This Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A,") addresses the financial condition of Pruco Life Insurance
Company, or the "Company," as of June 30, 2012, compared with December 31, 2011,
and its consolidated results of operations for the three and six months ended
June 30, 2012 and 2011. You should read the following analysis of our
consolidated financial condition and results of operations in conjunction with
the MD&A, the "Risk Factors" section, the statements under "Forward-Looking
Statements" and the audited Consolidated Financial Statements included in the
Company's Annual Report on Form 10-K and Form 10-K/A for the year ended
December 31, 2011, as well as the statements under "Forward-Looking Statements"
and the Unaudited Interim Consolidated Financial Statements included elsewhere
in this Quarterly Report on Form 10-Q.
Overview
The Company sells variable and fixed annuities, universal life insurance,
variable life insurance and term life insurance 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.
Products
Individual Annuities
The Company offers a wide array of annuities, including variable annuities that
are registered with the United States Securities and Exchange Commission (the
"SEC"), which may also include (1) fixed interest rate allocation options,
subject to a market value adjustment, and registered with the SEC, and (2) fixed
rate allocation options not subject to a market value adjustment and not
registered with the SEC. The Company also offers fixed annuitization options
during the payout phase of its variable annuities.
The Company offers variable annuities that provide our customers with
tax-deferred asset accumulation together with a base death benefit and a suite
of optional guaranteed death and living benefits. The benefit features
contractually guarantee the contractholder a return of no less than (1) total
deposits made to the contract less any partial withdrawals ("return of net
deposits"), (2) total deposits made to the contract less any partial withdrawals
plus a minimum return ("minimum return"), and/or (3) the highest contract value
on a specified date minus any withdrawals ("contract value"). These guarantees
may include benefits that are payable in the event of death, annuitization or at
specified dates during the accumulation period and withdrawal and income
benefits payable during specified periods. Our latest optional living benefits
guarantee, among other features, the ability to make withdrawals based on the
highest daily contract value plus a minimum return, credited for a period of
time. This highest daily guaranteed contract value is a notional amount that
forms the basis for determination of periodic withdrawals for the life of the
contractholder, and cannot be accessed as a lump-sum surrender value.
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Our variable annuity investment options provide our customers with the
opportunity to invest in proprietary and non-proprietary mutual funds,
frequently under asset allocation programs, and fixed-rate accounts. The
investments made by customers in the proprietary and non-proprietary mutual
funds generally represent separate account interests that provide a return
linked to an underlying investment portfolio. The general account investments
made in the fixed rate accounts are credited with interest at rates we
determine, subject to certain minimums. We also offer fixed annuities that
provide a guarantee of principal and interest credited at rates we determine,
subject to certain contractual minimums. Certain investments made in the
fixed-rate accounts of our variable annuities and certain fixed annuities impose
a market value adjustment if the invested amount is not held to maturity. Based
on the contractual terms, the market value adjustment can be positive, resulting
in an additional amount for the contractholder, or negative, resulting in a
deduction from the contractholder's account value or redemption proceeds.
The primary risk exposures of our variable annuity contracts relate 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, timing of annuitization and withdrawals, contract lapses and
contractholder mortality. The rate of return we realize from our variable
annuity contracts will vary based on the extent of the differences between our
actual experience and the assumptions used in the original pricing of these
products. As part of our risk management strategy we hedge or limit our exposure
to certain of these risks primarily through a combination of product design
elements, such as an asset transfer feature, externally purchased hedging
instruments and affiliated reinsurance arrangements with Pruco Re. Our returns
can also vary by contract based on our risk management strategy, including the
impact of any capital markets movements that we may hedge in Pruco Re, the
impact on that portion of our variable annuity contracts that benefit from the
asset transfer feature and the impact of risks we have deemed suitable to retain
and the impact of risks that are not able to be hedged.
As of June 30, 2012, approximately $54.1 billion or 87% of total variable
annuity account values contain a living benefit feature, compared to
approximately $44.0 billion or 86% as of December 31, 2011. As of June 30, 2012,
approximately $49.7 billion or 92% of variable annuity account values with
living benefit features included an asset transfer feature in the product
design, compared to approximately $39.6 billion or 90% as of December 31, 2011.
The increase in account values with living benefits and the asset transfer
feature reflects the impact of new business sales. The asset transfer feature,
included in the design of certain optional living benefits, transfers assets
between certain variable investments selected by the annuity contractholder and,
depending on the benefit feature, a fixed rate account in the general account or
a bond portfolio within the separate account. The asset transfer feature
associated with currently-sold benefit features transfers assets between certain
variable investments selected by the annuity contractholder and a designated
bond portfolio within the separate account. Therefore, it occurs at the
contractholder level rather than at the fund level. The transfers are based on
the static mathematical formula used with the particular optional benefit which
considers a number of factors, including the impact of investment performance on
the contractholders' total account value. In general, negative investment
performance may result in transfers to either a fixed rate account in the
general account or a bond portfolio within the separate account, and positive
investment performance may result in transfers to contractholder-selected
variable investments. Overall, the asset transfer feature helps to mitigate our
exposure to equity market risk and market volatility. Beginning in 2009, our
offerings of optional living benefit features associated with currently-sold
variable annuity products all include an asset transfer feature, and in 2009 we
discontinued any new sales of optional living benefit features without an asset
transfer feature. Other product design elements we utilize for certain products
to manage these risks include asset allocation restrictions and minimum issuance
age requirements.
As mentioned above, in addition to our asset transfer feature, we also manage
certain risks associated with our variable annuity products through hedging
programs and affiliated reinsurance agreements. Primarily in the reinsurance
affiliate, interest rate swaps, swaptions, floors and caps as well as equity
options and futures are purchased to hedge certain living benefit features
accounted for as embedded derivatives against changes in interest rates, equity
markets and market volatility. Historically, our hedging strategy sought to
generally match certain capital market sensitivities of the embedded derivative
liability as defined by accounting principles generally accepted in the United
States of America ("U.S. GAAP"), excluding the impact of the market-perceived
risk of our own non-performance, with capital market derivatives and options. In
the third quarter of 2010, the hedging strategy was revised as, management of
the Company and the reinsurance affiliate do not believe that the U.S. GAAP
value of the embedded derivative liability is an appropriate measure for
determining the hedge target. The hedge target is grounded in a
U.S. GAAP/capital markets valuation framework but incorporates two modifications
to the U.S. GAAP valuation assumptions. A credit spread is added to the
U.S. GAAP risk-free rate of return assumption used to estimate future growth of
bond investments in the customer separate account funds to account for the fact
that the underlying customer separate account funds which support these living
benefits are invested in assets that contain risk. The volatility assumption is
also adjusted to remove certain risk margins embedded in the value of the
embedded derivative liability under U.S. GAAP, as we believe the increase in the
liability driven by these margins is temporary and does reflect the economic
value of the liability. In addition, management of the Company and reinsurance
affiliate evaluate hedge levels versus the target given the overall capital
considerations of our ultimate parent Company, Prudential Financial Inc. and its
subsidiaries, and prevailing capital market conditions, and may decide to
temporarily hedge to an amount that differs from the hedge target definition.
