Management’s narrative addresses the financial condition of Pruco Life Insurance Company as of December 31, 2010, compared with December 31, 2009, and its results of operations for the years ended December 31, 2010 and 2009.
The Company sells universal life insurance, variable life insurance, term life insurance and variable annuities, primarily through third party distributors in the United States. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure, as the legal barriers that have historically segregated the markets of the financial services industry have been changed. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels. The Company also had marketed individual life insurance through its branch office in Taiwan. All insurance activity of the Taiwan branch has been ceded to an affiliate and the related assets and liabilities continue to be reflected in the Company’s statements of financial position.
Financial and Economic Environment. Our businesses and results of operations are impacted by general economic and market conditions and are sensitive to changes in equity markets and interest rates. The adverse market and economic conditions that began in the second half of 2007 have improved, with equity and fixed income markets continuing to recover. Interest rates and the pace and extent of changes in rates have impacted the profitability of certain products we offer as well as returns on the investment portfolio backing our insurance liabilities and equity.
Regulatory Environment. Our businesses are subject to comprehensive regulation and supervision. The financial market dislocations we have experienced have produced, and are expected to continue to produce, extensive changes in existing laws and regulations, and regulatory frameworks applicable to our businesses. In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law on July 21, 2010 made comprehensive changes to the regulation of financial services in the U.S. and subjects us to substantial additional federal regulation. In addition, state insurance laws regulate all aspects of our businesses and our insurance products are substantially affected by federal and state tax laws. Insurance regulators have begun to implement significant changes in the way in which industry participants must determine statutory reserves and statutory capital, particularly for products with embedded options and guarantees such as variable annuities, and are considering further potentially significant changes in these requirements. In addition, Congress from time to time considers legislation impacting U.S. federal income tax laws, such as the possible elimination of the dividends received deduction, which could adversely impact profitability or make our products less attractive to consumers.
The individual life market is mature and, due to the large number of competitors, competition is driven mainly by price and service. The economy has exacerbated pressure on pricing, creating an even greater challenge of maintaining pricing discipline. This has negatively impacted our individual life sales, in an industry which has shifted toward non-proprietary distribution channels, which are more price sensitive than proprietary distribution channels.
our returns on invested assets, including the impact of credit losses, net of the amounts we credit to policyholders’ accounts;
our ability to generate favorable investment results through asset/liability management and strategic and tactical asset allocation
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 that are incurred in producing new products. In addition, we also defer costs associated with sales inducements related to our variable 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 our deferred sales inducements, see Note 7 to the Consolidated Financial Statements. We amortize these deferred policy acquisition costs, or DAC, and deferred sales inducements (“DSI”), over the expected lives of the contracts, based on our estimates of the level and timing of gross profits or gross premiums, depending on the type of contract. As described in more detailed 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 or gross premiums. As of December 31, 2010, DAC for our life products was $1.7 billion and DAC for our annuity products was $1.7 billion. As of December 31, 2010, DSI was $538 million, related entirely to our annuity products.
Total gross profits include both actual experience and estimates of gross profits for future periods. We regularly evaluate and adjust the related DAC and DSI balances 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. Adjustments to the DAC and DSI balances include the impact to our estimate of total gross profits of the annual review of assumptions, quarterly adjustments for current period experience and quarterly adjustments for market performance related adjustments. Each of these adjustments is further discussed below in “- Annual assumptions review and quarterly adjustments.”
on the updated hedge target definition However, total gross profits for these purposes includes the difference between the value of the hedge target liability and asset value only to the extent this net amount is determined by management to be other than temporary, as well as the impact of assumption updates on the valuation of the hedge target liability. The determination of whether the difference between the value of the hedge target liability and asset value is other-than-temporary is based on an evaluation of the effectiveness of the hedge program. Management generally expects differences between the value of the hedge target liability and asset value to be temporary and to reverse over time. Such differences would not be included in total gross profits for purposes of determining the amortization rates. However, based on the effectiveness of the hedge program, management may determine that the difference between the value of the hedge target liability and the asset value is other-than-temporary and would include that amount in management’s best estimate of total gross profits for setting the DAC and DSI amortization rates. Management may also decide to temporarily hedge to an amount that differs from the target hedge definition, given overall capital considerations of our ultimate parent, Prudential Financial and its subsidiaries, as a whole, and prevailing market conditions. The impact from temporarily hedging to an amount that differs from the hedge target definition, as well as the results of the capital hedge program we began in the second quarter of 2009 and modified in 2010, are not considered in calculating total gross profits used to determine amortization rates nor included in actual gross profits used in calculating current period amortization.
For variable annuity contracts, DAC and DSI are more 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, and the shorter average life of the contracts.
