PRUCO LIFE INSURANCE CO – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Edgar Online, Inc.

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, 2013, compared with December 31, 2012, and its consolidated results of operations for the three and six months ended June 30, 2013 and 2012. 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, and the audited Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2012, 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 affiliated and unaffiliated distributors in the United States. 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.

Revenues and Expenses

The Company earns revenues principally from insurance premiums; mortality, expense, and asset administration fees from insurance and investment products; and investment of general account and other funds. The Company earns premiums primarily from the sale of individual life insurance. The Company earns mortality, expense fees, and asset administration fees on the servicing of separate account products including universal and variable life insurance and variable annuities. The Company's operating expenses principally consist of insurance benefits provided and reserves established for anticipated future insurance benefits, general business expenses, commissions and other costs of selling and servicing the various products we sell and interest credited on general account liabilities.

Effective February 25, 2013, the Advanced Series Trust ("AST") adopted a Rule 12b-1 Plan under the Investment Company Act of 1940 with respect to most of the AST portfolios that are primarily offered through the Company's variable annuity investment options. Under the Rule 12b-1 Plan, AST pays an affiliate of the Company for distribution and administrative services. Prior to the adoption of the 12b-1 Plan, the Company received an administrative service fee from AST and incurred expenses associated with administration services provided. While we expect the level of revenue and expenses of the Company in 2013 to decline relative to 2012 due to the elimination of the administrative services fee and related expenses, we do not expect a material impact to net income related to AST's adoption of the Rule 12b-1 Plan.

Profitability

The Company's profitability depends principally on its ability to price our insurance and annuity products at a level that enables us to earn a margin over the costs associated with providing benefits and administering those products. Profitability also depends on, among other items, our actuarial and policyholder behavior experience on insurance and annuity products, our ability to attract and retain customer assets, generate and maintain favorable investment results, and manage expenses.

See "Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2012 for a discussion of risks that have materially affected and may affect in the future the Company's business, results of operations or financial condition, or cause the Company's actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.

  Products  Individual Annuities  

The Company offers a wide array of annuities, including (1) variable annuities that are registered with the United States Securities and Exchange Commission (the "SEC"), including fixed interest rate allocation options, subject to a market value adjustment, 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.

We offer variable annuities that provide our contractholders 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"). We currently offer guarantees that are payable in the event of death, and withdrawal and income living benefits payable during specified periods. The majority of our current optional living benefits guarantees include, 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 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. The majority of our current optional living benefits can also be purchased with a companion optional death benefit, also based on a highest daily contract value. Certain inforce contracts include guaranteed benefits which are not currently offered, such as annuitization benefits and benefits payable at specified dates during the accumulation period. Late in the first quarter of 2013, we launched Prudential Defined Income Variable Annuity, or PDI, to complement the variable annuity products we offer with the highest daily benefit. PDI also provides for guaranteed lifetime contractholder withdrawal payments, but restricts contractholder asset allocation to a single bond sub-account within the separate accounts.

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Excluding our new PDI product, the majority of our variable annuities generally provide our contractholders with the opportunity to allocate purchase payments to sub-accounts that invest in underlying proprietary and non-proprietary mutual funds, frequently under asset allocation programs, and fixed-rate accounts. 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.

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, contractholder longevity/mortality, timing and amount of annuitization and withdrawals, withdrawal efficiency and contract lapses. The 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. Our returns can also vary due to the impact and effectiveness of our hedging programs for any capital markets movements that we may hedge, the impact of affiliated reinsurance, the impact of that portion of our variable annuity contracts with an asset transfer feature, the impact of risks we have retained and the impact of risks that are not able to be hedged.

