financial’s domestic and foreign insurance regulators convened a supervisory college. The purpose of the supervisory college is to promote ongoing supervisory coordination, facilitate the sharing of information among regulators and to enhance each regulator’s understanding of Prudential Financial’s risk profile.
ComFrame also requires each IAIG to conduct its own risk and solvency assessment (“ORSA”) to monitor and manage its overall solvency. In addition, state insurance regulators have focused attention on U.S. insurance solvency regulation pursuant to the NAIC’s “Solvency Modernization Initiative.” This initiative has resulted in the recent adoption of the NAIC Risk Management and Own Risk and Solvency Assessment model act
We are a licensed insurance company in New York, but are not domiciled in New York. The NY DFS has notified us that it does not agree with our calculation of statutory reserves (including the applicable credit for reinsurance) for New York purposes in respect of certain variable annuity products. We are currently in discussions with the NY DFS regarding the proper level of statutory reserves (including the applicable credit for reinsurance) for these products. If we are ultimately required to establish material additional reserves on a New York statutory accounting basis or cause material amounts of additional collateral to be posted with respect to such variable annuity or other products, our ability to deploy capital for other purposes could be affected.
In addition, the NAIC, the NY DFS and other regulators have increased their focus on life insurers’ use of captive reinsurance companies. If applicable insurance laws are changed in a way that impairs the use of captive reinsurance companies, our ability to write certain products and efficiently manage their associated risks could be adversely affected and we may need to increase prices on certain products, modify certain products or find alternate financing sources, any of which could adversely affect our competitiveness, capital and financial position and results of operations.
At this time we cannot predict the final outcome of the above regulatory developments, including what additional capital requirements, compliance and regulatory costs, or other burdens may be imposed on the Company.
We capitalize costs that are directly related to the acquisition of 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. See Note 2 to our Financial Statements for a discussion of the authoritative guidance adopted effective January 1, 2012, regarding which costs relating to the acquisition of new or renewal contracts qualify for deferral. We have also deferred costs associated with sales inducements related to our variable and fixed annuity contracts. Sales inducements are amounts that are credited to the policyholder’s account balance as an inducement to purchase the contract. For additional information about sales inducements, see Note 7 to the Financial Statements. We generally amortize these deferred policy acquisition costs, or DAC, and deferred sales inducements, or DSI, over the expected lives of the contracts, based on our estimates of the level and timing of gross profits. 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 profits. 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 “-Policyholder Liabilities.” As of December 31, 2013, DAC and DSI were $1,346 million and $809 million, respectively.
The near-term future rate of return assumptions used in evaluating DAC and DSI are derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider the historical equity returns over a period of time and initially adjust future projected returns over the next four years (the “near-term”) so that the assets are projected to grow at the long-term expected rate of return for the entire period. If the near-term projected future rate of return is greater than our near-term maximum future rate of return of 13%, we use our maximum future rate of return. As of December 31 2013, we assume an 8.0% long-term equity expected rate of return and a 3.9% near-term mean reversion equity rate of return.
We generally update the near term equity rates of return and our estimate of total gross profits each quarter to reflect the result of the reversion to the mean approach, which assumes a convergence to the long-term equity expected rates of return. These market performance related adjustments to our estimate of total gross profits result in cumulative adjustments to prior amortization, reflecting the application of the new required rate of amortization to all prior periods’ gross profits.
For variable annuity contracts, DAC and DSI are sensitive to changes in our future rate of return assumptions due primarily to the significant portion of gross profits that is dependent upon the total rate of return on assets held in separate account investment options. The following table provides a demonstration of the sensitivity of each of these balances relative to our future rate of return assumptions by quantifying the adjustments to each balance that would be required assuming both an increase and decrease in our future rate of return by 100 basis points. The sensitivity includes an increase and decrease of 100 basis points to both the near-term future rate of return assumptions used over the next four years, and the long-term expected rate of return used thereafter. The information below is for illustrative purposes only and considers only the direct effect of changes in our future rate of return on the DAC and DSI balances and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC and DSI. Further, this information does not reflect changes in reserves, such as the reserves for the guaranteed minimum death and optional living benefit features of our variable annuity products, or the impact that changes in such reserves may have on the DAC and DSI balance.
