Exhibit 99.1
Revised items in 2011 Annual Report on Form 10-K
PART II
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations, or “MD&A,” is omitted pursuant to General Instruction I (2) (a) of Form 10-K. The management narrative for Pruco Life Insurance Company of New Jersey that follows should be read in conjunction with the Forward-looking Statements included below the Table of Contents, “Risk Factors”, and the Financial Statements and related notes included in this Annual Report on Form 10-K.
Management’s narrative addresses the financial condition of Pruco Life Insurance Company of New Jersey as of December 31, 2011, compared with December 31, 2010, and its results of operations for the years ended December 31, 2011 and 2010.
Overview
The Company sells universal life insurance and variable life insurance, term life insurance and variable annuities, primarily through third party distributors in New Jersey and New York. These markets are subject to regulatory oversight, with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure as the legal barriers, that have historically segregated the markets of the financial services industry have been changed. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels.
Beginning in March 2010, Prudential Annuities Life Assurance Corporation (“PALAC”), an affiliate of the Company, ceased offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product in Pruco Life Insurance Company of New Jersey. In general, the new product line offers the same optional living benefits and optional death benefits as offered by PALAC’s existing variable annuities. However, subject to applicable contractual provisions and administrative rules, PALAC will continue to accept subsequent purchase payments on in force contracts under existing annuity products. These initiatives were implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. In addition, by limiting its variable annuity offerings to a single product line sold through the Company (and its parent) the Prudential Annuities business unit of Prudential Financial expects to convey a more focused, cohesive image in the marketplace.
Industry Trends
Our businesses are impacted by financial markets, economic conditions, regulatory oversight, and a variety of trends that affect the industries where we compete.
Financial and Economic Environment. Our businesses and results of operations are impacted by general economic and market conditions and are sensitive to the pace of and extent of changes in changes in equity markets and interest rates, as well as the changes in behavior of individuals and institutions that these changes in economic and market conditions may cause. Recent years have been affected by adverse global market conditions, and uncertainty continues to be a factor in the market environment. This uncertainty, particularly in the equity markets, has led to, among other things, increased demand for guaranteed retirement income solutions.
Volatile conditions continue to characterize the overall financial markets. The low interest rate environment we have experienced in recent years has impacted the profitability of certain products we offer as well as returns on the investment portfolio backing our insurance liabilities.
1
Regulatory Environment. Our businesses are subject to comprehensive regulation and supervision. The financial market dislocations we have experienced have produced, and are expected to continue to produce, extensive changes in existing laws and regulations, and regulatory frameworks applicable to our businesses. In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law on July 21, 2010 made comprehensive changes to the regulation of financial services in the U.S. and subjects us to substantial additional federal regulation. In addition, state insurance laws regulate all aspects of our businesses and our insurance products are substantially affected by federal and state tax laws. Insurance regulators have begun to implement significant changes in the way in which industry participants must determine statutory reserves and statutory capital, particularly for products with embedded options and guarantees such as variable annuities, and are considering further potentially significant changes in these requirements for life insurance products. In addition, there is general uncertainty regarding U.S. taxes both for individuals and corporations in light of the fact that many tax provisions recently enacted or extended will sunset by the end of 2012. In addition, the recommendations made by the President’s bipartisan National Commission on Fiscal Responsibility and Reform and other deficit reduction panels suggest the need to reform the U.S. Tax Code. Congress has held a number of hearings devoted to tax reform. Some of those hearings have discussed lowering the tax rates and broadening the base by reducing or eliminating certain tax expenditures. Reducing or eliminating certain tax expenditures could make our products less attractive to customers. It is unclear whether or when Congress may take up overall tax reform and what would be the impact of reform on the Company and its products.
Demographics. Income protection, wealth accumulation and the needs of retiring baby boomers continue to shape the insurance industry. Retirement security is one of the most critical issues in the U.S. for individuals and the investment professionals and institutions that support them. The risk and responsibility of retirement savings continues to shift to employees, away from the government and employers. Life insurance ownership among U.S. households has reached its lowest point in fifty years, with consumers citing other financial priorities and cost of insurance as reasons for the lack of coverage.
Competitive Environment. Our annuities business operates in a highly competitive environment. Market volatility in recent years led many companies within the industry to reduce risk in product features and increase costs. However, in 2011, certain of our competitors became more aggressive in product design and pricing, while we implemented modifications to scale back benefits and increase pricing for certain product features. In spite of this, we believe our current product offerings remain competitively positioned and that our differentiated risk management strategies will continue to provide us with an attractive risk and profitability profile. All of our new variable annuity sales, as well as a significant portion of our in force business, where an optional living benefit has been elected, include an asset transfer feature, which is a feature that is valued in the variable annuity market. As a result of the launch of the Company’s new product line in March 2010, an affiliated company, PALAC ceased selling variable annuity products. In general, the new product line offers the same optional living benefits and optional death benefits as offered by the Company’s existing variable annuities
The individual life market is mature and, due to the large number of competitors, competition is driven mainly by price and service. The economy has exacerbated pressure on pricing, creating an even greater challenge of maintaining pricing discipline. This has limited growth of our individual life sales, in an industry which has shifted toward non-proprietary distribution channels, which are more price sensitive than proprietary distribution channels.
Revenues and Expenses
The Company earns revenues principally from insurance premiums; mortality, expense, and asset administration fees from insurance and investment products; and investment of general account and other funds. The Company earns premiums primarily from the sale of individual life insurance. The Company earns mortality, expense fees, and asset administration fees on the servicing of separate account products including universal and variable life insurance and variable annuities. The Company’s operating expenses principally consist of insurance benefits provided, general business expenses, commissions and other costs of selling and servicing the various products we sell and interest credited on general account liabilities.
Profitability
The Company’s profitability depends principally on its ability and Prudential Insurance’s ability to price and manage risk on insurance and annuity products, to attract and retain customer assets, and to manage expenses. Specific drivers of our profitability include:
• | our ability to manufacture and distribute products and services and to introduce new products that gain market acceptance on a timely basis; |
• | our ability to price our insurance and annuity products at a level that enables us to earn a margin over the cost of providing benefits and the expense of acquiring customers and administering those products; |
2
• | our mortality and morbidity experience on individual life insurance and annuity products, including the extent and cost of reinsurance, which can fluctuate significantly from period to period; |
• | our actual policyholder behavior experience, including persistency, and benefit utilization and withdrawal rates for our variable annuity contracts, which could deviate significantly from our pricing assumptions; |
• | our persistency experience, which affects our ability to recover the cost of acquiring new business over the lives of the contracts; |
• | our cost of administering insurance contracts and providing asset management products and services; |
• | our ability to manage and control our operating expenses, including overhead expenses; |
• | our returns on invested assets, including the impact of credit losses, net of the amounts we credit to policyholders’ accounts; |
• | our assumptions with respect to rates of return; |
• | the amount of our assets under management and changes in their fair value, which affect the amount of asset administration fees we receive; |
• | our ability to generate favorable investment results through asset/liability management and strategic and tactical asset allocation; and where available and appropriate, our ability to take timely crediting rate actions to maintain investment spread margins; |
• | our credit and financial strength ratings; |
• | our ability to effectively utilize our tax capacity; and |
• | our reinsurance affiliates’ ability to manage risk and exposures, including the degree to which, and the effectiveness of, hedging these risks and exposures. |
In addition, factors such as credit market conditions, regulation, competition, interest rates, taxes, market fluctuations and general economic, market and political conditions affect our profitability. In some of our product lines, we share experience on mortality, morbidity, persistency and investment results with our customers, which can offset the impact of these factors on our profitability from those products.
See “Risk Factors” for a discussion of risks that have materially affected and may affect in the future the Company’s business, results of operations or financial condition, or cause the Company’s actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.
Accounting Policies & Pronouncements
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 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.
Deferred Policy Acquisition and Other Costs
We capitalize costs that are directly related to the acquisition or renewal of insurance and annuity contracts. These costs include incremental direct costs of contract acquisition with independent third parties or employees that are essential to the contract transaction, as well as the portion of employee compensation, including payroll fringe benefits, and other costs directly related to underwriting, policy issuance and processing, medical inspection, and contract selling for successfully negotiated contracts. We also defer costs associated with sales inducements related to our variable and fixed annuity contracts. Sales inducements are amounts that are credited to the policyholder’s account balance as an inducement to purchase the contract. For additional information about sales inducements, see Note 7 to the Financial Statements. We amortize these deferred policy acquisition costs, or DAC, and deferred sales inducements, or DSI, over the expected lives of the contracts, based on our estimates of the level and timing of gross profits or gross premiums, depending on the type of contract. As described in more 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 profits or gross premiums. As of December 31, 2011, DAC for life products was $126 million and DAC for our annuity products was $137 million. As of December 31, 2011, DSI was $48 million, related entirely to our annuity products.
3
Amortization methodologies
DAC associated with term life policies is amortized in proportion to gross premiums. We evaluate the recoverability of our DAC related to these policies as part of our premium deficiency testing. If a premium deficiency exists, we reduce DAC by the amount of the deficiency or to zero through a charge to current period earnings. If the deficiency is more than the DAC balance, we reduce the DAC balance to zero and increase the reserve for future policy benefits by the excess, by means of a charge to current period earnings. Generally, we do not expect significant deterioration in future experience, and therefore do not expect significant writedowns to the related DAC.
DAC and DSI associated with the variable and universal life policies and the variable and fixed annuity contracts is amortized over the expected life of these policies in proportion to total gross profits. DAC and DSI are also subject to recoverability testing which we perform at the end of each reporting period to ensure that each balance does not exceed the present value of estimated gross profits. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and the cost related to our guaranteed minimum death and guaranteed minimum income benefits. 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 (an SEC registrant) and has extensive transactions and relationships with other subsidiaries of Prudential Financial, including reinsurance agreements, as discussed in Note 13 to the Consolidated Financial Statements. Incorporating all product-related profits and losses in gross profits, including those that are reported in affiliated legal entities, produces a DAC 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.”
Total gross profits include both actual experience and estimates of gross profits for future periods. We regularly evaluate and adjust the related DAC and DSI balances with a corresponding charge or credit to current period earnings for the effects of our actual gross profits and changes in our assumptions regarding estimated future gross profits. Adjustments to the DAC and DSI balances include the impact to our estimate of total gross profits of the annual review of assumptions, 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.”
In addition to the gross profit components mentioned above, we also include the impact of the embedded derivatives associated with certain of the optional living benefit features of our variable annuity contracts and related hedging activities in actual gross profits used as the basis for calculating current period amortization, including any impacts that are recorded in the reinsurance affiliate. Prior to the third quarter of 2010, we also included the impact of these embedded derivatives and related hedging activities, excluding the impact of the market-perceived risk of the non-performance of the Company’s reinsurance affiliate, in our estimate of total gross profits used to determine the DAC and DSI amortization rates. In the third quarter of 2010, the hedging strategy of the Company and our reinsurance affiliate was revised, which resulted in a change in how certain gross profit components are used to determine the DAC and DSI amortization rates. Prior to the third quarter of 2010 the hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by U.S. GAAP, excluding the impact of the market-perceived risk of the non-performance of the reinsurance affiliate, with capital market derivatives. Under the current hedging strategy, 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 determine the fair value of the embedded derivative liability under U.S. GAAP, as the Company and the reinsurance affiliate believe the increase in the liability driven by these margins is temporary and does not reflect the economic value of the liability. For further discussion on the change in the hedging strategy refer to “Item 1 – Business - Products.”
As mentioned above, this change in the hedging strategy also led to a change in the components included in our estimate of total gross profits used to determine the DAC and DSI amortization rates. Beginning in the third quarter of 2010, management’s best estimate of the total gross profits associated with these optional living benefit features and related hedge positions is based on the updated hedge target definition as described above. However, total gross profits for these purposes includes the difference between the change in the value of the hedge target liability and the change in the asset value only to the extent this net amount is determined by management to be other-than-temporary, as well as the impact of assumption updates on the valuation of the hedge target liability. The determination of whether the difference between the change in the value of the hedge target liability and the change in the asset value is other-than-temporary is based on an evaluation of the effectiveness of the hedge program. Management generally expects differences between the change in the value of the hedge target liability and the change in the asset value to be temporary and to reverse over time. Such differences would not be
4
included in total gross profits for purposes of determining the amortization rates. However, based on the effectiveness of the hedge program, management may determine that the difference between the value of the hedge target liability and the asset value is other-than-temporary and would include that amount in our best estimate of total gross profits for setting the DAC and DSI amortization rates.
Management may also decide to temporarily hedge to an amount that differs from the hedge target definition, given overall capital considerations of our ultimate parent Company, Prudential Financial Inc. and its subsidiaries, and prevailing market conditions. The impact from temporarily hedging to an amount that differs from the hedge target definition, as well as the results of the capital hedge program we began in the second quarter of 2009 and modified in 2010, are not considered in calculating total gross profits used to determine amortization rates nor included in actual gross profits used in calculating current period amortization as these items are related to capital considerations and are not directly related to product profits.
Annual assumptions review and quarterly adjustments
Annually, during the third quarter, we perform a comprehensive review of the assumptions used in estimating gross profits for future periods. Although we review these assumptions on an ongoing basis throughout the year, we generally only update these assumptions and adjust the DAC and DSI balances during the third quarter, unless a material change that we feel is indicative of a long term trend is observed in an interim period. Over the last several years, the Company’s most significant assumption updates resulting in a change to expected future gross profits and the amortization of DAC and DSI have been related to lapse experience and other contractholder behavior assumptions, mortality, and revisions to expected future rates of returns on investments. We expect these assumptions to be the ones most likely to cause potential significant changes 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.
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. A significant portion of gross profits for our variable annuity 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, costs we incur associated with the guaranteed minimum death and guaranteed minimum income benefit features related to our variable annuity 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 fees we earn and decrease the costs we incur associated with the guaranteed minimum death and guaranteed minimum income benefit features related to our variable annuity contracts. The impact of increased fees results in higher expected future gross profits and lower DAC and DSI amortization for the period. 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.
5
The near-term future rate of return assumptions used in evaluating DAC and DSI are derived 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 future 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. Unless there is a sustained interim deviation, our long-term expected rate of return assumptions are generally not impacted by short-term market fluctuations. If the “near term” projected future rate of return is greater than our “near-term” maximum future rate of return, we use our maximum future rate of return. The following table sets forth the weighted average rate of return assumptions, per annum, for our domestic variable annuity and variable life insurance businesses as of December 31, 2011.
Variable Annuities | Variable Life Insurance | |||||||
Long-term equity expected rate of return | 9.2 % | 9.2 % | ||||||
Fixed income expected rate of return (1) | 4.5 % | 5.7 % | ||||||
Long-term blended expected rate of return(2) | 7.5 % | 7.7 % | ||||||
Near-term maximum equity rate of return | 13.0 % | 13.0 % | ||||||
Fixed income expected rate of return(1) | 4.5 % | 5.7 % | ||||||
Blended maximum expected rate of return (2) | 9.9 % | 9.8 % | ||||||
Near-term mean reversion blended rate of return | 9.4 % | 9.3 % |
(1) Fixed income expected rate of return for our variable annuities business is a levelized rate, blending current rates and long-term expected returns. Fixed income expected rate of return for our variable life insurance business is the long-term expected return, as a blend does not materially affect results due to the long duration of the liability.
(2) Blend is based on the long-term expected distribution of funds between equity and fixed income funds.
The weighted average rate of return assumptions described above are determined independently for variable annuities and variable life insurance and consider many factors specific to each business, including actual rates of return, liability durations, asset allocations and other factors. We update the rates of return and our estimate of total gross profits each quarter to reflect the result of the reversion to the mean approach. These market performance related adjustments to our estimate of total gross profits result in cumulative adjustments to prior amortization, reflecting the application of the new required rate of amortization to all prior periods’ gross profits. The new required rate of amortization is also applied prospectively to future gross profits in calculating amortization in future periods.
Sensitivity
Annuity Products
For variable annuity contracts, DAC and DSI are sensitive to changes in our future rate of return assumptions due primarily to the significant portion of gross profits that is dependent upon the total rate of return on assets held in separate account investment options, and the shorter average life of the contracts.
6
The following table provides a demonstration of the sensitivity of each of these balances relative to our future rate of return assumptions by quantifying the adjustments to each balance that would be required assuming both an increase and decrease in our future rate of return by 100 basis points. The sensitivity includes an increase and decrease of 100 basis points to both the near-term future rate of return assumptions used over the next four years, and the long-term expected rate of return used thereafter. While the information below is for illustrative purposes only and does not reflect our expectations regarding future rate of return assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change. This information considers only the direct effect of changes in our future rate of return on the DAC and DSI balances and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC and DSI. Further, this information does not reflect changes in reserves, such as the reserves for the guaranteed minimum death and optional living benefit features of our variable annuity products, or the impact that changes in such reserves may have on the DAC and DSI balance.
December 31, 2011 | ||||||||
Increase/ (Reduction) in DAC | Increase/ (Reduction) in DSI | |||||||
(in millions) | ||||||||
Increase in future rate of return by 100 basis points | $ | 2 | $ | 1 | ||||
Decrease in future rate of return by 100 basis points | $ | (2) | $ | (1) |
Life Products
For the variable and universal life policies, a significant portion of our gross profits is derived from mortality margins. As a result, our estimates of future gross profits are significantly influenced by our mortality assumptions. Our mortality assumptions represent our expected claims experience over the life of these policies and are developed based on Company experience. We review and update our mortality assumptions annually. Updates to our mortality assumptions in future periods could have a significant adverse or favorable effect on the results of our operations.
The DAC balance associated with the variable and universal life policies as of December 31, 2011 was $80 million. The following table provides a demonstration of the sensitivity of that DAC balance relative to our future mortality assumptions by quantifying the adjustments that would be required, assuming both an increase and decrease in our future mortality rate by 1%. While the information below is for illustrative purposes only and does not reflect our expectations regarding future mortality assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change. This information considers only the direct effect of changes in our mortality assumptions on the DAC balance and not changes in any other assumptions such as persistency, future rate of return, or expenses included in our evaluation of DAC, and does not reflect changes in reserves, such as the unearned revenue reserve, which would partially offset the adjustments to the DAC balance reflected below.
December 31, 2011 | ||||
Increase/ (Reduction) in DAC | ||||
(in millions) | ||||
Decrease in future mortality by 1% | $ | 1 | ||
Increase in future mortality by 1% | $ | (1) |
See “Results of Operations” for a discussion of the impact of DAC and DSI amortization on our results of the life and annuities products.
7
Valuation of Investments, Including Derivatives, 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 we generally use include swaps, futures, forwards and options. 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 the investments and derivatives, as referenced below.
• | Valuation of investments, including derivatives |
• | Recognition of other-than-temporary impairments |
• | Determination of the valuation allowance for losses on commercial mortgage and other loans |
We present our investments classified as available for sale, including fixed maturity and equity securities, our investments classified as trading, our derivatives, and our embedded derivatives at fair value in the statements of financial position. 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 10 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), net,” a separate component of equity. For our investments classified as trading, the impact of changes in fair value is recorded within “Other income.” In addition, investments classified as available-for-sale, are subject to impairment reviews to identify when a decline in value is other-than-temporary. For a discussion of our policies regarding other-than-temporary declines in investment value and the related methodology for recording other-than-temporary impairments of fixed maturity and equity securities, see Note 2 to the Financial Statements.
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. For a discussion of our policies regarding the valuation allowance for commercial mortgage and other loans see Note 2 to the Financial Statements.
Policyholder Liabilities
Future Policy Benefit Reserves
The future policy benefit reserves relate primarily to term life products and are determined in accordance with U.S. GAAP as the present value of expected future benefits to or on behalf of policyholders less the present value of future net premiums, which are discussed more fully in Note 7 to the Consolidated Financial Statements. The expected future benefits are determined using assumptions as to mortality and lapse. Reserve assumptions are based on best estimate assumptions as of the date the policy is issued with provisions for the risk of adverse deviation. After our reserves are initially established, we perform premium deficiency tests using best estimate assumptions as of the testing date without provisions for adverse deviation. If gross premium reserves determined based on these best estimate assumptions are greater than the net U.S. GAAP liabilities (i.e., reserves net of any DAC asset), the existing net U.S. GAAP liabilities are adjusted to the greater amount, first writing down DAC and then increasing reserves if needed. Mortality assumptions are generally based on the Company’s historical experience or standard industry tables, as applicable; our expense assumptions are based on current levels of maintenance costs, adjusted for the effects of inflation; and our interest rate assumptions are based on current and expected net investment returns. Unless a material change in mortality experience is observed in an interim period that we feel is indicative of a long term trend, we generally update our mortality assumptions annually in the third quarter of each year. Generally, we do not expect our mortality 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.
Future policy benefits also include reserves for guaranteed minimum death benefits (“GMDBs”) and optional living benefit features related to our variable annuity products. The optional living benefits are primarily accounted for as embedded derivatives, with fair values calculated as the present value of future expected benefit payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature. For additional information regarding the valuation of these optional living benefit features see Note 10 to the Financial Statements.
8
In establishing reserves for GMDBs, guaranteed minimum income benefits (“GMIBs”), and optional living benefits related to variable annuity contracts, we must make estimates and assumptions about the timing of annuitization, contract lapses and contractholder mortality, as well as interest rates and equity market returns. Assumptions relating to contractholder behavior, such as the timing of annuitization and contract lapses, are based on our experience by contract group, and vary by product type and year of issuance. Our dynamic lapse rate assumption applies a different lapse rate on a contract by contract basis based on a comparison of the GMDB or GMIB and the current policyholder account value as well as other factors such as the applicability of any surrender charges. In-the-money contracts are those with a GMDB or GMIB in excess of the current policyholder account value. Since in-the-money contracts are less likely to lapse, we apply a lower lapse rate assumption to these contracts. As an example, the lapse rate assumptions for contracts that are not in-the-money and out of their surrender charge period average between 7% and 15% per year, and the lapse rate assumptions for contracts that are in-the-money and out of their surrender charge period average between 0% and 15% per year. Mortality assumptions are generally based on our historical experience or standard industry tables, and also vary by contract group. Unless a material change in contractholder behavior or mortality experience that we feel is indicative of a long term trend is observed in an interim period, we generally update assumptions related to contractholder behavior and mortality in the third quarter of each year by considering recent company experience compared to the expected amounts. Over the last several years, the Company’s most significant assumption updates that have resulted in changes to our reserves for the GMDBs and GMIBs have been related to lapse experience and other contractholder behavior assumptions and revisions to expected future rates of returns on investments. The Company expects these assumptions to be the ones most likely to cause significant changes in the future. Changes in these assumptions can be offsetting and can also impact our DAC and other balances as discussed above. Generally, we do not expect our actual mortality 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.
The future rate of return assumptions used in establishing reserves for GMDBs and GMIBs related to variable annuity contracts are derived using a reversion to the mean approach, a common industry practice. For additional information regarding our future expected rate of return assumptions and our reversion to the mean approach see, “—Deferred Policy Acquisition and Other Costs.” The following table provides a demonstration of the sensitivity of the reserves for GMDBs and GMIBs related to variable annuity contracts relative to our future rate of return assumptions by quantifying the adjustments to these reserves that would be required assuming both a 100 basis point increase and decrease in our future rate of return. The sensitivity includes an increase and decrease of 100 basis points to both the near-term future rate of return assumptions used over the next four years, and the long-term expected rate of return used thereafter. While the information below is for illustrative purposes only and does not reflect our expectations regarding future rate of return assumptions, it is a near-term, reasonably likely change that illustrates the potential impact of such a change. This information considers only the direct effect of changes in our future rate of return on operating results due to the change in the reserve balance and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of the reserves, or any changes on DAC or other balances, discussed above in “—Deferred Policy Acquisition and Other Costs.”
December 31, 2011 | ||||
Increase/ (Reduction) in GMDB/GMIB Reserves | ||||
(in millions) | ||||
Decrease in future rate of return by 100 basis points | $ | 1 | ||
Increase in future rate of return by 100 basis points | $ | (1) |
Unearned revenue reserves for variable and universal life contracts
Our unearned revenue reserve, or URR, reported as a component of “Policyholders’ account balances,” is $84 million as of December 31, 2011. This reserve primarily relates to 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 amortized over the expected lives of the contracts in proportion to the products’ estimated gross profits, similar to DAC as discussed above.
For the variable and universal life policies, a significant portion of our gross profits is derived from mortality margins. As a result, our estimates of future gross profits are significantly influenced by our mortality assumptions. Our mortality assumptions represent our expected claims experience over the life of these policies and are developed based on Company experience or standard industry tables. Unless a material change in mortality experience that we feel is indicative of a long term trend is observed in an interim period, we generally update our mortality assumptions annually in the third quarter. Updates to our mortality assumptions in future periods could have a significant adverse or favorable effect on the results of the Company.
9
The following table provides a demonstration of the sensitivity of that URR balance relative to our future mortality assumptions by quantifying the adjustments that would be required, assuming both an increase and decrease in our future mortality rate by 1%. While the information below is for illustrative purposes only and does not reflect our expectations regarding future mortality assumptions, it is a near-term, reasonably likely hypothetical change that illustrates the potential impact of such a change on the URR balance and does not reflect the offsetting impact of such a change on the DAC balance as discussed above in “—Deferred Policy Acquisition Costs and Other Costs.” This information considers only the direct effect of changes in our mortality assumptions on the URR balance and not changes in any other assumptions such as persistency, future rate of return, or expenses included in our evaluation of URR.
December 31, 2011 | ||||
Increase/(Reduction) in URR | ||||
(in millions) | ||||
Decrease in future mortality by 1% | $ | 1 | ||
Increase in future mortality by 1% | $ | (1) |
The Company’s liability for future policy benefits also includes other net liabilities for guarantee benefits related to certain nontraditional long-duration life and annuity contracts, which are discussed more fully in Note 7 to the Financial Statements.
Taxes on Income
Our effective tax rate is based on income, non-taxable and non-deductible items, 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.
Tax regulations require items to be included in the tax return at different times from when the items are reflected in the financial statements. As a result, the effective tax rate reflected in the financial statements is different than the actual rate applied on the tax return. Some of these differences are permanent such as expenses that are not deductible in our tax return, and some differences are temporary, reversing over time, such as valuation of insurance reserves. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet been recognized in our financial statements.
The application of U.S. GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax assets to an amount that is more likely than not to be realized. Considerable judgment is required in determining whether a valuation allowance is necessary, and if so, the amount of such valuation allowance. In evaluating the need for a valuation allowance we consider many factors, including: (1) the nature of the deferred tax assets and liabilities; (2) whether they are ordinary or capital; (3) in which tax jurisdictions they were generated and the timing of their reversal; (4) taxable income in prior carryback years as well as projected taxable earnings exclusive of reversing temporary differences and carryforwards; (5) the length of time that carryovers can be utilized in the various taxing jurisdictions; (6) any unique tax rules that would impact the utilization of the deferred tax assets; and (7) any tax planning strategies that we would employ to avoid a tax benefit from expiring unused. Although realization is not assured, management believes it is more likely than not that the deferred tax assets, net of valuation allowances, will be realized.
An increase or decrease in our effective tax rate by one percent would have resulted in an increase or decrease in consolidated income from continuing operations in 2011 of $1.1 million.
U.S. GAAP prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that a company has taken or expects to take on tax returns. The application of this guidance is a two-step process, the first step being recognition. We determine whether it is more likely than not, based on the technical merits, that the tax position will be sustained upon examination. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. We measure the tax position as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate resolution with a taxing authority that has full knowledge of all relevant information. This measurement considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement using the facts, circumstances, and information available at the reporting date.
10
Our liability for income taxes includes the liability for unrecognized tax benefits and interest that relate to tax years still subject to review by the IRS 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 our liability for income taxes. The Federal statute of limitations for the 2002 tax year expired on April 30, 2009. The Federal statute of limitations for the 2003 tax year expired on July 31, 2009. The Federal statute of limitations for the 2004 through 2007 tax years will expire in June 2012, unless extended. Tax years 2008 through 2010 are still open for IRS examination. See Note 9 to the Consolidated Financial Statements for a discussion of the impact in 2009 and 2011 of changes to our total unrecognized tax benefits related to tax years for which the statute of limitations has expired. We do not anticipate any significant changes within the next 12 months to our total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.
Reserves for contingencies
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under U.S. GAAP, reserves 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
See Note 2 to the Financial Statements for a discussion of recently adopted accounting pronouncements.
The Company’s Changes in Financial Position and Results of Operations are described below.
1. Changes in Financial Position
2011 to 2010 Annual Comparison
Total assets increased $1,460 million, from $7,368 million at December 31, 2010 to $8,828 million at December 31, 2011. Separate account assets increased $1,220 million, from $5,038 million at December 31, 2010 to $6,258 million at December 31, 2011, primarily driven by positive net flows from new business sales.
Total investments increased by $211 million from $1,449 million at December 31, 2010 to $1.660 billion at December 31, 2011. This increase was primarily driven by customer deposits within the general account due to continued growth of the universal life in force and reinvestment of investment income.
Reinsurance recoverables increased by $103 million from $420 million at December 31, 2010 to $523 million at December 31, 2011 primarily driven by continued growth in the reinsured term life in force and a new reinsurance agreement in 2011 related to variable annuity living benefits. See Note 13 for further detail on these agreements.
Partially offsetting the increases are decreases in deferred policy acquisition costs (“DAC”) of $8 million from $271 million at December 31, 2010 to $263 million at December 31, 2011. The decrease is primarily driven by the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions, held in the reinsurance affiliate, offset by capitalization of commissions related to new business.
11
Total liabilities increased by $1,464 million, from $6,802 million at December 31, 2010 to $8,266 million at December 31, 2011, primarily due to an increase in separate account liabilities of $1.220 billion, offsetting the increase in separate account assets described above. Future policy benefits and other policyholder liabilities increased by $189 million, from $503 million at December 31, 2010 to $692 million at December 31, 2011, primarily driven by the impact of the mark-to-market in the liability for variable annuity living benefit embedded derivatives due to an increase in the present value of future expected benefit payments primarily driven by lower interest rates and continued growth in term in force. Policyholder account balances increased $79 million, from $1,054 million at December 31, 2010 to $1,133 million at December 31, 2011. The increase includes the impact of continued universal life customer deposits arising from business growth and variable life transfers from the separate accounts to the general account.
2. Results of Operations
2011 to 2010 Annual Comparison
Year Ended December 31, | ||||||||
2011 | 2010 | |||||||
(in thousands) | ||||||||
Operating results: | ||||||||
Revenues: | ||||||||
Annuity Products | $ | (28,754) | $ | 103,147 | ||||
Life Products and Other | 149,914 | 115,255 | ||||||
|
|
|
| |||||
$ | 121,160 | $ | 218,402 | |||||
|
|
|
| |||||
Benefits and expenses: | ||||||||
Annuity Products | $ | 148,544 | $ | 41,165 | ||||
Life Products and Other | 81,011 | 46,421 | ||||||
|
|
|
| |||||
$ | 229,555 | $ | 87,586 | |||||
|
|
|
| |||||
Income (loss) from Operations before Income Taxes | ||||||||
Annuity Products | $ | (177,298) | $ | 61,982 | ||||
Life Products and Other | 68,903 | 68,834 | ||||||
|
|
|
| |||||
$ | (108,395) | $ | 130,816 | |||||
|
|
|
|
Annuity Products
Income (Loss) from Operations before Income Taxes
2011 to 2010 Annual Comparison. Income (loss) from operations before income taxes decreased $239 million from income of $62 million in 2010 to a loss of $177 million in 2011. The primary driver of this decrease was net mark-to-market losses in 2011 related to the embedded derivatives associated with our non-reinsured living benefit features due to unfavorable market performance and a loss on the reinsurance of living benefits ceded to the reinsurance affiliate, effective in 2011. Also contributing to this decrease was higher amortization of deferred policy acquisition costs (“DAC”) and deferred sales inducements (“DSI”) related to the impact of the mark-to-market of the reinsured and non-reinsured liability for living benefit embedded derivatives and related hedge positions, held in the reinsurance affiliate, as discussed in more detail below. Another contributor to the decrease was an unfavorable variance related to adjustments to the amortization of DAC and DSI, and in the reserves for the guaranteed minimum death (“GMDB”) and income benefit (“GMIB”) features of our variable annuity products, primarily driven by the impact to the estimated profitability of the business of quarterly adjustments to reflect current period market performance and experience, as well as the impact of annual reviews and updates of the assumptions used in estimating the profitability of our business. Results for both years include the impact of these items which are discussed in more detail below.