Our risk management strategy helps to limit our exposure to certain of these risks primarily through a combination of product design elements, our living benefits hedging program and affiliated reinsurance arrangements. The product design elements we utilize for certain products include, among others, asset allocation restrictions, minimum issuance age requirements, certain limitations on the amount of subsequent contractholder deposits and an asset transfer feature. The objective of the asset transfer feature, included in the majority of our variable annuity contracts with optional living benefits features and all new contracts sold with our highest daily living benefits feature, is to help mitigate our exposure to equity market risk and market volatility by transferring assets between certain variable investment sub-accounts selected by the annuity contractholder and investments that are expected to be more stable (e.g., a separate account bond fund sub-account portfolio or a fixed-rate account in the general account). The transfers are based on the static mathematical formula used with the particular optional benefit which considers a number of factors, including, but not limited to, the impact of investment performance on the contractholder's total account value. This occurs at the contractholder level, rather than at the fund level, which we believe enhances our risk mitigation. As of June 30, 2013, approximately $70.8 billion or 89% of total variable annuity account values contain a living benefit feature, compared to approximately $64.7 billion or 89% as of December 31, 2012. As of June 30, 2013, approximately $66.3 billion or 94% of variable annuity account values with living benefit features included an asset transfer feature in the product design, compared to approximately $60.3 billion or 93% as of December 31, 2012.

As mentioned above, in addition to our asset transfer feature, we also manage certain risks associated with our variable annuity products through our living benefits hedging programs and affiliated reinsurance agreements. We reinsure the majority of our variable annuity living benefit guarantees to an affiliated reinsurance company, Pruco Reinsurance, Ltd. ("Pruco Re"). The living benefits hedging program is primarily executed within Pruco Re to manage capital markets risk associated with the reinsured optional living benefit guarantees. The program is also executed within the Company related to certain non-reinsured optional living benefit guarantees. This program represents a balance among three objectives that seek to: 1) provide severe scenario protection, 2) minimize net income volatility associated with an internally-defined hedge target, and 3) maintain capital efficiency. Through the hedge program, derivatives are purchased that seek to replicate the net change in an internally-defined hedge target. In addition to mitigating capital markets risk and income statement volatility, the hedging program is also focused on a long-term goal of accumulating assets that could be used to pay claims under these benefits irrespective of market path, recognizing that, under the terms of the contracts, we do not expect to begin substantial payment of such claims until at least five years in the future.

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, 2013, 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.

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 24% of our net individual life insurance in force at June 30, 2013. 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.

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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 13% of our net individual life insurance in force at June 30, 2013. 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 rate 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 two distinct living benefits options. Living Needs Benefit Rider 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. BenefitAccess Rider provides the ability to accelerate up to the full amount of the policy's death benefit in the event the insured becomes chronically ill or terminally ill. Receiving accelerated benefits under the rider will reduce, and in some cases, eliminate the policy's death benefit payable to the beneficiary. Any remaining death benefit is paid to the beneficiary at time of the insured's death.

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 Unaudited Interim 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 ("DAC") 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.  

The near-term future equity rate of return assumption used in evaluating DAC and deferred sales inducements for our variable annuity and variable life insurance products is derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider historical equity returns over a period of time and initially adjust future projected equity returns over the next four years (the "near-term") so that the assets are projected to grow at the long-term expected rate of return for the entire period. If the near-term projected future rate of return is greater than our near-term maximum future rate of return of 13%, we use our maximum future rate of return.

The weighted average rate of return assumptions for these businesses consider many factors specific to each business, including asset durations, asset allocations and other factors. We update the near term equity rates of return and our estimate of total gross profits each quarter to reflect the result of the reversion to the mean approach, which assumes a convergence to the long-term equity expected rates of return. These market performance related adjustments to our estimate of total gross profits result in cumulative adjustments to prior amortization, reflecting the application of the new required rate of amortization to all prior periods' gross profits. The new required rate of amortization is also applied prospectively to future gross profits in calculating amortization in future periods. As of June 30, 2013, our variable annuities and variable life insurance businesses assume an 8.0% long-term equity expected rate of return and a 6.7% near-term mean reversion equity rate of return.

Additional information on our policies for our critical accounting estimates listed above may be found in our Annual Report on Form 10-K for the year ended December 31, 2012, under "Management's Discussion and Analysis of Financial Condition and Results of Operations-Accounting Policies & Pronouncements-Application of Critical Accounting Estimates."

Adoption of New Accounting Pronouncements

See Note 2 to our Unaudited Interim Consolidated Financial Statements for a discussion of newly adopted accounting pronouncements.

Changes in Financial Position

June 30, 2013 versus December 31, 2012

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Total assets increased $13,446 million, from $102,222 million at December 31, 2012 to $115,668 million at June 30, 2013.

Separate account assets increased $7,756 million, from $80,887 million at December 31, 2012 to $88,643 million at June 30, 2013, primarily driven by market appreciation and positive net flows from variable annuity new business sales.