In addition to DAC and DSI, we also recognize an asset for value of business acquired, or VOBA. VOBA is an intangible asset which represents an adjustment to the stated value of acquired inforce insurance contract liabilities to present them at fair value, determined as of the acquisition date. It includes an explicit adjustment to reflect the cost of capital attributable to acquired insurance contracts. VOBA is amortized over the expected life of the acquired contracts in proportion to either gross premiums or estimated gross profits, depending on the type of contract. VOBA is subject to recoverablility testing. As of December 31, 2013, VOBA was $43.5 million. For additional information about VOBA including its bases for amortization, see Note 5 of the Financial Statements.
For our investments classified as available-for-sale, the impact of changes in fair value is recorded as an unrealized gain or loss in “Accumulated other comprehensive income (loss), net,” a separate component of equity. For our investments classified as trading, the impact of changes in fair value is recorded within “Asset administration fees and other income.” In addition, investments classified as available-for-sale are subject to impairment reviews to identify when a decline in value is other-than-temporary. For a discussion of our policies regarding other-than-temporary declines in investment value and the related methodology for recording other-than-temporary impairments of fixed maturity and equity securities, see Note 2 to the Financial Statements.
In addition to the impact of market performance relative to our future rate of return assumptions, other factors may also drive variability in the change in reserves, particularly during the third quarter when assumption updates are performed. As noted above, however, the impact on our results of operations of changes in these assumptions can be offsetting and we are unable to predict their movement or offsetting impact over time. In the third quarter of 2013, updates to lapse rate and utilization rate assumptions drove the most significant changes to these reserves. For a discussion of adjustments to the reserves for GMDBs and GMIBs for the years ended December 31, 2013 and 2012, see “-Results of Operations”.
The Company’s liability for future policy benefits also includes reserves based on the present value of estimated future payments to or on behalf of policyholders related to contracts that have annuitized, where the timing and amount of payment depends on policyholder mortality. Expected mortality is generally based on Company experience, industry data and/or other factors. Interest rate assumptions are based on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are “locked-in” upon the issuance of new insurance or annuity business with fixed and guaranteed terms, significant changes in experience or assumptions may require the Company to provide for expected future losses on a product by establishing premium deficiency reserves. Premium deficiency reserves are established, 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.
Total assets increased by $0.6 billion, from $52.9 billion at December 31, 2012 to $53.5 billion at December 31, 2013. Separate account assets increased $2.0 billion, primarily driven by market appreciation and the impact of the asset transfer feature which moved customer account values from the general account to the separate account due to favorable markets in 2013, partially offset by net outflows as a result of contractholder surrenders. DAC and DSI increased by $0.4 billion and $0.3 billion, respectively, resulting from the impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions due to higher interest rates, favorable market conditions and the assumption update. Partially offsetting the above increases was a $1.1 billion decrease in total investments mainly due to contractholder surrenders and the asset transfer feature which moved customer account values from the general account to the separate account due to favorable markets in 2013. Reinsurance recoverables also decreased $1.0 billion related to the reinsured liability for living benefit embedded derivatives primarily resulting from a decrease in the present value of future expected benefit payments driven by increases in interest rates as well as the impact of equity market appreciation.
Income from operations before income taxes increased $0.3 billion from $0.9 billion in 2012 to $1.2 billion in 2013. The increase was primarily driven by the impact on amortization of DAC and other costs, and on the reserves for the GMDB and GMIB features, of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and of changes in the estimated profitability of the business, as discussed in more detail below. Partially offsetting the benefit from these items was an unfavorable variance related to the mark-to-market of our non-reinsured living benefit features and related hedge positions, primarily due to larger hedge breakage losses in the current period driven by unfavorable fund performance as well as larger NPR losses.
The impact on the amortization of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions, and changes in the estimated profitability of the business resulted in a $1.0 billion and $0.6 billion net benefit in 2013 and 2012, respectively. 2013 had a larger amortization benefit driven by the impact of our annual reviews and updates of assumptions and changes in the valuation of the living benefit liabilities related to NPR, as well as the impact of positive market performance on contractholder accounts relative to our assumptions.
Revenues decreased $169 million, primarily driven by a $101 million decrease in realized investment gains/losses, net, primarily due to an unfavorable variance related to our non-reinsured living benefit features, as discussed above. Net investment income decreased $60 million as a result of lower average annuity account values in the general account, as discussed above. Asset management fees and other decreased $27 million primarily due to the elimination of the administrative service fees as a result of Advanced Series Trust Fund (“AST”)’s adoption of the Rule 12b-1 Plan, which is offset by the elimination of the related expenses within General, administrative and other expenses. Policy charges and fee income increased $12 million primarily driven by a favorable variance from lower market value adjustments paid to contractholders related to the Company’s market value adjusted investments option (“MVA”) primarily due to differences in market conditions and transfers of assets related to the asset transfer feature.