The application of U.S. GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax asset to an amount that is more likely than not to be realized. Considerable judgment is required in determining whether a valuation allowance is necessary, and if so, the amount of such valuation allowance. In evaluating the need for a valuation allowance we consider many factors, including: (1) the nature of the deferred tax assets and liabilities; (2) whether they are ordinary or capital; (3) in which tax jurisdictions they were generated and the timing of their reversal; (4) taxable income in prior carryback years as well as projected taxable earnings exclusive of reversing temporary differences and carryforwards; (5) the length of time that carryovers can be utilized in the various taxing jurisdictions; (6) any unique tax rules that would impact the utilization of the deferred tax assets; and (7) any tax planning strategies that we would employ to avoid a tax benefit from expiring unused. Although realization is not assured, management believes it is more likely than not that the deferred tax assets, net of valuation allowances, will be realized.
a significant component of the difference between our actual tax expense and the expected amount determined using the federal statutory tax rate of 35%. The U.S. Treasury Department and the Internal Revenue Service, or IRS, intend to address through regulations the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. On February 14, 2011, the Obama Administration released the “General Explanations of the Administration’s Revenue Proposals.” Although the Administration has not released proposed statutory language, one proposal would change the method used to determine the amount of the DRD. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulation or legislation, could increase our actual tax expense and reduce our consolidated net income.
An increase or decrease in our effective tax rate by one percent would have resulted in an increase or decrease in consolidated income from continuing operations in 2010 of $6.4 million.
See Note 2 to the Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.
Reinsurance recoverables increased by $331 million from $2.396 billion at December 31, 2009 to $2.727 billion at December 31, 2010 driven by continued growth in the term life in force covered under Prudential Arizona Reinsurance Captive Company, or “PARCC”, Prudential Arizona
2010 to 2009 Annual Comparison. Income from Operations before Income Taxes increased $360 million from $13 million in 2009 to $373 million in 2010. The increase was primarily driven by lower amortization of deferred policy acquisition costs (“DAC”) and deferred sales inducements (“DSI”) of $199 million driven by the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions, as discussed below. Also contributing to the increase was higher fee income, net of distribution costs, of $143 million, driven by higher average variable annuity asset balances invested in separate accounts. The increase in separate account balances was due primarily to positive net flows, net market appreciation, and net transfers of balances from the general account to the separate accounts. In addition, results included a favorable variance related to our capital hedging program of $85 million. Results for 2009 included $76 million of mark-to-market losses on these capital hedges driven by favorable market conditions during the year, compared to $9 million of mark-to-market gains in 2010, primarily related to equity market declines in the second quarter of 2010. During the second quarter of 2010, we terminated the capital hedge program in lieu of a new program managed at the Prudential Financial parent company level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial as a whole, under stress scenarios.
As mentioned above, the increase in income from operations in 2010 included a $199 million favorable variance in the amortization of DAC/DSI related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions. This impact primarily relates to updates to the inputs used in the valuation of the reinsured liability for living benefit embedded derivatives, primarily due to reductions in the expected lapse rate assumption based on actual experience in 2010. Also contributing to lower DAC/DSI amortization is the impact of a change in our market-perceived non-performance risk (NPR), and lower amortization rates used as a basis for amortizing DAC/DSI, as discussed below. We incorporate the market-perceived risk of non-performance of our affiliates’ in the valuation of the embedded derivatives associated with our living benefit features on our variable annuity contracts. Beginning in the first quarter of 2009, in light of developments including rating agency downgrades to the financial strength ratings of the Company, we incorporated an additional spread over LIBOR into the discount rate used in the valuation of the embedded derivative liabilities to reflect an increase in the market perceived risk of our non-performance, thereby reducing the value of the embedded derivative liabilities.
Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the guaranteed minimum death and income benefit, or GMDB / GMIB, features of our variable annuity products.
As shown in the table above, results for both periods include quarterly updates for the impact of fund performance on our DAC/DSI amortization and GMDB/GMIB reserves for our variable annuity products. Results for the year ended December 31, 2010 included benefits of $29 million associated with these quarterly updates due to overall favorable market performance. The actual rates of return on annuity account values was 3.3% for the first quarter of 2010, negative 6.0% for the second quarter of 2010, 7.7% for the third quarter of 2010, and 5.8% for the fourth quarter of 2010, compared to our expected rates of return of approximately 2.0% for each of the quarters of 2010. The updates for 2009 resulted in a benefit of $123 million due to favorable market performance.
The $56 million benefit for 2010 and the $72 million benefit for 2009 for the quarterly adjustments for current period experience shown in the table above primarily reflect the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as an update for current and future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products. The unfavorable variance related to the amortization of DAC/DSI was primarily driven by more favorable market conditions in 2009 compared to 2010. The unfavorable variance related to the adjustment to the GMDB/GMIB reserves was primarily driven by more favorable differences in actual lapse experience and contract guarantee claim costs in 2009 compared to 2010.
Asset administration fees increased by $45 million from $26 million in 2009 to $71 million in 2010, primarily due to higher average separate account asset balances and higher fee revenue from separate account funds invested in the Advanced Series Trust, driven by amendments to the revenue sharing agreement in April, 2009 and November, 2010. (See Note 13 to the Consolidated Financial Statements).
Policyholders benefits, including changes in reserves, increased $30 million, from a benefit of $14 million in 2009 to a charge of $16 million in 2010, primarily due to differences in the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, as discussed above.