The hedging strategy also includes a 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. The company owns a portion of the derivatives related to the program.
The program focuses on tail risk in order to protect statutory capital in a
cost-effective manner under stress scenarios. Prudential Financial assesses the
composition of the hedging program on an ongoing basis and may change it from
time to time based on an evaluation of its risk position or other factors.
Term Life Insurance
The Company offers a variety of term life insurance products which represent 63%
of our net individual life insurance in force at June 30, 2012, that provide
coverage for a specified time period. Most term products include a conversion
feature that allows the policyholder to convert the policy into permanent life
insurance coverage. The Company also offers term life insurance that provides
for a return of premium if the insured is alive at the end of the level premium
period. There continues to be significant demand for term life insurance
protection.
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The Company's profits from term insurance are not expected to directly
correlate, from a timing perspective, with the increase in term insurance in
force. This results from uneven product profitability patterns, as well as
varying costs of our ongoing capital management activities related to a portion
of the statutory reserves associated with these products, which may vary with
each year of business issued.
Variable Life Insurance
The Company offers a number of individual variable life insurance products which
represent 25% of our net individual life insurance in force at June 30, 2012.
Variable products provide a return linked to an underlying investment portfolio
selected by the policyholder while providing the policyholder with the
flexibility to change both the death benefit and premium payments. The
policyholder generally has the option of investing premiums in a fixed rate
option that is part of our general account and /or investing in separate account
investment options consisting of equity and fixed income funds. Funds invested
in the fixed rate option will accrue interest at rates we determine that vary
periodically based on our portfolio rate, subject to certain contractual
minimums. In the separate accounts, the policyholder bears the fund performance
risk. Each product provides for the deduction of charges and expenses from the
customer's contract fund. The Company also offers a variable product that has
the same basic features as our variable universal life product but also allows
for a more flexible guarantee against lapse where policyholders can select the
guarantee period. In a portion of the affluent market, we offer a private
placement variable universal life product, which also utilizes investment
options consisting of equity and fixed income funds. While variable life
insurance continues to be an important product, marketplace demand continues to
favor term and universal life insurance.
A significant portion of the Company's insurance profits are associated with our
large in force block of variable policies. Profit patterns on these policies are
not level and as the policies age, insureds generally begin paying reduced
policy charges. This reduction in policy charges, coupled with net policy count
and insurance in force runoff over time, reduces our expected future profits
from this product line. Asset management fees and mortality and expense fees are
a key component of variable life product profitability and vary based on the
average daily net asset value. Due to policyholder options under some of the
variable life contracts, lapses driven by periods of unfavorable equity market
performance may occur on a quarter lag with the market risk during this period
being borne by the Company.
Universal Life Insurance
The Company offers universal life insurance products which represent 12% of our
net individual life insurance in force at June 30, 2012. Universal life
insurance products may feature a fixed crediting rate that we determine and that
may vary periodically based on portfolio returns, subject to certain minimums,
flexible premiums and a choice of guarantees against lapse. They may feature an
equity index crediting rates subject to certain minimum and maximum rates.
Universal life policies provide for the deduction of charges and expenses from
the policyholders' contract fund.
The Company's profits from universal life insurance are impacted by mortality
and expense margins, interest spread on policyholder funds as well as the net
interest spread on capital management activities related to a portion of the
statutory reserves associated with these products.
Across our life insurance products we offer a living benefits option that allows
the policy owner to receive a portion of the life insurance benefit if the
insured is diagnosed with a terminal illness, or permanently confined to a
nursing home, in advance of death of the insured, to use as needed. The
remaining death benefit will be paid to the beneficiary upon the death of the
insured. We also have a variety of settlement and payment options for the
settlement of life insurance claims in addition to lump sum checks, including
placing benefits in retained asset accounts, which earn interest and are subject
to withdrawal in whole or in part at any time by the beneficiaries.
Significant Accounting Policies
For information on the Company's significant accounting policies, see Item 7.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in the Company's Annual Report on Form 10-K for the year ended
December 31, 2011.
Application of Critical Accounting Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America, or U.S. GAAP, requires the
application of accounting policies that often involve a significant degree of
judgment. Management, on an ongoing basis, reviews estimates and assumptions
used in the preparation of financial statements. If management determines that
modifications in assumptions and estimates are appropriate given current facts
and circumstances, results of operations and financial position as reported in
the Consolidated Financial Statements could change significantly.
Management believes the accounting policies relating to the following areas are
most dependent on the application of estimates and assumptions and require
management's most difficult, subjective, or complex judgments:
• Deferred policy acquisition and other costs;
• Valuation of investments, including derivatives, and the recognition of
other-than-temporary impairments;
• Policyholder liabilities;
• Taxes on income; and
• Reserves for contingencies, including reserves for losses in connection with
unresolved legal matters.
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In the first quarter of 2012, we revised the treatment of the results of the
living benefits hedging program in our best estimate of total gross profits used
to calculate the amortization of deferred policy acquisition costs ("DAC") and
deferred sales inducements ("DSI") associated with certain of our variable
annuity contracts. In 2011, we included certain results of the living benefits
hedging program in the reinsurance affiliate in our best estimate of gross
profits used to determine amortization rates only to the extent this net amount
was determined by management to be other-than-temporary. Beginning with the
first quarter of 2012, we are including certain results of the living benefits
hedging program in our best estimate of total gross profits used for determining
amortization rates each quarter without regard to the permanence of the changes.
Aside from this change, our policy for amortizing DAC and DSI remains as
described in our Annual Report on Form 10-K for the year ended December 31,
2011, under "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Accounting Policies & Pronouncements - Application of
Critical Accounting Estimates."
A discussion of each of the additional critical accounting estimates listed
above may also be found in our Annual Report on Form 10-K for the year ended
December 31, 2011, under "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Accounting Policies & Pronouncements -
Application of Critical Accounting Estimates."
Changes in Financial Position
June 30, 2012 versus December 31, 2011
Total assets increased $12,304 million, from $76,251 million at December 31,
2011 to $88,555 million at June 30, 2012.
Separate account assets increased $10,999 million, from $58,157 million at
December 31, 2011 to $69,156 million at June 30, 2012, primarily driven by
positive individual annuity net flows from new business sales and market
appreciation.
Reinsurance recoverables increased $557 million from $5,729 million at
December 31, 2011 to $6,286 million at June 30, 2012. The increase in
reinsurance recoverables was primarily driven by higher term reserves and
universal life policyholders' account balances ceded under existing affiliated
reinsurance agreements due to business growth. Also contributing to the increase
was an increase in the mark-to-market of the reinsurance recoverable related to
the reinsured liability for variable annuity living benefit embedded derivatives
primarily resulting from an increase in the present value of future expected
benefit payments driven by lower interest rates. See Note 8 to the Unaudited
Interim Consolidated Financial Statements for additional information regarding
affiliated reinsurance transactions.
