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PRUCO LIFE INSURANCE OF NEW JERSEY – 10-K – Management's Discussion and Analysis of Financial Condition and Results of Operations
You should read the following analysis of our financial condition and results of
operations in conjunction with the "Forward-Looking Statements" included below
the Table of Contents, "Risk Factors", and the Financial Statements included in
this Annual Report on Form 10-K.
Overview
The Company is licensed to sell variable annuities, universal life insurance,
variable life insurance and term life insurance in New Jersey and New York . The
Company only sells such products in New York primarily through affiliated and
unaffiliated distributors.
Annually during the second quarter of each year, we perform a comprehensive
review of actuarial assumptions. As part of this review, we may update these
assumptions and make refinements to our models based upon emerging experience,
future expectations and other data, including any observable market data. For
additional information, see "Accounting Policies & Pronouncements-Application of
Critical Accounting Estimates" below.
COVID-19
Since the first quarter of 2020, the novel coronavirus ("COVID-19") pandemic has
caused extreme stress and disruption in the global economy and financial markets
and elevated mortality and morbidity for the global population. The COVID-19
pandemic impacted our results of operations in the current period and could
continue to impact our results of operations in future periods.
Throughout the pandemic, COVID-19 had a significant net negative impact on our
underwriting results, reflecting unfavorable mortality and morbidity impacts in
our businesses. Beginning with the third quarter of 2022, the Company has
embedded COVID-19 considerations within its best estimate assumptions of future
expected mortality impacts for its applicable businesses. The ultimate impact on
our underwriting results, however, will continue to depend on various factors
including: an insured's age; geographic concentration; insured versus uninsured
populations among the fatalities; the transmissibility and virulence of the
virus, including the potential for further mutation; and the ongoing acceptance
and efficacy of the vaccines and other therapeutics.
Revenues and Expenses
The Company earns revenues principally from insurance premiums, mortality and expense fees, asset administration fees from insurance and investment products, and from net investment income on the investment of general account and other funds. The Company receives premiums primarily from the sale of individual life insurance and annuity products. The Company earns mortality and expense fees, and asset administration fees, primarily from the sale and servicing of universal life insurance and separate account products including 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, reinsurance premiums, commissions and other costs of selling and servicing the various products sold and interest credited on general account liabilities.
Industry Trends
Our business is impacted by financial markets, economic conditions, regulatory
oversight, and a variety of trends that affect the industries where we compete.
Financial and Economic Environment. Interest rates in theU.S. have experienced a sustained period of historically low levels, followed by a sharp rise in 2022. We expect that a continued level of higher interest rates will benefit our results over time. We continue to monitor current market conditions and the impact to our business from slowing or negative economic growth. In addition, we are subject to financial impacts associated with movements in equity markets and the evolution of the credit cycle as discussed in "Risk Factors". 31
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Demographics. Customer demographics continue to evolve and new opportunities present themselves in different consumer segments such as the millennial and multicultural markets. Consumer expectations and preferences are changing. We believe existing and potential customers are increasingly looking for cost-effective solutions that they can easily understand and access through technology-enabled devices. At the same time, income protection, wealth accumulation and the needs of retiring baby boomers are continuing to shape the insurance industry. A persistent retirement security gap exists in terms of both savings and protection. Despite the ongoing phenomenon of the risk and responsibility of retirement savings shifting from employers to employees, employers are becoming increasingly focused on the financial wellness of their employees.
Regulatory Environment. See "Business-Regulation" for a discussion of regulatory
developments that may impact the Company and the associated risks.
Competitive Environment. See "Business" for a discussion of the competitive
environment and the basis on which we compete.
Current Market Conditions
Geopolitical risk, rapidly rising interest rates and significant equity market declines, as we saw throughout 2022, among other factors, adversely impact our liquidity and capital positions, cash flows, results of operations, and financial position. Our statutory capital will also be negatively affected by increased reserve requirements due to our annual update of actuarial assumptions and other refinements, particularly in our individual life business, and will be negatively affected by asymmetrical and non-economic statutory accounting impacts from rising rates. As we navigate through the current environment, we may take actions consistent with our risk and capital frameworks, as necessary, to preserve our liquidity and capital positions. For additional information on how these conditions may also impact our income taxes, see Note 10 to the Financial Statements.
Impact of Changes in the Interest Rate Environment
As a financial services company, market interest rates are a key driver of our
liquidity and capital positions, cash flows, results of operations and financial
position. Changes in interest rates can affect these in several ways, including
favorable or adverse impacts to:
•investment-related activity, including: investment income returns, net
investment spread results,
new money rates, mortgage loan prepayments and bond redemptions;
•the valuation of fixed income investments and derivative instruments;
•collateral posting requirements, hedging costs and other risk mitigation
activities;
•customer account values and assets under management, including their impacts on
fee-related income;
•insurance reserve levels, market experience true-ups and amortization of
deferred policy acquisition costs ("DAC");
•policyholder behavior, including surrender or withdrawal activity; and
•product offerings, design features, crediting rates and sales mix.
See "Current Market Conditions" above, for how rapidly rising interest rates,
among other factors, adversely impact the Company's financial results. For
additional information regarding interest rate risks, see "Risk Factors-Market
Risk".
Accounting Policies & Pronouncements
Application of Critical Accounting Estimates
The preparation of financial statements in conformity with generally accepted accounting principles inthe United States of America ("U.S. GAAP") requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews the estimates and assumptions used in the preparation of our financial statements. If management determines that modifications to assumptions and estimates are appropriate given current facts and circumstances, the Company's results of operations and financial position as reported in the Financial Statements could change significantly.
The following sections discuss the accounting policies applied in preparing our
financial statements that management believes are most dependent on the
application of estimates and assumptions and require management's most
difficult, subjective or complex judgments.
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Table of Contents Insurance Assets
Deferred Policy Acquisition Costs and Deferred Sales Inducements
We capitalize costs that are directly related to the acquisition or renewal of
insurance and annuity contracts. These costs primarily include commissions, as
well as costs of policy issuance and underwriting and certain other expenses
that are directly related to successfully negotiated contracts. We have also
deferred costs associated with sales inducements offered in the past related to
variable and fixed annuity contracts. Sales inducements are amounts that are
credited to the policyholders' account balances mainly as an incentive to
purchase the contract. For additional information about sales inducements, see
Note 8 to the Financial Statements. We generally amortize DAC and deferred sales
inducements ("DSI") over the expected lives of the contracts, based on our
estimates of the level and timing of gross premiums or gross profits, depending
on the type of contract. As described in more detail below, in calculating DAC
and DSI amortization, we are required to make assumptions about investment
returns, mortality, persistency and other items that impact our estimates of the
level and timing of gross premiums or gross profits. We also periodically
evaluate the recoverability of our DAC and DSI. For certain contracts, this
evaluation is performed as part of our premium deficiency testing, as discussed
further below in "Insurance Liabilities-Future Policy Benefits". As of
December 31, 2022 , DAC for our life products was $364 million . There were no DAC
and DSI balances as of December 31, 2022 for our annuity products due to a
series of reinsurance transactions that the Company entered into on April 1,
2016 with The Prudential Insurance Company of America ("Prudential Insurance ").