We amortize DAC and DSI over the expected lives of the contracts based on the level and timing of gross profits on the underlying Annuity products. In calculating gross profits, we consider mortality, persistency, and other elements as well as
12
rates of return on investments associated with these contracts and include profits and losses related to these contracts that are reported affiliated legal entities other than the Company as a result of, for example, reinsurance agreements with those affiliated entities. The Company is an indirect subsidiary of Prudential Financial, Inc. (an SEC registrant) and has extensive transactions and relationships with other subsidiaries of Prudential Financial, Inc. including reinsurance agreements, as discussed in Note 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 economics of the products.
As mentioned above, included in the unfavorable variance from higher amortization of DAC and DSI, was higher amortization of $80 million related to the impact of the mark-to-market of the reinsured and non-reinsured liability for living benefit embedded derivatives and related hedge positions held in our reinsurance affiliate. This impact primarily relates to changes in the valuation of the living benefit liabilities in 2011 related to Non-performance risk (“NPR”) gains, which we and the reinsurance affiliate believe to be non-economic, and choose not to hedge, as discussed above, partially offset by the losses driven by the difference between the change in the fair value of the hedge target liability and the change in the fair value of the hedge assets in the reinsurance affiliate due to significant capital markets volatility in 2011.
To reflect NPR 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 were primarily driven by a higher base of embedded derivative liabilities. Significant declines in risk-free interest rates and the impact of account value performance drove increases in the embedded derivative liability base in 2011. The NPR gains in the reinsurance affiliate were larger in 2011 compared to 2010 resulting in an unfavorable variance from higher DAC and DSI amortization.
As shown in the following table, the loss from operations for 2011 included $7 million of net charges from adjustments to the amortization of DAC/ DSI and the reserves for the GMDB/GMIB features of our variable annuity products, compared to $7 million of benefits included in income from operations in 2010.
Year Ended December 31, 2011 | Year Ended December 31, 2010 | |||||||||||||||||||||||
Amortization of DAC and DSI (1) | Reserves for GMDB / GMIB (2) | Total | Amortization of DAC and DSI (1) | Reserves for GMDB / GMIB (2) | Total | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Quarterly market performance adjustment | $ | (3,790) | $ | (1,128) | $ | (4,918) | $ | 1,061 | $ | 73 | $ | 1,134 | ||||||||||||
Annual review / assumption updates | (1,349) | 984 | (365) | 2,721 | 99 | 2,820 | ||||||||||||||||||
Quarterly adjustment for current period experience and other updates (3) | (1,868) | 277 | (1,591) | 1,525 | 1,521 | 3,046 | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | (7,007) | $ | 133 | $ | (6,874) | $ | 5,307 | $ | 1,693 | $ | 7,000 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
(1) | Amounts reflect (charges) or benefits for (increases) or decreases, respectively, in the amortization of DAC and DSI. |
(2) | Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the GMDB / GMIB, features of our variable annuity products. |
(3) | Represents the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as updates for current and future expected claims costs associated with the GMDB/GMIB features of our variable annuity products. |
13
The $5 million of charges and $1 million of benefits in 2011 and 2010, respectively, relating to the quarterly market performance adjustments shown in the table above 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.
2011 | 2010 | |||||||||||||||||||||||||||||||||
First Quarter | Second Quarter | Third Quarter | Fourth Quarter | First Quarter | Second Quarter | Third Quarter | Fourth Quarter | |||||||||||||||||||||||||||
Actual rate of return | 3.4 % | 0.8 % | (10.2) % | 4.6 % | 3.3 % | (5.9) % | 7.7 % | 5.8 % | ||||||||||||||||||||||||||
Expected rate of return | 1.8 % | 1.8 % | 1.9 % | 2.3 % | 2.0 % | 2.0 % | 2.1 % | 2.0 % |
Overall lower than expected returns in 2011 decreased our estimate of total gross profits used as a basis for amortizing DAC/DSI and increased our estimate of future expected claims costs associated with the GMDB and GMIB features of our variable annuity products, by establishing a new, lower starting point for the variable annuity account values used in estimating those items for future periods. This change results in a higher required rate of amortization and higher required reserve provisions, which are applied to all prior periods. The resulting cumulative adjustment to prior amortization and reserve provisions are recognized in the current period. Overall higher than expected returns in 2010 had opposite impacts.
As discussed and shown in the table above, results for both periods include the impact of the annual reviews performed in the third quarter of the assumptions used in the reserves for the GMDB and GMIB features of our variable annuity products and in our estimate of total gross profits used as a basis for amortizing DAC/DSI. The third quarter of 2011 included less than $1 million of charges from these annual reviews, primarily related to a reduction of the weighted average future fixed rate of return assumption to 4.5% partially offset by a reduction of the assumption of the percentage of contracts with a GMIB feature that will annuitize based on the guaranteed value. The reduction in the weighted average future fixed rate of return assumption was driven by a refinement to our rate-setting methodology to reflect a lower interest rate assumption for the next five years to reflect current market conditions, and use the long-term assumed rate thereafter in determining the blended future fixed rate of return. The third quarter of 2010 included $3 million of benefits from these annual reviews, primarily related to reductions in lapse rate assumptions and more favorable assumptions relating to fee income.
For a further discussion of the assumptions, including our current near-term and long-term projected rates of return, used in estimating total gross profits used as the basis for amortizing DAC/DSI, and for estimating future expected claims costs associated with the GMDB and GMIB features of our variable annuity products, see “—Accounting Policies and Pronouncements—Application of Critical Accounting Estimates.”
The $2 million charge for 2011 and the $3 million benefit for 2010 shown in the table above reflect the quarterly adjustments for current period experience, also referred to as experience true-up adjustments. The experience true-up adjustments for 2011 include an increase in the amortization of DAC/DSI primarily driven by the determination that 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 was other-than-temporary, resulting in its inclusion in our best estimate of total gross profits used for setting amortization rates. The experience true-up adjustments for 2010 include a reduction in the amortization of DAC/DSI driven by higher than expected gross profits primarily from higher than expected fee income. The unfavorable variance related to the adjustment to the GMDB/GMIB reserves was primarily driven by differences in actual lapse experience and contract guarantee claim costs in 2010 compared to 2011.
As noted previously, the quarterly adjustments to reflect current period market performance and experience, and the annual review and update of assumptions impact the estimated the 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
2011 to 2010 Annual Comparison.
Revenues decreased $132 million from $103 million in 2010 to contra revenue of $29 million in 2011.
14
Net realized investment gains (losses) decreased $169 million from a benefit of $49 million in 2010, to a a loss of $120 million in 2011, primarily driven by an unfavorable variance due to mark-to-market losses related to the embedded derivatives associated with our non-reinsured living benefit features and related hedges, held in the reinsurance affiliate, due to unfavorable market performance in 2011 and a loss on the living benefits to our reinsurance affiliate effective in 2011.
Offsetting the decrease was an increase in policy charges and fee income, consisting primarily of mortality and expense and other insurance charges assessed on policyholders’ fund balances of $33 million from $31 million in 2010 to $64 million in 2011. The increase was primarily driven by higher average variable annuity account values invested in separate accounts due to positive net flows and favorable markets. Asset administration fees increased by $10 million from $6 million in 2010 to $16 million in 2011, primarily due to higher separate account asset balances, as discussed above.
Benefits and Expenses
2011 to 2010 Annual Comparison.
Benefits and expenses increased $108 million from $41 million in 2010 to $149 million in 2011.
Amortization of DAC increased by $74 million, from $2 million in 2010 to $76 million in 2011, primarily due to higher DAC amortization related to the impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions held in the reinsurance affiliate and the impact of our quarterly adjustments to reflect current period experience and market performance, as well as the annual assumption update, as discussed above.
Interest credited to policyholders’ account balances increased $24 million, from $11 million in 2010 to $35 million in 2011, primarily due to higher DSI amortization related to the impact of the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions held in the reinsurance affiliate and the impact of our quarterly adjustments to reflect current period experience and market performance, as well as the annual assumption update, as discussed above.
General and administrative expenses, net of capitalization, increased $8 million, from $27 million in 2010 to $35 million in 2011, primarily due to higher costs to support business growth.
Life Products and Other
Income from Operations before Income Taxes
2011 to 2010 Annual Comparison. Income from Operations before Income Taxes was $69 million in both the full years of 2011 and 2010. Results for the full year of 2011 benefited from lower amortization of deferred policy acquisition costs net of unearned revenue reserves partially offset by an increase in reserves for the guaranteed minimum death benefit feature in certain contracts, reflecting updates of our actuarial assumptions based on an annual review. The annual reviews update assumptions used in our estimate of total gross profits which forms the basis for amortizing deferred policy acquisition costs and unearned revenue reserves, as well as the reserve for the guaranteed minimum death benefit feature in certain contracts. Results for 2011 included a $1 million benefit from the annual review, primarily reflecting improved mortality assumptions based on experience. Results for 2010 included a $4 million benefit from the annual review, primarily reflecting methodology refinements related to the treatment of certain investment income in our assumptions, as well as improved future mortality expectations. The results also include a $1 million adjustment arising from the correction of an understatement of deferred reinsurance expense allowances related to affiliated reinsurance of our term business. These decreases were largely offset by higher income from continued universal life business growth.
Revenues
2011 to 2010 Annual Comparison. Revenues of $150 million in 2011 increased $35 million, from $115 million in 2010. Policy charges and fee income, consisting primarily of mortality and expense loading and other insurance charges assessed on general and separate account policyholders’ fund balances, increased $28 million from $22 million for the full year of 2010 to $50 million for the full year of 2011 including a $5 million lower increase in unearned revenue reserves due to the annual reviews of assumptions. Excluding this item, policy charges and fee income increased $23 million reflecting the impact of amending certain affiliated reinsurance treaties in 2010 to change settlement modes from monthly to annual which resulted in an increase in policy charges ceded to affiliated reinsurers in 2010, higher policy charges due to continued universal life sales and in force growth, and an increase in current period amortization of unearned revenue reserves due to changes in our estimates of total gross profits reflecting the impact of less favorable market conditions on separate account fund performance in 2011 compared to 2010.
15
Benefits and Expenses
2011 to 2010 Annual Comparison.Total benefits and expenses of $81 million in 2011 increased $35 million, from $46 million in 2010.
Policyholders’ benefits, including interest credited to policyholders’ account balances, increased $27 million, from $25 million in 2010 to $52 million in 2011. This increase includes $5 million from the impact of the annual reviews of assumptions on reserves for the guaranteed minimum death benefit feature in certain contracts which reduced policyholder benefits in 2010 and increased policyholder benefits in 2011. Excluding this item, policyholders’ benefits, including interest credited to policyholders’ account balances increased $22 million. This increase includes a decrease in reserves ceded due to the amendment of certain of our affiliated reinsurance treaties to change settlement modes from monthly to annual which increased ceded reserves in 2010 partially offset by higher reserves ceded due to decreased retention limits resulting from modifications to certain coinsurance treaties with affiliates in 2010.
Amortization of deferred policy acquisition costs increased $7 million from $7 million for the full year of 2010 to $14 million for the full year of 2011. This included a $4 million increase from the impacts of the annual reviews of assumptions. Excluding this item, amortization of deferred policy acquisition costs increased $3 million including an increase in current period amortization due to changes in our estimates of total gross profits reflecting the impact of less favorable market conditions on separate account fund performance in 2011 compared to 2010.
Liquidity and Capital Resources
Overview
Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long term financial resources available to support the operation of our businesses, fund business growth, and provide a cushion to withstand adverse circumstances. The ability to generate and maintain sufficient liquidity and capital depends on the profitability of our businesses, general economic conditions and our access to the capital markets through affiliates as described herein.
Management monitors the liquidity of Prudential Financial, Prudential Insurance and the Company on a daily basis and projects borrowing and capital needs over a multi-year time horizon through our quarterly planning process. We believe that cash flows from the sources of funds presently available to us are sufficient to satisfy the current liquidity requirements of Prudential Financial and the Company, including reasonably foreseeable contingencies.
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 “Other Business Regulation” in Part I for information regarding the potential effects of the Dodd-Frank bill on the Company and its affiliates.
General Liquidity
Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of the Company. We segment our investment portfolios and employ an asset/liability management approach specific to the requirements of our product lines. This enhances the discipline applied in managing the liquidity, as well as the interest rate and credit risk profiles, of each portfolio in a manner consistent with the unique characteristics of the product liabilities. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact of Prudential Funding, LLC’s financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company.
16
Liquidity is measured against internally developed benchmarks that take into account the characteristics of both the asset portfolio and the liabilities that they support. The results are affected substantially by the overall asset type and quality of our investments.
Cash Flow
The principal sources of the Company’s liquidity are premiums and certain annuity considerations, investment and fee income, investment maturities and sales as well as internal borrowings. The principal uses of that liquidity include benefits, claims, dividends paid to policyholders, and payments to policyholders and contractholders in connection with surrenders, withdrawals and net policy loan activity. Other uses of liquidity include commissions, general and administrative expenses, purchases of investments, and payments in connection with financing activities. As a result of the launch of its new annuity product line in March 2010, as discussed above, the Company has seen and expects to continue to see the overall level of these activities to increase.
We believe that the cash flows from our insurance and annuity operations are adequate to satisfy our current liquidity requirements, including under reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors such as future securities market conditions, changes in interest rate levels, customer behavior, policyholder perceptions of our financial strength, and the relative safety of competing products each of which could lead to reduced cash inflows or increased cash outflows. In addition, market volatility can impact the level of capital required to support our businesses, particularly in our annuity products. Our cash flows from investment activities result from repayments of principal, proceeds from maturities and sales of invested assets and investment income, net of amounts reinvested. The primary liquidity risks with respect to these cash flows are the risk of default by debtors or bond insurers, our counterparties’ willingness to extend repurchase and/or securities lending arrangements, commitments to invest and market volatility. We closely manage these risks through our credit risk management process and regular monitoring of our liquidity position. Further, the level of new business sales can also impact liquidity, and additional financing may be required due to the increase in annuity sales as previously discussed.
In managing our liquidity, we also consider the risk of policyholder and contractholder withdrawals of funds earlier than our assumptions when selecting assets to support these contractual obligations. We use surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of withdrawals of funds by customers from annuity contracts and deposit liabilities.
Individual life insurance policies are less susceptible to withdrawal than our annuity reserves and deposit liabilities because policyholders may be subject to a new underwriting process in order to obtain a new insurance policy. Our annuity reserves with guarantee features may be less susceptible to withdrawal than historical experience indicates, due to the current value of these guarantee features to policyholders as a result of market declines in recent years.
Gross account withdrawals amounted to approximately $83 million and $152 million for the years ended December 31, 2011 and 2010, respectively. Because these withdrawals were consistent with our assumptions in asset/liability management, the associated cash outflows did not have a material adverse impact on our overall liquidity.
Liquid Assets
Liquid assets include cash and cash equivalents, short-term investments, fixed maturities available-for-sale, equity securities available-for-sale and trading account assets. As of December 31, 2011 and 2010, the Company had liquid assets of $1.251 billion and $1.162 billion, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $27.8 million and $95.4 million as of December 31, 2011 and 2010, respectively. As of December 31, 2011, $1.113 billion, or 91%, of the fixed maturity investments company general account portfolios were rated investment grade. The remaining $107 million, or 9%, of these fixed maturity investments were rated non-investment grade. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures in order to evaluate the adequacy of our insurance operations’ liquidity under a variety of stress scenarios. We believe that the liquidity profile of our assets is sufficient to satisfy current liquidity requirements, including under foreseeable stress scenarios.
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. Historically, there has been no significant variation between the expected maturities of our investments and the payment of claims.
17
Our liquidity is managed through access to substantial investment portfolios as well as a variety of instruments available for funding and/or managing short-term cash flow mismatches, including from time to time those arising from claim levels in excess of projections. To the extent we need to pay claims in excess of projections, we may borrow temporarily or sell investments sooner than anticipated to pay these claims, which may result in increased borrowing costs or realized investment gains or losses affecting results of operations. We believe that borrowing temporarily or selling investments earlier than anticipated will not have a material impact on the liquidity of the Company. Payment of claims and sale of investments earlier than anticipated would have an impact on the reported level of cash flow from operating and investing activities, respectively, in our financial statements.
Prudential Funding, LLC
Prudential Funding, LLC, or Prudential Funding, a wholly owned subsidiary of Prudential Insurance, serves as an additional source of financing to meet our working capital needs. Prudential Funding operates under a support agreement with Prudential Insurance whereby Prudential Insurance has agreed to maintain Prudential Funding positive tangible net worth at all times. Prudential Funding borrows funds in the capital markets primarily through the direct issuance of commercial paper.
Capital
The Risk Based Capital, or RBC, ratio is a primary measure by which we evaluate the capital adequacy of the Company. We manage our RBC ratio to a level consistent with an “AA” ratings objective. RBC is determined by statutory formulas that consider risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products, 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. As of December 31, 2010, the RBC ratio for the Company exceeded the minimum levels required by applicable insurance regulations. Based upon December 31, 2011 amounts, the RBC ratios for the Company exceed the minimum level required by applicable insurance regulations. The reporting of RBC measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities.
The level of statutory capital of the Company can be materially impacted by interest rate and equity market fluctuations, changes in the values of derivatives, the level of impairments recorded, credit quality migration of investment portfolio, among other items. Further, the recapture of business subject to reinsurance arrangements due to defaults by, or credit quality migration affecting, the reinsurers could result in higher required statutory capital levels. The level of statutory capital of the Company is also affected by statutory accounting rules which are subject to change by insurance regulators.
During 2010, as part of its Capital Protection Framework, Prudential Financial developed a broad view of the impact of market distress on the statutory capital of Prudential Financial and its subsidiaries, as a whole. In the second quarter of 2010, the capital hedge program was terminated as described under “Item 1. Business—Products” and equity index-linked derivative transactions were entered into that are 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. 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 hedging programs and affiliated reinsurance arrangements. In the reinsurance affiliate, interest rate derivatives and equity options and futures are purchased to hedge certain optional living benefit features accounted for as embedded derivatives against changes in certain capital markets assumptions such as equity markets, interest rates, and market volatility. Prior to third quarter of 2010, the hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by U.S. GAAP, excluding the impact of the market-perceived risk of non-performance, with capital market derivatives. In the third quarter of 2010, the hedging strategy was revised as, in a low interest rate environment, management of the Company and reinsurance affiliates does not believe that the U.S. GAAP value of the embedded derivative liability is an appropriate measure for determining the hedge target. For additional information regarding the change in hedging strategy see “Item 1. Business—Products”.
We reinsure variable annuity living benefit guarantees to a captive reinsurance company, Pruco Reinsurance, Ltd. (“Pruco Re”). The variable annuity living benefit hedging program described above is primarily executed within Pruco Re. Effective as of July 1, 2011, Pruco Re re-domiciled from Bermuda to Arizona. At this time, Pruco Re must continue to maintain a statutory reserve credit trust for business reinsured from the Company in order for the Company to claim reinsurance reserve credit for the business ceded.
18
Reinsurance credit reserve requirements can move materially in either direction due to changes in equity markets and interest rates, actuarial assumptions and other factors. Higher reinsurance credit reserve requirements would necessitate depositing additional assets in the statutory reserve credit trusts held by Pruco Re, while lower reinsurance credit reserve requirements would allow assets to be removed from the statutory reserve credit trusts. We expect Prudential Financial would satisfy those additional needs through a combination of funding the reinsurance credit trusts with available cash, certain hedge assets or collateral associated with the hedge positions, and loans from Prudential Financial and/or affiliates. Prudential Financial also continues to evaluate other options to address reserve credit needs such as obtaining letters of credit. Lower equity markets and interest rates in 2011 led to an increase in the need to fund the captive reinsurance trusts by an amount of $13 million.
Debt Agreements
As of December 31, 2011, total short-term debt was $26 million and long-term debt was $44 million. The Company and its parent, Pruco Life, have an agreement with an affiliate, Prudential Funding, LLC, which allows it to borrow funds for working capital and liquidity needs. The borrowings under this agreement are limited to $200 million. The Company had $26 million in short term debt as of December 31, 2011, and no borrowings outstanding as of December 31, 2010. The Company also borrowed $44 million from Prudential Financial.
Contributed Capital
The Company received capital contributions from Pruco Life in the amount of $21 million in June 2011 and $17 million in December 2011 to fund acquisition costs for sales of variable annuities.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
Risk Management, Market Risk and Derivative Instruments
Risk management 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. We consider risk management an integral part of managing our core business.
Market risk is the risk of change in the value of financial instruments as a result of absolute or relative changes in interest rates, foreign currency exchange rates or equity or commodity prices. To varying degrees, the investment and trading activities supporting all of our products and services generate exposure to market risk. The market risk incurred and our strategies for managing this risk vary by product.
With respect to non-variable life insurance products, fixed rate annuities, the fixed rate accounts in our variable life insurance and annuity products, we incur market risk primarily in the form of interest rate risk. We manage this risk through asset/liability management strategies that seek to closely approximate the interest rate sensitivity, but not necessarily the exact cash flow characteristics, of the assets with the estimated interest rate sensitivity of the product liabilities. The Company also mitigates this risk through a market value adjusted (“MVA”) provision on the Company’s fixed investment option. This MVA provision limits interest rate risk when a contractholder withdraws funds or transfers funds to variable investment options before the end of the guarantee period. Our overall objective in these strategies is to limit the net change in value of assets and liabilities arising from interest rate movements. While it is more difficult to measure the interest sensitivity of our insurance liabilities than that of the related assets, to the extent that we can measure such sensitivities we believe that interest rate movements will generate asset value changes that substantially offset changes in the value of the liabilities relating to the underlying products.
For variable annuities and variable life insurance products excluding the fixed rate accounts associated with these products, and most separate accounts, we are exposed to the risk that asset based fees may decrease as a result of declines in assets under management due to changes in investment values. We also run the risk that asset administration fees calculated by reference to performance could be lower. The risk of decreased asset based and asset administration fees could also impact our estimates of total gross profits used as a basis for amortizing deferred policy acquisition and other costs. While a decrease in our estimates of total gross profits would accelerate amortization and decrease net income in a given period, it would not affect our cash flow or liquidity position in the current period.
For variable annuity and variable life insurance products with minimum guaranteed death benefits and variable annuity products with living benefits such as guaranteed minimum income, withdrawal, and accumulation benefits, we also face the risk that declines in the value of underlying investments as a result of interest rate, equity market, or market volatility changes
19
may increase our net exposure to the guarantees under these contracts. As part of our risk management strategy, we utilize product design elements such as asset allocation requirements, an asset transfer feature and minimum purchase age requirements, as well as reinsurance programs. These strategies exclude our guaranteed minimum income benefits and guaranteed minimum death benefits, which include risks we have deemed suitable to retain.
For a discussion of asset-based fees associated with our variable life products and our variable annuity contracts, our estimates of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, and the impact of our guaranteed minimum death and other benefits on the results of our life and annuities products, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
In addition, certain products supported by general account investments expose us to the risk that changes in interest rates will reduce the spread between the amounts that we are required to pay under the contracts and the rate of return we are able to earn on our general account investments supporting the contracts. Market fluctuations or changes in market conditions could also cause a change in consumer sentiment adversely affecting sales and persistency of our long-term savings, protection and other investment products. 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.”
The sources of our exposure to market risk are primarily related to, “other than trading” activities conducted primarily in our insurance and annuity operations. As part of our management of market risks, we use a variety of risk management tools and techniques which include sensitivity and Value-at-Risk, or VaR, measures, position and other limits based on type of risk, and various hedging methods.
Other Than Trading Activities
We hold the majority of our assets for “other than trading” activities in our insurance and annuities products. We incorporate asset/liability management techniques and other risk management policies and limits into the process of investing our assets. We use derivatives for hedging and other purposes in the asset/liability management process.
Insurance, Annuities and Guaranteed Products Asset/Liability Management
We seek to maintain interest rate and equity exposures within established ranges, which we periodically adjust based on market conditions and the design of related products sold to customers. Our risk managers establish investment risk limits for exposures to any issuer, geographic region, type of security or industry sector and oversee efforts to manage risk within policy constraints set by management and approved by the Investment Committee of Prudential Financial and the Board of Directors.
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 of duration with respect to changes in interest rates. We seek to manage our interest rate exposure by legal entity by matching the relative sensitivity of asset and liability values to interest rate changes, or controlling “duration mismatch” of assets and liabilities. We have target duration mismatch constraints for each entity. As of December 31, 2011 and 2010, the difference between the duration of assets and the target duration of liabilities in our duration-managed portfolios was within our constraint limits. We consider risk-based capital implications in our asset/liability management strategies.
We also perform portfolio stress testing as part of our regulatory cash flow testing. In this testing, we evaluate the impact of altering our interest-sensitive assumptions under various adverse interest rate environments. These interest-sensitive assumptions relate to the timing and amount of redemptions and prepayments of fixed-income securities and lapses and surrenders of insurance products and the potential impact of any guaranteed minimum interest rates. We evaluate any shortfalls that this cash flow testing reveals to determine if we need to increase statutory reserves or adjust portfolio management strategies.
Market Risk Related to Interest Rates
Our “other than trading” assets that subject us to interest rate risk include primarily fixed maturity securities, commercial loans and policy loans. In the aggregate, the carrying value of these assets represented 63% of our assets, other than assets that we held in separate accounts, as of December 31, 2011 and 61% as of December 31, 2010.
With respect to “other than trading” liabilities, we are exposed to interest rate risk through policyholders’ account balances relating to interest-sensitive life insurance, annuity and other investment-type contracts, collectively referred to as investment contracts, and through outstanding short term debt with affiliates.
We assess interest rate sensitivity for “other than trading” 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
20
prevailing interest rates. The following tables set forth the net estimated potential loss in fair value from a hypothetical 100 basis point upward shift as of December 31, 2011 and 2010, because 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.
December 31, 2011 | ||||||||||||||||
Notional Value of Derivatives | Fair Value | Hypothetical Fair Value After + 100 Basis Point Parallel Yield Curve Shift | Hypothetical Change in Fair Value | |||||||||||||
(in millions) | ||||||||||||||||
Financial Assets with Interest Rate Risk: | ||||||||||||||||
Financial Assets: | ||||||||||||||||
Fixed maturities, available for sale | $ | $ | 1,220 | $ | 1,165 | $ | (55) | |||||||||
Policy loans | 236 | 217 | (19) | |||||||||||||
Commercial loans | 248 | 240 | (8) | |||||||||||||
Derivatives: (1) | ||||||||||||||||
Futures | - | - | - | - | ||||||||||||
Swaps | 106 | 6 | 1 | (6) | ||||||||||||
Financial Liabilities with Interest Rate Risk: | ||||||||||||||||
Investment Contracts | (113) | (112) | 1 | |||||||||||||
|
| |||||||||||||||
Total Estimated Potential Loss | (87) | |||||||||||||||
|
|
(1) | Excludes variable annuity optional living benefits accounted for as embedded derivatives as the Company has generally entered into reinsurance agreements to transfer the risk related to these optional living benefits to an affiliate as part of its risk management strategy. |
December 31, 2010 | ||||||||||||||||
Notional Value of Derivatives | Fair Value | Hypothetical Fair Value After + 100 Basis Point Parallel Yield Curve Shift | Hypothetical Change in Fair Value | |||||||||||||
(in millions) | ||||||||||||||||
Financial Assets with Interest Rate Risk: | ||||||||||||||||
Financial Assets: | ||||||||||||||||
Fixed maturities, available for sale | $ | - | $ | 1,065 | $ | 1,023 | $ | (41) | ||||||||
Policy loans | - | 212 | 194 | (18) | ||||||||||||
Commercial loans | - | 192 | 186 | (6) | ||||||||||||
Derivatives: (1) | ||||||||||||||||
Futures | - | - | - | - | ||||||||||||
Swaps | 76 | (2) | (5) | (3) | ||||||||||||
Financial Liabilities with Interest Rate Risk: | ||||||||||||||||
Investment Contracts | 102 | 101 | (1) | |||||||||||||
|
| |||||||||||||||
Total Estimated Potential Loss | (69) | |||||||||||||||
|
|
(1) | Excludes variable annuity optional living benefits accounted for as embedded derivatives as the Company has generally entered into reinsurance agreements to transfer the risk related to these optional living benefits to an affiliate as part of its risk management strategy. |
21
The tables above do not include approximately $1.712 billion and $1.456 billion of insurance reserve and deposit liabilities as of December 31, 2011 and 2010, respectively. We believe that the interest rate sensitivities of these insurance liabilities offset, in large measure, the interest rate risk of the financial assets set forth in these tables. The tables above also exclude variable annuity optional living benefits accounted for as embedded derivatives as the Company generally reinsures to affiliates the risks associated with these benefits as part of its risk management strategy.
The estimated changes in fair values of the financial assets shown above relate to assets invested in support of the Company’s insurance liabilities, but do not include assets associated with products for which investment risk is borne primarily by the contractholders rather than the Company.
Market Risk Related to Equity Prices
We actively manage investment 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 for U.S. equities.
For equity investments within the separate accounts, the investment risk is borne primarily by the separate account contractholder rather than by the Company. As part of its risk management strategy the Company generally reinsures to affiliates the risks related to variable annuity optional living benefits accounted for as embedded derivatives. In addition to the hedging program in the reinsurance affiliates, in 2010, Prudential Financial changed the focus of its capital hedge program from the equity price risk associated with the annuities business to a broader view of equity market exposure of the statutory capital of Prudential Financial and its subsidiaries, as a whole. In the second quarter of 2010, Prudential Financial and its subsidiaries entered into equity index-linked derivative transactions that were designed to mitigate the overall impact of a severe equity market stress event on statutory capital. The program now focuses on tail risk to protect statutory capital in a cost-effective manner under stress scenarios. Prudential Financial assesses the composition of the hedging program on an ongoing basis and may change it from time to time based on an evaluation of its risk position or other factors.
Market Risk Related to Foreign Currency Exchange Rates
The Company does not have significant market risk exposure to foreign exchange rates.
Financial Derivatives
Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices, or the prices of securities or commodities. Derivative financial instruments may be exchange-traded or contracted in the over-the-counter market and include swaps, futures, options and forward contracts. See Note 11 to the Financial Statements for a description of derivative activities as of December 31, 2011 and 2010. Under insurance statutes, insurance companies may use derivative financial instruments to hedge actual or anticipated changes in their assets or liabilities, to replicate cash market instruments or for certain income-generating activities. These statutes generally prohibit the use of derivatives for speculative purposes. The Company uses derivative financial instruments primarily to manage market risk from changes in interest rates.