Total investments increased $464 million from $8.587 million at December 31,
2011 to $9,051 million at June 30, 2012. The increase in total investments was
primarily driven by continued universal life sales and in force growth.
Deferred policy acquisition costs increased $319 million from $2,546 million at
December 31, 2011 to $2,865 million at June 30, 2012. The increase is primarily
driven by the capitalization of commissions related to variable annuity sales.
Total liabilities increased $12,177 million, from $73,456 million at
December 31, 2011 to $85,633 million at June 30, 2012.
Separate account liabilities increased $10,999 million, offsetting the increase
in separate account assets described above.
Future policy benefits and other policyholder liabilities increased
$563 million, from $5,294 million at December 31, 2011 to $5,857 million at
June 30, 2012, primarily driven by an increase in reserves supporting term
business arising from business growth. Also contributing to the increase was an
increase in the liability for living benefit embedded derivatives, as described
above.
Policyholder account balances increased $453 million, from $7,812 million at
December 31, 2011 to $8,265 million at June 30, 2012, primarily driven by
continued universal life sales and in force growth.
Short-term and long-term debt to affiliates increased by $330 million, from
$1,301 million at December 31, 2011 to $1,631 million at June 30, 2012,
primarily driven by increased borrowings to fund new business commissions
resulting from annuity sales.
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Results of Operations
Three Months ended June 30, 2012 versus June 30, 2011
Three Months Ended
June 30,
2012 2011
(in thousands)
Operating results:
Revenues:
Annuity Products $ 367,441 $ 280,187
Life Products and Other 193,762 213,658
$ 561,203 $ 493,845
Benefits and expenses:
Annuity Products $ 914,571 $ 280,197
Life Products and Other 139,526 185,091
$ 1,054,097 $ 465,288
Income (loss) from Operations before Income Taxes
Annuity Products $ (547,130 ) $ (10 )
Life Products and Other 54,236 28,567
$ (492,894 ) $ 28,557
Annuity Products
Income (Loss) from Operations before Income Taxes
2012 to 2011 Three Month Comparison. Income (loss) from operations before income
taxes decreased $547 million from $0 million in the second quarter of 2011 to a
loss of $547 million in the second quarter of 2012. The decrease was primarily
driven by higher amortization of deferred policy acquisition costs ("DAC") and
deferred sales inducements ("DSI") primarily related to the impact of the
mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions, as discussed in more detail below. Also
contributing to the decrease was an unfavorable variance related to adjustments
to the amortization of DAC and DSI, and in the reserves for the guaranteed
minimum death ("GMDB") and income benefit ("GMIB") features of our variable
annuity products. These adjustments are primarily driven by the impact on the
estimated profitability of the business of quarterly adjustments to reflect
current period market performance and experience, and are discussed in more
detail below.
Excluding the items discussed above, income (loss) from operations before income
taxes increased compared to the second quarter of 2011 primarily driven by
higher fee income, net of distribution costs, due to higher average variable
annuity account values invested in separate accounts primarily due to positive
net flows from new business sales. The primary driver offsetting this increase
was higher general and administrative expenses, net of capitalization, primarily
due to higher costs associated with business development.
We amortize DAC and DSI over the expected lives of the contracts based on the
level and timing of gross profits on the underlying Annuity products. In
calculating gross profits, we consider mortality, persistency, and other
elements as well as rates of return on investments associated with these
contracts and include profits and losses related to these contracts that are
reported in affiliated legal entities other than the Company as a result of, for
example, reinsurance agreements with those affiliated entities. The Company is
an indirect subsidiary of Prudential Financial, Inc. (an SEC registrant) and has
extensive transactions and relationships with other subsidiaries of Prudential
Financial, Inc. including reinsurance agreements, as discussed in Note 8 to the
Unaudited Interim Consolidated Financial Statements. Incorporating all
product-related profits and losses in gross profits, including those that are
reported in affiliated legal entities, produces an amortization pattern
representative of the economics of the products.
As mentioned above, included in the unfavorable variance from higher
amortization of DAC and DSI, was $526 million of higher amortization 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 changes in the valuation of the reinsured living benefit liabilities in the
second quarter of 2012 related to NPR gains, which we and the reinsurance
affiliate believe to be non-economic, and choose not to hedge, as discussed
above, partially offset by losses driven by the difference between the change in
the fair value of the hedge target liability and the change in the fair value of
the hedge assets in the reinsurance affiliate due to unfavorable market
conditions in the second quarter of 2012.
To reflect the NPR of our affiliates in the valuation of the embedded derivative
liabilities, we incorporate an additional spread over LIBOR into the discount
rate used in the valuation. NPR gains in the reinsurance affiliate in the second
quarter of 2012 were primarily driven by a higher base of embedded derivatives
in a liability position as well as a widening of NPR spreads. Decreases in
risk-free interest rates and the impact of unfavorable account value
performance, drove increases in the embedded derivative liability base in the
second quarter of 2012. The NPR gains in the reinsurance affiliate were larger
in the second quarter of 2012 compared to the second quarter of 2011 resulting
in an unfavorable variance from higher offsetting DAC and DSI amortization.
As shown in the following table, the income from operations before income taxes
for the second quarter of 2012 included $52 million of charges from adjustments
to the reserves for the GMDB and GMIB features of our variable annuity products
and to the amortization of DAC and DSI, compared to $7 million of charges
included in the second quarter of 2011.
Three Months Ended June 30, 2012 Three Months Ended June 30, 2011
Amortization Reserves for Amortization Reserves for
of DAC and GMDB / of DAC and GMDB /
DSI (1) GMIB (2) Total DSI (1) GMIB (2) Total
(in thousands)
Quarterly market performance
adjustment $ (21,776 ) $ (28,760 ) $ (50,536 ) $ (7,168 ) $ (3,632 ) $ (10,799 )
Quarterly adjustment for current
period experience and other
updates (3) 832 (2,395 ) (1,563 ) 4,686 (1,352 ) 3,334
Total $ (20,944 ) $ (31,155 ) $ (52,099 ) $ (2,482 ) $ (4,984 ) $ (7,465 )
(1) Amounts reflect (charges) or benefits for (increases) or decreases,
respectively, in the amortization of DAC and DSI.
(2) Amounts reflect (charges) or benefits for reserve (increases) or decreases,
respectively, related to the GMDB / GMIB, features of our variable annuity
products.
(3) Represents the impact of differences between actual gross profits for the
period and the previously estimated expected gross profits for the period, as
well as updates for current and future expected claims costs associated with
the GMDB/GMIB features of our variable annuity products.
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The $51 million and $11 million of charges in the second quarter of 2012 and
2011, respectively, shown in the table above, relating to the quarterly market
performance adjustments are attributable to changes to our estimate of total
gross profits to reflect actual fund performance. The following table shows the
actual quarterly rates of return on variable annuity account values compared to
our previously expected quarterly rates of return used in our estimate of total
gross profits for the periods indicated.