Reinsurance recoverables increased $4,855 million from $7,032 million at December 31, 2012 to $11,887 million at June 30, 2013. The increase in reinsurance recoverables was primarily driven by liabilities ceded arising from coinsurance of the Hartford Life GUL business as well as higher term reserves and universal life policyholders' account balances ceded under affiliated reinsurance agreements due to business growth. Partially offsetting this is a decrease related to the mark-to-market of the reinsurance recoverable related to the reinsured liability for variable annuity living benefits accounted for as embedded derivatives, primarily resulting from a decrease in the present value of future expected benefit payments driven by higher interest rates and changes in equity markets. As of June 30, 2013 the reinsurance related to our variable annuity living benefits is in a liability position classified within "Other Liabilities". See Note 8 to the Unaudited Interim Consolidated Financial Statements for additional information regarding affiliated reinsurance transactions.

Deferred policy acquisition and deferred sales inducement costs increased $874 million from $4,467 million at December 31, 2012 to $5,341 million at June 30, 2013. The increase is primarily driven by the capitalization of commissions related to variable annuity new business sales and write-ups primarily associated with the impact of the mark-to-market of the reinsured liability for living benefits and related hedge positions.

Total investments increased $108 million from $9,092 million at December 31, 2012 to $9,200 million at June 30, 2013. The increase in total investments was primarily driven by continued universal life and term business growth, partially offset by unfavorable mark-to-market losses on bonds and interest rate derivatives due to rising interest rates.

Partially offsetting these increases was a decrease in cash and cash equivalents of $273 million from $412 million at December 31, 2012 to $139 million at June 30, 2013.

Total liabilities increased $12,891 million, from $98,706 million at December 31, 2012 to $111,687 million at June 30, 2013.

Separate account liabilities increased $7,756 million, offsetting the increase in separate account assets described above.

Policyholder account balances increased $5,075 million, from $8,557 million at December 31, 2012 to $13,632 million at June 30, 2013, primarily driven by liabilities assumed related to coinsurance of the Hartford Life GUL business and continued universal life business growth.

Other liabilities increased $180 million, from $727 million at December 31, 2012 to $907 million at June 30, 2013, primarily driven by the recognition of a liability resulting from the mark-to-market of the reinsurance related to the reinsured liability for variable annuity living benefit embedded derivatives due to higher interest rates and changes in equity markets.

Partially offsetting these increases was a decrease in future policy benefits and other policyholder liabilities of $132 million$6,697 million at December 31, 2012 to $6,565 million at June 30, 2013, primarily driven by mark-to-market decreases to the liability for living benefit embedded derivatives, as described above. Partially offsetting this are liabilities assumed related to coinsurance of the Hartford Life GUL business and an increase in reserves supporting term business arising from business growth.

                                                                    Three Months Ended                                                                       June 30,                                                               2013               2012                                                                    (in thousands) Operating results: Revenues: Annuity Products                                         $     451,032$      367,441 Life Products and Other                                        205,282             193,762                                                           $     656,314$      561,203  Benefits and expenses: Annuity Products                                         $      40,674$      914,571 Life Products and Other                                        189,227             139,526                                                           $     229,901$    1,054,097  Income (loss) from Operations before Income Taxes Annuity Products                                         $     410,358$     (547,130) Life Products and Other                                         16,055              54,236                                                           $     426,413$     (492,894)    Annuity Products 

Income (Loss) from Operations before Income Taxes

2013 to 2012 Three Month Comparison. Income from operations before income taxes increased $957 million from a loss of $547 million in the second quarter of 2012 to income of $410 million in the second quarter of 2013. Results for both periods include the impact on the amortization of DAC and DSI, and on reserves for the GMDB and GMIB features, of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and of changes in the estimated profitability of the business, as discussed in more detail below.

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Excluding these items, income (loss) from operations before income taxes increased $52 million, primarily driven by higher fee income, net of distribution costs, related to higher average variable annuity account values invested in separate accounts due to market appreciation and positive net flows from new business sales.

The following table reflects the impact on the amortization of DAC/DSI and on the GMDB/GMIB reserves of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions, and of changes in the estimated profitability of the business.