Interest credited to policyholders’ account balances decreased $35 million, from $125 million in 2009 to $90 million in 2010, primarily due to lower DSI amortization from the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions, discussed above. Partially offsetting this decrease was higher amortization of DSI from higher gross profits primarily due to higher fee income, and from the adjustments to our estimates of total gross profits used as the basis for amortizing DSI, shown in the table above.
Amortization of DAC decreased by $124 million, from $135 million in 2009 to $11 million in 2010. This decrease was primarily driven by lower DAC amortization from the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions, discussed above. Partially offsetting this decrease was an unfavorable variance related to the adjustments to our estimates of total gross profits used as the basis for amortizing DAC, as shown in the table above, and an increase in amortization from higher gross profits, primarily due to higher fee income.
Net realized investment gains/(losses) increased by $422 million from a loss of $407 million in 2009 to a gain of $15 million in 2010, primarily driven by $352 million of additional losses in 2009 related to the change in the value of the embedded derivative related to the reinsurance of the no-lapse guarantee on our universal life products with UPARC ($18 million loss for the year ended December 31, 2010 compared to a $370 million loss for the year ended December 31, 2009). The decrease in the value of this embedded derivative in 2009 was driven by the impact of higher interest rates. Increases in realized losses related to the valuation of the embedded derivative in 2010 driven by lower interest rates were entirely offset by the inclusion of non-performance risk. Net realized investment gains also increased $69 million due to $32 million of gains in 2010 on investments in derivatives and fixed maturities compared to $37 million of losses in 2009.
Net investment income increased $35 million, due to an increase in assets supporting our term and universal life products and growth in universal life and variable policyholder account balances due to increased policyholder deposits, as well as slight gains in 2010 on investments in real property separate account funds compared to losses in 2009.
2010 to 2009 Annual Comparison Benefits and expenses decreased $253 million from $586 million in 2009 to $333 million in 2010. Results benefitted $128 million primarily from lower amortization of deferred acquisition costs as well as a decrease in reserves for the guaranteed minimum death benefit feature in certain contracts from the impacts of the annual reviews conducted in both periods and a $155 million decrease in the change in reserves due to the amendment of certain of our affiliated reinsurance treaties to change settlement modes from monthly to annual resulting in an increase in ceded reserves.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, could result in the imposition of new capital, liquidity and other requirements on Prudential Financial and the Company. See “Other Business Regulation” in Part I for information regarding the potential effects of the Dodd-Frank bill on the Company and its affiliates.
Liquid assets include cash, cash equivalents, short-term investments, fixed maturities and public equity securities. As of December 31, 2010 and December 31, 2009 our insurance operations had liquid assets of $6.674 billion and $6.198 billion, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $612 million and $316 million as of December 31, 2010 and December 31, 2009, respectively. As of December 31, 2010, $5.495 billion, or 91% of the fixed maturity investments company general account portfolios were rated investment grade. The remaining $547.0 million, or 9%, of these fixed maturity investments were rated non-investment grade. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures in order to evaluate the adequacy of our insurance operations’ liquidity under a variety of stress scenarios. We believe that the liquidity profile of our assets is sufficient to satisfy current liquidity requirements, including under foreseeable stress scenarios.
The level of statutory capital 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, credit quality migration of investment portfolio, among other items. Further, the recapture of business subject to reinsurance arrangements due to defaults by, or credit quality migration affecting, the reinsurers could result in higher required statutory capital levels. The level of statutory capital of the Company is also affected by statutory accounting rules which are subject to change by insurance regulators.
Certain of the Company’s statutory reserves are ceded to an affiliated offshore captive reinsurance company. A reinsurance trust is established by the affiliated offshore captive reinsurance company to satisfy reinsurance reserve credit requirements. These reserve credits allow the Company to reduce the level of statutory capital it is required to hold. Reinsurance credit reserve requirements can move materially in either direction due to changes in equity markets and interest rates, actuarial assumptions and other factors. Higher reinsurance credit reserve requirements would necessitate depositing additional assets in the statutory reserve credit trusts, while lower reinsurance credit reserve requirements would allow assets to be removed from the statutory reserve credit trusts. We expect Prudential Financial would satisfy those additional needs through a combination of funding the reinsurance credit trusts with available cash, loans from Prudential Financial and/or affiliates and assets pledged to our affiliated offshore captive reinsurance company as collateral for hedging positions related to our living benefit features. Prudential Financial also continues to evaluate other options to address reserve credit needs such as obtaining letters of credit. Funding was provided to the captive reinsurance trusts of $201 million for the second quarter of 2010 to meet increased reserve credit requirements due to unfavorable equity market conditions lower interest rates, and an additional $20 million was provided for the third quarter of 2010 due to an update of actuarial assumptions based on an annual review, most notably a decrease in expected future lapse rates, partially offset by favorable equity market conditions. Due to favorable equity market conditions and higher interest rates in the fourth quarter of 2010, the need to fund the captive reinsurance trusts has declined by $348 million.
Information required with respect to this Item 8 regarding Financial Statements and Supplementary Data is set forth commencing on page hereof. See Index to Consolidated Financial Statements elsewhere in this Annual Report on Form 10-K.