Second Second
Quarter Quarter
Actual rate of return (2.1 )% 0.8 %
Expected rate of return 2.0 % 1.8 %
Lower than expected returns in the second quarter of 2012 decreased our estimate
of total gross profits used as a basis for amortizing DAC and DSI and increased
our estimate of future expected claims costs associated with the GMDB and GMIB
features of our variable annuity products, by establishing a new, lower starting
point for the variable annuity account values used in estimating those items for
future periods. This change results in a higher required rate of amortization
and higher required reserve provisions, which are applied to all prior periods.
The resulting cumulative adjustment to prior amortization and reserve provisions
are recognized in the current period. Lower than expected returns in the second
quarter of 2011 had similar, but less significant impacts due to a lesser
variance between actual and expected returns.
We derive our near-term future rate of return assumptions using a reversion to
the mean approach, a common industry practice. Under this approach, we consider
actual returns over a period of time and initially adjust 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. The near-term
future projected blended rate of return across all contract groups is 9.0% per
annum as of June 30, 2012, or approximately 2.2% per quarter.
The $2 million net charge and $3 million net benefit in the second quarter of
2012 and 2011, respectively, shown in the table above, reflect the quarterly
adjustments for current period experience, also referred to as experience
true-up adjustments. The net charge in the second quarter of 2012 was primarily
driven by differences in actual lapse experience and contract guarantee claim
costs. The experience true-up adjustments for the second quarter of 2011 were
primarily driven by a reduction in the amortization of DAC/DSI driven by higher
than expected gross profits primarily from higher than expected fee income.
As noted previously, the quarterly adjustments to reflect current period market
performance and experience impact the estimated profitability of our business.
Therefore, in addition to the current period impacts discussed above, these
items will also drive changes in our GMDB and GMIB reserves and the amortization
of DAC and DSI in future periods.
Revenues
2012 to 2011 Three Month Comparison. Revenues increased $87 million from
$280 million in the second quarter of 2011 to $367 million in the second quarter
of 2012.
Policy charges and fee income, consisting primarily of mortality and expense and
other insurance charges assessed on policyholders' fund balances, increased
$67 million from $193 million in the second quarter of 2011 to $260 million in
the second quarter of 2012. The increase was primarily driven by higher average
separate account asset balances due to positive net flows from new business
sales.
Asset administration fees increased by $15 million from $47 million in the
second quarter of 2011 to $62 million in the second quarter of 2012, primarily
due to higher average separate account asset balances, as discussed above.
Benefits and Expenses
2012 to 2011 Three Month Comparison. Benefits and expenses increased
$635 million from an expense of $280 million in the second quarter of 2011 to an
expense of $915 million in the second quarter of 2012.
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Amortization of DAC increased by $442 million, from $85 million in the second
quarter of 2011 to $527 million in the second quarter of 2012 primarily due to
higher DAC amortization related to the impact of the mark-to-market of the
reinsured liability for living benefit embedded derivatives and related hedge
positions and the impact of our quarterly adjustments to reflect current period
experience and market performance, as discussed above.
Interest credited to policyholders' account balances increased $134 million,
from $41 million in the second quarter of 2011 to $175 million in the second
quarter of 2012, due to higher DSI amortization primarily related to the impact
of the mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions and the impact of our quarterly
adjustments to reflect current period experience and market performance, as
discussed above.
General and administrative expenses, net of capitalization, increased by
$31 million, from $120 million in the second quarter of 2011 to $151 million in
the second quarter of 2012. The increase is primarily due to higher costs to
support business growth and higher asset based trail commissions due to higher
average variable annuity account values, as discussed above.
Policyholders benefits, including changes in reserves, increased $28 million,
from $23 million in the second quarter of 2011 to $51 million in the second
quarter of 2012, primarily due to the adjustments to the GMDB and GMIB reserves
related to the impact of our quarterly adjustments to reflect current period
experience and market performance, as discussed above.
Life Products and Other
Income from Operations before Income Taxes
2012 to 2011 Three month Comparison.Income from operations before income taxes
increased $25 million from $29 million in the second quarter of 2011 to
$54 million in the second quarter of 2012. The increase includes the impact of a
$13 million charge in the second quarter of 2011 arising from an understatement
of amortization of deferred policy acquisition costs in prior periods. Excluding
this adjustment, Income from Operations before Income Taxes increased
$12 million reflecting the impact of continued universal life and term business
growth, partially offset by a $2 million increase in policyholder benefits
including $1 million related to estimated payments arising from use of new
Social Security Master Death File matching criteria to identify deceased policy
and contract holders. The ongoing impact of variable life in force run-off and
an increase in amortization of deferred policy acquisition costs net of related
amortization of unearned revenue reserves, resulting from changes in our
estimates of total gross profits arising from separate account fund performance
were also partial offsets.
Revenues
2012 to 2011 Three month Comparison. Revenues decreased $20 million, from
$214 million in the second quarter of 2011 to $194 million in the second quarter
of 2012.
Policy charges and fee income, consisting primarily of mortality and expense
loading and other insurance charges assessed on general and separate account
policyholders' fund balances, decreased $23 million from $110 million in the
second quarter of 2011 to $87 million in the second quarter of 2012, including
the impact of the third quarter 2011 coinsurance agreement with PAR U, an
affiliated company (see Note 8 to the Unaudited Interim Consolidated Financial
Statements for more information) which resulted in the ceding of policy charge
income to this affiliate and the impact of the variable life in force run-off.
These decreases were partially offset by higher policy charges and fee income
driven by continued universal life business growth and an increase in the
amortization of unearned revenue reserves due to changes in our estimates of
total gross profits reflecting the impact of unfavorable market conditions on
separate account fund performance in the second quarter of 2012 compared to the
impact of favorable market conditions in the second quarter of 2011.
Net investment income decreased $3 million, from $69 million in the second
quarter of 2011 to $66 million in the second quarter of 2012. The decrease
includes the impact of transferring assets to PAR U, an affiliated company, as
part of the third quarter 2011 coinsurance agreement (see Note 8 to the
Unaudited Interim Consolidated Financial Statements for more information) and
lower invested asset yields, partially offset by higher investment income
arising from growth in asset balances from growth in our universal life and term
business.
Asset management fees and other revenue increased $6 million, from $14 million
in the second quarter of 2011 to $20 million in the second quarter of 2012
driven by amortization of the deferred gain arising from the third quarter 2011
coinsurance agreement with PAR U, an affiliate (see Note 8 to the Unaudited
Interim Consolidated Financial Statements for more information).
Benefits and Expenses
2012 to 2011 Three month Comparison. Total benefits and expenses decreased
$45 million, from $185 million in the second quarter of 2011 to $140 million in
the second quarter of 2012.