Limitations of VaR Models
Although VaR models are a recognized tool for risk management, they have inherent limitations, including reliance on historical data that may not be indicative of future market conditions or trading patterns. Accordingly, VaR models should not be viewed as a predictor of future results. We may incur losses that could be materially in excess of the amounts indicated by the models on a particular trading day or over a period of time, and there have been instances when results have fallen outside the values generated by our VaR models. A VaR model does not estimate the greatest possible loss. The results of these models and analysis thereof are subject to the judgment of our risk management personnel.
Item 8. Financial Statements and Supplementary Data
Information required with respect to this Item 8 regarding Financial Statements and Supplementary Data is set forth within the Index to Financial Statements elsewhere in this Annual Report.
22
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Financial Statements | Page# | |||
Management’s Annual Report on Internal Control Over Financial Reporting | F-2 | |||
F-3 | ||||
Financial Statements: | ||||
Statements of Financial Position - December 31, 2011 and 2010 | F-4 | |||
Statements of Operations and Comprehensive Income Years ended December 31, 2011, 2010 and 2009 | F-5 | |||
Statements of Stockholder’s Equity Years ended December 31, 2011, 2010 and 2009 | F-6 | |||
Years ended December 31, 2011, 2010 and 2009 | F-7 | |||
F-8 |
F-1
Management’s Annual Report on Internal Control Over Financial Reporting
Management of Pruco Life Insurance Company of New Jersey (“the Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. Management conducted an assessment of the effectiveness, as of December 31, 2011, of the Company’s internal control over financial reporting, based on the framework established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment under that framework, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2011.
Our internal control over financial reporting is a process designed by or under the supervision of our principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on our financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
This Annual Report does not include an attestation report of the Company’s registered public accounting firm, PricewaterhouseCoopers LLP, regarding internal control over financial reporting. Internal controls over Financial Reporting were not subject to attestation by the Company’s registered public accounting firm pursuant to final rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this Annual Report.
March 9, 2012
F-2
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholder of
Pruco Life Insurance Company of New Jersey:
In our opinion, the accompanying statements of financial position and the related statements of operations and comprehensive income, of equity and of cash flows present fairly, in all material respects, the financial position of Pruco Life Insurance Company of New Jersey (an indirect, wholly owned subsidiary of The Prudential Insurance Company of America) at December 31, 2011 and December 31, 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As described in Note 2 of the financial statements, the Company changed its method of determining and recording other-than-temporary impairment for debt securities on January 1, 2009, the manner in which it accounts for the costs associated with acquiring or renewing insurance contracts and the presentation of comprehensive income.
/s/ PRICEWATERHOUSECOOPERS LLP
New York, New York
March 9, 2012, except for the effects of the adoption of the new accounting guidance for the costs to acquire or renew insurance contracts, and the adoption of the accounting standard related to the presentation of comprehensive income discussed in Note 2, as to which the date is November 28, 2012.
F-3
Pruco Life Insurance Company of New Jersey
Statements of Financial Position
As of December 31, 2011 and 2010 (in thousands, except share amounts)
2011 | 2010 | |||||||
ASSETS | ||||||||
Fixed maturities available for sale, at fair value (amortized cost: 2011–$ 1,132,908; 2010–$1,007,655) | $ | 1,219,904 | $ | 1,064,541 | ||||
Equity securities available for sale, at fair value (cost: 2011–$1,521; 2010–$2,301) | 1,420 | 2,074 | ||||||
Trading account assets, at fair value | 1,569 | 0 | ||||||
Policy loans | 177,162 | 175,514 | ||||||
Short-term investments | 1,069 | 7,409 | ||||||
Commercial mortgage and other loans | 230,201 | 182,437 | ||||||
Other long-term investments | 29,075 | 16,913 | ||||||
|
|
|
| |||||
Total investments | 1,660,400 | 1,448,888 | ||||||
Cash and cash equivalents | 26,723 | 87,961 | ||||||
Deferred policy acquisition costs | 262,895 | 271,179 | ||||||
Accrued investment income | 17,275 | 16,365 | ||||||
Reinsurance recoverables | 522,762 | 419,858 | ||||||
Receivables from parents and affiliates | 23,148 | 25,833 | ||||||
Deferred sales inducements | 48,101 | 51,106 | ||||||
Other assets | 8,830 | 8,293 | ||||||
Separate account assets | 6,258,008 | 5,038,051 | ||||||
|
|
|
| |||||
TOTAL ASSETS | 8,828,142 | 7,367,534 | ||||||
|
|
|
| |||||
LIABILITIES AND EQUITY | ||||||||
LIABILITIES | ||||||||
Policyholders’ account balances | 1,133,080 | 1,054,013 | ||||||
Future policy benefits and other policyholder liabilities | 691,967 | 503,354 | ||||||
Cash collateral for loaned securities | 17,012 | 413 | ||||||
Securities sold under agreements to repurchase | 3,216 | 2,957 | ||||||
Income taxes | 23,178 | 86,999 | ||||||
Short-term debt to affiliates | 26,000 | 0 | ||||||
Long-term debt to affiliates | 44,000 | 0 | ||||||
Payables to parent and affiliates | 2,267 | 5,837 | ||||||
Other liabilities | 67,081 | 109,969 | ||||||
Separate account liabilities | 6,258,008 | 5,038,051 | ||||||
|
|
|
| |||||
TOTAL LIABILITIES | 8,265,809 | 6,801,593 | ||||||
|
|
|
| |||||
COMMITMENTS AND CONTINGENT LIABILITIES (See Note 12) | ||||||||
EQUITY | ||||||||
Common stock, ($5 par value; 400,000 shares, authorized, issued and outstanding) | 2,000 | 2,000 | ||||||
Additional paid-in capital | 207,928 | 169,742 | ||||||
Retained earnings | 305,281 | 365,068 | ||||||
Accumulated other comprehensive income | 47,124 | 29,131 | ||||||
|
|
|
| |||||
TOTAL EQUITY | 562,333 | 565,941 | ||||||
|
|
|
| |||||
TOTAL LIABILITIES AND EQUITY | $ | 8,828,142 | $ | 7,367,534 | ||||
|
|
|
|
See Notes to Financial Statements
F-4
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Statements of Operations and Comprehensive Income (Loss)
Years Ended December 31, 2011, 2010 and 2009 (in thousands)
2011 | 2010 | 2009 | ||||||||||
REVENUES | ||||||||||||
Premiums | $ | 15,305 | $ | 14,733 | $ | 17,031 | ||||||
Policy charges and fee income | 113,472 | 53,611 | 69,199 | |||||||||
Net investment income | 77,556 | 77,044 | 69,944 | |||||||||
Asset administration fees | 21,630 | 11,084 | 7,114 | |||||||||
Other income | 3,253 | 4,915 | 4,779 | |||||||||
Realized investment gains (losses), net: | ||||||||||||
Other-than-temporary impairments on fixed maturity securities | (7,483) | (21,164) | (14,461) | |||||||||
Other-than-temporary impairments on fixed maturity securities transferred to | ||||||||||||
Other Comprehensive Income | 7,215 | 18,612 | 8,391 | |||||||||
Other realized investment gains (losses), net | (109,788) | 59,567 | 19,584 | |||||||||
|
|
|
|
|
| |||||||
Total realized investment gains (losses), net | (110,056) | 57,015 | 13,514 | |||||||||
|
|
|
|
|
| |||||||
TOTAL REVENUES | 121,160 | 218,402 | 181,581 | |||||||||
|
|
|
|
|
| |||||||
BENEFITS AND EXPENSES | ||||||||||||
Policyholders’ benefits | 27,226 | (198) | 26,062 | |||||||||
Interest credited to policyholders’ account balances | 62,222 | 37,125 | 38,735 | |||||||||
Amortization of deferred policy acquisition costs | 90,046 | 8,662 | 16,370 | |||||||||
General, administrative and other expenses | 50,061 | 41,997 | 30,157 | |||||||||
|
|
|
|
|
| |||||||
TOTAL BENEFITS AND EXPENSES | 229,555 | 87,586 | 111,324 | |||||||||
|
|
|
|
|
| |||||||
INCOME (LOSS) FROM OPERATIONS BEFORE INCOME TAXES | (108,395) | 130,816 | 70,257 | |||||||||
|
|
|
|
|
| |||||||
Income Taxes: | ||||||||||||
Current | (715) | 23,841 | 20,362 | |||||||||
Deferred | (47,893) | 15,967 | (1,376) | |||||||||
|
|
|
|
|
| |||||||
Income tax (benefit) expense | (48,608) | 39,808 | 18,986 | |||||||||
|
|
|
|
|
| |||||||
|
|
|
|
|
| |||||||
NET INCOME (LOSS) | $ | (59,787) | $ | 91,008 | $ | 51,2791 | ||||||
|
|
|
|
|
| |||||||
Other comprehensive income (loss), before tax: | ||||||||||||
Foreign currency translation adjustments | (32) | (34) | 60 | |||||||||
Unrealized investment gains (losses) for the period | 21,317 | 19,876 | 76,123 | |||||||||
Reclassification adjustment for (gains) losses included in net income | 6,397 | 6,670 | 5,436 | |||||||||
|
|
|
|
|
| |||||||
Net unrealized investment gains (losses) | 27,714 | 26,546 | 81,559 | |||||||||
Other comprehensive income (loss), before tax: | 27,682 | 26,512 | 81,619 | |||||||||
Less: Income tax expense (benefit) related to: | ||||||||||||
Foreign currency translation adjustment | (11) | (12) | 21 | |||||||||
Net unrealized investment gains | 9,700 | 9,291 | 28,546 | |||||||||
Total | 9,689 | 9,279 | 28,567 | |||||||||
|
|
|
|
|
| |||||||
Other comprehensive income (loss), net of tax: | 17,993 | 17,233 | 53,052 | |||||||||
|
|
|
|
|
| |||||||
COMPREHENSIVE INCOME (LOSS) | $ | (41,794) | $ | 108,241 | $ | 104,323 | ||||||
|
|
|
|
|
|
See Notes to Financial Statements
F-5
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Statements of Stockholder’s Equity
Years Ended December 31, 2011, 2010 and 2009 (in thousands)
Common Stock | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income (Loss) | Total Equity | ||||||||||||||||
Balance, December 31, 2008 | $ | 2,000 | $ | 168,998 | $ | 273,964 | $ | (30,644) | $ | 414,318 | ||||||||||
Cumulative effect of adoption of accounting principle | - | - | (54,908) | (6,777) | (61,685) | |||||||||||||||
Impact of adoption of new guidance for other-than-temporary impairments of debt securities, net of taxes | - | - | 3,733 | (3,733) | - | |||||||||||||||
Comprehensive income: | ||||||||||||||||||||
Net income (loss) | - | - | 51,271 | - | 51,271 | |||||||||||||||
Other comprehensive income (loss), net of taxes | - | - | - | 53,052 | 53,052 | |||||||||||||||
|
| |||||||||||||||||||
Total comprehensive income | - | - | - | 104,323 | ||||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2009 | $ | 2,000 | $ | 168,998 | $ | 274,060 | $ | 11,898 | $ | 456,956 | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Affiliated Asset Transfers | - | 744 | - | - | 744 | |||||||||||||||
Comprehensive income: | ||||||||||||||||||||
Net income (loss) | - | - | 91,008 | - | 91,008 | |||||||||||||||
Other comprehensive income (loss), net of taxes | - | - | - | 17,233 | 17,233 | |||||||||||||||
|
| |||||||||||||||||||
Total comprehensive income | - | - | - | 108,241 | ||||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2010 | $ | 2,000 | $ | 169,742 | $ | 365,068 | $ | 29,131 | $ | 565,941 | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Contributed Capital | - | 38,000 | - | - | 38,000 | |||||||||||||||
Affiliated Asset Transfers | - | 186 | - | - | 186 | |||||||||||||||
Comprehensive income: | ||||||||||||||||||||
Net income (loss) | - | - | (59,787) | - | (59,787) | |||||||||||||||
Other comprehensive income (loss), net of taxes | - | - | - | 17,993 | 17,993 | |||||||||||||||
|
| |||||||||||||||||||
Total comprehensive income | - | - | - | (41,794) | ||||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2011 | $ | 2,000 | $ | 207,928 | $ | 305,281 | $ | 47,124 | $ | 562,333 | ||||||||||
|
|
|
|
|
|
|
|
|
|
See Notes to Financial Statements
F-6
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Statements of Cash Flows
Years Ended December 31, 2011, 2010 and 2009 (in thousands)
2011 | 2010 | 2009 | ||||||||||
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES: | ||||||||||||
Net income (loss) | $ | (59,787) | $ | 91,008 | $ | 51,271 | ||||||
Adjustments to reconcile net income (loss) to net cash provided by operating activities: | ||||||||||||
Policy charges and fee income | (25,622) | (13,636) | (15,562) | |||||||||
Interest credited to policyholders’ account balances | 62,222 | 37,125 | 38,735 | |||||||||
Realized investment (gains) losses, net | 110,056 | (57,015) | (13,514) | |||||||||
Amortization and other non-cash items | (2,359) | (3,906) | (271) | |||||||||
Change in: | ||||||||||||
Future policy benefits and other insurance liabilities | 93,600 | 90,575 | 71,430 | |||||||||
Reinsurance recoverables | (127,939) | (97,731) | (65,542) | |||||||||
Accrued investment income | (910) | 468 | (1,809) | |||||||||
Receivables from parent and affiliates | 2,213 | (6,108) | 15,115 | |||||||||
Payables to parent and affiliates | (3,569) | 1,643 | (5,628) | |||||||||
Deferred policy acquisition costs | (25) | (61,853) | (28,815) | |||||||||
Income taxes payable | (73,506) | 10,966 | 4,611 | |||||||||
Deferred sales inducements | (22,392) | (21,594) | (8,689) | |||||||||
Other, net | (13,260) | 15,508 | (8,966) | |||||||||
|
|
|
|
|
| |||||||
Cash flows from (used in) operating activities | $ | (61,278) | $ | (14,550) | $ | 32,366 | ||||||
|
|
|
|
|
| |||||||
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES: | ||||||||||||
Proceeds from the sale/maturity/prepayment of: | ||||||||||||
Fixed maturities, available for sale | $ | 171,016 | $ | 211,850 | $ | 254,335 | ||||||
Short-term investments | 21,230 | 42,060 | 47,394 | |||||||||
Policy loans | 20,142 | 17,827 | 20,554 | |||||||||
Commercial mortgage and other loans | 27,533 | 28,189 | 10,212 | |||||||||
Other long-term investments | 1,373 | 1,591 | 846 | |||||||||
Equity securities, available for sale | 474 | 2,000 | - | |||||||||
Payments for the purchase/origination of: | ||||||||||||
Fixed maturities, available for sale | (293,216) | (190,281) | (412,550) | |||||||||
Short-term investments | (14,899) | (21,491) | (67,219) | |||||||||
Policy loans | (14,130) | (15,966) | (13,030) | |||||||||
Commercial mortgage and other loans | (75,298) | (41,700) | (31,684) | |||||||||
Other long-term investments | (7,533) | (8,609) | (612) | |||||||||
Equity securities, available for sale | (1,347) | (158) | - | |||||||||
Notes receivable from parent and affiliates, net | 1,334 | 13,926 | 2,907 | |||||||||
Other | 24 | 320 | 616 | |||||||||
|
|
|
|
|
| |||||||
Cash flows from (used in) investing activities | $ | (163,297) | $ | 39,558 | $ | (188,230) | ||||||
|
|
|
|
|
| |||||||
CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES: | ||||||||||||
Policyholders’ account deposits | $ | 159,318 | $ | 171,435 | $ | 335,906 | ||||||
Policyholders’ account withdrawals | (83,438) | (151,600) | (213,085) | |||||||||
Net change in securities sold under agreement to repurchase and cash collateral for loaned securities | 16,859 | (29,304) | (5,954) | |||||||||
Dividend to parent | - | - | - | |||||||||
Contributed capital | 38,000 | 10 | - | |||||||||
Affiliated asset transfers | 186 | - | - | |||||||||
Net change in financing arrangements (maturities 90 days or less) | (11,588) | 39,811 | 1,787 | |||||||||
Net change in long-term borrowing | 44,000 | - | - | |||||||||
|
|
|
|
|
| |||||||
Cash flows from (used in) financing activities | $ | 163,337 | $ | 30,352 | $ | 118,654 | ||||||
|
|
|
|
|
| |||||||
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS | (61,238) | 55,360 | (37,210) | |||||||||
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR | 87,961 | 32,601 | 69,811 | |||||||||
|
|
|
|
|
| |||||||
CASH AND CASH EQUIVALENTS, END OF YEAR | $ | 26,723 | $ | 87,961 | $ | 32,601 | ||||||
|
|
|
|
|
| |||||||
SUPPLEMENTAL CASH FLOW INFORMATION | ||||||||||||
Income taxes paid | $ | 25,000 | $ | 28,842 | $ | 14,375 | ||||||
|
|
|
|
|
| |||||||
Interest paid | $ | 98 | $ | 4 | $ | 7 | ||||||
|
|
|
|
|
|
See Notes to Financial Statements
F-7
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements
1. BUSINESS AND BASIS OF PRESENTATION
Pruco Life Insurance Company of New Jersey, or the “Company,” is a wholly owned subsidiary of the Pruco Life Insurance Company, or “Pruco Life,” which in turn is a wholly owned subsidiary of The Prudential Insurance Company of America, or “Prudential Insurance.” Prudential Insurance is an indirect wholly owned subsidiary of Prudential Financial, Inc., or “Prudential Financial.” The Company sells variable annuities, universal life insurance, variable life insurance, and term life insurance, primarily through third party distributors only in New Jersey and New York, United States.
Beginning in March 2010, Prudential Annuities Life Assurance Corporation (“PALAC”), an affiliate of the Company, ceased offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product line in Pruco Life Insurance Company of New Jersey (and Pruco Life Insurance Company for the version of the product sold outside of New York). In general, the new product line offers the same optional living benefits and optional death benefits as offered by PALAC’s existing variable annuities. However, subject to applicable contractual provisions and administrative rules, PALAC will continue to accept subsequent purchase payments on in force contracts under existing annuity products. These initiatives were implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. In addition, by limiting its variable annuity offerings to a single product line, the Prudential Annuities business unit of Prudential Financial expects to convey a more focused, cohesive image in the marketplace.
Basis of Presentation
The Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America, or “U.S. GAAP.” The Company has extensive transactions and relationships with Prudential Insurance and other affiliates, (as more fully described in Note 13). Due to these relationships, it is possible that the terms of these transactions are not the same as those that would result from transactions among unrelated parties.
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The most significant estimates include those used in determining deferred policy acquisition costs and related amortization; amortization of deferred sales inducements; future policy benefits including guarantees; valuation of investments including derivatives and the recognition of other-than-temporary impairments; provision for income taxes and valuation of deferred tax assets; and reserves for contingent liabilities, including reserves for losses in connection with unresolved legal matters.
Reclassifications
Certain amounts in prior periods have been reclassified to conform to the current period presentation.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Investments and Investment Related Liabilities
The Company’s investments in debt and equity securities include fixed maturities; trading account assets; equity securities; and short-term investments. The accounting policies related to these, as well as commercial mortgage and other loans, are as follows:
Fixed maturities are comprised of bonds, notes and redeemable preferred stock. Fixed maturities classified as “available for sale” are carried at fair value. See Note 10 for additional information regarding the determination of fair value. Interest income, as well as the related amortization of premium and accretion of discount, is included in “Net investment income” under the effective yield method. For mortgage-backed and asset-backed securities, the effective yield is based on estimated cash flows, including prepayment assumptions based on data from widely accepted third-party data sources or internal estimates. In addition to prepayment assumptions, cash flow estimates vary based on assumptions regarding the underlying collateral, including default rates and changes in value. These assumptions can significantly impact income recognition and
F-8
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
the amount of other-than-temporary impairments recognized in earnings and other comprehensive income. For high credit quality mortgage-backed and asset-backed securities (those rated AA or above), cash flows are provided quarterly, and the amortized cost and effective yield of the security are adjusted as necessary to reflect historical prepayment experience and changes in estimated future prepayments. The adjustments to amortized cost are recorded as a charge or credit to net investment income in accordance with the retrospective method. For asset-backed and mortgage-backed securities rated below AA, the effective yield is adjusted prospectively for any changes in estimated cash flows. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Unrealized gains and losses on fixed maturities classified as “available for sale,” net of tax, and the effect on deferred policy acquisition costs, deferred sales inducements and future policy benefits that would result from the realization of unrealized gains and losses, are included in “Accumulated other comprehensive income (loss).”
Equity securities available for sale are comprised of common stock and non-redeemable preferred stock and are carried at fair value. The associated unrealized gains and losses, net of tax, and the effect on deferred policy acquisition costs, deferred sales inducements and future policy benefits that would result from the realization of unrealized gains and losses, are included in “Accumulated other comprehensive income (loss).” The cost of equity securities is written down to fair value when a decline in value is considered to be other-than-temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Dividends from these investments are recognized in “Net investment income” when declared.
Trading account assets at fair value are comprised of perpetual preferred stock. Realized and unrealized gains and losses for these investments are reported in “Other income.” Dividend income from these investments is reported in “Net investment income.”
Commercial mortgage and other loans consist of commercial mortgage loans and agricultural loans. Commercial mortgage loans are broken down by class which is based on property type (industrial properties, retail, office, multi-family/apartment, hospitality, and other). Commercial mortgage and other loans originated and held for investment are generally carried at unpaid principal balance, net of unamortized deferred loan origination fees and expenses and net of an allowance for losses. Commercial mortgage and other loans acquired, including those related to the acquisition of a business, are recorded at fair value when purchased, reflecting any premiums or discounts to unpaid principal balances.
Interest income, as well as prepayment fees and the amortization of the related premiums or discounts, related to commercial mortgage and other loans, are included in “Net investment income.”
Impaired loans include those loans for which it is probable that amounts due according to the contractual terms of the loan agreement will not all be collected. The Company defines “past due” as principal or interest not collected at least 30 days past the scheduled contractual due date. Interest received on loans that are past due, including impaired and non-impaired loans as well as loans that were previously modified in a troubled debt restructuring, is either applied against the principal or reported as net investment income based on the Company’s assessment as to the collectability of the principal. See Note 3 for additional information about the Company’s past due loans.
The Company discontinues accruing interest on loans after the loans become 90 days delinquent as to principal or interest payments, or earlier when the Company has doubts about collectability. When the Company discontinues accruing interest on a loan, any accrued but uncollectible interest on the loan and other loans backed by the same collateral, if any, is charged to interest income in the same period. Generally, a loan is restored to accrual status only after all delinquent interest and principal are brought current and, in the case of loans where the payment of interest has been interrupted for a substantial period, or the loan has been modified, a regular payment performance has been established.
The Company reviews the performance and credit quality of the commercial mortgage loan and agricultural loan portfolios on an on-going basis. Loans are placed on watch list status based on a predefined set of criteria and are assigned one of three categories. Loans are placed on “early warning” status in cases where, based on the Company’s analysis of the loan’s collateral, the financial situation of the borrower or tenants or other market factors, it is believed a loss of principal or interest could occur. Loans are classified as “closely monitored” when it is determined that there is a collateral deficiency or other credit events that may lead to a potential loss of principal or interest. Loans “not in good standing” are those loans where the Company has concluded that there is a high probability of loss of principal, such as when the loan is delinquent or in the process of foreclosure. As described below, in determining the allowance for losses, the Company evaluates each loan on the watch list to determine if it is probable that amounts due according to the contractual terms of the loan agreement will not be collected.
F-9
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Loan-to-value and debt service coverage ratios are measures commonly used to assess the quality of commercial mortgage loans. The loan-to-value ratio compares the amount of the loan to the fair value of the underlying property collateralizing the loan, and is commonly expressed as a percentage. Loan-to-value ratios greater than 100% indicate that the loan amount exceeds the collateral value. A smaller loan-to-value ratio indicates a greater excess of collateral value over the loan amount. The debt service coverage ratio compares a property’s net operating income to its debt service payments. Debt service coverage ratios less than 1.0 times indicate that property operations do not generate enough income to cover the loan’s current debt payments. A larger debt service coverage ratio indicates a greater excess of net operating income over the debt service payments. The values utilized in calculating these ratios are developed as part of the Company’s periodic review of the commercial mortgage loan and agricultural loan portfolio, which includes an internal appraisal of the underlying collateral value. The Company’s periodic review also includes a quality re-rating process, whereby the internal quality rating originally assigned at underwriting is updated based on current loan, property and market information using a proprietary quality rating system. The loan-to-value ratio is the most significant of several inputs used to establish the internal credit rating of a loan which in turn drives the allowance for losses. Other key factors considered in determining the internal credit rating include debt service coverage ratios, amortization, loan term, estimated market value growth rate and volatility for the property type and region. See Note 3 for additional information related to the loan-to-value ratios and debt service coverage ratios related to the Company’s commercial mortgage and agricultural loan portfolios.
The allowance for loan losses includes a loan specific reserve for each impaired loan that has a specifically identified loss and a portfolio reserve for probable incurred but not specifically identified losses. For impaired commercial mortgage loans and agricultural loans, the allowances for losses are determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or based upon the fair value of the collateral if the loan is collateral dependent. The portfolio reserves for probable incurred but not specifically identified losses in the commercial mortgage and agricultural loan portfolio segments considers the current credit composition of the portfolio based on an internal quality rating, (as described above). The portfolio reserves are determined using past loan experience, including historical credit migration, loss probability and loss severity factors by property type. These factors are reviewed each quarter and updated as appropriate.
The allowance for losses on commercial mortgage loans and agricultural loans can increase or decrease from period to period based on the factors noted above. “Realized investment gains (losses), net” includes changes in the allowance for losses. “Realized investment gains (losses), net” also includes gains and losses on sales, certain restructurings, and foreclosures.
When a commercial mortgage or other loan is deemed to be uncollectible, any specific valuation allowance associated with the loan is reversed and a direct write down to the carrying amount of the loan is made. The carrying amount of the loan is not adjusted for subsequent recoveries in value.
Policy loans are carried at unpaid principal balances. Interest income on policy loans is recognized in “Net investment income” at the contract interest rate when earned.
Securities repurchase and resale agreements and securities loaned transactions are used to earn spread income, to borrow funds, or to facilitate trading activity. Securities repurchase and resale agreements are generally short term in nature, and therefore, the carrying amounts of these instruments approximate fair value. As part of securities repurchase agreements or securities loan transactions the Company transfers U.S. government and government agency securities and receives cash as collateral. As part of securities resale agreements, the Company transfers cash as collateral and receives U.S. government securities. For securities repurchase agreements and securities loaned transactions used to earn spread income, the cash received is typically invested in cash equivalents, short term investments or fixed maturities.
Securities repurchase and resale agreements that satisfy certain criteria are treated as collateralized financing arrangements. These agreements are carried at the amounts at which the securities will be subsequently resold or reacquired, as specified in the respective agreements. For securities purchased under agreements to resell, the Company’s policy is to take possession or control of the securities and to value the securities daily. Securities to be resold are the same, or substantially the same, as the securities received. For securities sold under agreements to repurchase, the market value of the securities to be repurchased is monitored, and additional collateral is obtained where appropriate, to protect against credit exposure. Securities to be repurchased are the same, or substantially the same as those sold. Income and expenses related to these transactions executed within the insurance subsidiary used to earn spread income are reported as “Net investment income,” however, for transactions used to borrow funds, the associated borrowing cost is reported as interest expense (included in “General, administrative and other expenses”).
F-10
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Securities loaned transactions are treated as financing arrangements and are recorded at the amount of cash received. The Company obtains collateral in an amount equal to 102% and 105% of the fair value of the domestic and foreign securities, respectively. The Company monitors the market value of the securities loaned on a daily basis with additional collateral obtained as necessary. Substantially all of the Company’s securities loaned transactions are with large brokerage firms. Income and expenses associated with securities loaned transactions used to earn spread income are generally reported as “Net investment income;” however, for securities loaned transactions used for funding purposes the associated rebate is reported as interest expense (included in “General, administrative and other expenses”).
Other long-term investments consist of the derivatives, the Company’s investments in joint ventures and limited partnerships in which the Company does not exercise control, as well as investments in the Company’s own separate accounts, which are carried at fair value, and investment real estate. Joint venture and partnership interests are generally accounted for using the equity method of accounting, except in instances in which the Company’s interest is so minor that it exercises virtually no influence over operating and financial policies. In such instances, the Company applies the cost method of accounting. The Company’s share of net income from investments in joint ventures and partnerships is generally included in “Net investment income.”
“Short-term investments” primarily consist of highly liquid debt instruments with a maturity of greater than three months and less than twelve months when purchased. These investments are generally carried at fair value and include certain money market investments and other highly liquid debt instruments.
Realized investment gains (losses) are computed using the specific identification method. Realized investment gains and losses are generated from numerous sources, including the sale of fixed maturity securities, equity securities, investments in joint ventures and limited partnerships and other types of investments, as well as adjustments to the cost basis of investments for net other-than-temporary impairments recognized in earnings. Realized investment gains and losses are also generated from prepayment premiums received on private fixed maturity securities, allowance for losses on commercial mortgage and other loans and fair value changes on embedded derivatives and free-standing derivatives that do not qualify for hedge accounting treatment.
The Company’s available-for-sale securities with unrealized losses are reviewed quarterly to identify other-than-temporary impairments in value. In evaluating whether a decline in value is other-than-temporary, the Company considers several factors including, but not limited to the following: (1) the extent and the duration of the decline; (2) the reasons for the decline in value (credit event, currency or interest-rate related, including general credit spread widening); and (3) the financial condition of and near-term prospects of the issuer. With regard to available-for-sale equity securities, the Company also considers the ability and intent to hold the investment for a period of time to allow for a recovery of value. When it is determined that a decline in value of an equity security is other-than-temporary, the carrying value of the equity security is reduced to its fair value, with a corresponding charge to earnings.
Under the authoritative guidance for the recognition and presentation of other-than-temporary impairments for debt securities, an other-than-temporary impairment must be recognized in earnings for a debt security in an unrealized loss position when an entity either (a) has the intent to sell the debt security or (b) more likely than not will be required to sell the debt security before its anticipated recovery. For all debt securities in unrealized loss positions that do not meet either of these two criteria, the guidance requires that the Company analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows at the effective interest rate implicit in the debt security prior to impairment. The Company may use the estimated fair value of collateral as a proxy for the net present value if it believes that the security is dependent on the liquidation of collateral for recovery of its investment. If the net present value is less than the amortized cost of the investment, an other-than-temporary impairment is recognized.
Under the authoritative guidance for the recognition and presentation of other-than-temporary impairments, when an other-than-temporary impairment of a debt security has occurred, the amount of the other-than-temporary impairment recognized in earnings depends on whether the Company intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis. If the debt security meets either of these two criteria, the other-than-temporary impairment recognized in earnings is equal to the entire difference between the security’s amortized cost basis and its fair value at the impairment measurement date. For other-than-temporary impairments of debt securities that do not meet these criteria, the net amount recognized in earnings is equal to the difference between the amortized cost of the debt security
F-11
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
and its net present value calculated as described above. Any difference between the fair value and the net present value of the debt security at the impairment measurement date is recorded in “Other comprehensive income (loss).” Unrealized gains or losses on securities for which an other-than-temporary impairment has been recognized in earnings is tracked as a separate component of “Accumulated other comprehensive income (loss).”
