Prudential Annuities Life Assurance Corporation meets the conditions set forth
in General Instruction H(1)(a) and (b) on Form 10-Q and is therefore filing this
form with the reduced disclosure format.
This Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") addresses the financial condition of Prudential Annuities
Life Assurance Corporation ("PALAC" or the "Company"), formerly known as
American Skandia Life Assurance Corporation, as of June 30, 2012 compared with
December 31, 2011, and its results of operations for the three and six months
ended June 30, 2012 and 2011. You should read the following analysis of our
financial condition and results of operations in conjunction with the audited
Financial Statements, and the "Risk Factors" section included in the Company's
Annual Report on Form 10-K for the year ended December 31, 2011, the statements
under "Forward Looking Statements", and the Unaudited Interim Financial
Statements included elsewhere in this Quarterly Report on Form 10-Q.
General
The Company was established in 1988 and has been a significant provider of
variable annuity contracts for the individual market in the United States. The
Company's products have been sold primarily to individuals to provide for
long-term savings and retirement needs and to address the economic impact of
premature death, estate planning concerns and supplemental retirement income.
The investment performance of the registered investment companies supporting the
variable annuity contracts, which is principally correlated to equity market
performance, can significantly impact the market for the Company's products.
Products
The Company has sold a wide array of annuities, including deferred and immediate
variable annuities that are registered with the United States Securities and
Exchange Commission (the "SEC"), which may also include (1) fixed interest rate
allocation options, subject to a market value adjustment, and registered with
the SEC, and (2) fixed-rate allocation options not subject to a market value
adjustment and not registered with the SEC. In addition, the Company has a
relatively small in force block of variable life insurance policies, but it no
longer actively sells such policies.
Beginning in March 2010, the Company ceased offering its existing variable and
fixed annuity products (and where offered, the companion market value adjustment
option) to new investors upon the launch of a new product line in each of Pruco
Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are
affiliates of the Company within the Prudential Annuities business unit of
Prudential Financial, Inc. ("Prudential Financial")). However, subject to
applicable contractual provisions and administrative rules, the Company
continues to accept certain subsequent purchase payments on inforce contracts
under existing annuity products.
The Company's variable annuities provide its customers with tax-deferred asset
accumulation together with a base death benefit and a suite of optional
guaranteed death and living benefits. The benefit features contractually
guarantee the contractholder a return of no less than (1) total deposits made to
the contract less any partial withdrawals ("return of net deposits"), (2) total
deposits made to the contract less any partial withdrawals plus a minimum return
("minimum return"), and/or (3) the highest contract value on a specified date
minus any withdrawals ("contract value"). These guarantees may include benefits
that are payable in the event of death, annuitization or at specified dates
during the accumulation period and withdrawal and income benefits payable during
specified periods. Our optional living benefits guarantee, among other features,
the ability to make withdrawals based on the highest daily contract value plus a
minimum return, credited for a period of time. This highest daily guaranteed
contract value is a notional amount that forms the basis for determination of
periodic withdrawals for the life of the contractholder, and cannot be accessed
as a lump-sum surrender value.
Our variable annuity investment options provide our customers with the
opportunity to invest in proprietary and non-proprietary mutual funds,
frequently under asset allocation programs, and fixed-rate accounts. The
investments made by customers in the proprietary and non-proprietary mutual
funds generally represent separate account interests that provide a return
linked to an underlying investment portfolio. The general account investments
made in the fixed-rate accounts are credited with interest at rates we
determine, subject to certain minimums. We also offered fixed annuities that
provide a guarantee of principal and interest credited at rates we determine,
subject to certain contractual minimums. Certain investments made in the
fixed-rate accounts of our variable annuities and certain fixed annuities impose
a market value adjustment if the invested amount is not held to maturity. Based
on the contractual terms the market value adjustment can be positive, resulting
in an additional amount for the contractholder, or negative, resulting in a
deduction from the contractholder's account value or redemption proceeds.
The primary risk exposures of our variable annuity contracts relate to actual
deviations from, or changes to, the assumptions used in the original pricing of
these products, including equity market returns, interest rates, market
volatility, timing of annuitization and withdrawals, contract lapses and
contractholder mortality. The rate of return we realize from our variable
annuity contracts will vary based on the extent of the differences between our
actual experience and the assumptions used in the original pricing of these
products. As part of our risk management strategy we hedge or limit our exposure
to certain of these risks primarily through a combination of product design
elements, such as an asset transfer feature, externally purchased hedging
instruments and affiliated reinsurance arrangements with Pruco Re and Prudential
Insurance. Our returns can also vary by contract based on our risk management
strategy, including the impact of any capital markets movements that we may
hedge in the affiliate, the impact on that portion of our variable annuity
contracts that benefit from the asset transfer feature, the impact of risks we
have deemed suitable to retain and the impact of risks that are not able to be
hedged.