Policyholders' benefits, including interest credited to policyholders' account
balances, decreased $5 million, from $76 million in the second quarter of 2011
to $71 million in the second quarter of 2012. This decrease includes the impact
of the third quarter 2011 coinsurance agreement with PAR U (see Note 8 to the
Unaudited Interim Consolidated Financial Statements for more information on
reinsurance agreements), which drove a $12 million decline in interest credited
to policyholder account balances as a result of ceding a portion of universal
life policyholder account balances to PAR U and a $6 million lower increase in
reserves for future policy holder benefits, partially offset by increases in
both items arising from continued universal life business growth. The decrease
in policyholder's benefits, including interest credited to policyholders'
account balances, was partially offset by a $2 million increase in policyholder
benefits including a $1 million increase in reserves for estimated payments
arising from use of new Social Security Master Death File matching criteria to
identify deceased policy and contract holders.
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Amortization of deferred policy acquisition costs of $26 million in the second
quarter of 2012 decreased $33 million from $59 million in the second quarter of
2011. The decrease includes a $14 million decline in amortization of acquisition
costs associated with our universal life business driven by the third quarter
2011 coinsurance agreement with PAR U (see Note 8 to the Unaudited Interim
Consolidated Financial Statements), a $13 million decrease in amortization
arising from a charge in the second quarter of 2011 related to the
understatement of deferred reinsurance expense allowances related to affiliated
reinsurance of our term business in prior periods, and lower amortization
associated with our variable life business including the impact of on-going
in-force run off. These decreases were partially offset by a $1 million increase
in amortization due to changes in our estimates of total gross profits
reflecting the impact of unfavorable market conditions on separate account fund
performance in the second quarter of 2012 compared to the impact of favorable
market conditions in the second quarter of 2011.
Six Month Ended June 30,
2012 2011
(in thousands)
Operating results:
Revenues:
Annuity Products $ 707,976 $ 553,743
Life Products and Other 351,301 418,858
$ 1,059,277 $ 972,601
Benefits and expenses:
Annuity Products $ 631,336 $ 490,703
Life Products and Other 282,024 357,640
$ 913,360 $ 848,343
Income (loss) from Operations before Income Taxes
Annuity Products $ 76,640 $ 63,040
Life Products and Other 69,277 61,218
$ 145,917 $ 124,258
Annuity Products
Income (Loss) from Operations before Income Taxes
2012 to 2011 Six Month Comparison. Income from operations before income taxes
increased $14 million from $63 million for the six months ended June 30, 2011 to
$77 million for the six months ended June 30, 2012. The primary driver of the
increase in income period over period was due to higher fee income, net of
distribution costs, due to higher average variable annuity account values
invested in separate accounts primarily due to positive net flows from new
business sales. Partially offsetting this increase was higher amortization of
deferred policy acquisition costs ("DAC") and deferred sales inducements ("DSI")
primarily related to higher gross profits from the increase in fee income and
the impact of the mark-to-market of the reinsured liability for living benefit
embedded derivatives and related hedge positions, as discussed in more detail
below. Partially offsetting this decrease was a favorable variance related to
adjustments to the amortization of DAC and DSI, and in the reserves for the
guaranteed minimum death ("GMDB") and income benefit ("GMIB") features of our
variable annuity products. These adjustments are primarily driven by the impact
on the estimated profitability of the business of quarterly adjustments to
reflect current period market performance and experience, and are discussed in
more detail below.
Also offsetting the increase in fees was an unfavorable variance in the
mark-to-market related to the embedded derivatives associated with our
non-reinsured living benefit features and related hedges primarily due to
differences in market conditions. Also offsetting this increase were higher
general and administrative expenses, net of capitalization, primarily due to
higher costs to support business growth.
We amortize DAC and DSI over the expected lives of the contracts based on the
level and timing of gross profits on the underlying Annuity products. In
calculating gross profits, we consider mortality, persistency, and other
elements as well as rates of return on investments associated with these
contracts and include profits and losses related to these contracts that are
reported in affiliated legal entities other than the Company as a result of, for
example, reinsurance agreements with those affiliated entities. The Company is
an indirect subsidiary of Prudential Financial, Inc. (an SEC registrant) and has
extensive transactions and relationships with other subsidiaries of Prudential
Financial, Inc. including reinsurance agreements, as discussed in Note 8 to the
Unaudited Interim Consolidated Financial Statements. Incorporating all
product-related profits and losses in gross profits, including those that are
reported in affiliated legal entities, produces an amortization pattern
representative of the economics of the products.
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As mentioned above, included in the unfavorable variance from higher
amortization of DAC and DSI, was $34 million of higher amortization 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 changes in the valuation of the reinsured living benefit liabilities in the
first six months of 2012 related to NPR gains, which we and the reinsurance
affiliate believe to be non-economic, and choose not to hedge, as discussed
above, and differences between the change in the fair value of the hedge target
liability and the change in the fair value of the hedge assets in the
reinsurance affiliate due to differences in market conditions, as well as NPR
spread widening.
NPR gains in the reinsurance affiliate in 2012 were primarily driven by a higher
base of embedded derivatives in a liability position, primarily in the second
quarter of 2012, as well as a widening of NPR spreads. Decreases in risk-free
interest rates and the impact of unfavorable account value performance,
primarily in the second quarter of 2012, drove increases in the embedded
derivative liability base in 2012. The NPR gains in the reinsurance affiliate
resulted in an unfavorable variance from higher offsetting DAC and DSI
amortization.
As shown in the following table, the income from operations before income taxes
for the first six months of 2012 included $28 million of net benefits from
adjustments to the reserves for the GMDB and GMIB features of our variable
annuity products and to the amortization of DAC and DSI, compared to $9 million
of benefits included in the first six months of 2011.
Six Months Ended June 30, 2012 Six Months Ended June 30, 2011
Amortization Reserves for Amortization Reserves for
of DAC and GMDB / of DAC and GMDB /
DSI (1) GMIB (2) Total DSI (1) GMIB (2) Total
(in thousands)
Quarterly market performance
adjustment $ 3,750 $ 18,485 $ 22,235 $ (1,585 ) $ 3,513 $ 1,928
Quarterly adjustment for current
period experience and other
updates (3) 9,039 (3,720 ) 5,319 5,485 1,106 6,591
Total $ 12,789 $ 14,765 $ 27,554 $ 3,900 $ 4,619 $ 8,519
(1) Amounts reflect (charges) or benefits for (increases) or decreases,
respectively, in the amortization of DAC and DSI.
(2) Amounts reflect (charges) or benefits for reserve (increases) or decreases,
respectively, related to the GMDB / GMIB, features of our variable annuity
products.
(3) Represents the impact of differences between actual gross profits for the
period and the previously estimated expected gross profits for the period, as
well as updates for current and future expected claims costs associated with
the GMDB/GMIB features of our variable annuity products.
The $22 million and $2 million of net benefits in the first six months of 2012
and 2011, respectively, shown in the table above, relating to the quarterly
market performance adjustments are attributable to changes to our estimate of
total gross profits to reflect actual fund performance. The following table
shows the actual quarterly rates of return on variable annuity account values
compared to our previously expected quarterly rates of return used in our
estimate of total gross profits for the periods indicated.