For debt securities, the split between the amount of an other-than-temporary impairment recognized in other comprehensive income and the net amount recognized in earnings is driven principally by assumptions regarding the amount and timing of projected cash flows. For mortgage-backed and asset-backed securities, cash flow estimates consider the payment terms of the underlying assets backing a particular security, including prepayment assumptions, and are based on data from widely accepted third-party data sources or internal estimates. In addition to prepayment assumptions, cash flow estimates include assumptions regarding the underlying collateral including default rates and recoveries, which vary based on the asset type and geographic location, as well as the vintage year of the security. For structured securities, the payment priority within the tranche structure is also considered. For all other debt securities, cash flow estimates are driven by assumptions regarding probability of default and estimates regarding timing and amount of recoveries associated with a default. The Company has developed these estimates using information based on its historical experience as well as using market observable data, such as industry analyst reports and forecasts, sector credit ratings and other data relevant to the collectability of a security, such as the general payment terms of the security and the security’s position within the capital structure of the issuer.
The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. In periods subsequent to the recognition of an other-than-temporary impairment, the impaired security is accounted for as if it had been purchased on the measurement date of the impairment. For debt securities, the discount (or reduced premium) based on the new cost basis may be accreted into net investment income in future periods, including increases in cash flow on a prospective basis. In certain cases where there are decreased cash flow expectations, the security is reviewed for further cash flow impairments.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, amounts due from banks, certain money market investments, and other debt issues with maturities of three months or less when purchased. The Company also engages in overnight borrowing and lending of funds with Prudential Financial and affiliates which are considered cash and cash equivalents.
Deferred Policy Acquisition Costs
Costs that are directly related to the production of new insurance and annuity products are deferred to the extent such costs are deemed recoverable from future profits. Such deferred policy acquisition costs (“DAC”) include incremental direct costs of contract acquisition with independent third parties or employees that are essential to the contract transaction, as well as the portion of employee compensation directly related to underwriting, policy issuance and processing, medical inspection, and contract selling for successfully negotiated contracts. See below under “Adoption of New Accounting Pronouncements” for a discussion of the new authoritative guidance retrospectively adopted effective January 1, 2012, which is reflected in the Financial Statements. In each reporting period, capitalized DAC is amortized to “Amortization of deferred policy acquisition costs,” net of the accrual of imputed interest on DAC balances. DAC is subject to recoverability testing at the end of each reporting period to ensure that the capitalized amounts do not exceed the present value of anticipated gross profits or premiums less benefits and maintenance expenses, as applicable. DAC, for applicable products, is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges included in “Accumulated other comprehensive income (loss).”
Policy acquisition costs for interest sensitive and variable life products and fixed and variable deferred annuity products are deferred and amortized over the expected life of the contracts (approximately 25 – 99 years) in proportion to gross profits arising principally from investment results, mortality and expense margins, and surrender charges, based on historical and anticipated future experience, which is updated periodically. The Company uses a reversion to the mean approach to derive the blended future rate of return assumptions. However, if the projected future rate of return calculated using this approach is greater than the maximum future rate of return assumption, the maximum future rate of return is utilized in deriving the blended future rate of return assumption. In addition to the gross profit components previously mentioned, the impact of the embedded derivatives associated with certain optional living benefit features of the Company’s variable annuity contracts and related hedging activities are also included in actual gross profits used as the basis for calculating current period amortization and, in certain instances, in management’s estimate of total gross profits used for setting the amortization rate, regardless of
F-12
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
which affiliated legal entity this activity occurs. In calculating gross profits, 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 are also included. 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 described in Note 13. Incorporating all product-related profits and losses in gross profits, including those that are reported in affiliated legal entities, produces a DAC amortization pattern representative of the total economics of the products. The effect of changes to estimated gross profits on unamortized deferred acquisition costs is reflected in “Amortization of deferred policy acquisition costs” in the period such estimated gross profits are revised. DAC related to non-participating traditional individual life insurance is amortized in proportion to gross premiums.
For some products, policyholders can elect to modify product benefits, features, rights or coverages by exchanging a contract for a new contract or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. These transactions are known as internal replacements. If policyholders surrender traditional life insurance policies in exchange for life insurance policies that do not have fixed and guaranteed terms, the Company immediately charges to expense the remaining unamortized DAC on the surrendered policies. For other internal replacement transactions, except those that involve the addition of a non-integrated contract feature that does not change the existing base contract, the unamortized DAC is immediately charged to expense if the terms of the new policies are not substantially similar to those of the former policies. If the new terms are substantially similar to those of the earlier policies, the DAC is retained with respect to the new policies and amortized over the expected life of the new policies.
Reinsurance recoverables
Reinsurance recoverables include corresponding payables and receivables associated with reinsurance arrangements with affiliates. For additional information about these arrangements see Note 13 to the Financial Statements.
Separate Account Assets and Liabilities
Separate account assets are reported at fair value and represent segregated funds, which are invested for certain policyholders and other customers. The assets consist primarily of equity securities, fixed maturities, real estate related investments, real estate mortgage loans and short term investments and derivative instruments. The assets of each account are legally segregated and are generally not subject to claims that arise out of any other business of the Company. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities primarily represent the contractholder’s account balance in separate account assets and to a lesser extent borrowings of the separate account, and will be equal and offsetting to total separate account assets. See Note 7 to the Financial Statements for additional information regarding separate account arrangements with contractual guarantees. The investment income and realized investment gains or losses from separate accounts generally accrue to the policyholders and are not included in the Statements of Operations. Mortality, policy administration and surrender charges assessed against the accounts are included in “Policy charges and fee income.” Asset administration fees charged to the accounts are included in “Asset administration fees.”
Deferred sales inducements
The Company provides sales inducements to contractholders, which primarily reflect an up-front bonus added to the contractholder’s initial deposit for certain annuity contracts. These costs are deferred and recognized in “Deferred sales inducements”. They are amortized using the same methodology and assumptions used to amortize DAC. Sales inducements balances are subject to recoverability testing at the end of each reporting period to ensure that the capitalized amounts do not exceed the present value of anticipated gross profits. The Company records amortization of deferred sales inducements in “Interest credited to policyholders’ account balances.”
Other Assets and Other Liabilities
Other assets consist primarily of premiums due, certain restricted assets, and receivables resulting from sales of securities that had not yet settled at the balance sheet date. Other liabilities consist primarily of accrued expenses, technical overdrafts, derivatives, and payables resulting from purchases of securities that had not yet been settled at the balance sheet date.
Future Policy Benefits
The Company’s liability for future policy benefits is primarily comprised of the present value of estimated future payments to or on behalf of policyholders, where the timing and amount of payment depends on policyholder mortality or morbidity, less
F-13
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
the present value of future net premiums. For life insurance and annuity products, expected mortality and morbidity is generally based on the Company’s historical experience or standard industry tables including a provision for the risk of adverse deviation on our term life products. Interest rate assumptions are based on factors such as market conditions and expected investment returns. Although mortality and morbidity and interest rate assumptions are “locked-in” upon the issuance of new insurance or annuity products with fixed and guaranteed terms, significant changes in experience or assumptions may require the Company to provide for expected future losses on a product by establishing premium deficiency reserves. Premium deficiency reserves, if required, are determined based on assumptions at the time the premium deficiency reserve is established and do not include a provision for the risk of adverse deviation. The Company’s liability for future policy benefits also includes net liabilities for guarantee benefits related to certain nontraditional long-duration life and annuity contracts, which are discussed more fully in Note 7, and certain unearned revenues.
Policyholders’ Account Balances
The Company’s liability for policyholders’ account balances represents the contract value that has accrued to the benefit of the policyholder as of the balance sheet date. This liability is generally equal to the accumulated account deposits, plus interest credited, less policyholders’ withdrawals and other charges assessed against the account balance. These policyholders’ account balances also include a provision for benefits under non-life contingent payout annuities and certain unearned revenues.
Contingent Liabilities
Amounts related to contingent liabilities are accrued if it is probable that a liability has been incurred and an amount is reasonably estimable. Management evaluates whether there are incremental legal or other costs directly associated with the ultimate resolution of the matter that are reasonably estimable and, if so, they are included in the accrual.
Insurance Revenue and Expense Recognition
Premiums from individual life products, other than interest-sensitive life contracts, are recognized when due. When premiums are due over a significantly shorter period than the period over which benefits are provided, any gross premium in excess of the net premium (i.e., the portion of the gross premium required to provide for all expected future benefits and expenses) is deferred and recognized into revenue in a constant relationship to insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net premium method.
Certain individual annuity contracts provide the holder a guarantee that the benefit received upon death or annuitization will be no less than a minimum prescribed amount. These benefits are accounted for as insurance contracts and are discussed in further detail in Note 7. The Company also provides contracts with certain living benefits which are accounted for as embedded derivatives. These contracts are discussed in further detail in Note 7.
Amounts received as payment for interest-sensitive contracts, are reported as deposits to “Policyholders’ account balances.” Revenues from these contracts are reflected in “Policy charges and fee income” consisting primarily of fees assessed during the period against the policyholders’ account balances for mortality charges, policy administration charges and surrender charges. In addition to fees, the Company earns investment income from the investment of policyholders’ deposits in the Company’s general account portfolio. Fees assessed that represent compensation to the Company for services to be provided in future periods and certain other fees are deferred and amortized into revenue over the life of the related contracts in proportion to estimated gross profits. Benefits and expenses for these products include claims in excess of related account balances, expenses of contract administration, interest credited to policyholders’ account balances and amortization of DAC. Premiums, benefits and expenses are stated net of reinsurance ceded to other companies. Estimated reinsurance recoverables and the cost of reinsurance are recognized using assumptions consistent with those used to account for the underlying policies.
Asset Administration Fees
The Company receives asset administration fee income from policyholders’ account balances invested in The Prudential Series Funds or, “PSF,” which are a portfolio of mutual fund investments related to the Company’s separate account products. Also, the Company receives fee income calculated on contractholder separate account balances invested in the Advanced Series Trust Funds (see Note 13). In addition, the Company receives fees from policyholders’ account balances invested in funds managed by companies other than affiliates of Prudential Insurance. Asset administration fees are recognized as income when earned.
F-14
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Derivative Financial Instruments
Derivatives are financial instruments whose values are derived from interest rates, financial indices, or the values of securities. Derivative financial instruments generally used by the Company include swaps, futures, forwards and options which are contracted in the over-the-counter market with an affiliate. Derivative positions are carried at fair value, generally by obtaining quoted market prices or through the use of valuation models. Values can be affected by changes in interest rates, financial indices, values of securities, credit spreads, market volatility, expected returns, non-performance risks and liquidity. Values can also be affected by changes in estimates and assumptions, including those related to counterparty behavior and non-performance risk used in valuation models.
Derivatives are used to manage the characteristics of the Company’s asset/liability mix to manage the interest rate and currency characteristics of assets or liabilities. Additionally, derivatives may be used to seek to reduce exposure to interest rate, credit, foreign currency and equity risks associated with assets held or expected to be purchased or sold, and liabilities incurred or expected to be incurred.
Derivatives are recorded either as assets, within “Other long-term investments,” or as liabilities, within “Other liabilities,” except for embedded derivatives, which are recorded with the associated host contract. The Company nets the fair value of all derivative financial instruments with its affiliated counterparty for which a master netting arrangement has been executed. As discussed below and in Note 5, all realized and unrealized changes in fair value of derivatives, with the exception of the effective portion of cash flow hedges are recorded in current earnings. Cash flows from these derivatives are reported in the operating and investing activities sections in the Statements of Cash Flows based on the nature and purpose of the derivative.
The Company designates derivatives as either (1) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge), or (2) a derivative that does not qualify for hedge accounting.
To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated risk of the hedged item. Effectiveness of the hedge is formally assessed at inception and throughout the life of the hedging relationship. Even if a derivative qualifies for hedge accounting treatment, there may be an element of ineffectiveness of the hedge. Under such circumstances, the ineffective portion is recorded in “Realized investment gains (losses), net.”
The Company formally documents at inception all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives designated as cash flow hedges to specific assets and liabilities on the balance sheet or to forecasted transactions.
When a derivative is designated as a cash flow hedge and is determined to be highly effective, changes in its fair value are recorded in “Accumulated other comprehensive income (loss)” until earnings are affected by the variability of cash flows being hedged (e.g., when periodic settlements on a variable-rate asset or liability are recorded in earnings). At that time, the related portion of deferred gains or losses on the derivative instrument is reclassified and reported in the income statement line item associated with the hedged item.
If it is determined that a derivative no longer qualifies as an effective cash flow hedge, or management removes the hedge designation, the derivative will continue to be carried on the balance sheet at its fair value, with changes in fair value recognized currently in “Realized investment gains (losses), net.” In this scenario, the hedged asset or liability under a fair value hedge will no longer be adjusted for changes in fair value and the existing basis adjustment is amortized to the income statement line associated with the asset or liability. The component of “Accumulated other comprehensive income (loss)” related to discontinued cash flow hedges is reclassified to the income statement line associated with the hedged cash flows consistent with the earnings impact of the original hedged cash flows.
When hedge accounting is discontinued because it is probable that the forecasted transaction will not occur by the end of the specified time period, the derivative will continue to be carried on the balance sheet at its fair value, with changes in fair value recognized currently in “Realized investment gains (losses), net.” Gains and losses that were in “Accumulated other comprehensive income (loss)” pursuant to the hedge of a forecasted transaction are recognized immediately in “Realized investment gains (losses), net.”
If a derivative does not qualify for hedge accounting, all changes in its fair value, including net receipts and payments, are included in “Realized investment gains (losses), net” without considering changes in the fair value of the economically associated assets or liabilities.
F-15
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The Company is a party to financial instruments that contain derivative instruments that are “embedded” in the financial instruments. At inception, the Company assesses whether the economic characteristics of the embedded instrument are clearly and closely related to the economic characteristics of the remaining component of the financial instrument (i.e., the host contract) and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the embedded instrument possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, and (2) a separate instrument with the same terms would qualify as a derivative instrument, the embedded instrument qualifies as an embedded derivative that is separated from the host contract, carried at fair value, and changes in its fair value are included in “Realized investment gains (losses), net.” For certain financial instruments that contain an embedded derivative that otherwise would need to be bifurcated and reported at fair value, the Company may elect to classify the entire instrument as a trading account asset and report it within “Trading account assets, at fair value.”
The Company sells variable annuity contracts that include optional living benefit features that may be treated from an accounting perspective as embedded derivatives. The Company has reinsurance agreements to transfer the risk related to certain of these embedded derivatives to an affiliate, Pruco Reinsurance Ltd. (“Pruco Re”). The embedded derivatives related to the living benefit features and the related reinsurance agreements are carried at fair value and included in “Future policy benefits and other policyholder liabilities” and “Reinsurance recoverables,” respectively. Changes in the fair value are determined using valuation models as described in Note 10, and are recorded in “Realized investment gains (losses), net.”
Income Taxes
The Company is a member of the consolidated federal income tax return of Prudential Financial and primarily files separate company state and local tax returns. Pursuant to the tax allocation arrangement with Prudential Financial, total federal income tax expense is determined on a separate company basis. Members with losses record tax benefits to the extent such losses are recognized in the consolidated federal tax provision.
Deferred income taxes are recognized, based on enacted rates, when assets and liabilities have different values for financial statement and tax reporting purposes. A valuation allowance is recorded to reduce a deferred tax asset to the amount expected to be realized.
The Company’s liability for income taxes includes the liability for unrecognized tax benefits and interest and penalties which relate to tax years still subject to review by the Internal Revenue Service (“IRS”) or other taxing jurisdictions. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards (“tax attributes”), the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the liability for income taxes. The Company classifies all interest and penalties related to tax uncertainties as income tax expense. See Note 9 for additional information regarding income taxes.
Adoption of New Accounting Pronouncements
In January 2010, the FASB issued updated guidance that requires new fair value disclosures about significant transfers between Level 1 and 2 measurement categories and separate presentation of purchases, sales, issuances, and settlements within the roll forward of Level 3 activity. Also, this updated fair value guidance clarifies the disclosure requirements about level of disaggregation and valuation techniques and inputs. This new guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of Level 3 activity, which are effective for interim and annual reporting periods beginning after December 15, 2010. The Company adopted the guidance effective for interim and annual reporting periods beginning after December 15, 2009 on January 1, 2010. The Company adopted the guidance effective for interim and annual reporting periods beginning after December 15, 2010 on January 1, 2011. The required disclosures are provided in Note 4 and Note 5.
In April 2010, the FASB issued authoritative guidance clarifying that an insurance entity should not consider any separate account interests in an investment held for the benefit of policyholders to be the insurer’s interests, and should not combine those interests with its general account interest in the same investment when assessing the investment for consolidation, unless the separate account interests are held for a related party policyholder, whereby consolidation of such interests must be
F-16
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
considered under applicable variable interest guidance. This guidance is effective for interim and annual reporting periods beginning after December 15, 2010 and retrospectively to all prior periods upon the date of adoption, with early adoption permitted. The Company’s adoption of this guidance effective January 1, 2011 did not have a material effect on the Company’s financial position, results of operations, and financial statement disclosures.
In July 2010, the FASB issued updated guidance that requires enhanced disclosures related to the allowance for credit losses and the credit quality of a company’s financing receivable portfolio. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The Company adopted this guidance effective December 31, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning after December 15, 2010. The required disclosures are included above and in Note 3. In January 2011, the FASB deferred the disclosures required by this guidance related to troubled debt restructurings. These disclosures are effective for the first interim or annual reporting period beginning on or after June 15, 2011, concurrent with the effective date of guidance for determining what constitutes a troubled debt restructuring. The disclosures required by this guidance related to troubled debt restructurings were adopted in the third quarter of 2011 and are included above and in Note 3.
In April 2011, the Financial Accounting Standards Board (“FASB”) issued updated guidance clarifying which restructurings constitute troubled debt restructurings. It is intended to assist creditors in their evaluation of whether conditions exist that constitute a troubled debt restructuring. This new guidance is effective for the first interim or annual reporting period beginning on or after June 15, 2011 and should be applied retrospectively to the beginning of the annual reporting period of adoption. The Company’s adoption of this guidance in the third quarter of 2011 did not have a material effect on the Company’s financial position, results of operations, or financial statement disclosures.
Effective January 1, 2012 the Company adopted, retrospectively, updated guidance regarding the presentation of comprehensive income. The updated guidance eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. Under the updated guidance, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The updated guidance does not change the items that are reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The Company opted to present the total of comprehensive income, the components of net income, and the components of other comprehensive income in a single continuous statement of comprehensive income. The Financial Statements included herein reflect the adoption of this updated guidance.
Effective January 1, 2012, the Company adopted retrospectively new authoritative guidance to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. Under the amended guidance acquisition costs are to include only those costs that are directly related to the acquisition or renewal of insurance contracts by applying a model similar to the accounting for loan origination costs. An entity may defer incremental direct costs of contract acquisition with independent third parties or employees that are essential to the contract transaction, as well as the portion of employee compensation, including payroll fringe benefits, and other costs directly related to underwriting, policy issuance and processing, medical inspection, and contract selling for successfully negotiated contracts. Prior period financial information presented in these financial statements has been adjusted to reflect the retrospective adoption of the amended guidance. The impact of the retrospective adoption of this guidance on previously reported December 31, 2011 and December 31, 2010 balances was a reduction in “Deferred policy acquisition costs” of $91 and $95 million, an increase in “Policyholders’ Account Balances” of less than $1 million for both periods, and a reduction in “Total equity” of $59 and $62 million, respectively. The impact of the retrospective adoption of this guidance on previously reported income from continuing operations before income taxes for the years ended December 31, 2011, 2010 and 2009 was an increase of $1 million and decreases of $11 and $6 million, respectively. The lower level of costs now qualifying for deferral will be only partially offset by a lower level of amortization of “Deferred policy acquisition costs,” and, as such, will initially result in lower earnings in future periods primarily reflecting lower deferrals of wholesaler costs. While the adoption of this amended guidance changes the timing of when certain costs are reflected in the Company’s results of operations, it has no effect on the total acquisition costs to be recognized over time and has no impact on the Company’s cash flows.
F-17
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The following tables present amounts as previously reported in 2011 and the effect of the change due to the retrospective adoption of the amended guidance related to the deferral of acquisition costs as described above within the “Effect of Change” column.
Statements of Financial Position:
December 31, 2011 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
Deferred policy acquisition costs | $ | 354,167 | $ | (91,272 | ) | $ | 262,895 | |||||
TOTAL ASSETS | 8,919,414 | (91,272 | ) | 8,828,142 | ||||||||
Policyholders’ account balances | 1,132,897 | 183 | 1,133,080 | |||||||||
Income taxes payable | 55,188 | (32,010 | ) | 23,178 | ||||||||
TOTAL LIABILITIES | 8,297,636 | (31,827 | ) | 8,265,809 | ||||||||
Retained earnings | 370,352 | (65,071 | ) | 305,281 | ||||||||
Accumulated other comprehensive income | 41,498 | 5,626 | 47,124 | |||||||||
TOTAL EQUITY | 621,778 | (59,445 | ) | 562,333 | ||||||||
TOTAL LIABILITIES AND EQUITY | $ | 8,919,414 | $ | (91,272 | ) | $ | 8,828,142 |
December 31, 2010 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
Deferred policy acquisition costs | $ | 365,970 | $ | (94,791 | ) | $ | 271,179 | |||||
TOTAL ASSETS | 7,462,325 | (94,791 | ) | 7,367,534 | ||||||||
Policyholders’ account balances | 1,053,807 | 206 | 1,054,013 | |||||||||
Income taxes | 120,248 | (33,249 | ) | 86,999 | ||||||||
TOTAL LIABILITIES | 6,834,636 | (33,043 | ) | 6,801,593 | ||||||||
Retained earnings | 430,663 | (65,595 | ) | 365,068 | ||||||||
Accumulated other comprehensive income | 25,284 | 3,847 | 29,131 | |||||||||
TOTAL EQUITY | 627,689 | (61,748 | ) | 565,941 | ||||||||
TOTAL LIABILITIES AND EQUITY | $ | 7,462,325 | $ | (94,791 | ) | $ | 7,367,534 |
Statements of Operations:
Year Ended December 31, 2011 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
REVENUES | ||||||||||||
Policy charges and fee income | $ | 113,444 | $ | 28 | $ | 113,472 | ||||||
Total revenues | 121,132 | 28 | 121,160 | |||||||||
BENEFITS AND EXPENSES | ||||||||||||
Amortization of deferred policy acquisition costs | 105,101 | (15,055 | ) | 90,046 | ||||||||
General, administrative and other expenses | 35,785 | 14,276 | 50,061 | |||||||||
Total benefits and expenses | 230,334 | (779 | ) | 229,555 | ||||||||
INCOME FROM OPERATIONS BEFORE INCOME TAXES | (109,202 | ) | 807 | (108,395 | ) | |||||||
Income tax expense | (48,891 | ) | 283 | (48,608 | ) | |||||||
NET INCOME | $ | (60,311 | ) | $ | 524 | $ | (59,787 | ) |
F-18
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Year Ended December 31, 2010 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
REVENUES | ||||||||||||
Policy charges and fee income | $ | 53,446 | $ | 165 | $ | 53,611 | ||||||
Total revenues | 218,237 | 165 | 218,402 | |||||||||
BENEFITS AND EXPENSES | ||||||||||||
Amortization of deferred policy acquisition costs | 12,821 | (4,159 | ) | 8,662 | ||||||||
General, administrative and other expenses | 27,002 | 14,995 | 41,997 | |||||||||
Total benefits and expenses | 76,750 | 10,836 | 87,586 | |||||||||
INCOME FROM OPERATIONS BEFORE INCOME TAXES | 141,487 | (10,671 | ) | 130,816 | ||||||||
Income tax expense | 43,542 | (3,734 | ) | 39,808 | ||||||||
NET INCOME | $ | 97,945 | $ | (6,937 | ) | $ | 91,008 |
Year Ended December 31, 2009 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
REVENUES | ||||||||||||
Policy charges and fee income | $ | 69,234 | $ | (35 | ) | $ | 69,199 | |||||
Total revenues | 181,616 | (35 | ) | 181,581 | ||||||||
BENEFITS AND EXPENSES | ||||||||||||
Amortization of deferred policy acquisition costs | 22,842 | (6,472 | ) | 16,370 | ||||||||
General, administrative and other expenses | 17,950 | 12,207 | 30,157 | |||||||||
Total benefits and expenses | 105,589 | 5,735 | 111,324 | |||||||||
INCOME FROM OPERATIONS BEFORE INCOME TAXES | 76,027 | (5,770 | ) | 70,257 | ||||||||
Income tax expense | 21,006 | (2,020 | ) | 18,986 | ||||||||
NET INCOME | $ | 55,021 | $ | (3,750 | ) | $ | 51,271 |
Statements of Cash Flows:
Year Ended December 31, 2011 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
CASH FLOWS FROM OPERATING ACTIVITIES | ||||||||||||
Net income | $ | (60,311 | ) | $ | 524 | $ | (59,787 | ) | ||||
Policy charges and fee income | (25,594 | ) | (28 | ) | (25,622 | ) | ||||||
Change in: | ||||||||||||
Deferred policy acquisition costs | 754 | (779 | ) | (25 | ) | |||||||
Income taxes payable | (73,789 | ) | 283 | (73,506 | ) | |||||||
Cash flows from (used in) operating activities | $ | (61,278 | ) | $ | 0 | $ | (61,278 | ) |
F-19
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Year Ended December 31, 2010 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
CASH FLOWS FROM OPERATING ACTIVITIES | ||||||||||||
Net income | $ | 97,945 | $ | (6,937 | ) | $ | 91,008 | |||||
Policy charges and fee income | (13,471 | ) | (165 | ) | (13,636 | ) | ||||||
Change in: | ||||||||||||
Deferred policy acquisition costs | (72,689 | ) | 10,836 | (61,853 | ) | |||||||
Income taxes payable | 14,700 | (3,734 | ) | 10,966 | ||||||||
Cash flows from (used in) operating activities | $ | (14,550 | ) | $ | 0 | $ | (14,550 | ) |
Year Ended December 31, 2009 | ||||||||||||
|
| |||||||||||
As Previously Reported | Effect of Change | As Currently Reported | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
CASH FLOWS FROM OPERATING ACTIVITIES | ||||||||||||
Net income | $ | 55,021 | $ | (3,750 | ) | $ | 51,271 | |||||
Policy charges and fee income | (15,597 | ) | 35 | (15,562 | ) | |||||||
Change in: | ||||||||||||
Deferred policy acquisition costs | (34,550 | ) | 5,735 | (28,815 | ) | |||||||
Income taxes payable | 6,631 | (2,020 | ) | 4,611 | ||||||||
Cash flows from (used in) operating activities | $ | 32,366 | $ | 0 | $ | 32,366 |
Future Adoption of New Accounting Pronouncements
In December 2011, the FASB issued updated guidance regarding the disclosure of offsetting assets and liabilities. This new guidance requires an entity to disclose information on both a gross basis and net basis about instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. This new guidance is effective for annual reporting periods beginning on or after January 1, 2013, and interim reporting periods within those years, and should be applied retrospectively for all comparative periods presented. The Company is currently assessing the impact of the guidance on the Company’s consolidated financial position, results of operations, and financial statement disclosures.
In May 2011, the FASB issued updated guidance regarding the fair value measurements and disclosure requirements. The updated guidance clarifies existing guidance related to the application of fair value measurement methods and requires expanded disclosures. This new guidance is effective for the first interim or annual reporting period beginning after December 15, 2011 and should be applied prospectively. The Company expects this guidance to have an impact on its financial statement disclosures but limited, if any, impact on the Company’s financial position or results of operations.
In April 2011, the FASB issued updated guidance regarding the assessment of effective control for repurchase agreements. This new guidance is effective for the first interim or annual reporting period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. The Company’s adoption of this guidance effective January 1, 2012 is not expected to have a material effect on the Company’s consolidated financial position, results of operations, and financial statement disclosures.
F-20
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
3. INVESTMENTS
Fixed Maturities and Equity Securities
The following tables provide information relating to fixed maturities and equity securities (excluding investments classified as trading) as of the dates indicated:
December 31, 2011 | ||||||||||||||||||||
Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | Other-than- temporary impairments in AOCI (4) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fixed maturities, available-for-sale | ||||||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | 29,889 | $ | 6,049 | $ | - | $ | 35,939 | $ | - | ||||||||||
Obligations of U.S. states and their political subdivisions | - | - | - | - | - | |||||||||||||||
Foreign government bonds | 20,868 | 2,163 | - | 23,030 | - | |||||||||||||||
Public utilities | 119,583 | 10,810 | 225 | 130,169 | - | |||||||||||||||
All other corporate securities | 713,531 | 55,770 | 622 | 768,678 | (45) | |||||||||||||||
Asset-backed securities (1) | 72,050 | 1,647 | 2,065 | 71,632 | (3,513) | |||||||||||||||
Commercial mortgage-backed securities | 89,238 | 6,770 | 2 | 96,006 | - | |||||||||||||||
Residential mortgage-backed securities (2) | 87,749 | 6,859 | 158 | 94,450 | (391) | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Total fixed maturities, available-for-sale | $ | 1,132,908 | $ | 90,068 | $ | 3,072 | $ | 1,219,904 | $ | (3,949) | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Equity securities, available-for-sale | ||||||||||||||||||||
Common Stocks: | ||||||||||||||||||||
Industrial, miscellaneous & other | 405 | - | 70 | 335 | ||||||||||||||||
Non-redeemable preferred stocks | 1,116 | 1 | 32 | 1,085 | ||||||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Total equity securities, available-for-sale (3) | $ | 1,521 | $ | 1 | $ | 102 | $ | 1,420 | ||||||||||||
|
|
|
|
|
|
|
|
(1) | Includes credit tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, education loans, and other asset types. |
(2) | Includes publicly traded agency pass-through securities and collateralized mortgage obligations. |
(3) | During 2011, perpetual preferred stocks of $1.5 million were reclassified to “Trading Account Assets.” Prior periods were not restated. |
(4) | Represents the amount of other-than-temporary impairment losses in “Accumulated other comprehensive income (loss),” or “AOCI” which were not included in earnings. Amount excludes $3 million of net unrealized gains (losses) on impaired securities relating to changes in the fair value of such securities subsequent to the impairment measurement date. |
F-21
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
December 31, 2010 | ||||||||||||||||||||
Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | Other-than- temporary impairments in AOCI (3) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fixed maturities, available-for-sale | ||||||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | 34,292 | $ | 2,199 | $ | 41 | $ | 36,450 | $ | - | ||||||||||
Obligations of U.S. states and their political subdivisions | - | - | - | - | - | |||||||||||||||
Foreign government bonds | 21,034 | 1,644 | - | 22,678 | - | |||||||||||||||
Corporate securities | 707,754 | 47,472 | 2,945 | 752,281 | (26) | |||||||||||||||
Asset-backed securities (1) | 57,808 | 1,671 | 5,446 | 54,033 | (8,856) | |||||||||||||||
Commercial mortgage-backed securities | 97,467 | 5,721 | 87 | 103,101 | - | |||||||||||||||
Residential mortgage-backed securities (2) | 89,300 | 6,746 | 48 | 95,998 | (454) | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Total fixed maturities, available-for-sale | $ | 1,007,655 | $ | 65,453 | $ | 8,567 | $ | 1,064,541 | $ | (9,336) | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Equity securities, available-for-sale | ||||||||||||||||||||
Common Stocks: | ||||||||||||||||||||
Industrial, miscellaneous & other | 226 | 178 | 29 | 375 | ||||||||||||||||
Non-redeemable preferred stocks | 380 | - | 217 | 163 | ||||||||||||||||
Perpetual preferred stocks | 1,695 | - | 159 | 1,536 | ||||||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Total equity securities available-for-sale | $ | 2,301 | $ | 178 | $ | 405 | $ | 2,074 | ||||||||||||
|
|
|
|
|
|
|
|
(1) | Includes credit tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, education loans, and other asset types. |
(2) | Includes publicly traded agency pass-through securities and collateralized mortgage obligations. |
(3) | Represents the amount of other-than-temporary impairment losses in “Accumulated other comprehensive income (loss),” or “AOCI” which, were not included in earnings. Amount excludes $5 million of net unrealized gains (losses) on impaired securities relating to changes in the fair value of such securities subsequent to the impairment measurement date. |
The amortized cost and fair value of fixed maturities by contractual maturities at December 31, 2011, are as follows:
Available-for-Sale | ||||||||
Amortized Cost | Fair Value | |||||||
(in thousands) | ||||||||
Due in one year or less | $ | 48,539 | $ | 49,149 | ||||
Due after one year through five years | 324,229 | 350,238 | ||||||
Due after five years through ten years | 354,984 | 385,295 | ||||||
Due after ten years | 156,119 | 173,134 | ||||||
Asset-backed securities | 72,050 | 71,632 | ||||||
Commercial mortgage-backed securities | 89,238 | 96,006 | ||||||
Residential mortgage-backed securities | 87,749 | 94,450 | ||||||
|
|
|
| |||||
Total | $ | 1,132,908 | $ | 1,219,904 | ||||
|
|
|
|
Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Asset-backed, commercial mortgage-backed, and residential mortgage-backed securities are shown separately in the table above, as they are not due at a single maturity date.