See Note 6, Note 8 and Note 9 to the Financial Statements for additional
information.
Amortization methodologies
Gross Premiums. DAC associated with term life policies is primarily amortized in proportion to gross premiums. Gross premiums are defined as the premiums charged to a policyholder for an insurance contract. Gross Profits. DAC and DSI associated with the variable and universal life policies and the variable and fixed annuity contracts are generally amortized over the expected lives of these policies in proportion to total gross profits. Total gross profits include both actual gross profits and estimates of gross profits for future periods. Gross profits are defined as (i) amounts assessed for mortality, contract administration, surrender charges, and other assessments plus amounts earned from investment of policyholder balances less (ii) benefits in excess of policyholder balances, costs incurred for contract administration, the net cost of reinsurance for certain products, interest credited to policyholder balances and other credits. If significant negative gross profits are expected in any periods, the amount of insurance in force is generally substituted as the base for computing amortization.U.S. GAAP gross profits and amortization rates also include the impacts of the embedded derivatives associated with certain of the optional living benefit features of our variable annuity contracts, and index-linked crediting features of certain universal life contracts and related hedging activities. In calculating amortization expense, we estimate the amounts of gross profits that will be included in ourU.S. GAAP results and utilize these estimates to calculate distinct amortization rates and expense amounts. In addition, in calculating gross profits, we include the profits and losses related to contracts issued by the Company 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 (anSEC registrant) and has extensive transactions and relationships with other subsidiaries of Prudential Financial, including reinsurance agreements, as discussed in Note 9 and Note 13 to the 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 total economics of the products. For a further discussion of the amortization of DAC and DSI, see "-Results of Operations". We also regularly evaluate and adjust the related DAC and DSI balances with a corresponding charge or credit to current period earnings for the impact of actual gross profits and changes in our projections of estimated future gross profits on our DAC and DSI amortization rates. Adjustments to the DAC and DSI balances include the impact to our estimate of total gross profits of the annual review of assumptions, our quarterly adjustments for current period experience and our quarterly adjustments for market performance. Each of these adjustments is further discussed below in "-Annual assumptions review and quarterly adjustments."
Annual assumptions review and quarterly adjustments
We perform an annual comprehensive review of the assumptions used in estimating
gross profits for future periods. Over the last several years, the Company's
most significant assumption updates that have resulted in a change to expected
future gross profits and the amortization of DAC and DSI have been related to
lapse and other contractholder behavior assumptions, mortality, and revisions to
expected future rates of returns on investments. These assumptions may also
cause potential significant variability in amortization expense in the future.
The impact on our results of operations of changes in these assumptions can be
offsetting and we are unable to predict their movement or offsetting impact over
time.
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The quarterly adjustments for current period experience referred to above reflect the impact of differences between actual gross profits for a given period and the previously estimated expected gross profits for that period. To the extent each period's actual experience differs from the previous estimate for that period, the assumed level of total gross profits may change. In these cases, we recognize a cumulative adjustment to all previous periods' amortization, also referred to as an experience true-up adjustment. The quarterly adjustments for market performance referred to above reflect the impact of changes to our estimate of total gross profits to reflect actual fund performance and market conditions. A significant portion of gross profits for our variable annuity contracts and, to a lesser degree, our variable life contracts are dependent upon the total rate of return on assets held in separate account investment options. This rate of return influences the fees we earn on variable annuity and variable life contracts, costs we incur associated with the guaranteed minimum death and guaranteed minimum income benefit features related to our variable annuity contracts and expected claims to be paid on variable life contracts, as well as other sources of profit. Returns that are higher than our expectations for a given period produce higher than expected account balances, which increase the future fees we expect to earn on variable annuity and variable life contracts and decrease the future costs we expect to incur associated with the guaranteed minimum death and guaranteed minimum income benefit features related to our variable annuity contracts, as well as expected claims to be paid on variable life contracts. The opposite occurs when returns are lower than our expectations. The changes in future expected gross profits are used to recognize a cumulative adjustment to all prior periods' amortization. The weighted average rate of return assumptions used in developing estimated market returns consider many factors specific to each product type, including asset durations, asset allocations and other factors. With regard to equity market assumptions, the near-term future rate of return assumption used in evaluating DAC, other costs and liabilities for future policy benefits for certain of our products, primarily our domestic variable annuity and variable life insurance products, is generally updated each quarter and is derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider historical equity returns and adjust projected equity returns over an initial future period of five years (the "near-term") so that equity returns converge to the long-term expected rate of return. If the near-term projected future rate of return is greater than our near-term maximum future rate of return of 15.0%, we use our maximum future rate of return. If the near-term projected future rate of return is lower than our near-term minimum future rate of return of 0%, we use our minimum future rate of return. As ofDecember 31, 2022 , our variable annuities and variable life insurance businesses assume an 8.0% long-term equity expected rate of return and a 6.9% near-term mean reversion equity expected rate of return. With regard to interest rate assumptions used in evaluating DAC, DSI and liabilities for future policy benefits for certain of our products, we generally update the long-term and near-term future rates used to project fixed income returns annually and quarterly, respectively. As a result of our 2022 annual reviews and update of assumptions and other refinements, we kept our long-term expectation of the 10-yearU.S. Treasury rate unchanged and continue to grade to a rate of 3.25% over ten years. As part of our quarterly market experience updates, we update our near-term projections of interest rates to reflect changes in current rates. Insurance Liabilities Future Policy Benefits
Future Policy Benefit Reserves, including Unpaid Claims and Claim Adjustment
Expenses
We establish reserves for future policy benefits to, or on behalf of,
policyholders, using methodologies prescribed by
methodologies used include the following:
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•For some long-duration contracts, we utilize a net premium valuation
methodology in measuring the liability for future policy benefits. Under this
methodology, a liability for future policy benefits is accrued when premium
revenue is recognized. The liability, which represents the present value of
future benefits to be paid to or on behalf of policyholders and related expenses
less the present value of future net premiums (portion of the gross premium
required to provide for all benefits and expenses), is estimated using methods
that include assumptions applicable at the time the insurance contracts are made
with provisions for the risk of adverse deviation, as appropriate. Original
assumptions continue to be used in subsequent accounting periods to determine
changes in the liability for future policy benefits (often referred to as the
"lock-in concept"), unless a premium deficiency exists. The result of the net
premium valuation methodology is that the liability at any point in time
represents an accumulation of the portion of premiums received to date expected
to be needed to fund future benefits (i.e., net premiums received to date), less
any benefits and expenses already paid. The liability does not necessarily
reflect the full policyholder obligation the Company expects to pay at the
conclusion of the contract since a portion of that obligation would be funded by
net premiums received in the future and would be recognized in the liability at
that time. We perform premium deficiency tests using best estimate assumptions
as of the testing date without provisions for adverse deviation. If the
liabilities determined based on these best estimate assumptions are greater than
the net reserves (i.e., GAAP reserves net of any DAC or DSI asset), the existing
net reserves are first adjusted by reducing these assets by the amount of the
deficiency or to zero through a charge to current period earnings. If the
deficiency is more than these asset balances for insurance contracts, we then
increase the net reserves by the excess, again through a charge to current
period earnings. If a premium deficiency is recognized, the assumptions as of
the premium deficiency test date are locked-in and used in subsequent valuations
and the net reserves continue to be subject to premium deficiency testing. In
addition, for limited-payment contracts, future policy benefit reserves also
include a deferred profit liability representing gross premiums received in
excess of net premiums. The deferred profits are generally recognized in revenue
in a constant relationship with insurance in force or with the amount of
expected future benefit payments.