                                                                  Three months ended                                                                     June 30,                                                              2013                2012                                                                        (1)                                                                   (in millions) Impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions                                        $          271     $          (568) Impacts of changes in the estimated profitability of the business                                                       15                 (51)  Total                                                  $          286     $          (619)     

(1) Amounts reflect (charges) or benefits for (increases) or decreases,

respectively, in the amortization of DAC/DSI and for GMDB/GMIB reserve

(increases) or decreases, respectively.

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.

The impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions primarily relates to changes in the valuation of the reinsured living benefit liabilities related to NPR which we and the reinsurance affiliate believe to be non-economic, and choose not to hedge. The favorable variance was primarily driven by NPR losses in the reinsurance affiliate in 2013 due to a decrease in the base embedded derivative liability primarily driven by rising interest rates. The NPR losses in 2013 resulted in a DAC/DSI amortization benefit compared to NPR gains in 2012 which resulted in DAC/DSI amortization expense. The NPR gains in 2012 were primarily driven by an increase in the base embedded derivative liability driven by lower interest rates and unfavorable equity market conditions.

The impacts of changes in the estimated profitability of the business include adjustments to the reserves for the GMDB and GMIB features of our variable annuity products and to the amortization of DAC/DSI. These adjustments resulted in a net benefit of $15 million and a net charge of $51 million in the second quarter of 2013 and 2012, respectively. The net benefit in the second quarter of 2013 primarily reflects the impact of higher interest rates which increased future expected fixed income returns on contractholder accounts and lowered future expected claims relative to our assumptions. The net charge in the second quarter of 2012 primarily reflects negative equity market performance on contractholder accounts relative to our assumptions. For weighted average rate of return assumptions as of June 30, 2013 see "-Application of Critical Accounting Estimates" above.

Revenues, Benefits and Expenses

2013 to 2012 Three Month Comparison. Revenues increased $84 million. This increase was primarily driven by an increase of $117 million in policy charges and fee income, consisting primarily of mortality and expense and other insurance charges assessed on policyholders' fund balances driven by higher average separate account asset balances due to positive net flows from new business sales and market appreciation partially offset by $31 million increase in realized investment losses primarily due to an unfavorable variance in the mark to market related to embedded derivatives associated with our non-reinsured living benefit features and related hedges.

Benefits and expenses decreased $873 million. This decrease was primarily driven by a favorable variance of $649 million in DAC amortization and $192 million in interest credited to policyholders' account balances, which includes DSI amortization. Lower DAC and DSI amortization is related to the impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and the impact of changes in the estimated profitability of the business, as discussed above. Also contributing to the decrease was a decrease in policyholders benefits, including changes in reserves, of $33 million, primarily due to adjustments to the GMDB and GMIB reserves related to the impact of changes in the estimated profitability of the business, as discussed above.

Life Products and Other

Income from Operations before Income Taxes

2013 to 2012 Three Month Comparison. Income from operations before income taxes decreased $38 million. The decrease includes mark to market losses on derivative investments, higher general and administrative expenses, net of capitalization, reflecting higher distribution costs as a result of increased sales as well as higher compensation expenses, continued variable life inforce run-off, and the impact of the third quarter 2012 coinsurance agreement between PLNJ and PAR U. These decreases were partially offset by the impact of universal life product business growth. See Note 8 to the Unaudited Interim Consolidated Financial Statements for more information on related party transactions.

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Revenues, Benefits and Expenses

2013 to 2012 Three Month Comparison. Revenues increased $12 million. The increase includes the impact of universal life product business growth, partially offset by mark to market losses on derivative investments,, the impact of the third quarter 2012 coinsurance agreement between PLNJ and PAR U, and continued variable life inforce run-off. See Note 8 to the Unaudited Interim Consolidated Financial Statements for more information on related party transactions.

Benefits and expenses increased $50 million including higher general and administrative expenses, net of capitalization, reflecting higher distribution costs as a result of increased sales as well as higher compensation expenses, higher death benefits, and the impact of universal life business growth which drove growth in interest credited due to higher policyholder account balances and higher amortization of deferred policy acquisition costs.