As of June 30, 2012 approximately $39.0 billion or 82% of total variable annuity
account values contain a living benefit feature, compared to approximately $38.6
billion or 81% as of December 31, 2011. As of June 30, 2012 approximately $31.0
billion or 80% of variable annuity account values with living benefit features
included an asset transfer feature in the product design, compared to
approximately $30.6 billion or 79% as of
43
--------------------------------------------------------------------------------
Table of Contents
December 31, 2011. The asset transfer feature, included in the design of certain
optional living benefits, transfers assets between certain variable investments
selected by the annuity contractholder and, depending on the benefit feature, a
fixed rate account in the general account or a bond portfolio within a separate
account. The asset transfer feature associated with the most recently sold
products transfers assets between certain variable investments selected by the
annuity contractholder and a designated bond portfolio within the separate
account. The transfers are based on the static mathematical formula used with
the particular optional benefit which considers a number of factors, including
the impact of investment performance on the contractholder's total account
value. In general, negative investment performance may result in transfers to
either a fixed rate account in the general account or a bond portfolio within
the separate account, and positive investment performance may result in
transfers to contractholder-selected variable investments. Overall, the asset
transfer feature helps to mitigate our exposure to equity market risk and market
volatility. Other product design elements we utilize for certain products to
manage these risks include asset allocation restrictions and minimum issuance
age requirements.
As mentioned above, in addition to our asset transfer feature, we also manage
certain risks associated with our variable annuity products through hedging
programs and affiliated reinsurance agreements. Primarily in the reinsurance
affiliate, interest rate swaps, swaptions, floors and caps as well as equity
options and futures are purchased to hedge certain living benefit features
accounted for as embedded derivatives, against changes in equity markets,
interest rates, and market volatility. Historically, the hedging strategy sought
to generally match certain capital market sensitivities of the embedded
derivative liability as defined by accounting principles generally accepted in
the United States ("U.S. GAAP"), excluding the impact of the market's perception
of non-performance risk ("NPR"), with capital market derivatives and options. In
the third quarter of 2010, the hedging strategy was revised as, in a low
interest rate environment, management of the Company and the reinsurance
affiliate does not believe that the U.S. GAAP value of the embedded derivative
liability is an appropriate measure for determining the hedge target. The hedge
target continues to be grounded in a U.S GAAP/capital markets valuation
framework but incorporates two modifications to the U.S. GAAP valuation
assumptions. A credit spread is added to the U.S GAAP risk-free rate of return
assumption used to estimate future growth of bond investments in the customer
separate account funds to account for the fact that the underlying customer
separate account funds which support these living benefits are invested in
assets that contain risk. The volatility assumption is also adjusted to remove
certain risk margins embedded in the valuation technique used to fair value the
embedded derivative liability under U.S GAAP, as the increase in the liability
driven by these margins is temporary and does not reflect the economic value of
the liability. In addition, management of the Company and reinsurance affiliate
evaluate hedge levels versus the hedge target given overall capital
considerations of our ultimate parent Company, Prudential Financial, Inc. and
prevailing capital market conditions, and may decide to temporarily hedge to an
amount that differs from the hedge target definition.
The hedging strategy also includes a program managed at the Prudential Financial
parent company level that more broadly addresses equity market exposure of the
overall statutory capital of Prudential Financial as a whole, under stress
scenarios. The Company owns a portion of the derivatives related to this
program. The program focuses on tail risk in order to protect statutory capital
in a cost-effective manner under stress scenarios. Prudential Financial assesses
the composition of the hedging program on an ongoing basis and may change it
from time to time based on an evaluation of its risk position or other factors.
Significant Accounting Policies
For information on the Company's significant accounting policies, see Item 7.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in the Company's Annual Report on Form 10-K for the year ended
December 31, 2011.
Application of Critical Accounting Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America, or U.S. GAAP, requires the
application of accounting policies that often involve a significant degree of
judgment. Management, on an ongoing basis, reviews estimates and assumptions
used in the preparation of financial statements. If management determines that
modifications in assumptions and estimates are appropriate given current facts
and circumstances, results of operations and financial position as reported in
the Unaudited Interim Financial Statements could change significantly.
Management believes the accounting policies relating to the following areas are
most dependent on the application of estimates and assumptions and require
management's most difficult, subjective, or complex judgments:
• Deferred policy acquisition and other costs, including value of business
acquired;
• 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.
In the first quarter of 2012, we revised the treatment of the results of the
living benefits hedging program in our best estimate of total gross profits used
to calculate the amortization of deferred policy acquisition costs ("DAC") and
deferred sales inducements ("DSI") associated with certain of our variable
annuity contracts. In 2011, we included certain results of the living benefits
hedging program in the reinsurance affiliate, in our best estimate of gross
profits used to determine amortization rates only to the extent this net amount
was determined by management to be other-than-temporary. Beginning with the
first quarter of 2012, we are including certain results of the living benefits
hedging program, in our best estimate of total gross profits used for
determining amortization rates each quarter without regard to the permanence of
the changes. Aside from this change, our policy for amortizing DAC and DSI
remains as described in our Annual Report on Form 10-K for the year ended
December 31, 2011, under "Management's Discussion and Analysis of Financial
Condition and Results of Operations-Accounting Policies &
Pronouncements-Application of Critical Accounting Estimates."