F-22
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The following table depicts the sources of fixed maturity proceeds, equity security proceeds, and related investment gains (losses), as well as losses on impairments of both fixed maturities and equity securities:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Fixed maturities, available-for-sale | ||||||||||||
Proceeds from sales | $ | 36,118 | $ | 35,017 | $ | 59,587 | ||||||
Proceeds from maturities/repayments | 135,127 | 157,785 | 194,623 | |||||||||
Gross investment gains from sales, prepayments, and maturities | 2,614 | 4,160 | 1,540 | |||||||||
Gross investment losses from sales and maturities | (88) | (83) | (3,027) | |||||||||
Equity securities, available-for-sale | ||||||||||||
Proceeds from sales | $ | 2 | $ | - | $ | - | ||||||
Proceeds from maturities/repayments | 473 | 2,000 | - | |||||||||
Gross investment gains from sales | 368 | 139 | - | |||||||||
Gross investment losses from sales | - | - | - | |||||||||
Fixed maturity and equity security impairments | ||||||||||||
Net writedowns for other-than-temporary impairment losses | $ | (268) | $ | (2,554) | $ | (6,070) | ||||||
Writedowns for other-than-temporary impairment losses on equity securities | $ | (326) | $ | - | $ | (139) |
(1) | Excludes the portion of other-than-temporary impairments recorded in “Other comprehensive income (loss),” representing any difference between the fair value of the impaired debt security and the net present value of its projected future cash flows at the time of impairment. |
As discussed in Note 2, a portion of certain other-than-temporary impairment (“OTTI”) losses on fixed maturity securities are recognized in “Other comprehensive income (loss)” (“OCI”). The net amount recognized in earnings (“credit loss impairments”) represents the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment. Any remaining difference between the fair value and amortized cost is recognized in OCI. The following tables set forth the amount of pre-tax credit loss impairments on fixed maturity securities held by the Company as of the dates indicated, for which a portion of the OTTI loss was recognized in OCI, and the corresponding changes in such amounts.
Credit losses recognized in earnings on fixed maturity securities held by the Company for which a portion of the OTTI loss was recognized in OCI
Year Ended December 31, | Year Ended December 31, | |||||||
|
| |||||||
2011 | 2010 | |||||||
|
| |||||||
(in thousands) | (in thousands) | |||||||
Balance, beginning of period | $ | 6,763 | $ | 7,431 | ||||
Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period | (3,643) | (1,059) | ||||||
Credit loss impairments previously recognized on securities impaired to fair value during the period (1) | - | (992) | ||||||
Credit loss impairment recognized in the current period on securities not previously impaired | - | - | ||||||
Additional credit loss impairments recognized in the current period on securities previously impaired | 268 | 1,965 | ||||||
Increases due to the passage of time on previously recorded credit losses | 323 | 530 | ||||||
Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected | (273) | (1,112) | ||||||
|
| |||||||
Balance, end of period | $ | 3,438 | $ | 6,763 | ||||
|
|
(1) Represents circumstances where the Company determined in the current period that it intends to sell the security or it is more likely than not that it will be required to sell the security before recovery of the security’s amortized cost.
F-23
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Trading Account Assets
The following table provides information relating to trading account assets, at fair value as of the dates indicated:
December 31, 2011 | December 31, 2010 | |||||||||||||||
|
|
|
| |||||||||||||
Amortized Cost | Fair Value | Amortized Cost | Fair Value | |||||||||||||
|
|
|
|
|
|
|
| |||||||||
(in thousands) | ||||||||||||||||
Equity securities (1) | 1,695 | 1,569 | - | - | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total trading account assets | $ | 1,695 | $ | 1,569 | $ | - | $ | - | ||||||||
|
|
|
|
|
|
|
|
(1) During 2011, perpetual preferred stocks of $1.5 million were reclassified from “Equity Securities, available-for-sale”. Prior periods were not restated.
The net change in unrealized gains (losses) from trading account assets still held at period end, recorded within “Other income” was ($0.1) million, $0.0 and $0.0 during the years ended December 31, 2011, 2010 and 2009, respectively.
Commercial Mortgage and Other Loans
The Company’s commercial mortgage and other loans are comprised as follows as of the dates indicated:
2011 | 2010 | |||||||||||||||
Amount (in thousands) | % of Total | Amount (in thousands) | % of Total | |||||||||||||
Commercial mortgage and other loans by property type: | ||||||||||||||||
Industrial buildings | $ | 42,883 | 18.5 % | $ | 35,745 | 19.4 | % | |||||||||
Retail | 55,215 | 23.8 | 36,046 | 19.6 | ||||||||||||
Apartments/Multi-Family | 37,689 | 16.3 | 25,340 | 13.8 | ||||||||||||
Office buildings | 26,100 | 11.3 | 30,468 | 16.6 | ||||||||||||
Hospitality | 14,475 | 6.2 | 10,273 | 5.6 | ||||||||||||
Other | 37,150 | 16.0 | 33,834 | 18.4 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total commercial mortgage loans | 213,512 | 92.2 | 171,706 | 93.4 | ||||||||||||
Agricultural property loans | 18,098 | 7.8 | 12,140 | 6.6 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total commercial mortgage and agricultural loans by property type | 231,610 | 100.0 % | 183,846 | 100.0 | % | |||||||||||
|
|
|
| |||||||||||||
Valuation allowance | (1,410) | (1,409) | ||||||||||||||
|
|
|
| |||||||||||||
Total net commercial and agricultural mortgage loans by property type | $ | 230,200 | $ | 182,437 | ||||||||||||
|
|
|
|
The commercial mortgage and agricultural loans are geographically dispersed throughout the United States with the largest concentrations in Florida (10%), Texas (9%), and New Jersey (9%) at December 31, 2011.
Activity in the allowance for losses for all commercial mortgage and other loans, for the years ended December 31, 2011, 2010 and 2009, is as follows:
2011 (2) | 2010 (2) | 2009 (2) | ||||||||||
(in thousands) | ||||||||||||
Allowance for losses, beginning of year | $ | 1,409 | $ | 2,379 | $ | 1,444 | ||||||
Addition to / (release of) allowance of losses | 1 | (970) | 935 | |||||||||
|
|
|
|
|
| |||||||
Allowance for losses, end of year (1) | $ | 1,410 | $ | 1,409 | $ | 2,379 | ||||||
|
|
|
|
|
|
1) Agricultural loans represent $0.02 million, $0.02 million and $0.0 million of the ending allowance at December 31, 2011, 2010 and 2009, respectively.
2) Valuation allowances for 2011 and 2010 are presented in a format consistent with new disclosure requirements under the updated guidance issued by FASB in 2011. Valuation allowances for 2009 are provided consistent with the prior presentation.
F-24
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The following tables set forth the allowance for credit losses and the recorded investment in commercial mortgage and agricultural loans for the years ended December 31, 2011 and 2010:
December 31, 2011 | December 31, 2010 | |||||||
Total Loans | ||||||||
(in thousands) | ||||||||
Allowance for Credit Losses: | ||||||||
Ending Balance: individually evaluated for impairment (1) | $ | - | $ | 424 | ||||
Ending Balance: collectively evaluated for impairment (2) | 1,410 | 985 | ||||||
|
|
|
| |||||
Total ending balance | $ | 1,410 | $ | 1,409 | ||||
|
|
|
| |||||
Recorded Investment: (3) | ||||||||
Ending balance: individually evaluated for impairment (1) | $ | - | $ | 3,847 | ||||
Ending balance: collectively evaluated for impairment (2) | 231,612 | 179,999 | ||||||
|
|
|
| |||||
Total ending balance, gross of reserves | $ | 231,612 | $ | 183,846 | ||||
|
|
|
|
(1) | There were no agricultural loans individually evaluated for impairments at December 31, 2011 and December 31, 2010. |
(2) | Agricultural loans collectively evaluated for impairment had a recorded investment of $18 million and $12 million and related allowance of $0.0 million at December 31, 2011 and December 31, 2010, respectively. |
(3) | Recorded investment reflects the balance sheet carrying value gross of related allowance. |
Impaired loans include those loans for which it is probable that amounts due according to the contractual terms of the loan agreement will not all be collected.
As of December 31, 2011, there were no impaired commercial mortgage loans identified in management’s specific review. As of December 31, 2011 impaired commercial mortgage loans identified in management’s specific review of probable loan losses consisted of Hospitality commercial mortgage loans with a recorded investment of $3.8 million, an unpaid principal balance of $3.8 million and the related allowance for losses was $0.4 million. Recorded investment reflects the balance sheet carrying value gross of related allowance.
Impaired commercial mortgage and other loans with no allowance for losses are loans in which the fair value of the collateral or the net present value of the loans’ expected future cash flows equals or exceeds the recorded investment. As of December 31, 2011 and December 31, 2010, the Company held no such loans. See Note 2 for information regarding the Company’s accounting policies for non-performing loans.
As described in Note 2, loan-to-value and debt service coverage ratios are measures commonly used to assess the quality of commercial mortgage and other loans. As of December 31, 2011 and 2010, 94% of the $232 million recorded investment and 90% of the $184 million recorded investment, respectively, had a loan-to-value ratio of less than 80%. As of December 31, 2011 and 2010, 99% and 98% of the recorded investment, respectively, had a debt service coverage ratio of 1.0X or greater. As of December 31, 2011, approximately $2 million or 1% of the recorded investment had a loan-to-value ratio greater than 100% or debt service coverage ratio less than 1.0X, reflecting loans where the mortgage amount exceeds the collateral value or where current debt payments are greater than income from property operations; none of which related to agricultural loans. As of December 31, 2010, approximately $8 million or 4% of the recorded investment had a loan-to-value ratio greater than 100% or debt service coverage ratio less than 1.0X; none of which related to agricultural loans.
As of December 31, 2011 and 2010, all commercial mortgage and other loans were in current status. The Company defines current in its aging of past due commercial mortgage and agricultural loans as less than 30 days past due.
Commercial mortgage and other loans on nonaccrual status as of December 31, 2011 and 2010, $3.2 million and $3.8 million, respectively, primarily related to Hospitality. See Note 2 for further discussion regarding nonaccrual status loans.
For the year ended December 31 2011, there were no commercial mortgage and other loans sold or acquired.
F-25
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Other Long term Investments
“Other long-term investments” are comprised as follows at December 31:
2011 | 2010 | |||||||
(in thousands) | ||||||||
Company’s investment in Separate accounts | $ | 1,662 | $ | 1,893 | ||||
Joint ventures and limited partnerships | 20,725 | 15,020 | ||||||
Derivatives (1) | 6,688 | - | ||||||
|
|
|
| |||||
Total other long-term investments | $ | 29,075 | $ | 16,913 | ||||
|
|
|
|
(1) | A derivative balance of $(0.9) million at December 31, 2010 was reclassed to Other Liabilities. |
Net Investment Income
Net investment income for the years ended December 31, was from the following sources:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Fixed maturities, available-for-sale | $ | 57,285 | $ | 57,502 | $ | 53,615 | ||||||
Equity securities, available-for-sale | 12 | 148 | 218 | |||||||||
Trading account assets | 11 | - | - | |||||||||
Commercial mortgage and other loans | 12,187 | 11,264 | 9,822 | |||||||||
Policy loans | 9,503 | 9,363 | 9,177 | |||||||||
Short-term investments and cash equivalents | 85 | 129 | 434 | |||||||||
Other long-term investments | 1,718 | 1,691 | (666) | |||||||||
|
|
|
|
|
| |||||||
Gross investment income | 80,801 | 80,097 | 72,600 | |||||||||
Less: investment expenses | (3,245) | (3,053) | (2,656) | |||||||||
|
|
|
|
|
| |||||||
Net investment income | $ | 77,556 | $ | 77,044 | $ | 69,944 | ||||||
|
|
|
|
|
|
Carrying value for non-income producing assets included in fixed maturities totaled $0 million as of December 31, 2011. Non-income producing assets represent investments that have not produced income for the twelve months preceding December 31, 2011.
Realized Investment Gains (Losses), Net
Realized investment gains (losses), net, for the years ended December 31, were from the following sources:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Fixed maturities | $ | 2,257 | $ | 1,523 | $ | (7,557) | ||||||
Equity securities | 42 | 139 | (138) | |||||||||
Commercial mortgage and other loans | (1) | 970 | (935) | |||||||||
Short-term investments and cash equivalents | - | 5 | - | |||||||||
Joint ventures and limited partnerships | (44) | - | (124) | |||||||||
Derivatives | (112,310) | 54,378 | 22,268 | |||||||||
|
|
|
|
|
| |||||||
Realized investment gains (losses), net | $ | (110,056) | $ | 57,015 | $ | 13,514 | ||||||
|
|
|
|
|
|
F-26
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Net Unrealized Investment Gains (Losses)
Net unrealized investment gains and losses on securities classified as “available for sale” and certain other long-term investments and other assets are included in the Statements of Financial Position as a component of “Accumulated other comprehensive income (loss),” or “AOCI.” Changes in these amounts include reclassification adjustments to exclude from “Other comprehensive income (loss)” those items that are included as part of “Net income” for a period that had been part of “Other comprehensive income (loss)” in earlier periods. The amounts for the periods indicated below, split between amounts related to fixed maturity securities on which an OTTI loss has been recognized, and all other net unrealized investment gains and losses, are as follows:
Net Unrealized Investment Gains and Losses on Fixed Maturity Securities on which an OTTI loss has been recognized
Net Unrealized Gains (Losses) on Investments | Deferred Policy Acquisition Costs and Other Costs | Policy Holder Account Balances | Deferred Income Tax (Liability) Benefit | Accumulated Other Comprehensive Income (Loss) Related To Net Unrealized Investment Gains (Losses) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Balance, December 31, 2008 | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||
Cumulative impact of the adoption of new authoritative guidance on January 1, 2009 | (4,049) | 290 | - | 1,316 | (2,443) | |||||||||||||||
Cumulative impact of the retrospective adoption of new authoritative guidance on January 1, 2012 | - | - | - | - | - | |||||||||||||||
Net investment gains (losses) on investments arising during the period | 4,471 | - | - | (1,565) | 2,906 | |||||||||||||||
Reclassification adjustment for OTTI losses included in net income | 5,080 | - | - | (1,778) | 3,302 | |||||||||||||||
Reclassification adjustment for OTTI gains excluded from net income(1) | (11,483) | - | - | 4,019 | (7,464) | |||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs and other costs | - | 2,598 | - | (909) | 1,689 | |||||||||||||||
Impact of net unrealized investment (gains) losses on Policyholders’ account balance | - | - | (1,378) | 482 | (896) | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2009 | $ | (5,981) | $ | 2,888 | $ | (1,378) | $ | 1,565 | $ | (2,906) | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Net investment gains (losses) on investments arising during the period | (821) | - | - | 287 | (534) | |||||||||||||||
Reclassification adjustment for OTTI losses included in net income | 2,504 | - | - | (876) | 1,628 | |||||||||||||||
Reclassification adjustment for OTTI gains excluded from net income(1) | (11) | - | - | 4 | (7) | |||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs and other costs | - | (1,040) | - | 364 | (676) | |||||||||||||||
Impact of net unrealized investment (gains) losses on policyholders’ account balances | - | - | 594 | (208) | 386 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2010 | $ | (4,309) | $ | 1,848 | $ | (784) | $ | 1,136 | $ | (2,109) | ||||||||||
|
|
|
|
|
|
|
|
|
|
F-27
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Net investment gains (losses) on investments arising during the period | 843 | - | - | (295) | 548 | |||||||||||||||
Reclassification adjustment for OTTI losses included in net income | 2,049 | - | - | (717) | 1,332 | |||||||||||||||
Reclassification adjustment for OTTI gains excluded from net income(1) | - | - | - | - | - | |||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs | - | (1,109) | - | 388 | (721) | |||||||||||||||
Impact of net unrealized investment (gains) losses on policyholders’ account balances | - | - | 642 | (225) | 417 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2011 | $ | (1,417) | $ | 739 | $ | (142) | $ | 287 | $ | (533) | ||||||||||
|
|
|
|
|
|
|
|
|
|
All Other Net Unrealized Investment Gains and Losses in AOCI
Net Unrealized Gains/(Losses) on Investments(1) | Deferred Policy Acquisition Costs and Other Costs | Policy Holder Account Balances | Deferred Income Tax (Liability) Benefit | Accumulated Other Comprehensive Income (Loss) Related To Net Unrealized Investment Gains (Losses) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Balance, December 31, 2008 | $ | (70,920) | $ | 41,193 | $ | (17,457) | $ | 16,514 | $ | (30,670) | ||||||||||
Cumulative impact of the adoption of new authoritative guidance on January 1, 2009 | (2,016) | 33 | - | 694 | (1,289) | |||||||||||||||
Cumulative impact of the retrospective adoption of new authoritative guidance on January 1, 2012 | - | (10,502) | 74 | 3,650 | (6,778) | |||||||||||||||
Net investment gains (losses) on investments arising during the period | 91,116 | - | - | (31,891) | 59,225 | |||||||||||||||
Reclassification adjustment for (gains) losses included in net income | 2,616 | - | - | (916) | 1,700 | |||||||||||||||
Reclassification adjustment for OTTI losses excluded from net income(2) | 11,483 | - | - | (4,019) | 7,464 | |||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs | - | (46,579) | - | 16,303 | (30,276) | |||||||||||||||
Impact of net unrealized investment (gains) losses on policyholders’ account balances | - | - | 23,632 | (8,271) | 15,361 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2009 | $ | 32,279 | $ | (15,855) | $ | 6,249 | $ | (7,936) | $ | 14,737 | ||||||||||
Net investment gains (losses) on investments arising during the period | 24,868 | - | - | (8,704) | 16,164 | |||||||||||||||
Reclassification adjustment for (gains) losses included in net income | 4,166 | - | - | (1,458) | 2,708 | |||||||||||||||
Reclassification adjustment for OTTI losses excluded from net income(2) | 11 | - | - | (4) | 7 | |||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs and other costs | - | (8,437) | - | 2,953 | (5,484) | |||||||||||||||
Impact of net unrealized investment (gains) losses on policyholders’ account balances | - | - | 4,712 | (1,649 | ) | 3,063 | ||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2010 | $ | 61,324 | $ | (24,292 | ) | $ | 10,961 | $ | (16,798 | ) | $ | 31,195 |
F-28
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Net investment gains (losses) on investments arising during the period | 23,930 | - | - | (8,376) | 15,555 | |||||||||||||||
Reclassification adjustment for (gains) losses included in net income | 4,348 | - | - | (1,522) | 2,826 | |||||||||||||||
Reclassification adjustment for OTTI losses excluded | ||||||||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs | - | (7,406) | - | 2,592 | (4,814) | |||||||||||||||
Impact of net unrealized investment (gains) losses on policyholders’ account balances | - | - | 4,418 | (1,546) | 2,872 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, December 31, 2011 | $ | 89,602 | $ | (31,698) | $ | 15,379 | $ | (25,649) | $ | 47,634 | ||||||||||
|
|
|
|
|
|
|
|
|
|
(1) | Include cash flow hedges. See Note 5 for information on cash flow hedges. |
The table below presents net unrealized gains (losses) on investments by asset class at December 31:
December 31, 2011 | December 31, 2010 | December 31, 2009 | ||||||||||
(in thousands) | ||||||||||||
Fixed maturity securities on which an OTTI loss has been recognized | $ | (1,417) | $ | (4,309) | $ | (5,981) | ||||||
Fixed maturity securities, available for sale-all other | 88,414 | 61,195 | 31,975 | |||||||||
Equity securities, available for sale | (100) | (227) | (177) | |||||||||
Derivatives designated as cash flow hedges (1) | (630) | (1,100) | (675) | |||||||||
Other investments | 1,918 | 1,456 | 1,156 | |||||||||
|
|
|
|
|
| |||||||
Net unrealized gains (losses) on investments | $ | 88,185 | $ | 57,015 | $ | 26,298 | ||||||
|
|
|
|
|
|
(1) | See Note 5 for more information on cash flow hedges. |
Duration of Gross Unrealized Loss Positions for Fixed Maturities
The following table shows the fair value and gross unrealized losses aggregated by investment category and length of time that individual fixed maturity securities have been in a continuous unrealized loss position, at December 31:
December 31, 2011 | ||||||||||||||||||||||||
Less than twelve months | Twelve months or more | Total | ||||||||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Fixed maturities, available for sale | ||||||||||||||||||||||||
U.S. Treasury securities and obligations of | ||||||||||||||||||||||||
U.S. government authorities and agencies | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||||
Corporate securities | 31,041 | 670 | 998 | 177 | 32,039 | 847 | ||||||||||||||||||
Commercial mortgage-backed securities | - | - | 1,051 | 2 | 1,051 | 2 | ||||||||||||||||||
Asset-backed securities | 33,246 | 285 | 7,384 | 1,780 | 40,630 | 2,065 | ||||||||||||||||||
Residential mortgage-backed securities | 4,367 | 158 | - | - | 4,367 | 158 | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | 68,654 | $ | 1,113 | $ | 9,433 | $ | 1,959 | $ | 78,087 | $ | 3,072 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
F-29
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
December 31, 2010 | ||||||||||||||||||||||||
Less than twelve months | Twelve months or more | Total | ||||||||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Fixed maturities, available for sale | ||||||||||||||||||||||||
U.S. Treasury securities and obligations of | ||||||||||||||||||||||||
U.S. government authorities and agencies | $ | 2,078 | $ | 41 | $ | - | $ | - | $ | 2,078 | $ | 41 | ||||||||||||
Corporate securities | 73,679 | 2,524 | 6,545 | 421 | 80,224 | 2,945 | ||||||||||||||||||
Asset-backed securities | 10,608 | 169 | 16,442 | 5,277 | 27,050 | 5,446 | ||||||||||||||||||
Commercial mortgage-backed securities | 7,148 | 87 | - | - | 7,148 | 87 | ||||||||||||||||||
Residential mortgage-backed securities | 3,219 | 48 | - | - | 3,219 | 48 | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | 96,732 | $ | 2,869 | $ | 22,987 | $ | 5,698 | $ | 119,719 | $ | 8,567 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
The gross unrealized losses at December 31, 2011 and December 31, 2010 are composed of $1 million and $6 million, respectively, related to high or highest quality securities based on NAIC or equivalent rating and $2 million and $3 million, respectively, related to other than high or highest quality securities based on NAIC or equivalent rating. At December 31, 2011, $1.6 million of the gross unrealized losses represented declines in value of greater than 20%, $0.1 million of which had been in that position for less than six months, as compared to $5 million at December 31, 2010 that represented declines in value of greater than 20%, none of which had been in that position for less than six months. At December 31, 2011 and December 31, 2010, the $2 million and $6 million, respectively, of gross unrealized losses of twelve months or more were concentrated in asset backed securities. In accordance with its policy described in Note 2, the Company concluded that an adjustment to earnings for other-than-temporary impairments for these securities was not warranted at December 31, 2011 and December 31, 2010. These conclusions are based on a detailed analysis of the underlying credit and cash flows on each security. The gross unrealized losses are primarily attributable to credit spread widening and increased liquidity discounts. At December 31, 2011, the Company does not intend to sell the securities and it is not more likely than not that the Company will be required to sell the securities before the anticipated recovery of its remaining amortized cost basis.
Duration of Gross Unrealized Loss Positions for Equity Securities
The following table shows the fair value and gross unrealized losses aggregated by length of time that individual equity securities have been in a continuous unrealized loss position, at December 31:
December 31, 2011 | ||||||||||||||||||||||||
Less than twelve months | Twelve months or more | Total | ||||||||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Equity securities, available for sale | $ | 316 | $ | 102 | $ | - | $ | - | $ | 316 | $ | 102 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2010 | ||||||||||||||||||||||||
Less than twelve months | Twelve months or more | Total | ||||||||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Equity securities, available for sale | $ | 255 | $ | 245 | $ | 1,536 | $ | 160 | $ | 1,791 | $ | 405 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
At December 31, 2011, $99 thousand of the gross unrealized losses represented declines of greater than 20%, all of which have been in that position for less than nine months. At December 31, 2010, $245 thousand of the gross unrealized losses represented declines of greater than 20%, all of which have been in that position for less than six months. Included in the
F-30
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
December 31, 2010 table above are perpetual preferred securities. Perpetual preferred securities have characteristics of both debt and equity securities. Since an impairment model similar to fixed maturity securities is applied to these securities, an other-than-temporary impairment has not been recognized on certain perpetual preferred securities that have been in a continuous unrealized loss position for twelve months or more as of December 31, 2011 and December 31, 2010. In accordance with its policy described in Note 2, the Company concluded that an adjustment for other-than-temporary impairments for these equity securities was not warranted at December 31, 2011 and December 31, 2010.
Securities Pledged and Special Deposits
The Company pledges as collateral investment securities it owns to unaffiliated parties through certain transactions, including securities lending, securities sold under agreements to repurchase and futures contracts. At December 31, the carrying value of investments pledged to third parties as reported in the Statements of Financial Position included the following:
2011 | 2010 | |||||||
(in thousands) | ||||||||
Fixed maturity securities, available for sale - all other | $ 19,670 | $ 3,314 | ||||||
|
|
|
| |||||
Total securities pledged | $ 19,670 | $ 3,314 | ||||||
|
|
|
|
As of December 31, 2011, the carrying amount of the associated liabilities supported by the pledged collateral was $20.2 million. Of this amount, $3.2 million was “Securities sold under agreements to repurchase” and $17.0 million was “Cash collateral for loaned securities. As of December 31, 2010, the carrying amount of the associated liabilities supported by the pledged collateral was $3.4 million. Of this amount, $3.0 million was “Securities sold under agreements to repurchase” and $0.4 million was “Cash collateral for loaned securities.”
Fixed maturities of $0.5 million at December 31, 2010 were on deposit with governmental authorities or trustees as required by certain insurance laws.
4. DEFERRED POLICY ACQUISITION COSTS
The balances of and changes in deferred policy acquisition costs for the year ended December 31, are as follows:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Balance, beginning of year | $ | 271,179 | $ | 218,756 | $ | 232,145 | ||||||
Capitalization of commissions, sales and issue expenses | 90,072 | 70,516 | 44,965 | |||||||||
Amortization- Impact of assumption and experience unlocking and true-ups | (983) | 13,484 | 11,607 | |||||||||
Amortization- All other | (89,063) | (22,147) | (27,976) | |||||||||
Change in unrealized investment gains/(losses) | (8,310) | (9,430) | (41,985) | |||||||||
|
|
|
|
|
| |||||||
Balance, end of year | $ | 262,895 | $ | 271,179 | $ | 218,756 | ||||||
|
|
|
|
|
|
Deferred acquisition costs include reductions in capitalization and amortization related to reinsurance expense allowances resulting from the coinsurance treaties with Prudential Arizona Reinsurance Captive Company, or “PARCC,” and Prudential Arizona Reinsurance Term Company, or “PAR TERM” as discussed in Note 13.
Ceded capitalization was $19 million, $29 million and $15 million in 2011, 2010 and 2009, respectively. Ceded amortization relating to this treaty included amounted to $7 million, $9 million and $8 million in 2011, 2010 and 2009, respectively.
F-31
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
5. POLICYHOLDERS’ LIABILITIES
Future Policy Benefits
Future policy benefits at December 31 are as follows:
2011 | 2010 | |||||||
(in thousands) | ||||||||
Life insurance | $ | 602,884 | $ | 534,286 | ||||
Individual annuities | 6,744 | 6,149 | ||||||
Policy claims and other liabilities | 82,339 | (37,081) | ||||||
|
|
|
| |||||
Total future policy benefits | $ | 691,967 | $ | 503,354 | ||||
|
|
|
|
Life insurance liabilities include reserves for death benefits and other policy benefits. Individual annuity liabilities include reserves for annuities that are in payout status.
Future policy benefits for life insurance are generally equal to the aggregate of (1) the present value of future benefit payments and related expenses, less the present value of future net premiums, and (2) any premium deficiency reserves. Assumptions as to mortality and persistency are based on the Company’s experience, and in certain instances, industry experience, when the basis of the reserve is established. Interest rates range from 2.50% to 7.50 %.
Future policy benefits for individual and group annuities and supplementary contracts are generally equal to the aggregate of (1) the present value of expected future payments, and (2) any premium deficiency reserves. Assumptions as to mortality are based on the Company’s experience, and in certain instances, industry experience, when the basis of the reserve is established. The interest rates used in the determination of the present value range from 1.65% to 7.25%, with 0% of the reserves based on an interest rate in excess of 8%.
Future policy benefits for other contract liabilities are generally equal to the present value of expected future payments based on the Company’s experience. Other contract liabilities also includes liabilities for guarantee benefits related to certain nontraditional long-duration life and annuity contracts which are discussed more fully in Note 7. The interest rates used in the determination of the present values range from 1.39% to 5.88%.
Policyholders’ Account Balances
Policyholders’ account balances at December 31 are as follows:
2011 | 2010 | |||||||
(in thousands) | ||||||||
Interest-sensitive life contracts | $ | 794,528 | $ | 723,739 | ||||
Individual annuities | 207,149 | 210,671 | ||||||
Guaranteed interest accounts | 38,125 | 38,713 | ||||||
Other | 93,278 | 80,890 | ||||||
|
|
|
| |||||
Total policyholders’ account balances | $ | 1,133,080 | $ | 1,054,013 | ||||
|
|
|
|
Policyholders’ account balances represent an accumulation of account deposits plus credited interest less withdrawals, expenses and mortality charges, if applicable. Interest crediting rates for interest-sensitive contracts range from 3.00% to 4.60%. Interest crediting rates for individual annuities range from 1.00% to 4.93%. Interest crediting rates for guaranteed interest accounts range from 1.25% to 5.25%. Interest crediting rates range from 1.00% to 3.50% for other.