 Results of Operations                                                                     Six Months Ended                                                                      June 30,                                                              2013                 2012                                                                   (in thousands) Operating results: Revenues: Annuity Products                                       $       893,120$       707,976 Life Products and Other                                        453,527              351,301                                                         $     1,346,647$     1,059,277  Benefits and expenses: Annuity Products                                       $       109,896$       631,336 Life Products and Other                                        355,449              282,024                                                         $       465,345$       913,360  Income (loss) from Operations before Income Taxes Annuity Products                                       $       783,224$        76,640 Life Products and Other                                         98,078               69,277                                                         $       881,302$       145,917    Annuity Products 

Income (Loss) from Operations before Income Taxes

2013 to 2012 Six Month Comparison. Income from operations before income taxes increased $707 million from $77 million for the first six months of 2012 to $783 million in the first six months of 2013. Results for both periods include the impact on the amortization of DAC and DSI, and on reserves for the GMDB and GMIB features, of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and of changes in the estimated profitability of the business, as discussed in more detail below.

Excluding these items, income (loss) from operations before income taxes increased $108 million, primarily driven by higher fee income, net of distribution costs, related to higher average variable annuity account values invested in separate accounts due to market appreciation and positive net flows from new business sales.

The following table reflects the impact on the amortization of DAC/DSI and on the GMDB/GMIB reserves of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions, and of changes in the estimated profitability of the business.

                                                                    Six months ended                                                                      June 30,                                                                2013               2012                                                                         (1)                                                                    (in millions)

Impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions

                                                $         525      $         (85) Impacts of changes in the estimated profitability of the business                                                        17                 28  Total                                                    $         542      $         (57)     

(1) Amounts reflect (charges) or benefits for (increases) or decreases,

respectively, in the amortization of DAC/DSI and for GMDB/GMIB reserve

(increases) or decreases, respectively.

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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The impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions primarily relates to changes in the valuation of the reinsured living benefit liabilities related to NPR which we and the reinsurance affiliate believe to be non-economic, and choose not to hedge. The favorable variance was primarily driven by NPR losses in the reinsurance affiliate in 2013 due to a decrease in the base embedded derivative liability primarily driven by rising interest rates. The NPR losses in 2013 resulted in a DAC/DSI amortization benefit compared to NPR gains in 2012 which resulted in DAC/DSI amortization expense. The NPR gains in 2012 were primarily driven by an increase in the base embedded derivative liability driven by lower interest rates and unfavorable equity market conditions.

The impacts of changes in the estimated profitability of the business include adjustments to the reserves for the GMDB and GMIB features of our variable annuity products and to the amortization of DAC/DSI. These adjustments resulted in net benefits of $17 million and $28 million in the first six months of 2013 and 2012, respectively. The net benefit in the first six months of 2013 primarily reflects the impact of higher interest rates in the second quarter, as discussed above, and positive equity market performance on contractholder accounts in the first quarter relative to our assumptions. The net benefit in the first six months of 2012 primarily reflects the impact of overall positive equity market performance on contractholder accounts relative to our assumptions. For weighted average rate of return assumptions as of June 30, 2013 see "-Application of Critical Accounting Estimates" above.

Revenues, Benefits and Expenses

2013 to 2012 Six Month Comparison. Revenues increased $185 million. This increase was primarily driven by an increase of $236 million in policy charges and fee income, consisting primarily of mortality and expense and other insurance charges assessed on policyholders' fund balances driven by higher average separate account asset balances due to positive net flows from new business sales and market appreciation. Partially offset by a $44 million increase in realized investment losses due to an unfavorable variance in the mark to market related to embedded derivatives associated with our non-reinsured living benefit features and related hedges.

Benefits and expenses decreased $521 million. This decrease was primarily driven by a favorable variance of $420 million in DAC amortization and $122 million in interest credited to policyholders' account balances, which includes DSI amortization. Lower DAC and DSI amortization is related to the impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and the impact of changes in the estimated profitability of the business, as discussed above. Partially offsetting the decrease was an increase in general and administrative expenses, net of capitalization, of $15 million primarily driven by 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

2013 to 2012 Six Month Comparison. Income from operations before income taxes increased $29 million. The increase includes a realized investment gain of $57 million on a portion of an embedded derivative recaptured from an amendment to the reinsurance agreement of no-lapse guarantees with UPARC in the first quarter of 2013. This was partially offset by a $24 million loss from an amendment to the 2011 coinsurance agreement with PAR U also in the first quarter of 2013. Absent these impacts, income from operations before taxes decreased $4 million. The decrease includes higher general and administrative expenses, net of capitalization, reflecting higher distribution costs as a result of increased sales as well as higher compensation expenses, mark to market losses on derivative investments, the impact of the third quarter 2012 coinsurance agreement between PLNJ and PAR U, and the continued impact of variable life inforce run-off. These decreases were partially offset by the impact of universal life and term product business growth and a $23 million realized investment gain related to asset transfers to affiliates.