2012 2011
First Second First Second
Quarter Quarter Quarter Quarter
Actual rate of return 7.5 % (2.1 )% 3.4 % 0.8 %
Expected rate of return 2.3 % 2.0 % 1.8 % 1.8 %
Higher than expected returns in the first six months of 2012 increased our
estimate of total gross profits used as a basis for amortizing DAC and DSI and
decreased our estimate of future expected claims costs associated with the GMDB
and GMIB features of our variable annuity products, by establishing a new,
higher starting point for the variable annuity account values used in estimating
those items for future periods. This change results in a lower required rate of
amortization and lower required reserve provisions, which are applied to all
prior periods. The resulting cumulative adjustment to prior amortization and
reserve provisions are recognized in the current period. Higher than expected
returns in the first six months of 2011 had similar, but less significant
impacts due to a lesser variance between actual and expected returns.
As noted previously, the quarterly adjustments to reflect current period market
performance and experience impact the estimated profitability of our business.
Therefore, in addition to the current period impacts discussed above, these
items will also drive changes in our GMDB and GMIB reserves and the amortization
of DAC and DSI in future periods.
Revenues
2012 to 2011 Six Month Comparison. Revenues increased $154 million from
$554 million in the first six months of 2011 to $707 million in the first six
months of 2012.
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Policy charges and fee income, consisting primarily of mortality and expense and
other insurance charges assessed on policyholders' fund balances, increased
$143 million from $355 million in the first six months of 2011 to $498 million
in the first six months of 2012. The increase was primarily driven by higher
average separate account asset balances due to positive net flows from new
business sales.
Asset administration fees increased by $35 million from $86 million in the first
six months of 2011 to $122 million in the first six months of 2012, primarily
due to higher average separate account asset balances, as discussed above.
Partially offsetting these increases was a decrease in net realized investment
gains (losses) of $20 million from a gain of $24 million in the first six months
of 2011, to a gain of $4 million in the first six months of 2012, primarily
driven by an unfavorable variance in the mark-to market related to the embedded
derivatives associated with our non-reinsured living benefit features and
related hedges, as discussed above.
Benefits and Expenses
2012 to 2011 Six Month Comparison. Benefits and expenses increased $141 million
from $491 million in the first six months of 2011 to $631 million in the first
six months of 2012.
Amortization of DAC increased by $65 million, from $126 million in the first six
months of 2011 to $191 million in the first six months of 2012 primarily due to
higher gross profits from higher fee revenue in addition to the impact of the
mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions and the impact of our quarterly
adjustments to reflect current period experience and market performance, as
discussed above.
Interest credited to policyholders' account balances increased $16 million, from
$78 million in the first six months of 2011 to $94 million in the first six
months of 2012, primarily due to higher DSI amortization due to higher gross
profits from higher fee revenue in addition to the impact of the mark-to-market
of the reinsured liability for living benefit embedded derivatives and related
hedge positions and the impact of our quarterly adjustments to reflect current
period experience and market performance, as discussed above.
General and administrative expenses, net of capitalization, increased
$57 million, from $242 million in the first six months of 2011 to $299 million
in the first six months of 2012. The increase is primarily due to higher costs
associated with business development and higher asset based trail commissions
due to higher average variable annuity account values, as discussed above.
Life Products and Other
Income from Operations before Income Taxes
2012 to 2011 Six month Comparison. Income from operations before income taxes
increased $8 million from $61 million in the first six months of 2011 to
$69 million in the first six months of 2012. The increase includes the impact of
a $13 million charge in the second quarter of 2011 arising from an
understatement of amortization of deferred policy acquisition costs in prior
periods. Excluding this adjustment, Income from Operations before Income Taxes
decreased $5 million. This decrease includes the impact of amortization of
derivative costs and market value changes on derivatives that are part of the
Company's Capital Protection Framework (see the Liquidity and Capital Resources
section for additional information), the ongoing impact of variable life in
force run-off, and a $1 million increase in policyholder benefits including
$3 million related to estimated payments arising from use of new Social Security
Master Death File matching criteria to identify deceased policy and contract
holders These decreases were partially offset by the impact of continued
universal life and term business growth, and a decrease in amortization of
deferred policy acquisition costs net of related amortization of unearned
revenue reserves, resulting from changes in our estimates of total gross profits
arising from separate account fund performance.
Revenues
2012 to 2011 Six month Comparison. Revenues decreased $68 million, from
$419 million in the first six months of 2011 to $351 million in the first six
months of 2012.
Policy charges and fee income, consisting primarily of mortality and expense
loading and other insurance charges assessed on general and separate account
policyholders' fund balances, decreased $47 million from $221 million in the
first six months of 2011 to $174 million in the first six months of 2012,
including the impact of the third quarter 2011 coinsurance agreement with PAR U,
an affiliated company (see Note 8 to the Unaudited Interim Consolidated
Financial Statements for more information) which resulted in the ceding of
policy charge income to this affiliate and the impact of the variable life in
force run-off. Also contributing to the decline was a decrease in the
amortization of unearned revenue reserves due to changes in our estimates of
total gross profits reflecting the impact of more favorable market conditions on
separate account fund performance in the first six months of 2012 compared to
the first six months of 2011 and the impact of an overstatement of expected
gross profits in prior periods. Continued universal life business growth was a
partial offset to the decreases to policy charge and fee income.
Net realized investment gains decreased $18 million, from net gains of
$4 million in the first six months of 2011 to net losses of $14 million in the
first six months of 2012. The decrease was primarily driven by $12 million of
amortization of derivative costs related to derivatives that are part of the
Company's Capital Protection Framework (see the Liquidity and Capital Resources
section for additional information) and a $1 million decline in the market value
of these derivatives.
Net investment income decreased $10 million, from $139 million in the first six
months of 2011 to $129 million in the first six months of 2012. The decrease
includes the impact of transferring assets to PAR U, an affiliated company, as
part of the third quarter 2011 coinsurance agreement (see Note 8 to the
Unaudited Interim Consolidated Financial Statements for more information) and
lower invested asset yields, partially offset by higher investment income
arising from growth in asset balances from growth in our universal life and term
business.
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Asset management fees and other revenue increased $9 million, from $29 million
in the first six months of 2011 to $38 million in the first six months of 2012
driven by amortization of the deferred gain arising from the third quarter 2011
coinsurance agreement with PAR U, an affiliate (see Note 8 to the Unaudited
Interim Consolidated Financial Statements for more information).
Benefits and Expenses
2012 to 2011 Six month Comparison. Total benefits and expenses decreased
$76 million, from $358 million in the first six months of 2011 to $282 million
in the first six months of 2012.
