Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of Pruco Life Insurance Company of New Jersey as of December 31, 2005, compared with December 31, 2004, and its results of operations for the years ended December 31, 2005 and 2004.
You should read the following analysis of the Company’s financial condition and results of operations in conjunction with the Forward-Looking Statements included below the Table of Contents, “Risk Factors,” and Financial statements included in this Annual Report on Form 10-K
The Company earns revenues principally from insurance premiums; mortality, expense, and asset management fees from insurance and investment products; and investment of general account and other funds. The Company earns premiums primarily from the sale of individual life insurance. The Company earns mortality, expense, and asset management fees from the sale and servicing of separate account products including variable life insurance and variable annuities. The Company’s operating expenses principally consist of insurance benefits provided, general business expenses, commissions and other costs of selling and servicing the various products we sell and interest credited on general account liabilities.
As prescribed by GAAP, we present our fixed maturity investments classified as available for sale at fair value in the statements of financial position. The fair values for our public fixed maturity securities are based on quoted market prices or estimates from independent pricing services. However, for our investments in private securities such as private placement fixed maturity securities, which comprised 12% of our investments as of December 31, 2005, this information is not available. For these private fixed maturities, fair value is determined typically by using a discounted cash flow model, which relies upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions and takes into account, among other things, the credit quality of the issuer and the reduced liquidity associated with private placements.
We capitalize costs that vary with and are related primarily to the acquisition of new and renewal insurance and annuity contracts. These costs include primarily commissions, costs of policy issuance and underwriting, and variable field office expenses. We amortize these deferred policy acquisition costs, or DAC, over the expected lives of the contracts, based on the level and timing of either gross profits, or gross premiums, depending on the type of contract. As of December 31, 2005, DAC in our life business was $185 million and DAC in our annuity business was $41 million.
DAC associated with the variable and universal life policies of our domestic individual life insurance business and the variable and fixed annuity contracts of our individual annuities business is amortized over the expected life of these policies in proportion to gross profits. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts. We regularly evaluate and adjust the related DAC balance with a corresponding charge or credit to current period earnings for the effects of our actual gross profits and changes in our assumptions regarding estimated future gross profits. For variable annuity contracts, DAC is more sensitive to the effects of changes in our estimates of gross profits 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, and the shorter average life of the contracts. This rate of return influences the fees we earn, costs we incur associated with minimum death benefit and other contractual
guarantees specific to our variable annuity contracts, as well as other sources of profit. This is also true, to a lesser degree, for our variable life policies; however, the variable life policies derive a significant portion of their gross profits from margins in the cost of insurance charge.
An increase or decrease in our effective tax rate by one percent of income from operations before income taxes and cumulative effect of accounting change, would have resulted in a decline or increase in income from continuing operations before cumulative effect of accounting change in 2005 of $0.5 million.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service and other taxing jurisdictions for audits ongoing or not yet commenced. On January 26, 2006, the Internal Revenue Service (“IRS”) officially closed the audit of the parent company’s consolidated federal income tax returns for the 1997 to 2001 periods. As a result of certain favorable resolutions, the Company’s statement of operations for the year ended December 31, 2005 includes an income tax benefit of $5 million, reflecting a reduction in the Company’s liability for income taxes. The parent company’s consolidated federal income tax returns for the 2002 and 2003 periods are currently under examination.
Stockholder’s equity increased by $27 million, from $318 million at December 31, 2004, to $345 million at December 31, 2005, as a result of net income partly offset by a decrease in unrealized gains in the fixed maturity portfolios, mentioned above.
Net income increased by $14 million, from $25 million in 2004 to $39 million in 2005. The increase reflects a $15 million pre-tax benefit resulting from an update to our assumptions used to amortize DAC and other costs and a favorable adjustment of $3 million reflecting the resolution of substantially all issues relating to the Internal Revenue Service examination of the federal income tax returns for the 1997 to 2001 periods. In addition, 2005 results included a higher contribution from investment income, net of interest credited, reflecting improved investment yields and higher asset balances compared to the prior period.
Revenues decreased by $28 million, from $166 million 2004 to $138 million in 2005. Premiums decreased by $21 million, from $29 million in 2004 to $8 million in 2005, due to increased reinsurance premiums resulting from the coinsurance agreement with PARCC (see Note 13 to the Financial Statements). Premiums in the annuity business resulting from annuitizations were unchanged from the prior period.
Total benefits and expenses decreased by $45 million, from $130 million in 2004 to $85 million in 2005. Policyholders’ benefits, including related changes in reserves, were $25 million lower in 2005 than in 2004. Policyholders’ benefits decreased by $17 million, from $27 million in 2004 to $10 million in 2005, due to increased reinsurance coverage from the new excess of loss reinsurance agreement with Prudential Insurance (see Note 13 to the Financial Statements). Reserve provisions decreased by $8 million, from $13 million in 2004, due to increased reinsurance reserves resulting from the coinsurance agreement with PARCC discussed above, partly offset by higher reserves resulting from the update of GMDB assumptions.
General, administrative and other expenses, excluding DAC amortization, were $6 million lower in 2005 than in 2004. Net general and administrative expenses in 2005 were $4 million higher than in 2004, while net distribution costs decreased by $10 million due to reinsurance expense allowances, net of capitalization, in the life business as a result of the PARCC coinsurance agreement discussed above. These allowances are included in net distribution expense within operating expenses and reduce overall distribution costs.
Tax expense in 2005 increased $4 million, from $10 million in 2004 to $14 million in 2005. The increase was primarily due to the growth in operating income, including the update of assumptions described above, partly offset by a favorable adjustment of $3 million in the current year reflecting the resolution of substantially all issues relating to the Internal Revenue Service examination of the federal income tax returns for the 1997 to 2001 periods.