44--------------------------------------------------------------------------------
Table of Contents
A discussion of each of the additional critical accounting estimates listed
above may also be found in our Annual Report on Form 10-K for the year ended
December 31, 2011, under "Management's Discussion and Analysis of Financial
Condition and Results of Operations-Accounting Policies &
Pronouncements-Application of Critical Accounting Estimates."
Changes in Financial Position
2012 versus 2011
Total assets decreased by $0.1 billion, from $52.3 billion at December 31, 2011
to $52.2 billion at June 30, 2012. Total investments decreased $624 million
primarily related to asset sales associated with policyholder liability
surrenders and the asset transfer feature which moved customer account values to
the separate account due to favorable markets in 2012. DAC and DSI decreased by
$79 million and $48 million, respectively, resulting primarily from expected
amortization related to the runoff of the inforce block. Partially offsetting
these decreases, separate account assets increased $703 million primarily driven
by market appreciation, partially offset by net outflows as a result of the
discontinuation of new sales beginning in March 2010, discussed above.
Total liabilities increased by $0.1 billion, from $51.2 billion at December 31,
2011 to $51.3 billion at June 30, 2012. Separate account liabilities increased
by $703 million offsetting the increase in separate accounts assets above.
Partially offsetting the above increase was a $528 million decrease in
Policyholder's account balance driven by account value run off due to the
discontinuation of new sales and the asset transfer feature which moved customer
account values to the separate account due to favorable markets as discussed
above.
Stockholder's equity decreased by $115 million from $1,021 million at
December 31, 2011 to $906 million at June 30, 2012. The decrease in
stockholder's equity was primarily driven by a $248 million dividend to PFI,
partially offset by the Company's net income of $135 million.
Results of Operations
2012 versus 2011 Three Month Comparison
Net Income
Net income decreased $272 million from $35 million for the second quarter of
2011 to a loss of $237 million for the second quarter of 2012. The decrease was
driven by a $386 million decrease in income from operations before income taxes,
as discussed below, partially offset by a $114 million decrease in income tax
expense.
The decrease in income from operations before taxes was primarily driven by
higher amortization of DAC and DSI primarily related to the impact of the
mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions, as discussed below. Also contributing
to the decrease was an unfavorable variance related to adjustments to the
amortization of DAC and DSI, and to the reserves for the GMDB and GMIB features
of our variable annuity products, primarily driven by the impact to the
estimated profitability of the business of quarterly adjustments to reflect
current period market performance and experience. Results for both years include
the impact of these items which are discussed in more detail below.
Excluding items discussed above, income from operations before taxes decreased
$22 million compared to second quarter of 2011 primarily driven by a decline in
fees driven by lower average annuity account values invested in the separate
account driven by negative net flows as a result of contractholder surrenders.
There are limited offsetting inflows due to the discontinuation of new sales
discussed above.
We amortize DAC and other costs over the expected lives of the contracts based
on the level and timing of gross profits on the underlying product. 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 (an SEC registrant) and has
extensive transactions and relationships with other subsidiaries of Prudential
Financial, including reinsurance agreements, as discussed in Note 8 to the
Unaudited Interim Financial Statements. Incorporating all product-related
profits and losses in gross profits, including those that are reported in
affiliated legal entities, produces a DAC and other costs amortization pattern
representative of the total economics of the products.
As mentioned above, included in the unfavorable variance from higher
amortization of DAC and DSI, was $330 million of higher amortization primarily
related to the impact of the mark-to-market of the reinsured liability for
living benefit embedded derivatives and related hedge positions. This impact
primarily relates to changes in the valuation of the reinsured living benefit
liabilities in the second quarter of 2012 related to NPR gains, which we and the
reinsurance affiliate believe to be non-economic, and choose not to hedge, as
discussed above, partially offset by losses driven by differences between the
change in fair value of the hedge target liability and the change in the fair
value of the hedge assets in the reinsurance affiliate due to unfavorable market
conditions in the second quarter of 2012.
To reflect the NPR of our affiliates in the valuation of the embedded derivative
liabilities, we incorporate an additional spread over LIBOR into the discount
rate used in the valuation. Positive NPR adjustments in the reinsurance
affiliate in 2012 were primarily driven by a higher base of embedded derivative
liabilities as well as a widening of NPR spreads. Decreases in risk-free
interest rates and the impact of unfavorable account value performance, drove
increases in the embedded derivative liability base in the second quarter of
2012. The NPR gains in the reinsurance affiliate were larger in the second
quarter of 2012 compared to the second quarter of 2011 resulting in an
unfavorable variance from higher amortization of DAC and DSI.
45
--------------------------------------------------------------------------------
Table of Contents
As shown in the following table, the loss from operations for the second quarter
2012 included $58 million of charges from adjustments to the amortization of
DAC/DSI and the reserves for the GMDB and GMIB features of our variable annuity
products compared to $18 million of charges in the second quarter of 2011.