Policyholders' benefits, including interest credited to policyholders' account
balances, decreased $22 million, from $166 million in the first six months of
2011 to $144 million in first six months of 2012. This decrease includes the
impact of the third quarter 2011 coinsurance agreement with PAR U (see Note 8 to
the Unaudited Interim Consolidated Financial Statements for more information on
reinsurance agreements), which drove a $24 million decline in interest credited
to policyholder account balances as a result of ceding a portion of universal
life policyholder account balances to PAR U and a $14 million lower increase in
reserves for future policy holder benefits, partially offset by increases in
both items arising from continued universal life business growth. These
decreases were partially offset by a $1 million increase in policyholder
benefits driven by a $3 million increase in reserves for estimated payments
arising from use of new Social Security Master Death File matching criteria to
identify deceased policy and contract holders, partially offset by a $2 million
decrease in death benefits.
Amortization of deferred policy acquisition costs of $50 million in the first
six months of 2012 decreased $45 million from $95 million in the first six
months of 2012. The decrease was driven by a $21 million decline in amortization
of acquisition costs associated with our universal life business reflecting the
impact of the third quarter 2011 coinsurance agreement with PAR U (see Note 8 to
the Unaudited Interim Consolidated Financial Statements) and a $13 million
decrease in amortization arising from a charge in the second quarter of 2011
related to the understatement of deferred reinsurance expense allowances related
to affiliated reinsurance of our term business in prior periods. Lower
amortization of acquisition costs associated with our variable life business
including the impact of on-going in-force run off, a $2 million decrease due to
changes in our estimates of total gross profits reflecting the impact of more
favorable market conditions on separate account fund performance in the first
six months of 2012 compared to the first six months of 2011, and a $1 million
decrease due to an overstatement of expected gross profits in prior periods also
contributed to the decline.
Income Taxes
The income tax provision amounted to an expense of $38 million for the six
months ended June 30, 2012 compared to an expense of $24 million for the six
months ended June 30, 2011 primarily driven by higher pre-tax income in the
current period compared to the prior period.
The Company's liability for income taxes includes the 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 authorities.
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 statute of limitations for the 2004 through 2006
tax years will expire in December 2012, unless extended. The statute of
limitations for the 2007 tax year will expire in December 2013, unless extended.
Tax years 2008 through 2011 are still open for IRS examination. It is reasonably
possible that the total amount of unrecognized tax benefits will decrease
anywhere from $0 to $576 thousand within the next 12 months due to the
completion of the IRS examination for tax years 2007 through 2010.
The dividends received deduction ("DRD") reduces the amount of dividend income
subject to U.S. tax and is a significant component of the difference between the
Company's effective tax rate and the federal statutory tax rate of 35%. The DRD
for the current period was estimated using information from 2011, current year
results, and was adjusted to take into account the current year's equity market
performance. The actual current year DRD can vary from the estimate 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 mutual fund investments, changes in the account balances of variable life
and annuity contracts, and the Company's taxable income before the DRD.
In August 2007, the IRS released Revenue Ruling 2007-54, which included, among
other items, guidance on the methodology to be followed in calculating the DRD
related to variable life insurance and annuity contracts. In September 2007, the
IRS released Revenue Ruling 2007-61. Revenue Ruling 2007-61 suspended Revenue
Ruling 2007-54 and informed taxpayers that the U.S. Treasury Department and the
IRS intend to address through new guidance the issues considered in Revenue
Ruling 2007-54, including the methodology to be followed in determining the DRD
related to variable life insurance and annuity contracts. On February 13, 2012,
the Obama Administration released the "General Explanations of the
Administration's Revenue Proposals." 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 guidance or
legislation, could increase actual tax expense and reduce the Company's
consolidated net income. These activities had no impact on the Company's 2011 or
second quarter 2012 results.
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For tax years 2007 through 2011, the Company is participating in the IRS's
Compliance Assurance Program ("CAP"). Under CAP, the IRS assigns an examination
team to review completed transactions contemporaneously during these tax years
in order to reach agreement with the Company on how they should be reported in
the tax returns. If disagreements arise, accelerated resolutions programs are
available to resolve the disagreements in a timely manner before the tax returns
are filed. It is management's expectation this program will shorten the time
period between the filing of the Company's federal income tax returns and the
IRS's completion of its examination of the returns.
Liquidity and Capital Resources
Overview
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 operation of our businesses, 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 businesses, general economic conditions and our access to
the capital markets through affiliates as described herein.
Management monitors the liquidity of Prudential Financial, Prudential Insurance
and the Company on a daily basis and projects borrowing and capital needs over a
multi-year time horizon through our quarterly planning process. We believe that
cash flows from the sources of funds presently available to us are sufficient to
satisfy the current liquidity requirements of Prudential Financial and the
Company, including reasonably foreseeable stress scenarios.
We continue to refine our metrics for capital management. These refinements to
the current framework, which is primarily based on statutory risk based capital
measures, are designed to more appropriately reflect risks associated with our
businesses on a consistent basis across the Company. In addition, we continue to
use an economic capital framework for making certain business decisions.
Similar to our planning and management process for liquidity, we use a Capital
Protection Framework to ensure the availability of adequate capital under
reasonably foreseeable stress scenarios. The Capital Protection Framework is
used to assess potential capital needs arising from severe market related
distress and sources of capital available to us to meet those needs. Potential
sources include on-balance sheet capital, derivatives and other contingent
sources of capital.
On May 11, 2012 the final regulations of the Financial Stability Oversight
Council, created under the Dodd-Frank Wall Street Reform and Consumer Protection
Act, became effective setting forth the criteria by which it will designate the
non-bank financial companies that are to be subject to stricter prudential
standards (a "Covered Company"), including requirements and limitations relating
to capital, leverage, liquidity and other matters. The final rule made few
changes to the proposed rule on this subject issued in October 2011. See
"Item 1. - Business" in our 2011 Annual Report on Form 10-K for more information
regarding the potential impact of the Dodd-Frank Act on the Company.
General Liquidity
Our liquidity is managed to ensure stable, reliable and cost-effective sources
of cash flows to meet all of our obligations. Liquidity is provided by a variety
of sources, as described more fully below, including portfolios of liquid
assets. Our investment portfolios are integral to the overall liquidity of the
Company. We segment our investment portfolios and employ an asset/liability
management approach specific to the requirements of our product lines. This
enhances the discipline applied in managing the liquidity, as well as the
interest rate and credit risk profiles, of each portfolio in a manner consistent
with the unique characteristics of the product liabilities. We use a projection
process for cash flows from operations to ensure sufficient liquidity to meet
projected cash outflows, including claims. The impact of Prudential Funding,
LLC's financing capacity on liquidity (as described below) is considered in the
internal liquidity measures of the Company.
Liquidity is measured against internally developed benchmarks that take into
account the characteristics of both the asset portfolio and the liabilities that
they support. The results are affected substantially by the overall asset type
and quality of our investments.