6. REINSURANCE
The Company participates in reinsurance with its affiliates Prudential Insurance, PARCC, Pruco Re, PAR TERM, through various plans of reinsurance, primarily on a yearly renewable term and coinsurance basis. This reinsurance provides risk diversification, additional capacity for future growth and limits the maximum net loss potential. For coinsurance agreements, all significant risks are ceded to the reinsurer, including mortality,
F-32
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
investment, and lapse risk. For yearly renewable term agreements, mortality risk is the primary risk ceded to the reinsurer. Reinsurance ceded arrangements do not discharge the Company as the primary insurer. Ceded balances would represent a liability of the Company in the event the reinsurers were unable to meet their obligations to the Company under the terms of the reinsurance agreements. We believe a material reinsurance liability resulting from such inability of reinsurers to meet their obligations is unlikely.
The Company has entered into various reinsurance agreements with an affiliate, Pruco Re, to reinsure its living benefit features sold on certain of its annuities as part of its risk management and capital management strategies. For additional details on these agreements, see Note 13.
Reinsurance premiums, commissions, expense reimbursements, benefits and reserves related to reinsured long-duration contracts are accounted for using assumptions consistent with those used to account for the underlying contracts. Amounts recoverable from reinsurers, for long duration reinsurance arrangements, are estimated in a manner consistent with the claim liabilities and policy benefits associated with the reinsured policies. The affiliated reinsurance agreements are described further in Note 13.
Effective April 1, 2008, the Company entered into an agreement to reinsure certain variable Corporate Owned Life Insurance “COLI” policies with Pruco Life.
Reinsurance amounts included in the Statement of Operations and Comprehensive Income (Loss) for the years ended December 31 are below:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Direct premiums | $ | 167,113 | $ | 164,009 | $ | 158,678 | ||||||
Reinsurance ceded | (151,808) | (149,276) | (141,647) | |||||||||
|
|
|
|
|
| |||||||
Premiums | $ | 15,305 | $ | 14,733 | $ | 17,031 | ||||||
|
|
|
|
|
| |||||||
Direct policy charges and fees | $ | 161,829 | $ | 120,146 | $ | 108,396 | ||||||
Reinsurance ceded | (48,357) | (66,535) | (39,197) | |||||||||
|
|
|
|
|
| |||||||
Policy charges and fees | $ | 113,472 | $ | 53,611 | $ | 69,199 | ||||||
|
|
|
|
|
| |||||||
Policyholders’ benefits ceded | $ | 100,442 | $ | 95,634 | $ | 81,364 | ||||||
|
|
|
|
|
| |||||||
Realized capital gains (losses) net, associated with derivatives | $ | (26,567) | $ | (407) | $ | (44,367) | ||||||
|
|
|
|
|
|
Realized investment gains and losses include the reinsurance of certain of the Company’s embedded derivatives. Changes in the fair value of the embedded derivatives are recognized through “Realized investment gains (losses).” The Company has entered into reinsurance agreements to transfer the risk related to certain living benefit options to Pruco Re. The reinsurance agreements contain derivatives and have been accounted for in the same manner as an embedded derivative. See Note 11 for additional information related to the accounting for embedded derivatives.
Reinsurance premiums ceded for interest-sensitive products is accounted for as a reduction of policy charges and fee income. Reinsurance ceded for term insurance products is accounted for as a reduction of premiums.
Reinsurance recoverables included in the Company’s Statements of Financial Position at December 31, 2011 and 2010 were as follows:
December 31, 2011 | December 31, 2010 | |||||||
(in thousands) | ||||||||
Domestic life insurance-affiliated | $ | 467,687 | $ | 407,516 | ||||
Domestic individual annuities-affiliated | 53,696 | 11,110 | ||||||
Domestic life insurance-unaffiliated | 1,379 | 1,233 | ||||||
|
|
|
| |||||
$ | 522,762 | $ | 419,859 | |||||
|
|
|
|
F-33
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Substantially all reinsurance contracts are with affiliates as of December 31, 2011 and 2010. These contracts are described further in Note 13 of the Financial Statements.
The gross and net amounts of life insurance face amount in force as of December 31, 2011 and 2010 were as follows:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Gross life insurance face amount in force | $ | 97,879,303 | $ | 96,896,483 | $ | 95,400,464 | ||||||
Reinsurance ceded | (88,113,164) | (86,500,898) | (86,036,509) | |||||||||
|
|
|
|
|
| |||||||
Net life insurance face amount in force | $ | 9,766,139 | $ | 10,395,585 | $ | 9,363,955 | ||||||
|
|
|
|
|
|
7. CERTAIN NONTRADITIONAL LONG-DURATION CONTRACTS
The Company issues traditional variable annuity contracts through its separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contractholder. The Company also issues variable annuity contracts with general and separate account options where the Company contractually guarantees to 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”), or (3) the highest contract value on a specified date minus any withdrawals (“contract value”). These guarantees 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.
The Company also issues annuity contracts with market value adjusted investment options (“MVAs”), which provide for a return of principal plus a fixed rate of return if held to maturity, or, alternatively, a “market adjusted value” if surrendered prior to maturity or if funds are allocated to other investment options. The market value adjustment may result in a gain or loss to the Company, depending on crediting rates or an indexed rate at surrender, as applicable.
In addition, the Company issues variable life, variable universal life and universal life contracts where the Company contractually guarantees to the contractholder a death benefit even when there is insufficient value to cover monthly mortality and expense charges, whereas otherwise the contract would typically lapse (“no lapse guarantee”). Variable life and variable universal life contracts are offered with general and separate account options similar to variable annuities.
The assets supporting the variable portion of both traditional variable annuities and certain variable contracts with guarantees are carried at fair value and reported as “Separate account assets” with an equivalent amount reported as “Separate account liabilities.” Amounts assessed against the contractholders for mortality, administration, and other services are included within revenue in “Policy charges and fee income” and changes in liabilities for minimum guarantees are generally included in “Policyholders’ benefits.” In 2011, 2010 and 2009 there were no gains or losses on transfers of assets from the general account to a separate account.
For those guarantees of benefits that are payable in the event of death, the net amount at risk is generally defined as the current guaranteed minimum death benefit in excess of the current account balance at the balance sheet date. The Company’s primary risk exposures for these contracts relates to actual deviations from, or changes to, the assumptions used in the original pricing of these products, including equity market returns, contract lapses and contractholder mortality.
For guarantees of benefits that are payable at annuitization, the net amount at risk is generally defined as the present value of the minimum guaranteed annuity payments available to the contractholder determined in accordance with the terms of the contract in excess of the current account balance. The Company’s primary risk exposures for these contracts relates to actual deviations from, or changes to, the assumptions used in the original pricing of these products, including equity market returns, timing of annuitization, contract lapses and contractholder mortality.
For guarantees of benefits that are payable at withdrawal, the net amount at risk is generally defined as the present value of the minimum guaranteed withdrawal payments available to the contractholder determined in accordance with the terms of the contract in excess of the current account balance. For guarantees of accumulation balances, the net amount at risk is generally defined as the guaranteed minimum accumulation balance minus the current account balance. The Company’s primary risk
F-34
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
exposures for these contracts relates 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 or contractholder behavior used in the original pricing of these products.
The Company’s contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed may not be mutually exclusive. The liabilities related to the net amount at risk are reflected within “Future policy benefits.” As of December 31, 2011 and 2010, the Company had the following guarantees associated with these contracts, by product and guarantee type:
December 31, 2011 | December 31, 2010 | |||||||||||||||
In the Event of Death | At Annuitization / Accumulation (1) | In the Event of Death | At Annuitization / Accumulation (1) | |||||||||||||
(in thousands) | (in thousands) | |||||||||||||||
Variable Annuity Contracts | ||||||||||||||||
Return of Net Deposits | ||||||||||||||||
Account value | $ | 2,989,255 | $ | N/A | $ | 1,973,903 | $ | N/A | ||||||||
Net amount at risk | $ | 72,823 | $ | N/A | $ | 8,252 | $ | N/A | ||||||||
Average attained age of contractholders | 74 | N/A | 60 | N/A | ||||||||||||
Minimum return or contract value | ||||||||||||||||
Account value | $ | 1,290,856 | $ | 3,691,282 | $ | 1,036,830 | $ | 2,392,669 | ||||||||
Net amount at risk | $ | 91,715 | $ | 249,224 | $ | 36,926 | $ | 65,120 | ||||||||
Average attained age of contract holders | 72 | 59 | 64 | 59 | ||||||||||||
Average period remaining until earliest expected annuitization | N/A | 0.63 years | N/A | 1.58 years |
(1) | Includes income and withdrawal benefits as described herein |
Unadjusted Value | Adjusted Value | Unadjusted Value | Adjusted Value | |||||||||||||
Market value adjusted annuities | ||||||||||||||||
Account value | $ | 14,074 | $ | 14,428 | $ | 15,104 | $ | 15,827 |
December 31, 2011 | December 31, 2010 | |||||||
In the Event of Death | ||||||||
(in thousands) | ||||||||
Variable Life, Variable Universal Life and Universal Life Contracts | ||||||||
No Lapse Guarantees | ||||||||
Separate account value | $ | 576,747 | $ | 569,060 | ||||
General account value | $ | 217,849 | $ | 194,596 | ||||
Net amount at risk | $ | 6,137,072 | $ | 6,039,086 | ||||
Average attained age of contract holders | 50 years | 49 years |
Account balances of variable annuity contracts with guarantees were invested in separate account investment options as follows:
December 31, 2011 | December 31, 2010 | |||||||
(in thousands) | ||||||||
Equity funds | $ | 1,913,597 | $ | 1,677,692 | ||||
Bond funds | 1,972,145 | $ | 968,140 | |||||
Money market funds | 197,699 | 165,075 | ||||||
|
|
|
| |||||
Total | $ | 4,083,441 | $ | 2,810,907 | ||||
|
|
|
|
In addition to the above mentioned amounts invested in separate account investment options, $196.7 million and $199.8 million of account balances of variable annuity contracts with guarantees, inclusive of contracts with MVA feature were invested in general account investment options in 2011 and 2010, respectively.
F-35
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Liabilities for Guaranteed Benefits
The table below summarizes the changes in general account liabilities for guarantees on variable contracts. The liabilities for guaranteed minimum death benefits (“GMDB”) and guaranteed minimum income benefits (“GMIB”) are included in “Future policy benefits” and the related changes in the liabilities are included in “Policyholders’ benefits.” Guaranteed minimum income and withdrawal benefits (“GMIWB”), guaranteed minimum withdrawal benefits (“GMWB”) and guaranteed minimum accumulation benefits (“GMAB”) features are considered to be bifurcated embedded derivatives and are recorded at fair value. Changes in the fair value of these derivatives, including changes in the Company’s own risk of non-performance, along with any fees attributed or payments made relating to the derivative, are recorded in “Realized investment gains (losses), net.” See Note 10 for additional information regarding the methodology used in determining the fair value of these embedded derivatives. The liabilities for GMAB, GMWB and GMIWB are included in “Future policy benefits.”
GMDB | GMIB | GMWB - GMIWB - GMAB | Total | |||||||||||||||||
Variable Annuity | Variable Life, Variable Universal Life & Universal Life | Variable Annuity |
| |||||||||||||||||
(in thousands) | ||||||||||||||||||||
Balance as of December 31, 2008 | $ | 5,593 | $ | 11,276 | $ | 1,802 | $ | 63,903 | $ | 82,574 | ||||||||||
Incurred guarantee benefits (1) | (1,821) | 6,217 | (489) | (66,315) | (62,408) | |||||||||||||||
Paid guarantee benefits | (2,288) | (250) | - | - | (2,538) | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance as of December 31, 2009 | $ | 1,484 | $ | 17,243 | $ | 1,313 | $ | (2,412) | $ | 17,628 | ||||||||||
Incurred guarantee benefits (1) | 217 | 1,143 | (77) | (38,904) | (37,621) | |||||||||||||||
Paid guarantee benefits | (861) | - | - | - | (861) | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance as of December 31, 2010 | $ | 840 | $ | 18,386 | $ | 1,236 | $ | (41,316) | $ | (20,854) | ||||||||||
Incurred guarantee benefits (1) | 1,248 | 6,053 | 318 | 118,312 | 125,931 | |||||||||||||||
Paid guarantee benefits | (683) | - | - | - | (683) | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance as of December 31, 2011 | $ | 1,405 | $ | 24,439 | $ | 1,554 | $ | 76,996 | $ | 104,394 | ||||||||||
|
|
|
|
|
|
|
|
|
|
(1) | Incurred guarantee benefits include the portion of assessments established as additions to reserves as well as changes in estimates affecting the reserves. Also includes changes in the fair value of features considered to be embedded derivatives. |
The GMDB liability is determined each period end by estimating the accumulated value of a portion of the total assessments to date less the accumulated value of the death benefits in excess of the account balance. The GMIB liability is determined each period by estimating the accumulated value of a portion of the total assessments to date less the accumulated value of the projected income benefits in excess of the account balance. The portion of assessments used is chosen such that, at issue (or, in the case of acquired contracts, at the acquisition date), the present value of expected death benefits or expected income benefits in excess of the projected account balance and the portion of the present value of total expected assessments over the lifetime of the contracts are equal. The Company regularly evaluates the estimates used and adjusts the GMDB and GMIB liability balances, with an associated charge or credit to earnings, if actual experience or other evidence suggests that earlier assumptions should be revised.
The GMAB features provide the contractholder with a guaranteed return of initial account value or an enhanced value if applicable. The most significant of the Company’s GMAB features are the guaranteed return option (“GRO”) features, which includes an asset transfer feature that reduces the Company’s exposure to these guarantees. The GMAB liability is calculated as the present value of future expected payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature.
The GMWB features provide the contractholder with a guaranteed remaining balance if the account value is reduced to zero through a combination of market declines and withdrawals. The guaranteed remaining balance is generally equal to the protected value under the contract, which is initially established as the greater of the account value or cumulative deposits when withdrawals commence, less cumulative withdrawals. The contractholder also has the option, after a specified time period, to reset the guaranteed remaining balance to the then-current account value, if greater. The GMWB liability is calculated as the present value of future expected payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature.
F-36
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The GMIWB features, taken collectively, provides a contractholder two optional methods to receive guaranteed minimum payments over time, a “withdrawal” option or an “income” option. The withdrawal option (which is available under only one of the Company’s GMIWBs) guarantees that a contract holder can withdraw an amount each year until the cumulative withdrawals reach a total guaranteed balance. The income option (which varies among the Company’s GMIWBs) in general guarantees the contract holder the ability to withdraw an amount each year for life (or for joint lives, in the case of any spousal version of the benefit) where such amount is equal to a percentage of a protected value under the benefit. The contractholder also has the potential to increase this annual amount, based on certain subsequent increases in account value that may occur. Certain GMIWB features include an asset transfer feature that reduces the Company’s exposure to these guarantees. The GMIWB liability is calculated as the present value of future expected payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature.
As part of its risk management strategy, the Company limits its exposure to these risks through a combination of product design elements, such as an asset transfer feature, and affiliated reinsurance agreements. The asset transfer feature included in the design of certain optional living benefits transfers assets between certain variable investments selected by the annuity contractholder and, depending on the benefit feature, a fixed rate account in the general account or a bond portfolio within the separate accounts. 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 of the contractholder total account value. In general, negative investment performance may result in transfers to a fixed-rate account in the general account or a bond portfolio within the separate accounts, and positive investment performance may result in transfers back to contractholder-selected variable investments. Other product design elements utilized for certain products to manage these risks include asset allocation restrictions and minimum issuance age requirements. For risk management purposes the Company segregates the variable annuity living benefit features into those that include the asset transfer feature including certain GMIWB riders and certain GMAB riders that feature the GRO policyholder benefits; and those that do not include the asset transfer feature, including certain legacy GMIWB, GMWB, GMAB and GMIB riders. Living benefit riders that include the asset transfer feature also include GMDB riders, and as such the GMDB risk in these riders also benefits from the asset transfer feature.
Sales Inducements
The Company defers sales inducements and amortizes them over the life of the policy using the same methodology and assumptions used to amortize deferred policy acquisition costs. These deferred sales inducements are included in “Deferred Sales Inducements” in the Company’s Statements of Financial Position. The Company offers various types of sales inducements. These inducements include: (1) a bonus whereby the policyholder’s initial account balance is increased by an amount equal to a specified percentage of the customer’s initial deposit and (2) additional credits after a certain number of years a contract is held. Changes in deferred sales inducements, reported as “Interest credited to policyholders’ account balances,” are as follows:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Balance, beginning of year | $ | 51,106 | $ | 30,265 | $ | 28,015 | ||||||
Capitalization | 22,596 | 21,594 | 8,689 | |||||||||
Amortization- Impact of assumption and experience unlocking and true-ups | (2,290) | 874 | 822 | |||||||||
Amortization- All other | (23,105) | (1,579) | (5,485) | |||||||||
Change in unrealized investment gains and (losses) | (206) | (48) | (1,776) | |||||||||
|
|
|
|
|
| |||||||
Balance, end of year | $ | 48,101 | $ | 51,106 | $ | 30,265 | ||||||
|
|
|
|
|
|
8. STATUTORY NET INCOME AND SURPLUS AND DIVIDEND RESTRICTIONS
The Company is required to prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the New Jersey Department of Banking and Insurance. Statutory accounting practices primarily differ from GAAP by charging policy acquisition costs to expense as incurred, establishing future policy benefit liabilities using different actuarial assumptions and valuing investments, deferred taxes, and certain assets on a different basis.
F-37
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Statutory net income (loss) of the Company amounted to $13 million, $52 million, and $4 million for the years ended December 31, 2011, 2010 and 2009, respectively. Statutory surplus of the Company amounted to $260 million and $216 million at December 31, 2011 and 2010, respectively.
The Company prepares its statutory financial statements in accordance with accounting practices prescribed or permitted by the New Jersey Department of Banking and Insurance. Prescribed statutory accounting practices include publications of the NAIC, state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
The Company is subject to New Jersey law, which limits the amount of dividends that insurance companies can pay to stockholders without approval of the New Jersey Department of Banking and Insurance. The maximum dividend, which may be paid in any twelve-month period without notification or approval, is limited to the greater of 10% of statutory surplus as of December 31 of the preceding year or the net gain from operations of the preceding calendar year. Cash dividends may only be paid out of surplus derived from realized net profits. Based on these limitations, there is $26 million capacity to pay a dividend in 2012 without prior approval. The Company did not pay any dividends in 2011.
9. INCOME TAXES
The components of income tax expense (benefit) for the years ended December 31, were as follows:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Current tax expense (benefit): | ||||||||||||
U.S. | $ | (715) | $ | 23,841 | $ | 20,362 | ||||||
|
|
|
|
|
| |||||||
Total | (715) | 23,841 | 20,362 | |||||||||
|
|
|
|
|
| |||||||
Deferred tax expense (benefit): | ||||||||||||
U.S. | (47,893) | 15,967 | (1,376) | |||||||||
|
|
|
|
|
| |||||||
Total | (47,893) | 15,967 | (1,376) | |||||||||
|
|
|
|
|
| |||||||
Total income tax expense (benefit) on income from continuing operations | (48,608) | 39,808 | 18,986 | |||||||||
Other comprehensive income (loss) | 9,689 | 9,279 | 28,567 | |||||||||
Cumulative effect of changes in accounting policy | - | - | 2,010 | |||||||||
|
|
|
|
|
| |||||||
Total income tax expense (benefit) on continuing operations | $ | (38,919) | $ | 49,087 | $ | 49,563 | ||||||
|
|
|
|
|
|
The Company’s income (loss) from continuing operations before income taxes includes income (loss) from domestic operations of ($109.2) million, $141.5 million and $76.0 million, and no income from foreign operations for the years ended December 31, 2011, 2010 and 2009, respectively.
The Company’s actual income tax expense for the years ended December 31, differs from the expected amount computed by applying the statutory federal income tax rate of 35% to income from continuing operations before income taxes and cumulative effect of accounting change for the following reasons:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Expected federal income tax expense (benefit) | $ | (37,938) | $ | 45,784 | 24,591 | |||||||
Non-taxable investment income | (7,885) | (4,449) | (3,240) | |||||||||
Tax Credits | (1,368) | (362) | (195) | |||||||||
Expiration of statute of limitations and related interest | - | - | (2,695) | |||||||||
Other | (1,417) | (1,165) | 525 | |||||||||
|
|
|
|
|
| |||||||
Total income tax expense (benefit) on income from continuing operations | $ | (48,608) | $ | 39,808 | $ | 18,986 | ||||||
|
|
|
|
|
|
F-38
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Deferred tax assets and liabilities at December 31, resulted from the items listed in the following table:
2011 | 2010 | |||||||
(in thousands) | ||||||||
Deferred tax assets | ||||||||
Insurance reserves | $ | 47,597 | $ | 3,398 | ||||
Investments | 4,696 | - | ||||||
Other | 929 | 7,252 | ||||||
|
|
|
| |||||
Deferred tax assets | $ | 53,222 | $ | 10,650 | ||||
|
|
|
| |||||
Deferred tax liabilities | $0 | |||||||
Deferred acquisition costs | $ | 46,444 | $ | 52,192 | ||||
Investments | $0 | 1,159 | ||||||
Net Unrealized gains on securities | 31,085 | 20,341 | ||||||
Deferred Annuity Bonus | 16,835 | 17,887 | ||||||
|
|
|
| |||||
Deferred tax liabilities | $ | 94,364 | $ | 91,579 | ||||
|
|
|
| |||||
Net deferred tax asset (liability) | $ | (41,142) | $ | (80,929) | ||||
|
|
|
|
The application of U.S. GAAP requires the Company to evaluate the recoverability of deferred tax assets and establish a valuation allowance if necessary to reduce the deferred tax asset to an amount that is more likely than not expected to be realized. Considerable judgment is required in determining whether a valuation allowance is necessary, and if so, the amount of such valuation allowance. In evaluating the need for a valuation allowance the Company considers many factors, including: (1) the nature of the deferred tax assets and liabilities; (2) whether they are ordinary or capital; (3) in which tax jurisdictions they were generated and the timing of their reversal; (4) taxable income in prior carryback years as well as projected taxable earnings exclusive of reversing temporary differences and carryforwards; (5) the length of time that carryovers can be utilized in the various taxing jurisdictions; (6) any unique tax rules that would impact the utilization of the deferred tax assets; and (7) any tax planning strategies that the Company would employ to avoid a tax benefit from expiring unused. Although realization is not assured, management believes it is more likely than not that the deferred tax assets, net of valuation allowances, will be realized. The company had no valuation allowance as of December 31, 2011, and 2010.
Management believes that based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets. Adjustments to the valuation allowance will be made if there is a change in management’s assessment of the amount of deferred tax asset that is realizable.
F-39
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The Company’s unrecognized tax benefits for the periods indicated are as follows:
Unrecognized tax benefits prior to 2002 | Unrecognized tax benefits 2002 and forward | Total unrecognized tax benefits all years | ||||||||||
(in thousands) | ||||||||||||
Amounts as of December 31, 2008 | $ | 3,596 | $ | 1,517 | $ | 5,113 | ||||||
Increases in unrecognized tax benefits taken in prior | - | - | - | |||||||||
period | - | (210) | (210) | |||||||||
(Decreases) in unrecognized tax benefits taken in | - | - | ||||||||||
prior period | - | |||||||||||
Settlements with taxing authorities | - | |||||||||||
(Decreases) in unrecognized tax benefits as a result | - | - | ||||||||||
of lapse of the applicable statute of limitations | (2,107) | (2,107) | ||||||||||
|
|
|
|
|
| |||||||
Amounts as of December 31, 2009 | $ | 1,489 | $ | 1,307 | $ | 2,796 | ||||||
Increases in unrecognized tax benefits taken in prior | ||||||||||||
period | - | - | - | |||||||||
(Decreases) in unrecognized tax benefits taken in | ||||||||||||
prior period | - | (1,177) | (1,177) | |||||||||
|
|
|
|
|
| |||||||
Amounts as of December 31, 2010 | $ | 1,489 | $ | 130 | $ | 1,619 | ||||||
Increases in unrecognized tax benefits taken in prior | - | - | ||||||||||
period | - | - | - | |||||||||
(Decreases) in unrecognized tax benefits taken in | - | - | ||||||||||
prior period | (1,489) | (17) | (1,506) | |||||||||
|
|
|
|
|
| |||||||
Amounts as of December 31, 2011 | $ | - | $ | 113 | $ | 113 | ||||||
|
|
|
|
|
| |||||||
Unrecognized tax benefits that, if recognized, would | - | - | ||||||||||
favorably impact the effective rate as of | 0 | 0 | ||||||||||
December 31, 2009 | $ | 1,489 | $ | - | $ | 1,489 | ||||||
|
|
|
|
|
| |||||||
Unrecognized tax benefits that, if recognized, would | - | - | ||||||||||
favorably impact the effective rate as of | - | - | ||||||||||
December 31, 2010 | $ | 1,489 | $ | - | $ | 1,489 | ||||||
|
|
|
|
|
| |||||||
Unrecognized tax benefits that, if recognized, would | - | - | ||||||||||
favorably impact the effective rate as of | (1,489) | - | (1,489) | |||||||||
December 31, 2011 | $ | - | $ | - | $ | - | ||||||
|
|
|
|
|
|
The Company classifies all interest and penalties related to tax uncertainties as income tax expense (benefit). The amounts recognized in the financial statements for tax-related interest and penalties for the years ended December 31, are as follows:
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Interest and penalties recognized in the statements of operations | $ | - | $ | (1,100) | $ | 400 | ||||||
Interest and penalties recognized in liabilities in the statements of financial position | $ | - | $ | - | $ | 1,100 |
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 (“IRS”) 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 Federal statute of limitations for the 2002 tax year expired on April 30, 2009. The Federal statute of limitations for the 2003 tax year expired on July 31, 2009. The Federal statute of limitations for the 2004 through 2007 tax years will expire in June 2012, unless extended. Tax years 2008 through 2010 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.
F-40
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
During the fourth quarter of 2011, the Company’s parent, Prudential Financial, reached an agreement with the IRS on the resolution of the proposed foreign tax credits disallowance. The settlement of the foreign tax credit transactions for 2004 through 2006 marked the conclusion of the IRS audits for those years. As a result, all unrecognized tax positions plus interest relating to tax years prior to 2007 were recognized in 2011.
The dividends received deduction (“DRD”) reduces the amount of dividend income subject to U.S. tax and is the primary component of the non-taxable investment income shown in the table above, and, as such, 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 2010, 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 2009, 2010 or 2011 results.
In December 2006, the IRS completed all fieldwork with respect to its examination of the consolidated federal income tax returns for tax years 2002 and 2003. The final report was initially submitted to the Joint Committee on Taxation for their review in April 2007. The final report was resubmitted in March 2008 and again in April 2008. The Joint Committee returned the report to the IRS for additional review of an industry issue regarding the methodology for calculating the DRD related to variable life insurance and annuity contracts. The IRS completed its review of the issue and proposed an adjustment with respect to the calculation of the DRD. In order to expedite receipt of an income tax refund related to the 2002 and 2003 tax years, the Company agreed to such adjustment. The report, with the adjustment to the DRD, was submitted to the Joint Committee on Taxation in October 2008. The Company was advised on January 2, 2009 that the Joint Committee completed its consideration of the report and took no exception to the conclusions reached by the IRS. Accordingly, the final report was processed and a $157 million refund was received in February 2009. The Company believed that its return position with respect to the calculation of the DRD was technically correct. Therefore, the Company filed protective refund claims on October 1, 2009 to recover the taxes associated with the agreed upon adjustment. The IRS recently issued an Industry Director Directive (“IDD”) stating that the methodology for calculating the DRD set forth in Revenue Ruling 2007-54 should not be followed. The IDD also confirmed that the IRS guidance issued before Revenue Ruling 2007-54, which guidance the Company relied upon in calculating its DRD, should be used to determine the DRD. The Company’s parent, Prudential Financial, has received a refund of approximately $3 million pursuant to the protective refund claims. These activities had no impact on the Company’s 2009, 2010 or 2011 results.
For tax years 2007 through 2011, the Company is participating in the IRS’s Compliance Assurance Program (“CAP”). Under CAP, the IRS assigns an examination team to review completed transactions contemporaneously during these tax years in order to reach agreement with the Company on how they should be reported in the tax returns. If disagreements arise, accelerated resolutions programs are available to resolve the disagreements in a timely manner before the tax returns are filed. It is management’s expectation this program will shorten the time period between the filing of the Company’s federal income tax returns and the IRS’s completion of its examination of the returns.
F-41
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
10. FAIR VALUE OF ASSETS AND LIABILITIES
Fair Value Measurement – Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The authoritative guidance around fair value established a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs to valuation techniques into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:
Level 1 - Fair value is based on unadjusted quoted prices in active markets that are accessible to the Company for identical assets or liabilities. These generally provide the most reliable evidence and are used to measure fair value whenever available. Active markets are defined as having the following characteristics for the measured asset/liability: (i) many transactions, (ii) current prices, (iii) price quotes not varying substantially among market makers, (iv) narrow bid/ask spreads and (v) most information publicly available. The Company’s Level 1 assets and liabilities primarily include certain cash equivalents and certain short term investments, and equity securities. Prices are obtained from readily available sources for market transactions involving identical assets or liabilities.
Level 2 - Fair value is based on significant inputs, other than Level 1 inputs, that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets and liabilities, quoted market prices in markets that are not active for identical or similar assets or liabilities, and other market observable inputs. The Company’s Level 2 assets and liabilities include: fixed maturities (corporate public and private bonds, most government securities, certain asset-backed and mortgage-backed securities, etc.), certain equity securities (mutual funds, which do not actively trade and are priced based on a net asset value), certain short-term investments and certain cash equivalents (primarily commercial paper), and certain over-the-counter derivatives. Valuations are generally obtained from third party pricing services for identical or comparable assets or liabilities or through the use of valuation methodologies using observable market inputs. Prices from services are validated through comparison to trade data and internal estimates of current fair value, generally developed using market observable inputs and economic indicators.
Level 3 - Fair value is based on at least one or more significant unobservable inputs for the asset or liability. These inputs reflect the Company’s assumptions about the inputs market participants would use in pricing the asset or liability. The Company’s Level 3 assets and liabilities primarily include: certain private fixed maturities and equity securities, certain manually priced public equity securities and fixed maturities, certain highly structured over-the-counter derivative contracts, certain consolidated real estate funds for which the Company is the general partner, and embedded derivatives resulting from certain products with guaranteed benefits. Prices are determined using valuation methodologies such as option pricing models, discounted cash flow models and other similar techniques. Non-binding broker quotes, which are utilized when pricing service information is not available, are reviewed for reasonableness based on the Company’s understanding of the market, and are generally considered Level 3. Under certain conditions, based on its observations of transactions in active markets, the Company may conclude the prices received from independent third party pricing services or brokers are not reasonable or reflective of market activity. In those instances, the Company may choose to over-ride the third-party pricing information or quotes received and apply internally- developed values to the related assets or liabilities. To the extent the internally-developed valuations use significant unobservable inputs, they are classified as Level 3. As of December 31, 2011 and December 31, 2010, these over-rides on a net basis were not material.
F-42
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Assets and Liabilities by Hierarchy Level - The tables below present the balances of assets and liabilities measured at fair value on a recurring basis, as of the dates indicated.