Three Months Ended June 30, 2012 Three Months Ended June 30, 2011
Amortization of Reserves for Amortization of Reserves for
DAC and Other GMDB / DAC and Other GMDB /
Costs (1) GMIB (2) Total Costs (1) GMIB (2) Total
(in thousands)
Quarterly market performance
adjustment $ (24,905 ) $ (17,996 ) $ (42,901 ) $ (7,059 ) $ (2,387 ) $ (9,446 )
Quarterly adjustment for current
period experience (3) (13,939 ) (1,143 ) (15,082 ) (8,711 ) (231 ) (8,942 )
Total $ (38,844 ) $ (19,139 ) $ (57,983 ) $ (15,770 ) $ (2,618 ) $ (18,388 )
(1) Amounts reflect (charges) or benefits for (increases) or decreases,
respectively, in the amortization of deferred policy acquisition, or DAC,
and other costs.
(2) Amounts reflect (charges) or benefits for reserve (increases) or decreases,
respectively, related to the guaranteed minimum death and income benefit,
or GMDB / GMIB, features of our variable annuity products.
(3) Represents the impact of differences between actual gross profits for the
period and the previously estimated expected gross profits for the period,
as well as updates for current and future expected claims costs associated
with the GMDB/GMIB features of our variable annuity products.
The $43 million and $9 million of net charges in the second quarter of 2012 and
2011, respectively, shown in the table above, relating to the quarterly market
performance adjustments are attributable to changes to our estimate of total
gross profits to reflect actual fund performance.
2012 2011
Second Quarter Second Quarter
Actual rate of return (1.7 )% 0.8 %
Expected rate of return 1.6 % 1.5 %
Lower than expected returns in the second quarter of 2012 decreased our estimate
of total gross profits used as a basis for amortizing DAC and other costs and
increased our estimate of future expected claims costs associated with the GMDB
and GMIB features of our variable annuity products, by establishing a new, lower
starting point for the variable annuity account values used in estimating those
items for future periods. This change results in a higher required rate of
amortization and higher required reserve provisions, which are applied to all
prior periods. The resulting cumulative adjustment to prior amortization and
reserve provisions are recognized in the current period. Lower than expected
returns in the second quarter of 2011 had similar, but less significant impacts
due to a lesser variance between actual and expected returns.
We derive our near-term future rate of return assumptions using a reversion to
the mean approach, a common industry practice. Under this approach, we consider
actual returns over a period of time and initially adjust projected returns over
the next four years (the "near-term") so that the assets are projected to grow
at the long-term expected rate of return for the entire period. The near-term
future projected blended rate of return across all contract groups is 7.2% per
annum as of June 30, 2012, or approximately 1.8% per quarter.
The $15 million and $9 million of net charges in the second quarter of 2012 and
2011, respectively, shown in the table above, reflect the quarterly adjustments
for current period experience and other updates, also referred to as experience
true-up adjustments. The unfavorable variance related to the amortization of DAC
and other costs was primarily driven by the difference in the change of the fair
value of the hedge target liability and the change in the fair value of the
hedge assets in the reinsurance affiliate, as discussed above.
As noted previously, the quarterly adjustments to reflect current period market
performance and experience impact the estimated profitability of our business.
Therefore, in addition to the current period impacts discussed above, these
items will also drive changes in our GMDB and GMIB reserves and the amortization
of DAC/DSI in future periods.
Revenues
Revenues decreased $28 million, from $403 million for the second quarter of 2011
to $375 million for the second quarter of 2012.
Policy charges and fee income and Asset management fees and other income
decreased by $24 million from $290 million for the second quarter of 2011 to
$266 million for the second quarter of 2012. The decrease was primarily driven
by a lower fees and asset management income due to lower average variable
annuity asset balances in the second quarter of 2012 invested in the separate
accounts due to negative net flows as a result of contractholder surrenders.
There are limited offsetting inflows due to the discontinuation of new sales.
Partially offsetting these decreases, were lower market value adjustments paid
to contractholders related to the Company's market value adjusted investments
option ("MVA") driven by differences in market conditions and transfers of
assets due to the asset transfer feature.
46
--------------------------------------------------------------------------------
Table of Contents
Net investment income decreased $8 million from $77 million for the second
quarter of 2011 to $69 million for the second quarter of 2012 as a result of
lower reinvestment yields over the past year due to the lower interest rate
environment.
Realized investment gains/losses, net, increased by $5 million from $30 million
for second quarter of 2011 to $35 million for the second quarter of 2012. This
increase was primarily driven by a favorable variance related to higher than
prior year quarter NPR gains due to the mark-to-market of the non-reinsured
living benefit embedded derivative liabilities, partially offset by higher
realized losses due to increased trading activity due to market conditions and
transfers of assets due to the asset transfer feature.
Benefits and Expenses
Benefits and expenses increased $358 million from $358 million for the second
quarter of 2011 to $716 million for the second quarter of 2012.
Amortization of deferred policy acquisition costs increased by $224 million,
from $117 million for the second quarter of 2011 to $341 million for second
quarter of 2012, primarily due to higher DAC amortization related to the impact
of the mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions and the impact of our quarterly
adjustments to reflect current period experience and market performance, as
discussed above.