•For certain contract features, such as those related to guaranteed minimum
death benefits ("GMDB"), guaranteed minimum income benefits ("GMIB") and
no-lapse guarantees, a liability is established when associated assessments
(which include policy charges for administration, mortality, expense, surrender,
and other, regardless of how characterized) are recognized. This liability is
established using current best estimate assumptions and is based on the ratio of
the present value of total expected excess payments (e.g., payments in excess of
account value) over the life of the contract divided by the present value of
total expected assessments (i.e., benefit ratio). The liability equals the
current benefit ratio multiplied by cumulative assessments recognized to date,
plus interest, less cumulative excess payments to date. The result of the
benefit ratio method is that the liability at any point in time represents an
accumulation of the portion of assessments received to date expected to be
needed to fund future excess payments, less any excess payments already paid.
The liability does not necessarily reflect the full policyholder obligation the
Company expects to pay at the conclusion of the contract since a portion of that
excess payment would be funded by assessments received in the future and would
be recognized in the liability at that time. Similar to as described above for
DAC, the reserves are subject to adjustments based on annual reviews of
assumptions and quarterly adjustments for experience, including market
performance. These adjustments reflect the impact on the benefit ratio of using
actual historical experience from the issuance date to the balance sheet date
plus updated estimates of future experience. The updated benefit ratio is then
applied to all prior periods' assessments to derive an adjustment to the reserve
recognized through a benefit or charge to current period earnings.
•For certain product guarantees, primarily certain optional living benefit
features of the variable annuity products including guaranteed minimum
accumulation benefits ("GMAB"), guaranteed minimum withdrawal benefits ("GMWB")
and guaranteed minimum income and withdrawal benefits ("GMIWB"), the benefits
are accounted for as embedded derivatives using a fair value accounting
framework. The fair value of these contracts is calculated as the present value
of expected future benefit payments to contractholders less the present value of
assessed rider fees attributable to the embedded derivative feature. Under U.S.
GAAP, the fair values of these benefit features are based on assumptions a
market participant would use in valuing these embedded derivatives. Changes in
the fair value of the embedded derivatives are recorded quarterly through a
benefit or charge to current period earnings. For additional information
regarding the valuation of these embedded derivatives, see Note 5 to the
Financial Statements.
The assumptions used in establishing reserves are generally based on the
Company's experience, industry experience and/or other factors, as applicable.
We update our actuarial assumptions, such as mortality and policyholder behavior
assumptions annually, unless a material change is observed in an interim period
that we feel is indicative of a long-term trend. Generally, we do not expect
trends to change significantly in the short-term and, to the extent these trends
may change, we expect such changes to be gradual over the long-term.
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The following paragraphs provide additional details about the reserves we have
established:
The reserves for future policy benefits of our individual annuity business
relate to reserves for the GMDB and GMIB features of our variable annuities, and
for the optional living benefit features that are accounted for as embedded
derivatives. As discussed above, in establishing reserves for GMDBs and GMIBs,
we utilize current best estimate assumptions. The primary assumptions used in
establishing these reserves generally include annuitization, lapse, withdrawal
and mortality assumptions, as well as interest rate and equity market return
assumptions. Lapse rates are adjusted at the contract level based on the
in-the-moneyness of the benefit and reflect other factors, such as the
applicability of any surrender charges. Lapse rates are reduced when contracts
are more in-the-money. Lapse rates are also generally assumed to be lower for
the period where surrender charges apply. For life contingent payout annuity
contracts, we establish reserves using best estimate assumptions with provisions
for adverse deviations as of inception or best estimate assumptions as of the
most recent loss recognition date.
The reserves for certain optional living benefit features, including GMAB, GMWB
and GMIWB are accounted for as embedded derivatives at fair value, as described
above. This methodology could result in either a liability or contra-liability
balance, given changing capital market conditions and various actuarial
assumptions. Since there is no observable active market for the transfer of
these obligations, the valuations are calculated using internally-developed
models with option pricing techniques. The models are based on a risk neutral
valuation framework and incorporate premiums for risks inherent in valuation
techniques, inputs, and the general uncertainty around the timing and amount of
future cash flows. The significant inputs to the valuation models for these
embedded derivatives include capital market assumptions, such as interest rate
levels and volatility assumptions, the Company's market-perceived risk of its
own non-performance risk ("NPR"), as well as actuarially determined assumptions,
including mortality rates and contractholder behavior, such as lapse rates,
benefit utilization rates and withdrawal rates. Capital market inputs and actual
contractholders' account values are updated each quarter based on capital market
conditions as of the end of the quarter, including interest rates, equity
markets and volatility. In the risk neutral valuation, the initial swap curve
drives the total returns used to grow the contractholders' account values.
Through the first quarter of 2022, the Company's discount rate assumption was
based on the London Inter-Bank Offered Rate ("LIBOR") swap curve adjusted for an
additional spread, which included an estimate of NPR . As of the second quarter
of 2022, the Company's discount rate assumption substituted the Secured
Overnight Financial Rate ("SOFR") for LIBOR as part of the annual assumptions
update. The discount rate assumption continues to use an additional spread which
includes an estimate of NPR . Actuarial assumptions, including contractholder
behavior and mortality, are reviewed at least annually and updated based upon
emerging experience, future expectations and other data, including any
observable market data, such as available industry studies or market
transactions such as acquisitions and reinsurance transactions. For additional
information regarding the valuation of these optional living benefit features,
see Note 5 to the Financial Statements.
The reserves for future policy benefits of our individual life business relate
to term life, universal life and variable life products. For term life
contracts, the future policy benefit reserves are generally calculated using the
net premium valuation methodology, as described above. The primary assumptions
used in determining expected future benefits and expenses include mortality,
lapse, investment yield and maintenance expense assumptions. For variable and
universal life products, which include universal life contracts that contain
no-lapse guarantees, reserves for future policy benefits are primarily
established using the reserving methodology for GMDB and GMIB contracts. As
discussed above, in establishing reserves for GMDBs and GMIBs, we utilize
current best estimate assumptions. The primary assumptions used in establishing
these reserves generally include mortality, lapse, and premium pattern, as well
as interest rate and equity market return assumptions. Reserves also include
claims reported but not yet paid, and claims incurred but not yet reported.
Policyholders' Account Balances
The policyholders' account balances liability represents the contract value that
has accrued to the benefit of the policyholder as of the balance sheet date.