As of December 31, 2011 | ||||||||||||||||
Level 1 | Level 2 | Level 3 | Total | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities, available for sale: | ||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | - | $ | 35,938 | $ | - | $ | 35,938 | ||||||||
Obligations of U.S. states and their political subdivisions | - | 2,826 | - | 2,826 | ||||||||||||
Foreign government bonds | - | 23,031 | - | 23,031 | ||||||||||||
Corporate securities | - | 894,266 | 1,755 | 896,021 | ||||||||||||
Asset-backed securities | - | 53,005 | 18,627 | 71,632 | ||||||||||||
Commercial mortgage-backed securities | - | 96,006 | - | 96,006 | ||||||||||||
Residential mortgage-backed securities | - | 94,450 | - | 94,450 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | - | 1,199,522 | 20,382 | 1,219,904 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Other trading account assets: | ||||||||||||||||
|
|
|
|
|
|
|
| |||||||||
Equity Securities | - | - | 1,569 | 1,569 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | - | - | 1,569 | 1,569 | ||||||||||||
Equity securities, available for sale: | 276 | - | 1,144 | 1,420 | ||||||||||||
Short-term investments | 1,069 | - | - | 1,069 | ||||||||||||
Cash equivalents | 10,000 | 14,381 | - | 24,381 | ||||||||||||
Other long-term investments | - | 6,670 | 18 | 6,688 | ||||||||||||
Other assets | - | 8,647 | 53,677 | 62,324 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total excluding separate account assets | 11,345 | 1,229,220 | 76,790 | 1,317,355 | ||||||||||||
Separate account assets (1) | 141,133 | 6,110,880 | 5,995 | 6,258,008 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total assets | $ | 152,478 | $ | 7,340,100 | $ | 82,785 | $ | 7,575,363 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Other liabilities | - | - | - | - | ||||||||||||
Future policy benefits | - | - | 76,996 | 76,996 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total liabilities | $ | - | $ | - | $ | 76,996 | $ | 76,996 | ||||||||
|
|
|
|
|
|
|
|
As of December 31, 2010 | ||||||||||||||||
Level 1 | Level 2 | Level 3 | Total | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities, available for sale: | ||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | - | $ | 36,450 | $ | - | $ | 36,450 | ||||||||
Foreign government bonds | - | 22,678 | - | 22,678 | ||||||||||||
Corporate securities | - | 748,645 | 3,636 | 752,281 | ||||||||||||
Asset-backed securities | - | 37,414 | 16,619 | 54,033 | ||||||||||||
Commercial mortgage-backed securities | - | 103,101 | - | 103,101 | ||||||||||||
Residential mortgage-backed securities | - | 95,998 | - | 95,998 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | - | 1,044,286 | 20,254 | 1,064,541 | ||||||||||||
Equity securities, available for sale: | 283 | 1,536 | 255 | 2,074 | ||||||||||||
Short-term investments | 359 | 7,050 | - | 7,409 | ||||||||||||
Cash equivalents | 5,000 | 23,383 | - | 28,383 | ||||||||||||
Other long-term investments | - | - | - | - | ||||||||||||
Other assets | - | 2,792 | 16,996 | 19,788 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total excluding separate account assets | 5,642 | 1,079,047 | 37,505 | 1,122,194 | ||||||||||||
Separate account assets (1) | 132,005 | 4,900,653 | 5,393 | 5,038,051 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total assets | $ | 137,647 | $ | 5,979,700 | $ | 42,898 | $ | 6,160,245 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Other liabilities | - | 898 | - | 898 | ||||||||||||
Future policy benefits | - | - | (41,316) | (41,316) | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total liabilities | $ | - | $ | 898 | $ | (41,316) | $ | (40,418) | ||||||||
|
|
|
|
|
|
|
|
F-43
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
(1) | Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account assets classified as Level 3 consist primarily of real estate and real estate investment funds. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Consolidated Statement of Financial Position. |
(2) | Includes reclassifications to conform to current period presentation. |
The methods and assumptions the Company uses to estimate the fair value of assets and liabilities measured at fair value on a recurring basis are summarized below. Information regarding separate account assets is excluded as the risk associated with these assets is primarily borne by Company’s customers and policyholders.
Fixed Maturity Securities– The fair values of the Company’s public fixed maturity securities are generally based on prices obtained from independent pricing services. Prices from pricing services are sourced from multiple vendors, and a vendor hierarchy is maintained by asset type based on historical pricing experience and vendor expertise. The Company generally receives prices from multiple pricing services for each security, but ultimately uses the price from the pricing service highest in the vendor hierarchy based on the respective asset type. To validate reasonableness, prices are reviewed by internal asset managers through comparison with directly observed recent market trades and internal estimates of current fair value, developed using market observable inputs and economic indicators. Consistent with the fair value hierarchy described above, securities with validated quotes from pricing services are generally reflected within Level 2, as they are primarily based on observable pricing for similar assets and/or other market observable inputs. If the pricing information received from third party pricing services is not reflective of market activity or other inputs observable in the market, the Company may challenge the price through a formal process with the pricing service. If the pricing service updates the price to be more consistent in comparison to the presented market observations, the security remains within Level 2.
If the Company ultimately concludes that pricing information received from the independent pricing service is not reflective of market activity, non-binding broker quotes are used, if available. If the Company concludes the values from both pricing services and brokers are not reflective of market activity, it may over-ride the information from the pricing service or broker with an internally-developed valuation. As of December 31, 2011 and December 31, 2010, over-rides on a net basis were not material. Internally-developed valuations or non-binding broker quotes are also used to determine fair value in circumstances where vendor pricing is not available. These estimates may use significant unobservable inputs, which reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset. Circumstances where observable market data are not available may include events such as market illiquidity and credit events related to the security. Pricing service over-rides, internally-developed valuations and non-binding broker quotes are generally included in Level 3 in the fair value hierarchy.
The fair value of private fixed maturities, which are primarily comprised of investments in private placement securities, originated by internal private asset managers, are primarily determined using a discounted cash flow model. In certain cases these models primarily use observable inputs with a discount rate based upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions, taking into account, among other factors, the credit quality and industry sector of the issuer and the reduced liquidity associated with private placements. Generally, these securities have been reflected within Level 2. For certain private fixed maturities, the discounted cash flow model may also incorporate significant unobservable inputs, which reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset. To the extent management determines that such unobservable inputs are not significant to the price of a security, a Level 2 classification is made. Otherwise, a Level 3 classification is used.
Private fixed maturities also include debt investments in funds that, in addition to a stated coupon, pay a return based upon the results of the underlying portfolios. The fair values of these securities are determined by reference to the funds’ net asset value (“NAV”). Since the NAV at which the funds trade can be observed by redemption and subscription transactions between third parties, the fair values of these investments have been reflected within Level 2 in the fair value hierarchy.
Trading Account Assets– Trading account assets are comprised of perpetual preferred. Fair values of perpetual preferred stock based on observable market inputs are classified within Level 2. However, when prices from independent pricing services are based on non-binding broker quotes as the directly observable market inputs become unavailable, the fair value of perpetual preferred stock are classified as Level 3.
F-44
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Equity Securities – Equity securities consist principally of investments in common and preferred stock of publicly traded companies, perpetual preferred stock, privately traded securities, as well as common stock mutual fund shares. The fair values of most publicly traded equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value hierarchy. Estimated fair values for most privately traded equity securities are determined using valuation and discounted cash flow models that require a substantial level of judgment. In determining the fair value of certain privately traded equity securities the discounted cash flow model may also use unobservable inputs, which reflect the Company’s assumptions about the inputs market participants would use in pricing the asset. Most privately traded equity securities are classified within Level 3. The fair values of common stock mutual fund shares that transact regularly (but do not trade in active markets because they are not publicly available) are based on transaction prices of identical fund shares and are classified within Level 2 in the fair value hierarchy. The fair values of preferred equity securities are based on prices obtained from independent pricing services. These prices are then validated for reasonableness against recently traded market prices. Accordingly, these securities are generally classified within Level 2 in the fair value hierarchy. Fair values of perpetual preferred stock based on observable market inputs are classified within Level 2. However, when prices from independent pricing services are based on non-binding broker quotes as the directly observable market inputs become unavailable, the fair value of perpetual preferred stock are classified as Level 3.
Derivative Instruments– Derivatives are recorded at fair value either as assets, within “Other long-term investments,” or as liabilities, within “Other liabilities,” except for embedded derivatives which are recorded with the associated host contract. The fair values of derivative contracts are determined based on quoted prices in active exchanges or through the use of valuation models. The fair values of derivative contracts can be affected by changes in interest rates, foreign exchange rates, credit spreads, market volatility, expected returns, non-performance risk, liquidity and other factors. Liquidity valuation adjustments are made to reflect the cost of exiting significant risk positions, and consider the bid-ask spread, maturity, complexity, and other specific attributes of the underlying derivative position.
The majority of the Company’s derivative positions are traded in the over-the-counter (OTC) derivative market and are classified within Level 2 in the fair value hierarchy. OTC derivatives classified within Level 2 are valued using models generally accepted in the financial services industry that use actively quoted or observable market input values from external market data providers, third-party pricing vendors and/or recent trading activity. The fair values of most OTC derivatives, including interest rate and cross currency swaps, are determined using discounted cash flow models. These models’ key inputs include the contractual terms of the respective contract, along with significant observable inputs, including interest rates, currency rates, credit spreads, equity prices, index dividend yields, non-performance risk and volatility.
To reflect the market’s perception of its own and the counterparty’s non-performance risk, the Company incorporates additional spreads over London Interbank Offered Rate (“LIBOR”) into the discount rate used in determining the fair value of OTC derivative assets and liabilities which are uncollateralized. The additional credit spread over LIBOR rates is determined taking into consideration publicly available information relating to the financial strength of the Company. The Company adjusts these credit spreads to remove any illiquidity risk premium, which is subject to a floor based on a percentage of the credit spread. Most OTC derivative contract inputs have bid and ask prices that are actively quoted or can be readily obtained from external market data providers. The Company’s policy is to use mid-market pricing in determining its best estimate of fair value.
Derivatives classified as Level 3 may include first-to-default credit basket swaps and other structured products. These derivatives are valued based upon models with some significant unobservable market inputs or inputs from less actively traded markets. The fair values of first to default credit basket swaps are derived from relevant observable inputs such as: individual credit default spreads, interest rates, recovery rates and unobservable model-specific input values such as correlation between different credits within the same basket. Level 3 methodologies are validated through periodic comparison of the Company’s fair values to broker-dealer values. As of December 31, 2011, and December 31, 2010, there were derivatives with the fair value of $18 thousand and $0 classified within Level 3, and all other derivatives were classified within Level 2. See Note 11 for more details on the fair value of derivative instruments by primary underlying.
Cash Equivalents and Short-Term Investments– Cash equivalents and short-term investments include money market instruments, commercial paper and other highly liquid debt instruments. Money market instruments are generally valued using unadjusted quoted prices in active markets that are accessible for identical assets and are primarily classified as Level 1.
F-45
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The remaining instruments in the Cash Equivalents and Short-term Investments category are typically not traded in active markets; however, their fair values are based on market observable inputs and, accordingly, these investments have been classified within Level 2 in the fair value hierarchy.
Other Assets– Other assets carried at fair value include reinsurance recoverables related to the reinsurance of our living benefit guarantees on certain of our variable annuities. These guarantees are described further below in “Future Policy Benefits.” Also included in other assets are certain universal life products that contain a no-lapse guarantee provision. The reinsurance agreements covering these guarantees are derivatives and are accounted for in the same manner as an embedded derivative.
Future Policy Benefits– The liability for future policy benefits includes general account liabilities for guarantees on variable annuity contracts, including guaranteed minimum accumulation benefits (“GMAB”), guaranteed minimum withdrawal benefits (“GMWB”) and guaranteed minimum income and withdrawal benefits (“GMIWB”), accounted for as embedded derivatives. The fair values of the GMAB, GMWB, and GMIWB liabilities are calculated as the present value of future expected benefit payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature. This methodology could result in either a liability or asset balance, given changing capital market conditions and various policyholder behavior 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 determination of these risk premiums requires the use of management judgment.
The Company is also required to incorporate the market-perceived risk of its own non-performance (“NPR”) in the valuation of the embedded derivatives associated with its optional living benefit features and no-lapse feature on certain universal life products. Since insurance liabilities are senior to debt, the Company believes that reflecting the financial strength ratings of the Company in the valuation of the liability or contra-liability appropriately takes into consideration its NPR. To reflect NPR, the Company incorporates an additional credit spread over LIBOR rates into the discount rate used in the valuations of the embedded derivatives associated with its optional living benefit features. The additional credit spread over LIBOR rates is determined taking into consideration publicly available information relating to the financial strength of the Company. The Company adjusts these credit spreads to remove any illiquidity risk premium, which is subject to a floor based on a percentage of the credit spread. The additional credit spread over LIBOR rates incorporated into the discount rate as of December 31, 2011 generally ranged from 125 to 250 basis points for the portion of the interest rate curve most relevant to these liabilities. This additional spread is applied at an individual contract level and only to those individual living benefit contracts in a liability position and not to those in a contra-liability position.
Other significant inputs to the valuation models for the embedded derivatives associated with the optional living benefit features of the Company’s variable annuity products include capital market assumptions, such as interest rate and implied volatility assumptions, as well as various policyholder behavior assumptions that are actuarially determined, including lapse rates, benefit utilization rates, mortality rates and withdrawal rates. These assumptions are reviewed at least annually, and updated based upon historical experience and give consideration to any observable market data, including market transactions such as acquisitions and reinsurance transactions. Since many of the assumptions utilized in the valuation of the embedded derivatives associated with the Company’s optional living benefit features are unobservable and are considered to be significant inputs to the liability valuation, the liability included in future policy benefits has been reflected within Level 3 in the fair value hierarchy.
As of December 31, 2011, the fair value of the embedded derivatives associated with the optional living benefit features of before the NPR adjustment was a net liability of $344 million. This net liability was comprised of $360 million of individual living benefit contracts in a liability position net of $15 million of individual living benefit contracts in a contra-liability position. At December 31, 2011, NPR resulted in a $267 million cumulative decrease to the embedded derivative liability, reflecting the additional credit spread over LIBOR the Company incorporated into the discount rate used in the valuations of those embedded derivatives in a liability position. Significant declines in risk-free interest rates and the impact of account value performance in 2011 drove an increase in the embedded derivative liability associated with the optional living benefit features of the Company’s variable annuity products as of December 31, 2011. These factors, as well as widening of the spreads used in valuing NPR, also drove offsetting increases in the NPR adjustment. As a result, the increase in these embedded derivative liabilities are largely offset by corresponding increases in the reinsurance recoverable associated with the affiliated reinsurance.
F-46
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Transfers between Levels 1 and 2– During the twelve months ended December 31, 2011, there were no material transfers between Level 1 and Level 2.
Changes in Level 3 assets and liabilities - The following tables provide a summary of the changes in fair value of Level 3 assets and liabilities for the year ended December 31, 2011, as well as the portion of gains or losses included in income for the year ended December 31, 2011 attributable to unrealized gains or losses related to those assets and liabilities still held at December 31, 2011.
Year Ended December 31, 2011 | ||||||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Asset- Backed Securities | Fixed Maturities Available For Sale - Commercial Mortgage- Backed Securities | Equity Securities, Available for Sale | Other Assets | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fair value, beginning of period | $ | 3,636 | $ | 16,619 | $ | - | $ | 255 | $ | 16,996 | ||||||||||
Total gains (losses) (realized/unrealized): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | 2 | - | - | (516) | (25,919) | |||||||||||||||
Asset management fees and other income | - | - | - | - | - | |||||||||||||||
Interest credited to policyholder account balances | - | - | - | - | - | |||||||||||||||
Included in other comprehensive income (loss) | (96) | (121) | 0 | 398 | (13) | |||||||||||||||
Net investment income | 59 | 256 | (0) | - | - | |||||||||||||||
Purchases | 1,300 | 11,089 | 5,019 | 1,000 | 68,593 | |||||||||||||||
Sales | (99) | - | - | - | - | |||||||||||||||
Issuances | 73 | - | - | - | - | |||||||||||||||
Settlements | (148) | (5,251) | - | - | (1) | |||||||||||||||
Foreign currency translation | - | - | - | - | - | |||||||||||||||
Transfers into Level 3 (2) | 900 | - | - | 1,536 | - | |||||||||||||||
Transfers out of Level 3 (2) | (3,872) | (3,965) | (5,019) | - | (5,979) | |||||||||||||||
Other (4) | - | - | - | (1,529) | - | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Fair value, end of period | $ | 1,755 | $ | 18,627 | $ | - | $ | 1,144 | $ | 53,677 | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Unrealized gains (losses) for the period relating to those | ||||||||||||||||||||
Level 3 assets that were still held at the end of the period (3): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | $ | - | $ | - | $ | - | $ | (454) | $ | 18,797 | ||||||||||
Asset management fees and other income | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||
Interest credited to policyholder account balances | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||
Included in other comprehensive income (loss) | $ | (96) | $ | (109) | $ | 0 | $ | 359 | $ | - |
F-47
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Year Ended December 31, 2011 | ||||||||||||||||
Separate Account Assets (1) | Future Policy Benefits | Other Long- Term Investments | Other Trading Account Assets - Equity Securities | |||||||||||||
(in thousands) | ||||||||||||||||
Fair value, beginning of period | $ | 5,393 | $ | 41,316 | $ | 0 | $ | - | ||||||||
Total gains (losses) (realized/unrealized): | ||||||||||||||||
Included in earnings: | ||||||||||||||||
Realized investment gains (losses), net | - | (94,684) | 18 | - | ||||||||||||
Asset management fees and other income | - | - | - | 40 | ||||||||||||
Interest credited to policyholder account balances | 602 | - | - | - | ||||||||||||
Included in other comprehensive income | - | - | - | - | ||||||||||||
Net investment income | - | - | - | - | ||||||||||||
Purchases | - | (23,628) | - | - | ||||||||||||
Sales | - | - | - | - | ||||||||||||
Issuances | - | - | - | - | ||||||||||||
Settlements | - | - | - | - | ||||||||||||
Foreign currency translation | - | - | - | - | ||||||||||||
Transfers into Level 3 (2) | - | - | - | - | ||||||||||||
Transfers out of Level 3 (2) | - | - | - | - | ||||||||||||
Other (4) | - | - | - | 1,529 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Fair value, end of period | $ | 5,995 | $ | (76,996) | $ | 18 | $ | 1,569 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Unrealized gains (losses) for the period relating to those | ||||||||||||||||
Level 3 assets that were still held at the end of the period (3): | ||||||||||||||||
Included in earnings: | ||||||||||||||||
Realized investment gains (losses), net | $ | - | $ | (94,098) | $ | - | $ | - | ||||||||
Asset management fees and other income | $ | - | $ | - | $ | - | $ | - | ||||||||
Interest credited to policyholder account balances | $ | 602 | $ | - | $ | - | $ | - | ||||||||
Included in other comprehensive income | $ | - | $ | - | $ | - | $ | - |
(1) Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Statements of Financial Position.
(2) Transfers into or out of Level 3 are generally reported as the value as of the beginning of the quarter in which the transfer occurs.
(3) Unrealized gains or losses related to assets still held at the end of the period do not include amortization or accretion of premiums and discounts.
(4) Other primarily represents reclasses of certain assets between reporting categories.
Transfers –As a part of an ongoing monitoring assessment of pricing inputs to ensure appropriateness of the level classification in the fair value hierarchy the Company may reassign level classification from time to time. As a result of such a review, in the first quarter of 2011, it was determined that the pricing inputs for perpetual preferred stocks provided by third party pricing services were primarily based on non-binding broker quotes which could not always be verified against directly observable market information. Consequently, perpetual preferred stocks were transferred into Level 3 within the fair value hierarchy. This represents the majority of the transfers into Level 3 for Equity Securities Available-for-Sale. Other transfers into Level 3 were primarily the result of unobservable inputs utilized within valuation methodologies and the use of broker quotes (that could not be validated) when previously, information from third party pricing services (that could be validated) was utilized. Transfers out of Level 3 were primarily due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company was able to validate.
F-48
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Changes in Level 3 assets and liabilities-The following tables provide a summary of the changes in fair value of Level 3 assets and liabilities for the year ended December 31, 2010, as well as the portion of gains or losses included in income for the year ended December 31, 2010 attributable to unrealized gains or losses related to those assets and liabilities still held at December 31, 2010.
Year Ended December 31, 2010 | ||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Asset- Backed Securities | Equity Securities, Available for Sale | Other Assets | |||||||||||||
|
| |||||||||||||||
(in thousands) | ||||||||||||||||
Fair value, beginning of period | $ | 2,398 | $ | 25,259 | $ | 576 | $ | 16,039 | ||||||||
Total gains (losses) (realized/unrealized): | ||||||||||||||||
Included in earnings: | ||||||||||||||||
Realized investment gains (losses), net | 8 | (139) | - | (443) | ||||||||||||
Asset management fees and other income | - | - | - | - | ||||||||||||
Included in other comprehensive income (loss) | 514 | (1,258) | (374) | 263 | ||||||||||||
Net investment income | 34 | 164 | - | - | ||||||||||||
Purchases, sales, issuances, and settlements | (149) | 9,049 | 53 | 1,137 | ||||||||||||
Foreign currency translation | - | - | - | - | ||||||||||||
Transfers into Level 3 (2) | 957 | - | - | - | ||||||||||||
Transfers out of Level 3 (2) | (127) | (16,456) | - | - | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Fair value, end of period | $ | 3,636 | $ | 16,619 | $ | 255 | $ | 16,996 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Unrealized gains (losses) for the period relating to those | ||||||||||||||||
Level 3 assets that were still held at the end of the period (3): | ||||||||||||||||
Included in earnings: | ||||||||||||||||
Realized investment gains (losses), net | $ | 10 | $ | (41) | $ | - | $ | (303) | ||||||||
Asset management fees and other income | $ | - | $ | - | $ | - | $ | - | ||||||||
Included in other comprehensive income (loss) | $ | 514 | $ | (1,258) | $ | (374) | $ | 263 |
Year Ended December 31, 2010 | ||||||||||||
Separate Account Assets (1) | Future Policy Benefits | Other Liabilities | ||||||||||
(in thousands) | ||||||||||||
Fair value, beginning of period | $ | 5,104 | $ | 2,412 | $ | (67) | ||||||
Total gains (losses) (realized/unrealized): | ||||||||||||
Included in earnings: | ||||||||||||
Realized investment gains (losses), net | - | 47,655 | 67 | |||||||||
Asset management fees and other income | - | - | - | |||||||||
Interest credited to policyholder account balances | 289 | - | - | |||||||||
Included in other comprehensive income | - | - | - | |||||||||
Net investment income | - | - | - | |||||||||
Purchases, sales, issuances, and settlements | - | (8,751) | - | |||||||||
Foreign currency translation | - | - | - | |||||||||
Transfers into Level 3 (2) | - | - | - | |||||||||
Transfers out of Level 3 (2) | - | - | - | |||||||||
|
|
|
|
|
| |||||||
Fair value, end of period | $ | 5,393 | $ | 41,316 | $ | - | ||||||
|
|
|
|
|
| |||||||
Unrealized gains (losses) for the period relating to those | ||||||||||||
Level 3 assets that were still held at the end of the period (3): | ||||||||||||
Included in earnings: | ||||||||||||
Realized investment gains (losses), net | $ | - | $ | 8,290 | $ | 70 | ||||||
Asset management fees and other income | $ | - | $ | - | $ | - | ||||||
Interest credited to policyholder account balances | $ | 289 | $ | - | $ | - | ||||||
Included in other comprehensive income | $ | - | $ | - | $ | - |
F-49
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
(1) Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Consolidated Statement of Financial Position.
(2) Transfers into or out of Level 3 are generally reported as the value as of the beginning of the quarter in which the transfer occurs.
(3) Unrealized gains or losses related to assets still held at the end of the period do not include amortization or accretion of premiums and discounts.
Transfers –As part of an ongoing assessment of pricing inputs to ensure appropriateness of the level classification in the fair value hierarchy the Company may reassign level classification from time to time. As a result of such a review, it was determined that the pricing inputs for perpetual preferred stocks provided by third party pricing services were primarily based on non-binding broker quotes which could not always be verified against directly observable market information. Consequently, perpetual preferred stocks were transferred into Level 3 within the fair value hierarchy. Other transfers into Level 3 were primarily the result of unobservable inputs utilized within valuation methodologies and the use of broker quotes (that could not be validated) when previously, information from third party pricing services (that could be validated) was utilized. Transfers out of Level 3 were primarily due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company was able to validate.
Transfers between Levels 1 and 2-During the year ended December 31, 2011, there were no material transfers between Level 1 and Level 2.
Changes in Level 3 assets and liabilities-The following tables provide a summary of the changes in fair value of Level 3 assets and liabilities for the year ended December 31, 2009, as well as the portion of gains or losses included in income for the year ended December 31, 2009 attributable to unrealized gains or losses related to those assets and liabilities still held at December 31, 2009.
Year Ended December 31, 2009 | ||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Asset- Backed Securities | Equity Securities, Available for Sale | Other Assets | |||||||||||||
(in thousands) | ||||||||||||||||
Fair value, beginning of period | $ | 266 | $ | 5,732 | $ | 121 | $ | 58,880 | ||||||||
Total gains (losses) (realized/unrealized): | ||||||||||||||||
Included in earnings: | ||||||||||||||||
Realized investment gains (losses), net | (506) | (1,634) | - | (44,396) | ||||||||||||
Asset management fees and other income | - | - | - | - | ||||||||||||
Included in other comprehensive income (loss) | 449 | 9,708 | 455 | 590 | ||||||||||||
Net investment income | (1) | 121 | - | - | ||||||||||||
Purchases, sales, issuances, and settlements | (169) | (1,780) | - | 965 | ||||||||||||
Foreign currency translation | - | - | - | - | ||||||||||||
Transfers into Level 3 (2) | 2,413 | 13,858 | - | - | ||||||||||||
Transfers out of Level 3 (2) | (54) | (746) | - | - | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Fair value, end of period | $ | 2,398 | $ | 25,259 | $ | 576 | $ | 16,039 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Unrealized gains (losses) for the period relating to those | ||||||||||||||||
Level 3 assets that were still held at the end of the period (3): | ||||||||||||||||
Included in earnings: | ||||||||||||||||
Realized investment gains (losses), net | $ | (506) | $ | (1,383) | $ | - | $ | (43,833) | ||||||||
Asset management fees and other income | $ | - | $ | - | $ | - | $ | - | ||||||||
Interest credited to policyholder account balances | $ | - | $ | - | $ | - | $ | - | ||||||||
Included in other comprehensive income (loss) | $ | 447 | $ | 9,605 | $ | 455 | $ | 590 |
F-50
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Year Ended December 31, 2009 | ||||||||||||
Separate (1) | Future Policy Benefits | Other Liabilities | ||||||||||
|
| |||||||||||
(in thousands) | ||||||||||||
Fair value, beginning of period | $ | 6,494 | $ | (63,903) | (4,272) | |||||||
Total gains (losses) (realized/unrealized): | ||||||||||||
Included in earnings: | ||||||||||||
Realized investment gains (losses), net | - | 69,126 | 4,205 | |||||||||
Interest credited to policyholder account balances | (1,335) | - | - | |||||||||
Included in other comprehensive income (loss) | - | - | - | |||||||||
Net investment income | - | - | - | |||||||||
Purchases, sales, issuances, and settlements | 38 | (2,811) | - | |||||||||
Foreign currency translation | - | - | - | |||||||||
Transfers into Level 3 (2) | - | - | - | |||||||||
Transfers out of Level 3 (2) | (93) | - | - | |||||||||
|
|
|
|
|
| |||||||
Fair value, end of period | $ | 5,104 | $ | 2,412 | (67) | |||||||
|
|
|
|
|
| |||||||
Unrealized gains (losses) for the period relating to those | ||||||||||||
Level 3 assets that were still held at the end of the period (3): | ||||||||||||
Included in earnings: | ||||||||||||
Realized investment gains (losses), net | $ | - | $ | 68,705 | $ | 4,208 | ||||||
Asset management fees and other income | $ | - | $ | - | $ | - | ||||||
Interest credited to policyholder account balances | $ | (1,335) | $ | - | $ | - | ||||||
Included in other comprehensive income (loss) | $ | - | $ | - | $ | - |
(1) | Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Statement of Financial Position. |
(2) | Transfers into or out of Level 3 are generally reported as the value as of the beginning of the quarter in which the transfer occurs. |
(3) | Unrealized gains or losses related to assets still held at the end of the period do not include amortization or accretion of premiums and discounts. |
Transfers – Transfers out of Level 3 for Fixed Maturities Available for Sale – Asset-Backed Securities totaled $4.0 million for the year ended December 31, 2011 resulting from the Company’s conclusion that the market for asset-backed securities collateralized by sub-prime mortgages became increasingly active, as evidenced by orderly transactions. The pricing received from independent pricing services could be validated by the Company, as discussed in detail above. There were no transfers into Level 3.
Fair Value of Financial Instruments – The Company is required by U.S. GAAP to disclose the fair value of certain financial instruments including those that are not carried at fair value. For the following financial instruments the carrying amount equals or approximates fair value: fixed maturities classified as available-for-sale, trading account assets, equity securities, securities purchased under agreements to resell, short-term investments, cash and cash equivalents, accrued investment income, separate account assets, securities sold under agreements to repurchase, and cash collateral for loaned securities, as well as certain items recorded within other assets and other liabilities such as broker-dealer related receivables and payables. See Note 11 for a discussion of derivative instruments.
The following table discloses the Company’s financial instruments where the carrying amounts and fair values differ:
December 31, 2011 | December 31, 2010 | |||||||||||||||
Carrying Amount | Fair value | Carrying Amount | Fair value | |||||||||||||
(in thousands) | ||||||||||||||||
Assets: | ||||||||||||||||
Commercial mortgage and other loans | $ | 230,201 | $ | 247,865 | $ | 182,437 | $ | 192,102 | ||||||||
Policy loans | 177,162 | 235,706 | 175,514 | 211,513 | ||||||||||||
Liabilities: | ||||||||||||||||
Policyholder account balances - investment contracts | 113,938 | 113,010 | 102,593 | 101,551 | ||||||||||||
Short-term and long-term debt to affiliates | 70,000 | 70,293 | - | - |
F-51
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The fair values presented above for those financial instruments where the carrying amounts and fair values may differ have been determined by using available market information and by applying market valuation methodologies, as described in more detail below.
Commercial mortgage and other loans
The fair value of commercial mortgage and other loans is primarily based upon the present value of the expected future cash flows discounted at the appropriate U.S. Treasury rate adjusted for appropriate credit spread for similar quality loans. The quality ratings for these loans, a primary determinant of the credit spread and a significant component of the pricing input, are based on internally developed methodology. The internally derived credit spreads take into account public corporate bond spreads of similar quality and maturity, public commercial mortgage-backed securities spreads, third-party mortgage loan survey spreads and other relevant market information such as pricing indications from market participants on new originations, and where applicable adjustments for property types and locations.
Policy Loans
The fair value of policy loans is calculated using a discounted cash flow model based upon current U.S. Treasury rates and historical loan repayment patterns.
Investment Contracts – Policyholders’ Account Balances
Only the portion of policyholders’ account balances related to products that are investment contracts (those without significant mortality or morbidity risk) are reflected in the table above. For fixed deferred annuities, payout annuities and other similar contracts without life contingencies, fair values are derived using discounted projected cash flows based on interest rates that are representative of the Company’s claims paying ratings, and hence reflect the Company’s own nonperformance risk. For those balances that can be withdrawn by the customer at any time without prior notice or penalty, the fair value is the amount estimated to be payable to the customer as of the reporting date, which is generally the carrying value.