Interest credited to policyholders' account balances increased $123 million,
from $104 million for the second quarter of 2011 to $227 million for second
quarter of 2012, due to higher DSI amortization primarily related to the impact
of the mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions and the impact of our quarterly
adjustments to reflect current period experience and market performance as
discussed above. Also, interest credited to policyholders' account balances
decreased due to lower average crediting rates due to crediting rate resets.
Policyholders' benefits increased $14 million, from $27 million for the second
quarter of 2011 to $41 million for the second quarter of 2012, primarily due to
the adjustments to the reserves for the GMDB/GMIB benefit features of our
variable annuity products to reflect current period experience and market
performance, as discussed above.
2012 versus 2011 Six Month Comparison
Net Income
Net income decreased $21 million from $156 million for the six months ended
June 30, 2011 to $135 million for the six months ended June 30, 2012. The
decrease is driven by a $15 million lower income from operations before income
taxes and a $6 million increase in income tax expense as discussed below.
The decrease in income from operations before taxes was driven by a decrease of
$77 million in fee income, due to lower average variable annuity asset balances
in 2012 invested in separate accounts due negative net flows as a result of
contractholder surrenders. Partially offsetting the above decrease in income
from operations before income taxes was a favorable variance from lower
amortization of DAC and other costs primarily related to the impact of the
mark-to-market of the reinsured liability for living benefit embedded
derivatives and related hedge positions, as discussed in more detail below. Also
serving as a partial offset was a favorable variance related to adjustments to
the reserves for the guaranteed minimum death ("GMDB") and income benefit
("GMIB") features of our variable annuity products and deferred policy
acquisition and other costs. These adjustments are discussed in more detail
below.
We amortize DAC and other costs over the expected lives of the contracts based
on the level and timing of gross profits on the underlying product. 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 (an SEC registrant) and has
extensive transactions and relationships with other subsidiaries of Prudential
Financial, including reinsurance agreements, as discussed in Note 8 to the
Unaudited Interim Financial Statements. Incorporating all product-related
profits and losses in gross profits, including those that are reported in
affiliated legal entities, produces a DAC and other costs amortization pattern
representative of the economics of the products.
As mentioned above, included in the favorable variance from lower amortization
of DAC and DSI, was $25 million of lower amortization primarily related to the
impact of the mark-to-market of the reinsured liability for living benefit
embedded derivatives and related hedge positions. Lower amortization primarily
relates to changes in the valuation of the reinsured living benefit liabilities
in 2012 related NPR, which we and the reinsurance affiliate believe to be
non-economic, and choose not to hedge, as discussed above, and differences
between the change in the fair value of the hedge target liability and the
change in the fair value of the hedge assets in the reinsurance affiliate due to
differences in market performance.
As shown in the following table, the loss from operations for the six months
ended June 30, 2012 included $34 million of benefits from adjustments to the
amortization of DAC/DSI and the reserves for the GMDB and GMIB features of our
variable annuity products compared to $5 million of charges for the six months
ended June 30, 2011.
47
--------------------------------------------------------------------------------
Table of Contents
Six Months Ended June 30, 2012 Six Months Ended June 30, 2011
Amortization of Reserves for Amortization of Reserves for
DAC and Other GMDB / DAC and Other GMDB /
Costs (1) GMIB (2) Total Costs (1) GMIB (2) Total
(in thousands)
Quarterly market performance
adjustment $ 6,237 13,079 $ 19,316 $ 2,192 4,835 $ 7,027
Quarterly adjustment for current
period experience (3) 12,236 2,446 14,682 (16,548 ) 4,600 (11,948 )
Total $ 18,473 $ 15,525 $ 33,998 $ (14,356 ) $ 9,435 $ (4,921 )
(1) Amounts reflect (charges) or benefits for (increases) or decreases,
respectively, in the amortization of deferred policy acquisition, or DAC,
and other costs.
(2) Amounts reflect (charges) or benefits for reserve (increases) or decreases,
respectively, related to the guaranteed minimum death and income benefit,
or GMDB / GMIB, features of our variable annuity products.
(3) Represents the impact of differences between actual gross profits for the
period and the previously estimated expected gross profits for the period,
as well as updates for current and future expected claims costs associated
with the GMDB/GMIB features of our variable annuity products.
The $19 million and $7 million of net benefits for the first six months of 2012
and 2011, respectively, shown in the table above, relating to the quarterly
market performance adjustments are attributable to changes to our estimate of
total gross profits to reflect actual fund performance. The following table
shows the actual quarterly rates of return on variable annuity account values
compared to our previously expected quarterly rates of return used in our
estimate of total gross profits for the periods indicated.
2012 2012 2011 2011
First Quarter Second Quarter First Quarter Second Quarter
Actual rate of return 7.5 % (1.7 )% 3.6 % 0.8 %
Expected rate of return 1.9 % 1.6 % 1.5 % 1.5 %
Higher than expected returns in 2012 increased our estimate of total gross
profits used as a basis for amortizing DAC and other costs and decreased our
estimate of future expected claims costs associated with the GMDB and GMIB
features of our variable annuity products, by establishing a new, higher
starting point for the variable annuity account values used in estimating those
items for future periods. This change results in a lower required rate of
amortization and lower required reserve provisions, which are applied to all
prior periods. The resulting cumulative adjustment to prior amortization and
reserve provisions are recognized in the current period. Higher than expected
returns in 2011 had similar, but less significant impacts due to a lesser
variance between actual and expected returns.