Benefits and expenses decreased $492 million primarily driven by a decrease in DAC amortization of $198 million and a $178 million decrease in interest credited to policyholders’ account balance, which includes DSI amortization. Changes in DAC and DSI amortization were related to the impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and the impact of changes in the estimated profitability of the business, as discussed above. Policyholders’ benefits decreased $95 million primarily due to a benefit in GMDB/GMIB reserves as a result of assumption updates and changes in the estimated profitability of the business. General, administrative and other expenses decreased $22 million primarily as a result of AST’s adoption of the Rule 12b-1 Plan, as discussed above.
Our income tax provision amounted to an income tax expense of $332 million and $224 million in 2013 and 2012, respectively. The increase in income tax expense primarily reflects the increase in pre-tax income from continuing operations for the year ended December 31, 2013.
For additional information regarding income taxes, see Note 9 to the Financial Statements.
Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long term financial resources available to support the operations of our business, fund business growth, and provide a cushion to withstand adverse circumstances. The ability to generate and maintain sufficient liquidity and capital depends on the profitability of our business, general economic conditions and our access to the capital markets through affiliates as described herein.
On September 19, 2013, the Financial Stability Oversight Council made a final determination that Prudential Financial is a “Designated Financial Company” under the Dodd-Frank Act. As a Designated Financial Company, Prudential Financial is now subject to supervision and examination by the Federal Reserve Bank of Boston and to stricter prudential regulatory standards, which include or will include requirements and limitations (some of which are the subject of ongoing rule-making) relating to risk-based capital, leverage, liquidity, stress-testing, overall risk management, resolution plans, early remediation; and may also include additional standards regarding capital, public disclosure, short-term debt limits, and other related subjects. In addition, on July 18, 2013, the Financial Stability Board, consisting of representatives of national financial authorities of the G20 nations, identified Prudential Financial as a global systemically important insurer. See “Business-Regulation” and “Risk Factors” for information on these recent actions and their impact.
Effective for the year ended December 31, 2013, the NAIC has adopted a change to the methodology for calculating RBC risk charges associated with commercial and agricultural mortgage loans. Prior to the adoption of this methodology change, the risk charges were calculated based on an insurance company’s portfolio level experience as compared to an industry average. The newly adopted change considers each loan’s risk in the calculation of these risk charges. We estimate that our ratio will be greater than 400% as of December 31, 2013, including the impact of the aforementioned change in methodology for calculating RBC risk charges associated with commercial and agricultural mortgage loans.
The regulatory capital level of the Company can be materially impacted by interest rate and equity market fluctuations, changes in the values of derivatives, the level of impairments recorded, and credit quality migration of the investment portfolio, among other items. Further, the recapture of business subject to third-party reinsurance arrangements due to defaults by, or credit quality migration affecting, the third-party reinsurers or for other reasons could negatively impact regulatory capital.
On December 16, 2013 and June 26, 2013, the Company paid dividends of $100 million and $184 million, respectively, to our parent, Prudential Annuities, Inc. On December 11, 2012 and June 29, 2012, the Company paid dividends of $160 million and $248 million, respectively, to Prudential Annuities, Inc. On November 29, 2011 and June 30, 2011, the Company paid dividends of $318 million and $270 million, respectively, to Prudential Annuities, Inc.
Effective August 31, 2013, the Company re-domesticated from Connecticut to Arizona, and, as a result, PALAC is able to claim reinsurance reserve credit for business ceded to Pruco Re without the need for Pruco Re to post collateral.
Liquid assets include cash, short-term investments, fixed maturities that are not designated as held-to-maturity and public equity securities. As of December 31, 2013 and 2012, the Company had liquid assets of $3.4 billion and $4.3 billion, respectively. The portion of liquid assets comprised of cash and short-term investments was $0.1 billion as of December 31, 2013 and 2012. As of December 31, 2013, $3.1 million, or 93%, of the fixed maturity investments company general account portfolios were rated high or highest quality based on NAIC or equivalent rating. The remaining $0.2 million, or 7%, of these fixed maturity investments were rated other than high or highest quality.