Short-term and long-term debt to affiliates
The fair value of short-term and long-term debt is generally determined by either prices obtained from independent pricing services, which are validated by the Company, or discounted cash flow models. These fair values consider the Company’s own non-performance risk. Discounted cash flow models predominately use market observable inputs such as the borrowing rates currently available to the Company for debt and financial instruments with similar terms and remaining maturities. For commercial paper issuances and other debt with a maturity of less than 90 days, the carrying value approximates fair value.
11. DERIVATIVE INSTRUMENTS
Types of Derivative Instruments and Derivative Strategies
Interest Rate Contracts
Interest rate swaps are used by the Company to manage interest rate exposures arising from mismatches between assets and liabilities (including duration mismatches) and to hedge against changes in the value of assets it anticipates acquiring and other anticipated transactions and commitments. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed rate and floating rate interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the contract and no principal payments are made by either party. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty at each due date.
Equity Contracts
Equity index options are contracts which will settle in cash based on differentials in the underlying indices at the time of exercise and the strike price. The Company uses combinations of purchases and sales of equity index options to hedge the effects of adverse changes in equity indices within a predetermined range. These hedges do not qualify for hedge accounting.
F-52
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Foreign Exchange Contracts
Currency derivatives, including currency swaps and forwards, are used by the Company to reduce risks from changes in currency exchange rates with respect to investments denominated in foreign currencies that the Company either holds or intends to acquire or sell.
Under currency swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between one currency and another at an exchange rate and calculated by reference to an agreed principal amount. Generally, the principal amount of each currency is exchanged at the beginning and termination of the currency swap by each party. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty for payments made in the same currency at each due date.
Credit Contracts
Credit derivatives are used by the Company to enhance the return on the Company’s investment portfolio by creating credit exposure similar to an investment in public fixed maturity cash instruments. With credit derivatives the Company can sell credit protection on an identified name, or a basket of names in a first to default structure, and in return receive a quarterly premium. With first to default baskets, the premium generally corresponds to a high proportion of the sum of the credit spreads of the names in the basket. If there is an event of default by the referenced name or one of the referenced names in a basket, as defined by the agreement, then the Company is obligated to pay the counterparty the referenced amount of the contract and receive in return the referenced defaulted security or similar security. See credit derivatives written section for discussion of guarantees related to credit derivatives written. In addition to selling credit protection, the Company may purchase credit protection using credit derivatives in order to hedge specific credit exposures in the Company’s investment portfolio.
Embedded Derivatives
The Company sells variable annuity contracts that include certain optional living benefit features that are treated, for accounting purposes, as embedded derivatives. The Company has reinsurance agreements to transfer the risk related to certain of these embedded derivatives to an affiliate, Pruco Reinsurance Ltd. (“Pruco Re”). The embedded derivatives related to the living benefit features and the related reinsurance agreements are carried at fair value. Mark-to-market changes in the fair value of the underlying contractual guarantees are determined using valuation models as described in Note 7, and are recorded in “Realized investment gains (losses), net.”
The Company invests in fixed maturities that, in addition to a stated coupon, provide a return based upon the results of an underlying portfolio of fixed income investments and related investment activity. The Company accounts for these investments as available-for-sale fixed maturities containing embedded derivatives. Such embedded derivatives are marked to market through “Realized investment gains (losses), net,” based upon the change in value of the underlying portfolio.
The fair value of the embedded derivatives included in Future policy benefits was a liability of $77 million and a contra-liability of $41 million as of December 31, 2011 and December 31, 2010, respectively. The fair value of the embedded derivatives related to the reinsurance of certain of these benefits to Pruco Re included in “Reinsurance Recoverable” was an asset of $54 million as of December 31, 2011 and an asset of $11 million as of December 31, 2010.
F-53
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The table below provides a summary of the gross notional amount and fair value of derivatives contracts, excluding embedded derivatives which are recorded with the associated host, by the primary underlying. Many derivative instruments contain multiple underlyings.
December 31, 2011 | December 31, 2010 | |||||||||||||||||||||||
Primary Underlying | Notional Amount | Fair Value | Notional Amount | Fair Value | ||||||||||||||||||||
Assets | Liabilities | Assets | Liabilities | |||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Qualifying Hedges | ||||||||||||||||||||||||
Currency/Interest Rate | $ | 14,972 | $ | 221 | $ | (846) | $ | 11,018 | $ | - | $ | (1,104) | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total Qualifying Hedges | $ | 14,972 | $ | 221 | $ | (846) | $ | 11,018 | $ | - | $ | (1,104) | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Non-Qualifying Hedges | ||||||||||||||||||||||||
Interest Rate | $ | 57,200 | $ | 8,442 | $ | - | $ | 47,000 | $ | 1,737 | $ | (1,006) | ||||||||||||
Credit | 17,000 | 118 | (339) | 8,900 | 1,206 | (878) | ||||||||||||||||||
Currency/Interest Rate | 16,615 | - | (909) | 9,115 | - | (853) | ||||||||||||||||||
Equity | - | - | - | - | - | - | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total Non-Qualifying Hedges | 90,815 | 8,560 | (1,248) | 65,015 | 2,943 | (2,737) | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total Derivatives (1) | $ | 105,787 | $ | 8,781 | $ | (2,094) | $ | 76,033 | $ | 2,943 | $ | (3,841) | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
(1) Excludes embedded derivatives which contain multiple underlyings. The fair value of these embedded derivatives was a liability of $80 million as of December 31, 2011 and a conta-liability of $38 million as of December 31, 2010 included in “Future policy benefits” and “Fixed maturities available for sale.”
Cash Flow Hedges
The Company uses currency swaps in its cash flow hedge accounting relationships. This instrument is only designated for hedge accounting in instances where the appropriate criteria are met. The Company does not use futures, credit, and equity or embedded derivatives in any of its cash flow hedge accounting relationships.
The following table provides the financial statement classification and impact of derivatives used in qualifying and non-qualifying hedge relationships, excluding the offset of the hedged item in an effective hedge relationship:
Year Ended December 31, | ||||||||||||
2011 | 2010 | 2009 | ||||||||||
(in thousands) | ||||||||||||
Qualifying Hedges | ||||||||||||
Cash flow hedges | ||||||||||||
Currency/Interest Rate | ||||||||||||
Net investment income | $ | (41) | $ | 45 | $ | 3 | ||||||
Other income | 2 | 2 | (12) | |||||||||
Accumulated Other Comprehensive Income (1) | 471 | (426) | (711) | |||||||||
|
|
|
|
|
| |||||||
Total cash flow hedges | $ | 432 | $ | (379) | $ | (720) | ||||||
|
|
|
|
|
| |||||||
Non-qualifying hedges | ||||||||||||
Realized investment gains (losses) | ||||||||||||
Interest Rate | $ | 9,402 | $ | 6,717 | $ | (6,086) | ||||||
Currency/Interest Rate | (181) | 617 | (880) | |||||||||
Credit | 68 | (762) | 2,763 | |||||||||
Equity | - | - | - | |||||||||
Embedded Derivatives | (121,599) | 47,806 | 26,471 | |||||||||
|
|
|
|
|
| |||||||
Total non-qualifying hedges | $ | (112,310) | $ | 54,378 | $ | 22,268 | ||||||
|
|
|
|
|
| |||||||
Total Derivative Impact | $ | (111,878) | $ | 53,999 | $ | 21,548 | ||||||
|
|
|
|
|
|
(1) | Amounts deferred in “Accumulated other comprehensive income (loss).” |
F-54
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
For the period ending December 31, 2011, the ineffective portion of derivatives accounted for using hedge accounting was not material to the Company’s results of operations and there were no material amounts reclassified into earnings relating to instances in which the Company discontinued cash flow hedge accounting because the forecasted transaction did not occur by the anticipated date or within the additional time period permitted by the authoritative guidance for the accounting for derivatives and hedging.
Presented below is a roll forward of current period cash flow hedges in “Accumulated other comprehensive income (loss)” before taxes:
(in thousands) | ||||
Balance, December 31, 2010 | $ | (1,100) | ||
Net deferred gains on cash flow hedges from January 1 to December 31, 2011 | (7,152) | |||
Amount reclassified into current period earnings | 7,622 | |||
|
| |||
Balance, December 31, 2011 | $ | (630) | ||
|
|
As of December 31, 2011, the Company does not have any qualifying cash flow hedges of forecasted transactions other than those related to the variability of the payment or receipt of interest or foreign currency amounts on existing financial instruments. The maximum length of time for which these variable cash flows are hedged is 15 years. Income amounts deferred in “Accumulated other comprehensive income (loss)” as a result of cash flow hedges are included in “Net unrealized investment gains (losses)” in the Statements of Equity.
Credit Derivatives Written
The Company holds certain externally managed investments in the European market which contain embedded derivatives whose fair value are primarily driven by changes in credit spreads. These investments are medium term notes that are collateralized by investment portfolios primarily consisting of investment grade European fixed income securities, including corporate bonds and asset-backed securities, and derivatives, as well as varying degrees of leverage. The notes have a stated coupon and provide a return based on the performance of the underlying portfolios and the level of leverage. The Company invests in these notes to earn a coupon through maturity, consistent with its investment purpose for other debt securities. The notes are accounted for under U.S. GAAP as available for sale fixed maturity securities with bifurcated embedded derivatives (total return swaps). Changes in the value of the fixed maturity securities are reported in Equity under the heading “Accumulated Other Comprehensive Income” and changes in the market value of the embedded total return swaps are included in current period earnings in “Realized investment gains (losses), net.” The Company’s maximum exposure to loss from these interests was $7 million at December 31, 2011 and December 31, 2010. The fair value of the embedded derivatives included in Fixed maturities, available for sale was a liability of $3 million at December 31, 2011 and December 31, 2010.
The Company writes credit derivatives under which the Company is obligated to pay the counterparty the referenced amount of the contract and receive in return the defaulted security or similar security. The Company’s maximum amount at risk under these credit derivatives, assuming the value of the underlying referenced securities become worthless, is $10 million and $0 million notional of credit default swap (“CDS”) selling protection with an associated fair value of approximately less than $1 million, at December 31, 2011 and December 31, 2010, respectively, These credit derivatives generally have maturities of five to ten years and consist of corporate securities within the finance industry. At December 31, 2011, the underlying credits have an NAIC designation rating of 1.
In addition to writing credit protection, the Company has purchased credit protection using credit derivatives in order to hedge specific credit exposures in the Company’s investment portfolio. As of December 31, 2011 and December 31, 2010, the Company had $7 million and $9 million of outstanding notional amounts, respectively, reported at fair value as a liability of $0.2 million and an asset of $0.3 million, respectively.
Credit Risk
The Company is exposed to credit-related losses in the event of non-performance by our counterparty to financial derivative transactions. Generally, the credit exposure of the Company’s over-the-counter (OTC) derivative transactions is represented by the contracts with a positive fair value (market value) at the reporting date after taking into consideration the existence of netting agreements.
F-55
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
The Company has credit risk exposure to an affiliate, Prudential Global Funding, LLC related to its over-the-counter derivative transactions. Prudential Global Funding, LLC manages credit risk with external counterparties by entering into derivative transactions with highly rated major international financial institutions and other creditworthy counterparties, and by obtaining collateral where appropriate.
Under fair value measurements, the Company incorporates the market’s perceptions of its own and the counterparty’s non-performance risk in determining the fair value of the portion of its OTC derivative assets and liabilities that are uncollateralized. Credit spreads are applied to the derivative fair values on a net basis by counterparty. To reflect the Company’s own credit spread a proxy based on relevant debt spreads is applied to OTC derivative net liability positions. Similarly, the Company’s counterparty’s credit spread is applied to OTC derivative net asset positions.
12. COMMITMENTS, CONTINGENT LIABILITIES AND LITIGATION AND REGULATORY MATTERS
Commitments
The Company has made commitments to fund $6 million of commercial loans as of December 31, 2011. The Company also made commitments to purchase or fund investments, mostly private fixed maturities, of $20 million as of December 31, 2011.
Contingent Liabilities
On an ongoing basis, the Company’s internal supervisory and control functions review the quality of sales, marketing and other customer interface procedures and practices and may recommend modifications or enhancements. From time to time, this review process results in the discovery of product administration, servicing or other errors, including errors relating to the timing or amount of payments or contract values due to customers. In certain cases, if appropriate, the Company may offer customers remediation and may incur charges, including the costs of such remediation, administrative costs and regulatory fines.
The Company is subject to the laws and regulations of states and other jurisdictions concerning the identification, reporting and escheatment of unclaimed or abandoned funds, and is subject to audit and examination for compliance with these requirements. For additional discussion of these matters, see “Litigation and Regulatory Matters” below.
It is possible that the results of operations or the cash flow of the Company in a particular quarterly or annual period could be materially affected as a result of payments in connection with the matters discussed above or other matters depending, in part, upon the results of operations or cash flow for such period. Management believes, however, that ultimate payments in connection with these matters, after consideration of applicable reserves and rights to indemnification, should not have a material adverse effect on the Company’s financial position.
Litigation and Regulatory Matters
The Company is subject to legal and regulatory actions in the ordinary course of its business. Pending legal and regulatory actions include proceedings specific to the Company and proceedings generally applicable to business practices in the industry in which it operates. The Company is subject to class action lawsuits and other litigation involving a variety of issues and allegations involving sales practices, claims payments and procedures, premium charges, policy servicing and breach of fiduciary duty to customers. The Company is also subject to litigation arising out of its general business activities, such as its investments, contracts, leases and labor and employment relationships, including claims of discrimination and harassment, and could be exposed to claims or litigation concerning certain business or process patents. In some of the pending legal and regulatory actions, plaintiffs are seeking large and/or indeterminate amounts, including punitive or exemplary damages. In addition, the Company, along with other participants in the businesses in which it engages, may be subject from time to time to investigations, examinations and inquiries, in some cases industry-wide, concerning issues or matters upon which such regulators have determined to focus. In some of the Company’s pending legal and regulatory actions, parties are seeking large and/or indeterminate amounts, including punitive or exemplary damages. The outcome of litigation or a regulatory matter, and the amount or range of potential loss at any particular time, is often inherently uncertain. The following is a summary of certain pending proceedings.
F-56
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
In January 2012, aqui tamaction on behalf of the State of Illinois,Total Asset Recovery Services v. Met Life Inc, et al., Prudential Financial, Inc., The Prudential Insurance Company of America, and Prudential Holdings, LLC, filed in the Circuit Court of Cook County, Illinois, was served on the Company. The complaint alleges that the Company failed to escheat life insurance proceeds to the State of Illinois in violation of the Illinois False Claims Whistleblower Reward and Protection Act and seeks injunctive relief, compensatory damages, civil penalties, treble damages, prejudgment interest, attorneys’ fees and costs. In March 2012, aqui tamaction on behalf of the State of Minnesota,Total Asset Recovery v. MetLife Inc., et al., Prudential Financial Inc., The Prudential Insurance Company of America and Prudential Holdings, Inc., filed in the Fourth Judicial District, Hennepin County, in the State of Minnesota was served on the Company. The complaint alleges that the Company failed to escheat life insurance proceeds to the State of Minnesota in violation of the Minnesota False Claims Act and seeks injunctive relief, compensatory damages, civil penalties, treble damages, prejudgment interest, attorneys’ fees and costs.
In January 2012, a Global Resolution Agreement entered into by the Company and a third party auditor became effective upon its acceptance by the unclaimed property departments of 20 states and jurisdictions. Under the terms of the Global Resolution Agreement, the third party auditor acting on behalf of the signatory states will compare expanded matching criteria to the Social Security Master Death File (“SSMDF”) to identify deceased insureds and contract holders where a valid claim has not been made. In February 2012, a Regulatory Settlement Agreement entered into by the Company to resolve a multi-state market conduct examination regarding its adherence to state claim settlement practices became effective upon its acceptance by the insurance departments of 20 states and jurisdictions. The Regulatory Settlement Agreement applies prospectively and requires the Company to adopt and implement additional procedures comparing its records to the SSMDF to identify unclaimed death benefits and prescribes procedures for identifying and locating beneficiaries once deaths are identified. Other jurisdictions that are not signatories to the Regulatory Settlement Agreement are considering proposals that would apply prospectively and require life insurance companies to take additional steps to identify unreported deceased policy and contract holders. These prospective changes and any escheatable property identified as a result of the audits and inquiries could result in: (1) additional payments of previously unclaimed death benefits; (2) the payment of abandoned funds to U.S. jurisdictions; and (3) changes in the Company’s practices and procedures for the identification of escheatable funds and beneficiaries, which would impact claim payments and reserves, among other consequences.
The Company is one of several companies subpoenaed by the New York Attorney General regarding its unclaimed property procedures. Additionally, the New York Department of Insurance (“NYDOI”) has requested that 172 life insurers (including the Company) provide data to the NYDOI regarding use of the SSMDF. The New York Office of Unclaimed Funds recently notified the Company that it intends to conduct an audit of the Company’s compliance with New York’s unclaimed property laws. The Minnesota Attorney General has also requested information regarding the Company’s use of the SSMDF and its claim handling procedures and the Company is one of several companies subpoenaed by the Minnesota Department of Commerce, Insurance Division. In February 2012, the Massachusetts Office of the Attorney General requested information regarding the Company’s unclaimed property procedures.
In July 2010, the Company, along with other life insurance industry participants, received a formal request for information from the State of New York Attorney General’s Office in connection with its investigation into industry practices relating to the use of retained asset accounts. In August 2010, the Company received a similar request for information from the State of Connecticut Attorney General’s Office. The Company is cooperating with these investigations. The Company has also been contacted by state insurance regulators and other governmental entities, including the U.S. Department of Veterans Affairs and Congressional committees regarding retained asset accounts. These matters may result in additional investigations, information requests, claims, hearings, litigation, adverse publicity and potential changes to business practices.
The Company’s litigation and regulatory matters are subject to many uncertainties, and given their complexity and scope, their outcome cannot be predicted. It is possible that the Company’s results of operations or cash flow in a particular quarterly or annual period could be materially affected by an ultimate unfavorable resolution of pending litigation and regulatory matters depending, in part, upon the results of operations or cash flow for such period. In light of the unpredictability of the Company’s litigation and regulatory matters, it is also possible that in certain cases an ultimate unfavorable resolution of one or more pending litigation or regulatory matters could have a material adverse effect on the Company’s financial position. Management believes, however, that, based on information currently known to it, the ultimate outcome of all pending litigation and regulatory matters, after consideration of applicable reserves and rights to indemnification, is not likely to have a material adverse effect on the Company’s financial position.
F-57
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
13. RELATED PARTY TRANSACTIONS
The Company has extensive transactions and relationships with Prudential Insurance and other affiliates. Although we seek to ensure that these transactions and relationships are fair and reasonable, it is possible that the terms of these transactions are not the same as those that would result from transactions among unrelated parties.
Expense Charges and Allocations
Many of the Company’s expenses are allocations or charges from Prudential Insurance or other affiliates. These expenses can be grouped into general and administrative expenses and agency distribution expenses.
The Company’s general and administrative expenses are charged to the Company using allocation methodologies based on business production processes. Management believes that the methodology is reasonable and reflects costs incurred by Prudential Insurance to process transactions on behalf of the Company. The Company operates under service and lease agreements whereby services of officers and employees, supplies, use of equipment and office space are provided by Prudential Insurance. The Company reviews its allocation methodology periodically which it may adjust accordingly. General and administrative expenses include allocations of stock compensation expenses related to a stock option program and a deferred compensation program issued by Prudential Financial. The expense charged to the Company for the stock option program was less than $0.1 million for the twelve months ended December 31, of 2011, 2010 and 2009. The expense charged to the Company for the deferred compensation program was less than $0.6 million, $0.5 million and $0.3 million for the twelve months ended December 31, of 2011, 2010 and 2009 respectively.
The Company is charged for its share of employee benefits expenses. These expenses include costs for funded and non-funded contributory and non-contributory defined benefit pension plans. Some of these benefits are based on final group earnings and length of service while others are based on an account balance, which takes into consideration age, service and earnings during career. The Company’s share of net expense for the pension plans was $1.5 million and $1.3 million in 2011 and 2010, respectively.
Prudential Insurance sponsors voluntary savings plans for its employees (401(k) plans). The plans provide for salary reduction contributions by employees and matching contributions by the Company of up to 4% of annual salary. The Company’s expense for its share of the voluntary savings plan was $0.7 million, $0.7 million and $0.5 million in 2011, 2010 and 2009, respectively.
The Company is charged distribution expenses from Prudential Insurance’s agency network for both its domestic life and annuity products through a transfer pricing agreement, which is intended to reflect a market based pricing arrangement.
Corporate Owned Life Insurance
The Company has sold two Corporate Owned Life Insurance, or “COLI”, policies to Prudential Insurance and one to Prudential Financial. The cash surrender value included in separate accounts for these COLI contracts was $1.1 billion and at December 31, 2011 and $1.0 billion at December 31, 2010, respectively. Fees related to these COLI policies were $16 million, $25 million and $23 million for the years ending December 31, 2011, 2010 and 2009, respectively.
Reinsurance with Affiliates
Pruco Life
Effective April 1, 2008, the Company entered into an agreement to reinsure certain variable COLI policies with Pruco Life. Reinsurance recoverables related to this agreement were $7 million and $5 million as of December 31, 2011 and December 31, 2010, respectively. Fees ceded to Pruco Life were $8 million, $10 million, and $6 million for the years ended December 31, 2011, 2010, and 2009, respectively. Benefits ceded were $2 million, $1 million and $2 million for the years ended December 31, 2011, 2010 and 2009, respectively. The Company is not relieved of its primary obligation to the policyholder as a result of this agreement.
F-58
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
PARCC
The Company reinsures 90% of the risks under its term life insurance policies, written prior to January 1, 2010, excluding My Term and ROP Term life insurance, through an automatic coinsurance agreement with PARCC. The Company is not relieved of its primary obligation to the policyholder as a result of this agreement. Reinsurance recoverables related to this agreement were $403 million and $360 million as of December 31, 2011 and December 31, 2010, respectively. Premiums ceded to PARCC in 2011, 2010 and 2009 were $125 million, $134 million and $140 million, respectively. Benefits ceded in 2011, 2010 and 2009 were $52 million, $53 million and $53 million, respectively. Reinsurance expense allowances, net of capitalization and amortization were $26 million, $29 million and $31 million for the years ended December 31, 2011, 2010 and 2009, respectively.
PAR TERM
The Company reinsures 95% of the risks under its term life insurance policies issued on or after January 1, 2010, excluding My Term, through an automatic coinsurance agreement with PAR TERM. The Company is not relieved of its primary obligation to the policyholder as a result of this agreement. Reinsurance recoverables related to this agreement were $28 million and $10 million as of December 31, 2011 and December 31, 2010, respectively. Premiums ceded to PAR TERM in 2011 and 2010 were $24 million and $11 million, respectively. Benefits ceded to PAR TERM in 2011 and 2010 were $4 million and less than $1 million, respectively. Reinsurance expense allowances, net of capitalization and amortization were $4 million and $2 million for the years ended December 31, 2011 and 2010, respectively.
Prudential Insurance
The Company has a yearly renewable term reinsurance agreement with Prudential Insurance and reinsures the majority of all mortality risks not otherwise reinsured. The reinsurance recoverables related to this agreement were $30 million and $31 million as of December 31, 2011 and December 31, 2010, respectively. Premiums and fees ceded to Prudential Insurance in 2011, 2010 and 2009 were $41 million, $58 million and $33 million respectively. Benefits ceded to Prudential in 2011, 2010 and 2009 were $42 million, $40 million and $29 million, respectively. The Company is not relieved of its primary obligation to the policyholder as a result of this agreement.
Pruco Reinsurance
The Company uses reinsurance as part of its risk management and capital management strategies for certain of its optional living benefit features.
The following table provides information relating to fees ceded to Pruco Reinsurance (“Pruco Re”) under these agreements which are included in “Realized investment (losses) gains, net” on the Statement of Operations and Comprehensive Income for the dates indicated.
Year Ended | ||||||||||||
December 31, 2011 | December 31, 2010 | December 31, 2009 | ||||||||||
(in thousands) | ||||||||||||
Pruco Reinsurance | ||||||||||||
Effective October 1, 2011 | ||||||||||||
Highest Daily Lifetime Income (“HDI”) | 9,369 | - | - | |||||||||
Spousal Highest Daily Lifetime Income (“SHDI”) | 2,973 | - | - | |||||||||
Highest Daily Lifetime 6 Plus (“HD6 Plus”) | 40,887 | - | - | |||||||||
Spousal Highest Daily Lifetime 6 Plus (“SHD6 Plus”) | 14,490 | - | - | |||||||||
Effective Since 2006 | ||||||||||||
Spousal Lifetime Five (“SLT5”) | $ | 173 | $ | 167 | $ | 149 | ||||||
Effective Since 2005 | ||||||||||||
Lifetime Five (“LT5”) | 1,244 | 1,195 | 1,080 | |||||||||
|
|
|
|
|
| |||||||
Total Pruco Reinsurance | $ | 69,136 | $ | 1,362 | $ | 1,229 | ||||||
|
|
|
|
|
|
F-59
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
Effective October 1, 2011 the Company ceded the HDI, SHDI, HD6+ and SHD6+ benefits to Pruco Re, as noted in the table above. The Company paid an initial premium of $62.3 million and established a reinsurance recoverable of $30.7 million resulting in an initial ceding loss of $31.6 million, recognized in “realized gains (losses)” in 2011.
The Company’s reinsurance recoverables related to the above product reinsurance agreements were $54 million and $11 million as of December 31, 2011, and December 31, 2010, respectively. Realized gains (losses) were ($27) million, ($0.4) million and ($44) million for the years ended December 31, 2011, 2010 and 2009, respectively. Change in realized gains (losses) for 2011 includes the loss of reinsurance ceded in 2011 as noted above as well as changes in market conditions. Changes in realized gains (losses) for the 2010 and 2009 periods were primarily due to changes in market conditions in the period. The underlying assets as of December 31, 2011, and December 31, 2010 are reflected in “Reinsurance recoverables” in the Company’s Statement of Financial Position.
Deferred Policy Acquisition Costs Ceded to Term Reinsurance Affiliates
In 2009 when implementing a revision to the reinsurance treaties with PARCC and PAR TERM modifications were made affecting premiums. The related impact on the deferral of ceded reinsurance expense allowances did not reflect this change resulting in the understatement of deferred reinsurance expense allowances. During second quarter 2011, the Company recorded the correction, charging $1 million to net DAC amortization which represented the cumulative impact of this change. These adjustments are not material to any previously reported quarterly or annual financial statements.
Affiliated Asset Administration Fee Income
Effective April 15, 2009, the Company amended an existing agreement to add AST Investment Services, Inc., formerly known as American Skandia Investment Services, Inc, as a party whereas the Company receives fee income calculated on contractholder separate account balances invested in the Advanced Series Trust, formerly known as American Skandia Trust. Income received from AST Investment Services, Inc. related to this agreement was $12.3 million, $3.7 million, and $1.1 million for the years ended December 31, 2011, 2010, and 2009 respectively. These revenues are recorded as “Asset administration fees” in the Statements of Operations and Comprehensive Income (Loss).
The Company participates in a revenue sharing agreement with Prudential Investments LLC, whereby the Company receives fee income from policyholders’ account balances invested in The Prudential Series Fund (“PSF”). Income received from Prudential Investments LLC, related to this agreement was $6.0 million, $5.7 million, and $5.0 million for the years ended December 31, 2011, 2010, and 2009 respectively. These revenues are recorded as “Asset administration fees” in the Statements of Operations and Comprehensive Income (Loss).
Affiliated Asset Transfers
The Company buys and sells assets to and from affiliated companies.
In December 2010, the Company amended certain of its affiliated reinsurance treaties to change the settlement mode from monthly to annual. As a result of these treaty amendments, we were required to pay Prudential Insurance the premium difference that resulted. Settlement of the premium difference was made by transfer of securities that had an amortized cost of $19 million and a fair market value of $20 million. The difference between amortized cost and fair market value was accounted for as an increase of $1 million to additional paid-in capital, net of taxes in 2010.
In December 2011, the Company purchased commercial loan securities from its parent company, Pruco Life. These securities had an amortized cost of $10 million and a fair market value of $11 million. The difference between amortized cost and fair market value of these transfers was accounted for as a decrease of $1 million to additional paid-in capital, net of taxes in 2011.
In December 2011, the Company sold fixed maturity securities to its parent company, Pruco Life. These securities had an amortized cost of $13 million and a fair market value of $14 million. The difference between amortized cost and fair market of these transfers was accounted for as an increase of $1 million to additional paid-in capital, net of taxes in 2011.
Debt Agreements
The Company and its parent, Pruco Life, have an agreement with an affiliate, Prudential Funding, LLC, which allows it to borrow funds for working capital and liquidity needs. The borrowings under this agreement are limited to $200 million. The Company had $15 million in Pru Funding short term debt and $11 million in PFI short term debt as of December 31, 2011, and no short-term debt outstanding as of December 31, 2010.
F-60
PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY
Notes to Financial Statements - (Continued)
On December 16, 2011 the Company entered into a series of four $11 million borrowings with Prudential Financial, totaling $44 million. The loans have fixed interest rates ranging from 2.65% to 3.61% and maturity dates staggered one year apart, from December 16, 2013 to December 16, 2016. The total related interest expense was $0.06 million for the year ended December 31, 2011.
Contributed Capital
In June 2011, the Company received a capital contribution from Pruco Life in the amount of $21 million to fund acquisition costs for sales of variable annuities.
In December 2011, the Company received a capital contribution from Pruco Life in the amount of $17 million to fund acquisition costs for sales of variable annuities.
Derivative Trades
In the ordinary course of business, the Company enters into over-the-counter (“OTC”) derivative contracts with an affiliate, Prudential Global Funding, LLC. For these OTC derivative contracts, Prudential Global Funding, LLC has a substantially equal and offsetting position with external counterparties.
14. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The unaudited quarterly results of operations for the years ended December 31, 2011 and 2010 are summarized in the table below:
Three Months Ended | ||||||||||||||||
|
| |||||||||||||||
March 31 | June 30 | September 30 | December 31 | |||||||||||||
(in thousands) | ||||||||||||||||
2011 | ||||||||||||||||
Total revenues | $ | 80,087 | $ | 60,305 | $ | (51,055) | $ | 31,823 | ||||||||
Total benefits and expenses | 39,265 | 46,653 | 111,568 | 32,069 | ||||||||||||
Income (loss) from operations before income taxes | 40,822 | 13,652 | (162,623) | (246) | ||||||||||||
Net income (loss) | $ | 28,566 | $ | 10,231 | $ | (101,424) | $ | 2,840 | ||||||||
|
|
|
|
|
|
|
| |||||||||
2010 | ||||||||||||||||
Total revenues | $ | 53,557 | $ | 39,034 | $ | 51,823 | $ | 73,988 | ||||||||
Total benefits and expenses | 30,872 | 55,748 | 5,524 | (4,558) | ||||||||||||
Income (loss) from operations before income taxes | 22,685 | (16,714) | 46,299 | 78,546 | ||||||||||||
Net income (loss) | $ | 16,907 | $ | (11,703) | $ | 34,649 | $ | 51,155 | ||||||||
|
|
|
|
|
|
|
|
F-61