The $15 million benefit for the six months ended June 30, 2012 and the $12
million charge for the six months ended June 30, 2011 shown in the table above
reflect the quarterly adjustments for current period experience, also referred
to as actual experience true-up adjustments. The favorable variance related to
the amortization of DAC and other costs was primarily driven by the difference
in the change of the fair value of the hedge target liability and the change in
the fair value of the assets in the reinsurance affiliate, as discussed above.
Revenues
Revenues decreased $85 million, from $774 million for the six months ended
June 30, 2011 to $689 million for the six months ended June 30, 2012.
Policy charges and fee income and Asset management fees and other income
decreased $37 million, from $573 million for the six months ended June 30, 2011
to $535 million for the six months ended June 30, 2012 driven by lower fee and
asset management income primarily driven by an decrease in average variable
annuity asset balances invested in separate accounts as discussed above.
Partially offsetting the above decrease was a favorable variance of $40 million
from lower market value adjustments related to the Company's market value
adjusted investment option (the "MVA option") driven by differences in market
conditions and transfers of assets to the separate account primarily due to the
asset transfer feature.
Realized investment gains/losses, net, decreased by $29 million from $28 million
for the six months ended June 30, 2011 to a loss of $1 million for the six
months ended June 30, 2012. This decrease was driven by a $31 million
unfavorable variance due to differences in market conditions and transfers of
assets due to the asset transfer feature, partially offset by lower losses
related to the mark-to-market of the non-reinsured living benefit embedded
derivative liabilities.
Net investment income decreased $15 million from $158 million for the six months
ended June 30, 2011 to $143 million for the six months ended June 30, 2012 as a
result of lower reinvestment yields over the past year due to the low interest
environment.
Benefits and Expenses
Benefits and expenses decreased $70 million from $569 million for the six months
ended June 30, 2011 to $499 million for the six months ended June 30, 2012.
48
--------------------------------------------------------------------------------
Table of Contents
Interest credited to policyholders' account balances decreased $31 million, from
$171 million for the six months ended June 30, 2011 to $140 million for the six
months ended June 30, 2012, due to lower DSI amortization primarily related to
the impact of the mark-to-market of the reinsured liability for living benefit
embedded derivatives and related hedge positions and quarterly adjustments to
reflect current period experience and market performance, as discussed above.
Also contributing to the decrease was lower interest credited to policyholders'
account balances due to lower crediting rates driven by crediting rate resets.
Amortization of deferred policy acquisition costs decreased by $30 million, from
$140 million for the six months ended June 30, 2011 to $110 million for the six
months ended June 30, 2012, primarily due to lower DAC amortization related to
the impact of the mark-to-market of the reinsured liability for living benefit
embedded derivatives and related hedge positions and quarterly adjustments to
reflect current period experience and market performance, as discussed above.
Policyholders' benefits decreased $9 million, from $41 million for the six
months ended June 30, 2011 to $32 million for the six months ended June 30,
2012, primarily due to the adjustments to the reserves for the GMDB/GMIB benefit
features of our variable annuity products related to our quarterly adjustments
to reflect current period experience and market performance, as discussed above.
Income Taxes
The income tax provision amounted to an expense of $55 million and $49 million
for the six months ended June 30, 2012 and 2011, respectively. This is primarily
driven by the increase in forecasted full year pre-tax income as of June 30,
2012 compared to June 30, 2011.
The Company's liability for income taxes includes the liability for unrecognized
tax benefits, interest and penalties which relate to tax years still subject to
review by the Internal Revenue Service ("IRS") or other taxing authorities.
Audit periods remain open for review until the statute of limitations has
passed. Generally, for tax years which produce net operating losses, capital
losses or tax credit carryforwards ("tax attributes"), the statute of
limitations does not close, to the extent of these tax attributes, until the
expiration of the statute of limitations for the tax year in which they are
fully utilized. The completion of review or the expiration of the statute of
limitations for a given audit period could result in an adjustment to the
liability for income taxes. Tax years 2009 through 2011 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 2011, current year
results, and was adjusted to take into account the current year's equity market
performance. The actual current year DRD can vary from the estimate based on
factors such as, but not limited to, changes in the amount of dividends received
that are eligible for the DRD, changes in the amount of distributions received
from mutual fund investments, changes in the account balances of variable life
and annuity contracts, and the Company's taxable income before the DRD.
In August 2007, the IRS released Revenue Ruling 2007-54, which included, among
other items, guidance on the methodology to be followed in calculating the DRD
related to variable life insurance and annuity contracts. In September 2007, the
IRS released Revenue Ruling 2007-61. Revenue Ruling 2007-61 suspended Revenue
Ruling 2007-54 and informed taxpayers that the U.S. Treasury Department and the
IRS intend to address through new guidance the issues considered in Revenue
Ruling 2007-54, including the methodology to be followed in determining the DRD
related to variable life insurance and annuity contracts. On February 13, 2012,
the Obama Administration released the "General Explanations of the
Administration's Revenue Proposals." One proposal would change the method used
to determine the amount of the DRD. A change in the DRD, including the possible
retroactive or prospective elimination of this deduction through guidance or
legislation, could increase actual tax expense and reduce the Company's
consolidated net income. These activities had no impact on the Company's 2011 or
second quarter 2012 results.