This liability is primarily associated with the accumulated account deposits,
plus interest credited, less policyholder withdrawals and other charges assessed
against the account balance, as applicable. The liability also includes
provisions for benefits under non-life contingent payout annuities. Our unearned
revenue reserve ("URR") is also reported as a component of Policyholders'
account balances and had a balance of $303 million as of December 31, 2022 . This
reserve primarily relates to the variable and universal life products and
represents policy charges for services to be provided in future periods. The
charges are deferred as unearned revenue and are generally amortized over the
expected life of the contract in proportion to the product's estimated gross
profits, similar to DAC and DSI as discussed above. Policyholders' account
balances also include amounts representing the fair value of embedded derivative
instruments associated with the index-linked features of certain universal life
products. For additional information regarding the valuation of these embedded
derivatives, see Note 5 to the Financial Statements.
Sensitivities for Insurance Assets and Liabilities
The following table summarizes the impact that could result on each of the listed financial statement balances from changes in certain key assumptions. The information below is for illustrative purposes and includes only the hypothetical direct impact onDecember 31, 2022 balances of changes in a single assumption and not changes in any combination of assumptions. 36
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Additionally, the illustration of the insurance assumption impacts below reflects a parallel shift in the insurance assumptions; however, these may be non-parallel in practice. Changes in current assumptions could result in impacts to financial statement balances that are in excess of the amounts illustrated. A description of the estimates and assumptions used in the preparation of each of these financial statement balances is provided above. For traditional long-duration and limited-payment contracts,U.S. GAAP requires the original assumptions used when the contracts are issued to be locked-in and that those assumptions be used in all future liability calculations as long as the resulting liabilities are adequate to provide for the future benefits and expenses (i.e., there is no premium deficiency). Therefore, these products are not reflected in the sensitivity table below unless the hypothetical change in assumption would result in an adverse impact that would cause a premium deficiency. Similarly, the impact of any favorable hypothetical change in assumptions for traditional long duration and limited-payment contracts is not reflected in the table below given that the current assumption is required to remain locked-in and instead the positive impacts would be recognized into net income over the life of the policies in force. The impacts presented within this table exclude the related impacts of our asset liability management strategy which seeks to offset the changes in certain of the balances presented within this table and is primarily composed of investments and derivatives. See further below for a discussion of the estimates and assumptions involved with the application ofU.S. GAAP accounting policies for these instruments and "Quantitative and Qualitative Disclosures about Market Risk" for hypothetical impacts on related balances as a result of changes in certain significant assumptions. December 31, 2022 Increase (Decrease) in Future Policy Benefits and Deferred Policy Reinsurance Policyholders' Acquisition Costs Recoverables Account Balances Net Impact (in millions) Hypothetical change in current assumptions: Long-term interest rate: Increase by 25 basis points $ 0 $ (5) $ (5)$ 0 Decrease by 25 basis points $ 0 $ 5 $ 5$ 0
Long-term equity expected rate of return:
Increase by 50 basis points $ 5 $ (5) $ 0$ 0 Decrease by 50 basis points $ (5) $ 5 $ 0$ 0
Increase by 50 basis points $ 0 $ (85) $ (90)$ 5 Decrease by 50 basis points $ 0 $
90 $ 100$ (10) Mortality: Increase by 1% $ 0 $ (5) $ (10)$ 5 Decrease by 1% $ 0 $ 5 $ 10$ (5) Lapse: Increase by 10% $ 0 $ (35) $ (40)$ 5 Decrease by 10% $ 0 $ 35 $ 40$ (5)
Valuation of Investments, Including Derivatives, Measurement of Allowance for
Credit Loss and the Recognition of Other-than-Temporary Impairments
Our investment portfolio consists of public and private fixed maturity
securities, commercial mortgage and other loans, equity securities, other
invested assets and derivative financial instruments. Derivatives are financial
instruments whose values are derived from interest rates, foreign exchange
rates, financial indices or the values of securities. Derivative financial
instruments that are generally used include swaps, futures, forwards and options
and may be exchange-traded or contracted in the over-the-counter ("OTC") market.
We are also party to financial instruments that contain derivative instruments
that are "embedded" in the financial instruments. Management believes the
following accounting policies related to investments, including derivatives, are
most dependent on the application of estimates and assumptions. Each of these
policies is discussed further within other relevant disclosures related to
investments and derivatives, as referenced below:
•Valuation of investments, including derivatives;
•Measurement of the allowance for credit losses on fixed maturity securities classified as available-for-sale, commercial mortgage loans, and other loans; and
•Recognition of other-than-temporary impairments ("OTTI") for equity method
investments.
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We present at fair value in the statements of financial position our debt
security investments classified as available-for-sale, investments classified as
trading, and certain fixed maturities, equity securities, and certain
investments within "Other invested assets," such as derivatives. For additional
information regarding the key estimates and assumptions surrounding the
determination of fair value of fixed maturity and equity securities, as well as
derivative instruments, embedded derivatives and other investments, see Note 5
to the Financial Statements.
For our investments classified as available-for-sale, the impact of changes in
fair value is recorded as an unrealized gain or loss in "Accumulated other
comprehensive income (loss)" ("AOCI"), a separate component of equity. For our
investments classified as trading, and equity securities, the impact of changes
in fair value is recorded within "Other income". Our commercial mortgage and
other loans are carried primarily at unpaid principal balances, net of
unamortized deferred loan origination fees and expenses and unamortized premiums
or discounts and a valuation allowance for losses.
In addition, an allowance for credit losses is measured each quarter for
available-for-sale fixed maturity securities, commercial mortgage and other
loans. For additional information regarding our policies regarding the
measurement of credit losses, see Note 2 to the Financial Statements.
For equity method investments, the carrying value of these investments is written down or impaired to fair value when a decline in value is considered to be other-than-temporary. For additional information regarding our OTTI policies, see Note 2 to the Financial Statements.
Taxes on Income
Our effective tax rate is based on income, non-taxable and non-deductible items,
tax credits, statutory tax rates and tax planning opportunities available in the
various jurisdictions in which we operate. Inherent in determining our annual
tax rate are judgments regarding business plans, planning opportunities and
expectations about future outcomes. The Dividend Received Deduction ("DRD") is a
major reason for the difference between the Company's effective tax rate and the
U.S. federal statutory rate. The DRD is an estimate that incorporates the prior
and current year information, as well as the current year's equity market
performance. Both the current estimate of the DRD and the DRD in future periods
can vary 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 underlying fund investments, changes in the account
balances of variable life and annuity contracts, and the Company's taxable
income before the DRD.
An increase or decrease in our effective tax rate by one percentage point would
have resulted in a decrease or increase in our 2022 "Income tax expense
(benefit)" of
The CARES Act. OnMarch 27, 2020 , the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") was enacted into law. One provision of the CARES Act amends the Tax Act of 2017 and allows companies with net operating losses ("NOLs") originating in 2018, 2019 or 2020 to carry back those losses up to five years. For 2020, the Company recorded an income tax benefit of$7 million from carrying the 2020 NOL back to tax years that have a 35% tax rate.
Contingencies
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. UnderU.S. GAAP, accruals for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated, such as in connection with an unresolved legal matter. The initial reserve reflects management's best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure.