Revenues, Benefits and Expenses

2013 to 2012 Six Month Comparison. Revenues increased $102 million. The increase includes a net benefit of $33 million related to the amendments to the reinsurance agreements discussed above. Absent these impacts, revenues increased $70 million. The increase includes the impact of universal life and term product business growth and realized investment gains of $23 million related to asset transfers to affiliates. These increases were partially offset by mark to market losses on derivative investments, the impact of the third quarter 2012 coinsurance agreement between PLNJ and PAR U, and continued variable life inforce run-off. See Note 8 to the Unaudited Interim Consolidated Financial Statements for more information on related party transactions.

Benefits and expenses increased $73 million including higher general and administrative expenses, net of capitalization, reflecting higher distribution costs as a result of increased sales as well as higher compensation expenses, higher death benefits, the impact of universal life business growth which drove growth in interest credited due to higher policyholder account balances and higher amortization of deferred policy acquisition costs.

Income Taxes

The income tax provision amounted to an expense of $114 million and a benefit of $140 million for the three months ended June 30, 2013 and 2012, respectively. The income tax provision amounted to an expense of $222 million and $38 million for the six months ended June 30, 2013 and 2012, respectively. The increases in income tax expense were primarily driven by the increases in pre-tax income.

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

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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 February 2014, unless extended. The statute of limitations for the 2007 through 2009 tax years will expire in December 2014, unless extended. Tax years 2010 through 2012 are still open for IRS examination.

The Company does not anticipate any significant changes within the next 12 months to its total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.

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 2012, 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. In May 2010, the IRS issued an Industry Director Directive ("IDD") confirming that the methodology for calculating the DRD set forth in Revenue Ruling 2007-54 should not be followed. The IDD also confirmed that the IRS guidance issued before Revenue Ruling 2007-54, which guidance the Company relied upon in calculating its DRD, should be used to determine the DRD. For the last several years, the revenue proposals included in the Obama Administration's budgets included a proposal that 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 results for 2012, or for the six months ended June 30, 2013.

For tax years 2007 through 2012, 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  

This section supplements and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" included in our Annual Report on Form 10-K for the year ended December 31, 2012.

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 operations 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 available to us are sufficient to satisfy the current liquidity requirements of Prudential Financial and the Company, including reasonably foreseeable stress scenarios. We have a capital management framework in place that facilitates the allocation of capital and approval of capital uses, and we forecast capital sources and uses on a quarterly basis. Furthermore, we employ a "Capital Protection Framework" to ensure the availability of sufficient capital resources to maintain adequate capitalization and competitive risk-based capital ratios under reasonably foreseeable stress scenarios.

The Financial Stability Oversight Council has made a proposed determination that Prudential Financial should be subject to stricter prudential regulatory standards and supervision by the Board of Governors of the Federal Reserve System under the Dodd-Frank Act. This stricter prudential regulation may include new capital and liquidity standards, including requirements regarding risk-based capital, leverage, liquidity, stress-testing and other matters. In addition, the Financial Stability Board, consisting of representatives of national financial authorities of the G20 nations, identified Prudential Financial as a global systemically important insurer. For information on recent actions and the potential impact of the Dodd-Frank Act, see "Business-Regulation" and "Risk Factors" included in our 2012 Annual Report on Form 10-K for the year ended December 31, 2012 and updated "Risk Factors" included in this Quarterly Report on Form 10-Q.

Capital

The Risk Based Capital, or RBC, ratio is a primary measure of the capital adequacy of the Company. 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

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insurer's products and liabilities, interest rate risks and general business risks. RBC is calculated based on statutory financial statements and risk formulas consistent with NAIC practices. The RBC ratio calculations are intended to assist insurance regulators in measuring the insurer's solvency and ability to pay future claims. 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, but is available to the public. The RBC ratio is an annual calculation, however, as of June 30, 2013 we estimate that the Company's RBC ratio exceeds the minimum level required by applicable insurance regulations.