The Company is not currently under audit by the IRS or any state or local
jurisdiction for the years prior to 2009.
In 2009, the Company joined in filing the consolidated federal tax return with
its parent, Prudential Financial. For tax years 2009 through 2011, the Company
is participating in the IRS's Compliance Assurance Program ("CAP"). Under CAP,
the IRS assigns an examination team to review completed transactions
contemporaneously during these tax years in order to reach agreement with the
Company on how they should be reported in the tax returns. If disagreements
arise, accelerated resolutions programs are available to resolve the
disagreements in a timely manner before the tax returns are filed. It is
management's expectation this program will shorten the time period between the
filing of the Company's federal income tax returns and the IRS's completion of
its examination of the returns.
Liquidity and Capital Resources
Overview
Liquidity refers to the ability to generate sufficient cash resources to meet
the payment obligations of the Company. Capital refers to the long term
financial resources available to support the operation of our business, 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 business, general economic conditions and our access to the
capital markets through affiliates as described herein.
Management monitors the liquidity of Prudential Financial, Prudential Insurance
and the Company on a daily basis and projects borrowing and capital needs over a
multi-year time horizon through our quarterly planning process. We believe that
cash flows from the sources of funds presently available to us are sufficient to
satisfy the current liquidity requirements of Prudential Financial, and the
Company, including reasonably foreseeable stress scenarios.
49
--------------------------------------------------------------------------------
Table of Contents
We continue to refine our metrics for capital management. These refinements to
the current framework, which is primarily based on statutory risk based capital
measures, are designed to more appropriately reflect risks associated with our
businesses on a consistent basis across the Company. In addition, we continue to
use an economic capital framework for making certain business decisions.
Similar to our planning and management process for liquidity, we use a Capital
Protection Framework to ensure the availability of adequate capital under
reasonably foreseeable stress scenarios. The Capital Protection Framework is
used to assess potential capital needs arising from severe market related
distress and sources of capital available to us to meet those needs. Potential
sources include on-balance sheet capital, derivatives and other contingent
sources of capital.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law
on July 21, 2010, could result in the imposition of new capital, liquidity and
other requirements on Prudential Financial and the Company. See Item 1.
Business-"Regulatory Environment" in Part I of the Company's Annual Report on
Form 10-K for the year ended December 31, 2011 for information regarding the
potential effects of the Dodd-Frank Act on the Company and its affiliates.
The Company paid an extra-ordinary dividend of $270 million, $318 million and
$248 million to our ultimate parent, Prudential Financial, on June 30,
2011, November 30, 2011 and June 29, 2012, respectively.
General Liquidity
Our liquidity is managed to ensure stable, reliable and cost-effective sources
of cash flows to meet all of our obligations. Liquidity is provided by a variety
of sources, as described more fully below, including portfolios of liquid
assets. Our investment portfolios are integral to the overall liquidity of the
Company. We use a projection process for cash flows from operations to ensure
sufficient liquidity to meet projected cash outflows, including claims. The
impact of Prudential Funding, LLC's financing capacity on liquidity (as
described below) is considered in the internal liquidity measures of the
Company.
Liquidity is measured against internally developed benchmarks that take into
account the characteristics of both the asset portfolio and the liabilities that
they support. The results are affected substantially by the overall asset type
and quality of our investments.
Cash Flow
The principal sources of the Company's liquidity are certain annuity
considerations, investment and fee income, investment maturities, 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. As discussed
above, in March 2010, the Company ceased offering its existing variable annuity
products to new investors upon the launch of a new product line by certain
affiliates. Therefore, the Company expects to continue to see the overall level
of cash flows to decrease going forward as the book of business runs off.
We believe that the cash flows from our annuity operations are adequate to
satisfy our current liquidity requirements including under reasonably
foreseeable stress scenarios. The continued adequacy of this liquidity will
depend upon factors such as future securities market conditions, changes in
interest rate levels, customer behavior, policyholder perceptions of our
financial strength, and the relative safety of competing products, each of which
could lead to reduced cash inflows or increased cash outflows. In addition,
market volatility can impact the level of capital required to support our
businesses. Our cash flows from investment activities result from repayments of
principal, proceeds from maturities and sales of invested assets and investment
income, net of amounts reinvested. The primary liquidity risks with respect to
these cash flows are the risk of default by debtors or bond insurers, our
counterparties' willingness to extend repurchase and/or securities lending
arrangements, commitments to invest and market volatility. We closely manage
these risks through our credit risk management process and regular monitoring of
our liquidity position.
In managing our liquidity, we also consider the risk of policyholder and
contractholder withdrawals of funds earlier than our assumptions when selecting
assets to support these contractual obligations. We use surrender charges and
other contract provisions to mitigate the extent, timing and profitability
impact of withdrawals of funds by customers from annuity contracts and deposit
liabilities.