Adoption of New Accounting Pronouncements
ASU 2018-12, Financial Services - Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, was issued by theFinancial Accounting Standards Board ("FASB") onAugust 15, 2018 , and was amended by ASU 2019-09, Financial Services - Insurance (Topic 944): Effective Date, issued inOctober 2019 , and ASU 2020-11,Financial Services-Insurance (Topic 944): Effective Date and Early Application, issued inNovember 2020 . The Company will adopt ASU 2018-12 effectiveJanuary 1, 2023 using the modified retrospective transition method where permitted, and apply the guidance as ofJanuary 1, 2021 (and record transition adjustments as ofJanuary 1, 2021 ) in the 2023 financial statements. The Company has an established governance framework to manage the implementation of the standard. The Company has substantially completed its implementation efforts including, but not limited to, implementing refinements to key accounting policy decisions, modifications to actuarial valuation models, updates to data sourcing capabilities, automation of key financial reporting and analytical processes and updates to internal control over financial reporting and disclosure. 38
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ASU 2018-12 will impact, at least to some extent, the accounting and disclosure requirements for all long-duration insurance and investment contracts issued by the Company. The Company expects the standard to have a significant financial impact on the Financial Statements and will significantly increase disclosures. As of theJanuary 1, 2021 transition date, the Company estimates that the implementation of the standard will result in approximately a$150 million decrease to$50 million increase to "Total equity", largely from remeasuring in force contract liabilities using upper-medium grade fixed income instrument yields as of the transition date and from other changes in reserves. As ofSeptember 30, 2022 , the Company does not expect the estimated impacts to change significantly. In addition to the impacts to the balance sheet, the Company also expects an impact to the pattern of earnings emergence following the transition date. See Note 2 to the Financial Statements for a more detailed discussion of ASU 2018-12, as well as other accounting pronouncements issued but not yet adopted and newly adopted accounting pronouncements. Changes in Financial Position
2022 to 2021 Annual Comparison
Total assets decreased
•Separate account assets decreased
market performance, increase in interest rates and net outflows; and
•Reinsurance recoverables decreased
variable annuity reinsured living benefit liabilities resulting from a decrease
in future expected benefit payments from rising interest rates.
Total liabilities decreased
to
•Separate account liabilities decreased
decrease in Separate account assets, as discussed above; and
•Future policy benefits decreased
reserves related to our variable annuity living benefit liabilities, as
discussed above.
Total equity increased$58 million primarily driven by$325 million of capital contributions fromPruco Life Insurance Company to fund additional reserve requirements and net income of$51 million , partially offset by a$318 million decrease in other comprehensive income (loss), net of tax primarily driven by net unrealized losses on fixed maturity investments from rising interest rates. Results of Operations
Income (loss) from Operations before Income Taxes
2022 to 2021 Annual Comparison
Income from operations before income taxes decreased$11 million from income of$64 million in 2021 to income of$53 million in 2022. The impact from our annual reviews and update of assumptions and other refinements was relatively flat at a net loss of$1 million . Excluding the impact of our annual reviews and update of assumptions and other refinements, income decreased$10 million primarily driven by:
•Lower Policy charges and fee income primarily driven by an increase in cost of
reinsurance from business growth;
•Higher General and administrative expenses driven by an increase in corporate
allocated overhead expenses; and
•Higher Interest credited to policyholders' account balances due to higher
crediting rates and business growth.
Partially offset by:
•Higher Realized investment gains (losses), net primarily driven by favorable
impacts from the higher interest rates decreasing the present value of the
Indexed Universal Life embedded derivative liability.
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Revenues, Benefits and Expenses
2022 to 2021 Annual Comparison
Revenues increased$7 million from a gain of$232 million in 2021 to a gain of$239 million in 2022. This includes a favorable comparative net increase of$13 million from our annual reviews and update of assumptions and other refinements, as mentioned above. Excluding the impact of our annual reviews and update of assumptions and other refinements, Revenues decreased$6 million primarily driven by:
•Lower Policy charges and fee income driven by an increase in cost of
reinsurance from business growth in addition to the slower recognition of
unearned revenue reserve amortization due to higher interest rates increasing
expected gross profit emergence in future periods;
Partially offset by:
•Higher Realized investment gains (losses), net primarily driven by favorable
impacts from the higher interest rates decreasing the present value of the
Indexed Universal Life embedded derivative liability.
Benefits and expenses increased$18 million from an expense of$168 million in 2021 to an expense of$186 million in 2022. This includes an unfavorable comparative net increase of$14 million from our annual reviews and update of assumptions and other refinements, as mentioned above. Excluding the impact of our annual reviews and update of assumptions and other refinements, the increase was$4 million primarily driven by:
•Higher General and administrative expenses driven by an increase in corporate
allocated overhead expenses;
•Higher Interest credited to policyholders' account balances due to higher
crediting rates and business growth;
Partially offset by:
•Lower Amortization of deferred policy acquisition costs primarily due to the
slower amortization from higher interest rates increasing expected gross profits
emergence in future periods.
Risks and Risk Mitigants
Variable Annuity Risks and Risk Mitigants. 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 capital
markets assumptions such as equity market returns, interest rates and market
volatility, along with actuarial assumptions such as contractholder mortality,
the timing and amount of annuitization and withdrawals, and contract lapses. For
these risk exposures, achievement of our expected returns is subject to the risk
that actual experience will differ from the assumptions used in the original
pricing of these products. Prudential Financial manages our exposure to certain
risks driven by fluctuations in capital markets primarily through a combination
of Product Design Features and an Asset Liability Management Strategy ("ALM"),
as discussed below. Sales of traditional variable annuities with guaranteed
living benefit riders have been discontinued as of December 31, 2020 . See
"Business-Products" section for more information about these products.
Product Design Features:
A portion of the variable annuity contracts that we offer include an asset
transfer feature. This feature is implemented at the contract level, and
transfers assets between certain variable investment sub-accounts selected by
the annuity contractholder and, depending on the benefit feature, a fixed-rate
account in the general account or a bond fund sub-account within the separate
account. The objective of the asset transfer feature is to reduce our exposure
to equity market risk and market volatility. The asset transfer feature
associated with our highest daily living benefit products uses a designated bond
fund sub-account within the separate account. The transfers are based on a
static mathematical formula used with the particular benefit which considers a
number of factors, including, but not limited to, the impact of investment
performance on the contractholder's total account value. Other product design
features we utilize include, among others, asset allocation restrictions,
minimum issuance age requirements and certain limitations on the amount of
contractholder purchase payments, as well as a required minimum allocation to
our general account for certain of our products. We continue to introduce
products that diversify our risk profile and have incorporated provisions in
product design allowing frequent revisions of key pricing elements for certain
of our products. In addition, there is diversity in our fee arrangements, as
certain fees are primarily based on the benefit guarantee amount, the
contractholder account value and/or premiums, which helps preserve certain
revenue streams when market fluctuations cause account values to decline.