Cash Flow
The principal sources of the Company's liquidity are premiums and certain
annuity considerations, investment and fee income, investment maturities and
sales as well as internal borrowings. The principal uses of that liquidity
include benefits, claims, dividends paid to policyholders, and payments to
policyholders and contractholders in connection with surrenders, withdrawals and
net policy loan activity. Other uses of liquidity include commissions, general
and administrative expenses, purchases of investments, and payments in
connection with financing activities.
We believe that the cash flows from our insurance and annuity operations are
adequate to satisfy our current liquidity requirements, including under
reasonably foreseeable stress scenarios. The continued adequacy of this
liquidity will depend upon factors such as future securities market conditions,
changes in interest rate levels, customer behavior, policyholder perceptions of
our financial strength, and the relative safety of competing products, each of
which could lead to reduced cash inflows or increased cash outflows. In
addition, market volatility can impact the level of capital required to support
our businesses, particularly in our annuity products. Our cash flows from
investment activities result from repayments of principal, proceeds from
maturities and sales of invested assets and investment income, net of amounts
reinvested. The primary liquidity risks with respect to these cash flows are the
risk of default by debtors or bond insurers, our counterparties' willingness to
extend repurchase and/or securities lending arrangements, commitments to invest
and market volatility. We closely manage these risks through our credit risk
management process and regular monitoring of our liquidity position. Further,
the level of new business sales can also impact liquidity, and additional
financing may be required due to the increase in annuity sales as previously
discussed.
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In managing our liquidity, we also consider the risk of policyholder and
contractholder withdrawals of funds earlier than our assumptions when selecting
assets to support these contractual obligations. We use surrender charges and
other contract provisions to mitigate the extent, timing and profitability
impact of withdrawals of funds by customers from annuity contracts and deposit
liabilities.
Individual life insurance policies are less susceptible to withdrawal than our
annuity reserves and deposit liabilities because policyholders may be subject to
a new underwriting process in order to obtain a new insurance policy. Our
annuity reserves with guarantee features may be less susceptible to withdrawal
than historical experience indicates, due to the current value of these
guarantee features to policyholders as a result of market declines in recent
years.
Gross account withdrawals amounted to approximately $1,444 million and
$1,415 million for the six months ended June 30, 2012 and 2011, respectively.
Because these withdrawals were consistent with our assumptions in
asset/liability management, the associated cash outflows did not have a material
adverse impact on our overall liquidity.
Liquid Assets
Liquid assets include cash and cash equivalents, short-term investments, fixed
maturities that are not designated as held-to-maturity and public equity
securities. As of June 30, 2012 and December 31, 2011 the Company had liquid
assets of $6.498 billion and $6.149 billion, respectively. The portion of liquid
assets comprised of cash and cash equivalents and short-term investments was
$599 million and $571 million as of June 30, 2012 and December 31, 2011,
respectively. As of June 30, 2012, $5.456 billion, or 93%, of the fixed maturity
investments company general account portfolios were rated investment grade. The
remaining $410 million, or 7%, 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 reasonably foreseeable stress scenarios.
Given the size and liquidity profile of our investment portfolios, we believe
that claim experience varying from our projections does not constitute a
significant liquidity risk. Our asset/liability management process takes into
account the expected maturity of investments and expected claim payments as well
as the specific nature and risk profile of the liabilities. To the extent we
need to pay claims in excess of projections, we may borrow temporarily or sell
investments sooner than anticipated to pay these claims, which may result in
increased borrowing costs or realized investment gains or losses affecting
results of operations. We believe that borrowing temporarily or selling
investments earlier than anticipated will not have a material impact on the
liquidity of the Company. However, payment of claims and sale of investments
earlier than anticipated would have an impact on the reported level of cash flow
from operating and investing activities, respectively, in our financial
statements. Historically, there has been no significant variation between the
expected maturities of our investments and the payment of claims.
Prudential Funding, LLC
Prudential Funding, LLC, or Prudential Funding, a wholly owned subsidiary of
Prudential Insurance, serves as an additional source of financing to meet our
working capital needs. Prudential Funding operates under a support agreement
with Prudential Insurance whereby Prudential Insurance has agreed to maintain
Prudential Funding positive tangible net worth at all times. Prudential Funding
borrows funds in the capital markets primarily through the direct issuance of
commercial paper.
Capital
The Risk Based Capital, or RBC, ratio is a primary measure by which we evaluate
the capital adequacy of the Company. Prudential Financial manages its domestic
insurance subsidiaries RBC ratios to a level that is consistent with the ratings
targets for those subsidiaries. RBC is determined by statutory guidelines and
formulas that consider among other things, risks related to the type and quality
of the invested assets, insurance-related risks associated with an insurer's
products and liabilities, interest rate risks and general business risks. The
RBC ratio calculations are intended to assist insurance regulators in measuring
the adequacy of an insurer's statutory capitalization. The RBC ratio is an
annual calculation, however as of June 30, 2012 we estimate the RBC ratios for
the Company exceed the minimum level required by applicable insurance
regulations. The reporting of RBC measures is not intended for the purpose of
ranking any insurance company or for use in connection with any marketing,
advertising or promotional activities.
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.
As part of its Capital Protection Framework, Prudential Financial has developed
a broad view of the impact of market distress on the statutory capital of
Prudential Financial and its subsidiaries, as a whole. The framework includes a
program designed to mitigate the impact of a severe equity market stress event
on the statutory capital of Prudential Financial and its subsidiaries, as a
whole. The program focuses on tail risk to protect statutory capital in a
cost-effective manner under stress scenarios. Prudential Financial assesses the
composition of the hedging program on an ongoing basis and may change it from
time to time based on an evaluation of its risk position or other factors.
In addition to hedging equity market exposure, we also manage certain risks
associated with our variable annuity products primarily through affiliated
reinsurance arrangements. We reinsure variable annuity living benefit guarantees
to a captive reinsurance company, Pruco Re. Effective as of July 1, 2011, Pruco
Re re-domiciled from Bermuda to Arizona. As a result, beginning in the third
quarter of 2011, the Company is able to claim statutory reinsurance reserve
credit for business ceded to Pruco Re without any need for Pruco Re to
collateralize its obligations under the
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reinsurance arrangement. However, for business ceded to Pruco Re by PLNJ, Pruco
Re's obligations under the reinsurance arrangement must continue to be
collateralized in order for PLNJ to claim a reinsurance reserve credit for their
business ceded. This requirement is satisfied by Pruco Re by depositing assets
into statutory reserve credit trusts.
Debt Agreements
As of June 30, 2012 and December 31, 2011, total short- and long-term debt of
the Company was $1,631 million and $1,301 million, respectively. The total
related interest expense was $10.1 million and $7.7 million for the three months
ended June 30, 2012 and 2011, respectively. The Company is authorized to borrow
funds up to $2.2 billion from affiliates to meet its capital and other funding
needs. The Company had $193 million in short term debt as of June 30, 2012, and
$129 million as of December 31, 2011. The Company also borrowed $650 million
from Prudential Insurance, $472 million from Prudential Financial and
$316 million with Washington Street Investment, as long term debt as of June 30,
2012.