The regulatory capital level of the Company can be materially impacted by interest rate and equity market fluctuations, changes in the values of derivatives, the level of impairments recorded, credit quality migration of the investment portfolio, and business growth, among other items. Further, the recapture of business subject to reinsurance arrangements due to defaults by, or credit quality migration affecting, the reinsurers or for other reasons could result in higher required statutory capital levels. The regulatory capital level of the Company is also affected by statutory accounting rules which are subject to change by insurance regulators.

We employ a "Capital Protection Framework" to ensure sufficient capital resources are available to maintain adequate capitalization and a competitive risk based capital ratio, under reasonably foreseeable stress scenarios. The Capital Protection Framework incorporates the potential impacts from market related stresses, including equity markets, interest rates, and credit losses. Potential sources of capital include on-balance sheet capital, derivatives, reinsurance and contingent sources of capital. Although we continue to enhance our approach, we believe we currently have sufficient resources to maintain adequate capitalization and a competitive RBC ratio under reasonably foreseeable stress scenarios.

Prudential Financial uses captive reinsurance companies to more effectively manage our capital on an economic basis and to enable the aggregation and transfer of risks. To support the risks they assume, the captives are capitalized to a level consistent with our "AA" financial strength rating targets. All of the captive reinsurance companies are wholly-owned subsidiaries and are located domestically, typically in the state of domicile of the direct writing insurance subsidiary that cedes the majority of business to the captive. In addition to state insurance regulation, the captives are subject to internal policies governing their activities. In the normal course of business, Prudential Financial provides support to these captives through net worth maintenance agreements and/or guarantees of certain of the captives' obligations. Recently, the NAIC and the New York State Department of Financial Services have examined life insurers' use of captive reinsurance companies. We cannot predict what, if any, changes may result from these reviews. If applicable insurance laws are changed in a way that impairs the use of captive reinsurance companies, our ability to write certain products and efficiently manage their associated risks could be adversely affected and/or we may need to increase prices on certain products or find alternate financing sources, which could adversely affect our competitiveness, capital and financial position and results of operations. For further information on our specific uses of captive reinsurance companies, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" included in our Annual Report on Form 10-K for the year ended December 31, 2012.

We manage certain risks associated with our variable annuity products through arrangements with an affiliated domestic captive reinsurance company. We reinsure variable annuity living benefit guarantees to an affiliated domestic captive reinsurance company, Pruco Re. This enables Prudential Financial to execute its living benefit hedging program within one legal entity, Pruco Re. Since Pruco Re is domiciled and subject to regulation in the State of Arizona, 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 reinsurance arrangement. However, for business ceded to Pruco Re by PLNJ, Pruco Re must collateralize its obligations under the reinsurance arrangement in order for PLNJ to claim a reinsurance reserve credit for its business ceded. This requirement is satisfied by Pruco Re depositing assets into statutory reserve credit trusts.

Liquidity

There have been no material changes to the liquidity position of the Company since December 31, 2012. We continue to believe that cash generated by ongoing operations and the liquidity profile of our assets provide sufficient liquidity under reasonably foreseeable stress scenarios for the Company.

The principal sources of the Company's cash 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, 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 use a projection process for cash flows from operations to ensure sufficient liquidity is available to meet projected cash outflows, including claims.

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 each 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.

Liquid assets include cash and cash equivalents, short-term investments and fixed maturities that are not designated as held-to-maturity and public equity securities. As of June 30, 2013 and December 31, 2012, the Company had liquid assets of $6,578 million and $6,676 million, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $213 million and $524 million as of June 30, 2013 and December 31, 2012, respectively. As of June 30, 2013, $5,914 million, or 93%, of the fixed maturity investments in company general account portfolios were rated high or highest quality based on NAIC or equivalent rating. The remaining $415 million, or 7%, of these fixed maturity investments were rated other than high or highest quality.

Prudential Financial and Prudential Funding, LLC, or Prudential Funding, a wholly-owned subsidiary of Prudential Insurance, borrow funds in the capital markets primarily through the direct issuance of commercial paper. The borrowings serve 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.

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