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Asset Liability Management Strategy (including fixed income instruments and
derivatives):
We employ an ALM strategy that utilizes a combination of both traditional fixed
income instruments and derivatives to meet expected liabilities associated with
our variable annuity living benefit guarantees. The economic liability we manage
with this ALM strategy consists of expected living benefit claims under less
severe market conditions, which are managed using fixed income instruments,
derivatives, or a combination thereof, and potential living benefit claims
resulting from more severe market conditions, which are hedged using derivative
instruments. For our Prudential Defined Income ("PDI") variable annuity, we
utilize fixed income instruments to meet expected liabilities. For the portion
of our ALM strategy executed with derivatives, we enter into a range of
exchange-traded and over-the-counter equity, interest rate and credit
derivatives, including, but not limited to: equity and treasury futures; total
return, credit default and interest rate swaps; and options including equity
options, swaptions, and floors and caps. The intent of this strategy is to more
efficiently manage the capital and liquidity associated with these products
while continuing to mitigate fluctuations in net income due to movements in
capital markets. To achieve this, we periodically review and recalibrate the ALM
strategy by optimizing the mix of derivatives and fixed income instruments to
achieve expected outcomes.
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Income Taxes
The differences between income taxes expected at the
income tax rate of 21% applicable for 2022, 2021 and 2020, and the reported
income tax expense (benefit) are provided in the following table:
Year Ended December 31,
2022 2021 2020
(in millions)
Expected federal income tax expense (benefit) at federal
statutory rate $ 11 $ 13 $ 9
Non-taxable investment income (6) (6) (6)
Tax credits (3) (3) (2)
Changes in tax law 0 0 (7)
Other 0 1 0
Reported income tax expense (benefit) $ 1 $ 4 $ (6)
Effective tax rate 2.7 %
6.9 % (15.1) %
Effective Tax Rate
The effective tax rate is the ratio of "Income tax expense (benefit)" divided by "Income (loss) from operations before income taxes." Our effective tax rate for fiscal years 2022, 2021 and 2020 was 2.7%, 6.9% and (15.1)%, respectively. For a detailed description of the nature of each significant reconciling item, see Note 10 to the Financial Statements.
Unrecognized Tax Benefits
The Company's liability for income taxes includes the liability for unrecognized tax benefits and interest that relate to tax years still subject to review by the Internal Revenue Service or other taxing authorities. The completion of review or the expiration of the Federal statute of limitations for a given audit period could result in an adjustment to the liability for income taxes. The Company had no unrecognized benefit as ofDecember 31, 2022 , 2021 and 2020. We do not anticipate any significant changes within the next twelve months to our total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.
Income Tax Expense vs. Income Tax Paid in Cash
Income tax expense recorded underU.S. GAAP routinely differs from the income taxes paid in cash in any given year. Income tax expense recorded underU.S. GAAP is based on income reported in our Statements of Operations for the current period and it includes both current and deferred taxes. Income taxes paid during the year include tax installments made for the current year as well as tax payments and refunds related to prior periods.
For additional information regarding income tax related items, see
"Business-Regulation" and Note 10 to the Financial Statements.
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 operations of our business, fund
business growth, and provide a cushion to withstand adverse circumstances. Our
ability to generate and maintain sufficient liquidity and capital depends on the
profitability of our business, general economic conditions and our access to the
capital markets and the alternative sources of liquidity and capital described
herein.
Effective and prudent liquidity and capital management is a priority across the
organization. Management monitors the liquidity of the Company on a daily basis
and projects borrowing and capital needs over a multi-year time horizon. We use
a Risk Appetite Framework ("RAF") to ensure that all risks taken by the Company
align with our capacity and willingness to take those risks. The RAF provides a
dynamic assessment of capital and liquidity stress impacts, including scenarios
similar to, and more severe than, those occurring due to COVID-19, and is
intended to ensure that sufficient resources are available to absorb those
impacts. We believe that our capital and liquidity resources are sufficient to
satisfy the capital and liquidity requirements of the Company.
Our businesses are subject to comprehensive regulation and supervision by
domestic and international regulators. These regulations currently include
requirements (many of which are the subject of ongoing rule-making) relating to
capital and liquidity management. For information on these regulatory
initiatives and their potential impact on us, see "Business-Regulation" and
"Risk Factors".
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Capital
We manage to regulatory capital levels consistent with our "AA" ratings targets.
We utilize the risk-based capital ("RBC") ratio as a primary measure of capital
adequacy. RBC is calculated based on statutory financial statements and risk
formulas consistent with the practices of the National Association of Insurance
Commissioners ("NAIC"). RBC considers, 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. RBC ratio calculations are intended to assist insurance regulators in
measuring an 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 Company's capital levels
substantially exceed the minimum level required by applicable insurance
regulations. Our regulatory capital levels may be affected in the future by
changes to the applicable regulations, proposals for which are currently under
consideration by both domestic and international insurance regulators.
The regulatory capital level of the Company can be materially impacted by
interest rate and equity market fluctuations, changes in the values of
derivatives, the level of impairments recorded, and credit quality migration of
the investment portfolio, among other items. In addition, the reinsurance of
business or the recapture of business subject to reinsurance arrangements due to
defaults by, or credit quality migration affecting, the reinsurers or for other
reasons could negatively impact regulatory capital levels. The Company's
regulatory capital level is also affected by statutory accounting rules, which
are subject to change by each applicable insurance regulator.
Captive Reinsurance Companies
Prudential Financial and the Company use captive reinsurance companies for our individual life business to more effectively manage our reserves and capital on an economic basis and to enable the aggregation and transfer of risks. The captive reinsurance companies assume business from affiliates only. To support the risks they assume, our captives are capitalized to a level we believe is consistent with the "AA" financial strength rating targets of Prudential Financial's insurance subsidiaries. All of the captive reinsurance companies are wholly-owned subsidiaries of Prudential Financial 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 contributes capital to the captives to support business growth and other needs. Prudential Financial has also entered into support agreements with several of the captives in connection with financing arrangements. Prudential Financial's life insurance subsidiaries are subject to a regulation entitled "Valuation of Life Insurance Policies Model Regulation," commonly known as "Regulation XXX," and a supporting guideline entitled "The Application of the Valuation of Life Insurance Policies Model Regulation," commonly known as "Guideline AXXX." The regulation and supporting guideline require insurers to establish statutory reserves for term and universal life insurance policies with long-term premium guarantees at a level that exceeds what our actuarial assumptions for this business would otherwise require. Prudential Financial uses captive reinsurance companies to finance the portion of the reserves for this business that we consider to be non-economic as described below under "-Financing Activities-Term and Universal Life Reserve Financing."
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 use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact ofPrudential Funding, LLC's ("Prudential Funding"), a wholly-owned subsidiary ofPrudential Insurance , 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. We consider attributes of the various categories of liquid assets (e.g., type of asset and credit quality) in calculating internal liquidity measures to evaluate our liquidity under various stress scenarios, including company-specific and market-wide events. 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. The principal sources of the Company's liquidity are premiums and certain annuity considerations, investment and fee income, investment maturities, sales of investments and 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, the payment of dividends and returns of capital to the parent company, hedging and reinsurance activity and payments in connection with financing activities. 43
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In managing liquidity, we 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.
Liquid Assets
Liquid assets include cash and cash equivalents, short-term investments,U.S. Treasury fixed maturities, fixed maturities that are not designated as held-to-maturity, and public equity securities. As ofDecember 31, 2022 and 2021, the Company had liquid assets of$1,987 million and$2,088 million , respectively. The portion of liquid assets comprised cash and cash equivalents and short-term investments was$263 million and$146 million as ofDecember 31, 2022 and 2021, respectively. As ofDecember 31, 2022 ,$1,673 million , or 97%, of the fixed maturity investments in the Company's general account portfolios were rated high or highest quality based on NAIC or equivalent rating.