Gross account withdrawals amounted to approximately $1,206 million and $1,562
million as of June 30, 2012 and 2011, respectively. Because these withdrawals
were consistent with our assumptions in asset/liability management, the
associated cash outflows did not have a material adverse impact on our overall
liquidity.
Liquid Assets
Liquid assets include cash, cash equivalents, short-term investments, fixed
maturities that are not designated as held-to-maturity and public equity
securities. As of June 30, 2012 and December 31, 2011, the Company had liquid
assets of $4.9 billion and $5.6 billion, respectively, which includes a portion
financed with asset-based financing. The portion of liquid assets comprised of
cash and cash equivalents and short-term investments was $0.1 billion as of
June 30, 2012 and $0.2 billion as of December 31, 2011. We consider attributes
of the various categories of liquid assets (for example, type of asset and
credit quality) in calculating internal liquidity measures in order to evaluate
the adequacy of our operations' liquidity under a variety of stress scenarios.
We believe that the liquidity profile of our assets is sufficient to satisfy
current liquidity requirements, including under reasonably foreseeable stress
scenarios.
50
--------------------------------------------------------------------------------
Table of Contents
Given the size and liquidity profile of our investment portfolios, we believe
that claim experience varying from our projections does not constitute a
significant liquidity risk. Our asset/liability management process takes into
account the expected maturity of investments and expected claim payments as well
as the specific nature and risk profile of the liabilities.
Prudential Funding, LLC
Prudential Funding, LLC, or Prudential Funding, a wholly owned subsidiary of
Prudential Insurance, serves as an additional source of financing to meet our
working capital needs. Prudential Financial operates under a support agreement
with Prudential Insurance whereby Prudential Insurance has agreed to maintain
Prudential Funding positive tangible net worth at all times. Prudential Funding
borrows funds in the capital markets primarily through the direct issuance of
commercial paper.
Capital
The Risk Based Capital, or RBC, ratio is a primary measure by which we evaluate
the capital adequacy of the Company. Prudential Financial manages its domestic
insurance subsidiaries RBC ratios to a level that is consistent with the ratings
targets for those subsidiaries. RBC is determined by statutory guidelines and
formulas that consider among other things, risks related to the type and quality
of the invested assets, insurance-related risks associated with an insurer's
products and liabilities, interest rate risks and general business risks. The
RBC ratio calculations are intended to assist insurance regulators in measuring
the adequacy of an insurer's statutory capitalization. The RBC ratio is an
annual calculation, however, as of June 30, 2012, we estimate that the RBC
ratios for the Company would exceed the minimum level required by applicable
insurance regulations. The reporting of RBC measures is not intended for the
purpose of ranking any insurance company or for use in connection with any
marketing, advertising or promotional activities.
The level of statutory capital of the Company can be materially impacted by
interest rate and equity market fluctuations, changes in the values of
derivatives, the level of impairments recorded credit quality migration of
investment portfolio, among other items. Further, the recapture of business
subject to reinsurance arrangements due to defaults by, or credit quality
migration affecting, the reinsurers could result in higher required statutory
capital levels. The level of statutory capital of the Company is also affected
by statutory accounting rules which are subject to change by insurance
regulators.
As part of its Capital Protection Framework, Prudential Financial has developed
a broad view of the impact of market distress on the statutory capital of
Prudential Financial and its subsidiaries, as a whole. The framework includes
programs designed to mitigate the impact of a severe equity market stress event
on the statutory capital of Prudential Financial and its subsidiaries, as whole.
The program focuses on tail risk to protect statutory capital in a
cost-effective manner under stress scenarios. The Company purchased a portion of
the derivative under this program in 2010. Prudential Financial assesses the
composition of the hedging program on an ongoing basis and may change it from
time to time based on an evaluation of its risk position or other factors.
In addition to hedging equity market exposure, we also manage certain risks
associated with our variable annuity products through affiliated reinsurance
arrangements. We reinsure variable annuity living benefit guarantees to a
captive reinsurance company, Pruco Re. Effective as of July 1, 2011, Pruco Re
domiciled from Bermuda to Arizona. At this time, Pruco Re continues to maintain
the statutory reserve credit trust for business reinsured from the Company.
Reinsurance credit reserve requirements can move materially in either direction
due to changes in equity markets and interest rates, actuarial assumptions and
other factors. Higher statutory reinsurance credit reserve requirements would
necessitate depositing additional assets in the statutory reserve credit trusts
held by Pruco Re, while lower statutory reinsurance credit reserve requirements
would allow assets to be removed from the statutory reserve credit trusts. We
expect Prudential Financial would satisfy those additional needs through a
combination of funding the reinsurance credit trusts with available cash, loans
from Prudential Financial and/or affiliates and by re-hypothecating assets that
were otherwise pledged to Pruco Re under hedging positions related to our living
benefit features. Prudential Financial also continues to evaluate other options
to address reserve credit needs such as obtaining letters of credit. Lower
interest rates in the first six months of 2012 led to an increase in our need to
fund the captive reinsurance trusts by an amount of $319 million.