Financing Activities
Term and Universal Life Reserve Financing
For business written prior to the implementation of principle-based reserving, Regulation XXX and Guideline AXXX require domestic life insurers to establish statutory reserves for term and universal life insurance policies with long-term premium guarantees that are consistent with the statutory reserves required for other individual life policies with similar guarantees. Many market participants believe that these levels of reserves are excessive relative to the levels reasonably required to maintain solvency for moderately adverse experience. The difference between the statutory reserve and the amount necessary to maintain solvency for moderately adverse experience is considered to be the non-economic portion of the statutory reserve. The Company uses affiliated captive reinsurance companies to finance the portion of the statutory reserves required to be held under Regulation XXX and Guideline AXXX that is considered to be non-economic. The financing arrangements involve the reinsurance of term and universal life business to our affiliated captive reinsurers and the issuance of surplus notes by those affiliated captives that are treated as capital for statutory purposes. These surplus notes are subordinated to policyholder obligations, and the payment of principal and interest on the surplus notes can only be made with prior insurance regulatory approval. As ofDecember 31, 2022 , the affiliated captive reinsurance companies have entered into agreements with external counterparties providing for the issuance of up to an aggregate of$16,050 million of surplus notes by our affiliated captive reinsurers in return for the receipt of credit-linked notes ("Credit-Linked Note Structures"), of which$14,070 million of surplus notes was outstanding, compared to an aggregate issuance capacity of$14,600 million , of which$12,721 million was outstanding as ofDecember 31, 2021 . These amounts reflect an increased Credit Link Note Structure expanded inDecember 2022 for Guideline AXXX reserves, of which$2,100 million was outstanding as ofDecember 31, 2022 . Under the agreements, the affiliated captive receives in exchange for the surplus notes one or more credit-linked notes issued by a special-purpose affiliate of the Company with an aggregate principal amount equal to the surplus notes outstanding. The affiliated captive holds the credit-linked notes as assets supporting Regulation XXX or Guideline AXXX non-economic reserves, as applicable. The captive can redeem the principal amount of the outstanding credit-linked notes for cash upon the occurrence of, and in an amount necessary to remedy, a specified liquidity stress event affecting the captive. Under the agreements, the external counterparties have agreed to fund any such payments under the credit-linked notes in return for the receipt of fees. Under certain of the transactions, Prudential Financial has agreed to make capital contributions to the captive to reimburse it for investment losses in excess of specified amounts and/or has agreed to reimburse the external counterparties for any payments made under the credit-linked notes. To date, no such payments under the credit-linked notes have been required. Under these transactions, because valid rights of set-off exist, interest and principal payments on the surplus notes and on the credit-linked notes are settled on a net basis, and the surplus notes are reflected in the Company's total consolidated borrowings on a net basis. As ofDecember 31, 2022 , our affiliated captive reinsurance companies had outstanding an aggregate of$3,025 million of debt issued for the purpose of financing Regulation XXX and Guideline AXXX non-economic reserves, of which approximately$925 million relates to Regulation XXX reserves and approximately$2,100 million relates to Guideline AXXX reserves. In addition, as ofDecember 31, 2022 , for purposes of financing Guideline AXXX reserves, one of our affiliated captives had approximately$3,982 million of surplus notes outstanding that were issued to affiliates. The Company has introduced updated versions of its individual life products in conjunction with the requirement to adopt principle-based reserving byJanuary 1, 2020 . These updated products are currently priced to support the principle-based statutory reserve level without the need for reserve financing. 44
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market Risk
Market risk is defined as the risk of loss from changes in interest rates, equity prices and foreign currency exchange rates resulting from asset/liability mismatches where the change in the value of our liabilities is not offset by the change in value of our assets. EffectiveApril 1, 2016 , the Company reinsured variable annuity base contracts, along with the living benefit guarantees, toPrudential Insurance under a coinsurance and modified coinsurance agreement. This reinsurance agreement covers new and in-force business. As ofDecember 31, 2020 , the Company discontinued the sales of traditional variable annuities with guaranteed living benefit riders which has no impact on the reinsurance agreement. Additionally, the living benefit hedging program related to the living benefit guarantees as well as the product risks for retained and reinsured businesses are being managed withinPrudential Insurance . For additional information regarding the potential impacts of interest rate and other market fluctuations, as well as general economic and market conditions on our businesses and profitability, see Item 1A. "Risk Factors" above. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Overview-Current Market Conditions" above, for how rapidly rising interest rates, among other factors, adversely impact the Company's financial results. For additional information regarding our liquidity and capital resources, which may be impacted by changing market risks, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" above.
Market Risk Management
Management of market risk, which we consider to be a combination of both investment risk and market risk exposures, includes the identification and measurement of various forms of risk, the establishment of risk thresholds and the creation of processes intended to maintain risks within these thresholds while optimizing returns on the underlying assets or liabilities. As an indirect wholly-owned subsidiary of Prudential Financial, the Company benefits from the risk management strategies implemented by Prudential Financial.
Our risk management process utilizes a variety of tools and techniques,
including:
•Measures of price sensitivity to market changes (e.g., interest rates, equity
index prices, foreign exchange);
•Asset/liability management;
•Stress scenario testing;
•Hedging programs and affiliated reinsurance; and
•Risk management governance, including policies, limits and a committee that
oversees investment and market risk.
Market Risk Mitigation
Risk mitigation takes three primary forms:
•Asset/Liability Management: Managing assets to liability-based measures. For
example, investment policies identify target durations for assets based on
liability characteristics and asset portfolios are managed to within ranges
around them. This mitigates potential unanticipated economic losses from
interest rate movements.
•Hedging: Using derivatives to offset risk exposures. For example, for our
variable annuities, potential living benefit claims resulting from more severe
market conditions are hedged using derivative instruments.
•Management of portfolio concentration risk: For example, ongoing monitoring and
management of key rate, currency and other concentration risks support
diversification efforts to mitigate exposure to individual markets and sources
of risk.
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Market Risk Related to Interest Rates
We perform liability-driven investing and engage in careful asset/liability management. Asset/liability mismatches create the risk that changes in liability values will differ from the changes in the value of the related assets. Additionally, changes in interest rates may impact other items including, but not limited to, the following: •Net investment spread between the amounts that we are required to pay and the rate of return we are able to earn on investments for certain products supported by general account investments;
•Asset-based fees earned on assets under management or contractholder account
values;
•Estimated total gross profits and the amortization of deferred policy
acquisition and other costs;
•Net exposure to the guarantees provided under certain products; and
•Our capital levels.
In order to mitigate the impact that an unfavorable interest rate environment
has on our net interest margins, we employ a proactive asset/liability
management program, which includes strategic asset allocation and derivative
strategies within a disciplined risk management framework. These strategies seek
to match the characteristics of our products, and to approximate the interest
rate sensitivity of the assets with the estimated interest rate sensitivity of
the product liabilities. Our asset/liability management program also helps
manage duration gaps, currency and other risks between assets and liabilities
through the use of derivatives. We adjust this dynamic process as products
change, as customer behavior changes and as changes in the market environment
occur. As a result, our asset/liability management process has permitted us to
manage interest rate risk successfully through several market cycles.
We use duration and convexity analyses to measure price sensitivity to interest
rate changes. Duration measures the relative sensitivity of the fair value of a
financial instrument to changes in interest rates. Convexity measures the rate
of change in duration with respect to changes in interest rates. We use
asset/liability management and derivative strategies to manage our interest rate
exposure by matching the relative sensitivity of asset and liability values to
interest rate changes, or by controlling the "duration mismatch" of assets and
liability duration targets. In certain markets, capital market limitations that
hinder our ability to acquire assets that approximate the duration of some of
our liabilities are considered in setting duration targets. We consider
risk-based capital and tax implications as well as current market conditions in
our asset/liability management strategies.
The Company also mitigates interest rate risk through a market value adjusted
("MVA") provision on certain of the Company's annuity products' fixed investment
options. This MVA provision limits interest rate risk by subjecting the
contractholder to an MVA when funds are withdrawn or transferred to variable
investment options before the end of the guarantee period. In the event of
rising interest rates, which generally make the fixed maturity securities
underlying the guarantee less valuable, the MVA could be negative. In the event
of declining interest rates, which generally make the fixed maturity securities
underlying the guarantee more valuable, the MVA could be positive. The resulting
increase or decrease in the value of the fixed option, from calculation of the
MVA, is designed to offset the decrease or increase in the market value of the
securities underlying the guarantee.
We assess the impact of interest rate movements on the value of our financial
assets, financial liabilities and derivatives using hypothetical test scenarios
that assume either upward or downward 100 basis point parallel shifts in the
yield curve from prevailing interest rates, reflecting changes in either credit
spreads or the risk-free rate. The following table sets forth the net estimated
potential loss in fair value on these financial instruments from a hypothetical
100 basis point upward shift at December 31, 2022 and 2021. This table is
presented on a gross basis and excludes offsetting impacts to insurance
liabilities that are not considered financial liabilities under U.S. GAAP. This
scenario results in the greatest net exposure to interest rate risk of the
hypothetical scenarios tested at those dates. While the test scenario is for
illustrative purposes only and does not reflect our expectations regarding
future interest rates or the performance of fixed-income markets, it is a
near-term, reasonably possible hypothetical change that illustrates the
potential impact of such events. These test scenarios do not measure the changes
in value that could result from non-parallel shifts in the yield curve which we
would expect to produce different changes in discount rates for different
maturities. As a result, the actual loss in fair value from a 100 basis point
change in interest rates could be different from that indicated by these
calculations. The estimated changes in fair values do not include separate
account assets.
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As of December 31, 2022 As of December 31, 2021
Hypothetical Hypothetical
Change in Change in
Notional Fair Value Fair Value Notional Fair Value Fair Value
(in millions)
Financial assets with interest rate
risk:
Fixed maturities(1) $ 1,743 $ (166) $ 1,972 $ (213)
Policy loans 212 0 211 0
Commercial mortgage and other loans 142 (7) 122 (5)
Derivatives:
Swaps $ 171 16 (2) $ 190 9 (1)
Options 509 (20) 0 489 (2) 0
Forwards 8 0 0 5 0 0
Variable annuity and other living
benefit feature embedded derivatives (407) 212 (822)
412
Indexed universal life contracts (108) 17 (153) 25 Total embedded derivatives(2) (515) 229 (975) 437 Financial liabilities with interest rate risk(3): Policyholders' account balances-investment contracts (217) 1 (244) 1 Net estimated potential gain (loss)(4) $ 55 $
219
(1)Includes assets classified as "Fixed maturities, available-for-sale, at fair value" and "Fixed maturities, trading, at fair value." (2)Excludes any offsetting impact of derivative instruments purchased to hedge changes in the embedded derivatives. Amounts reported gross of reinsurance. (3)Excludes$5 billion as of bothDecember 31, 2022 and 2021, of insurance reserve and deposit liabilities that are not considered financial liabilities. We believe that the interest rate sensitivities of these insurance liabilities would serve as an offset to the net interest rate risk of the financial assets and financial liabilities, including investment contracts. (4)Excludes reinsurance recoverable which largely offsets the gains and losses of embedded derivatives related primarily to certain features associated with variable annuity contracts and "Policyholders' account balances-investment contracts."
Market Risk Related to Equity Prices
We have exposure to equity price risk through our investments in equity securities, equity-based derivatives and embedded derivatives associated with certain of the optional living benefit features of variable annuity and index-linked crediting features of indexed universal life contracts. As discussed above, our variable annuity optional living benefits accounted for as embedded derivatives are generally reinsured to an affiliate as part of our risk management strategy. Changes in equity prices may impact other items including, but not limited to, the following:
•Asset-based fees earned on assets under management or contractholder account
value;
•Estimated total gross profits and the amortization of deferred policy
acquisition and other costs; and
•Net exposure to the guarantees provided under certain products.
We manage equity price risk against benchmarks in respective markets. We benchmark our return on equity holdings against a blend of market indices, mainly the S&P 500 and Russell 2000 forU.S. equities. We benchmark foreign equities against the Tokyo Price Index, and the MSCI EAFE, a market index of European, Australian, and Far Eastern equities. We target price sensitivities that approximate those of the benchmark indices. For equity investments within the separate accounts, the investment risk is borne by the separate account contractholder rather than by the Company. We estimate our equity risk from a hypothetical 10% decline in equity benchmark levels. As ofDecember 31, 2022 , excluding the embedded derivatives associated with variable annuity contracts (generally reinsured to an affiliate as part of our risk management strategy as discussed above), the impact from this hypothetical scenario was primarily from embedded derivatives associated with indexed universal life contracts of fair value and hypothetical change in fair value of$(108) million and$3 million , respectively. While this scenario is for illustrative purposes only and does not reflect our expectations regarding future performance of equity markets, it does represent near-term, reasonably possible hypothetical changes that illustrate the potential impact of such event.
Market Risk Related to Foreign Currency Exchange Rates
The Company does not have significant market risk exposure to foreign exchange
rates.
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Table of Contents Derivatives We use derivative financial instruments primarily to reduce market risk from changes in interest rates, equity prices and foreign currency exchange rates, including their use to alter interest rate or foreign currency exposures arising from mismatches between assets and liabilities. Our derivatives primarily include swaps, futures, options and forward contracts that are exchange-traded or contracted in the OTC market. For additional information regarding our derivative activities, see Note 4 to the Financial Statements.
Market Risk Related to Certain Variable Annuity Products
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 capital market assumptions, such as equity market
returns, interest rates and market volatility, and actuarial assumptions. For
our capital market assumptions, we hedge or limit our exposure to the risk
created by capital market fluctuations through affiliated reinsurance. Certain
variable annuity optional living benefit features are accounted for as embedded
derivatives and recorded at fair value.
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PRUCO LIFE INSURANCE CO – 10-K – Management's Discussion and Analysis of Financial Condition and Results of Operations
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