Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2011
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Transition Period from to
Commission File Number 033-44202
Prudential Annuities Life Assurance Corporation
(Exact Name of Registrant as Specified in its Charter)
Connecticut | 06-1241288 | |
(State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification Number) |
One Corporate Drive
Shelton, Connecticut 06484
(203) 926-1888
(Address and Telephone Number of Registrant’s Principal Executive Offices)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of the Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer | ¨ | Accelerated filer | ¨ | |||
Non-accelerated filer | x | Smaller reporting company | ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of August 12, 2011, 25,000 shares of the registrant’s Common Stock (par value $100) consisting of 100 voting shares and 24,900 non-voting shares, were outstanding. As of such date, Prudential Annuities, Inc. formerly known as American Skandia, Inc., an indirect wholly owned subsidiary of Prudential Financial, Inc., a New Jersey corporation, owned all of the registrant’s Common Stock.
Prudential Annuities Life Assurance Corporation meets the conditions set
forth in General Instruction (H) (1) (a) and (b) on Form 10-Q and
is therefore filing this Form 10-Q in the reduced disclosure format.
Table of Contents
Page | ||||||||
PART I | ||||||||
Item 1. | ||||||||
Unaudited Interim Statements of Financial Position | 4 | |||||||
5 | ||||||||
Unaudited Interim Statement of Equity | 6 | |||||||
Unaudited Interim Statements of Cash Flows | 7 | |||||||
8 | ||||||||
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 39 | ||||||
Item 4. | 48 | |||||||
PART II | ||||||||
Item 1. | 49 | |||||||
Item 1A. | 49 | |||||||
Item 6. | 50 | |||||||
51 |
2
Table of Contents
FORWARD LOOKING STATEMENTS
Certain of the statements included in this Quarterly Report on Form 10-Q, including but not limited to those in Management’s Discussion and Analysis of Financial Condition and Results of Operations, constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Words such as “expects,” “believes,” “anticipates,” “includes,” “plans,” “assumes,” “estimates,” “projects,” “intends,” “should,” “will,” “shall” or variations of such words are generally part of forward-looking statements. Forward-looking statements are made based on management’s current expectations and beliefs concerning future developments and their potential effects upon Prudential Annuities Life Assurance Corporation. There can be no assurance that future developments affecting Prudential Annuities Life Assurance Corporation will be those anticipated by management. These forward-looking statements are not a guarantee of future performance and involve risks and uncertainties, and there are certain important factors that could cause actual results to differ, possibly materially, from expectations or estimates reflected in such forward-looking statements, including, among others: (1) general economic, market and political conditions, including the performance and fluctuations of fixed income, equity, real estate and other financial markets; (2) the availability and cost of additional debt or equity capital or external financing for our operations; (3) interest rate fluctuations or prolonged periods of low interest rates; (4) the degree to which we choose not to hedge risks, or the potential ineffectiveness or insufficiency of hedging or risk management strategies we do implement, with regard to variable annuity or other product guarantees; (5) any inability to access our credit facilities; (6) reestimates of our reserves for future policy benefits and claims; (7) differences between actual experience regarding mortality, morbidity, persistency, surrender experience, interest rates, or market returns and the assumptions we use in pricing our products, establishing liabilities and reserves or for other purposes; (8) changes in our assumptions related to deferred policy acquisition costs or value of business acquired; (9) changes in our financial strength or credit ratings; (10) investment losses, defaults and counterparty non-performance; (11) competition in our product lines and for personnel; (12) changes in tax law; (13) regulatory or legislative changes, including the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act; (14) inability to protect our intellectual property rights or claims of infringement of the intellectual property rights of others; (15) adverse determinations in litigation or regulatory matters and our exposure to contingent liabilities; (16) domestic or international military actions, natural or man-made disasters including terrorist activities or pandemic disease, or other events resulting in catastrophic loss of life; (17) ineffectiveness of risk management policies and procedures in identifying, monitoring and managing risks; (18) interruption in telecommunication, information technology or other operational systems or failure to maintain the security, confidentiality or privacy of sensitive data on such systems; and (19) changes in statutory or U.S. GAAP accounting principles, practices or policies. Prudential Annuities Life Assurance Corporation does not intend, and is under no obligation, to update any particular forward-looking statement included in this document. See “Risk Factors” included in the Annual Report on Form 10-K for the year ended December 31, 2010 for a discussion of certain risks relating to our businesses and investment in our securities.
See Notes to Unaudited Interim Financial Statements
3
Table of Contents
Prudential Annuities Life Assurance Corporation
Unaudited Interim Statements of Financial Position
As of June 30, 2011 and December 31, 2010 (in thousands, except share amounts)
June 30, | December 31, | |||||||
2011 | 2010 | |||||||
ASSETS | ||||||||
Fixed maturities available for sale, at fair value (amortized cost, 2011: $4,442,638; 2010: $4,964,264 ) | $ | 4,887,194 | $ | 5,456,221 | ||||
Trading account assets, at fair value | 38,792 | 79,605 | ||||||
Equity securities available for sale, at fair value (cost, 2011:$16,335; 2010: $14,484) | 19,717 | 17,587 | ||||||
Commercial mortgage and other loans, net of valuation allowance | 397,969 | 431,432 | ||||||
Policy loans | 14,193 | 13,905 | ||||||
Short-term investments | 285,594 | 228,383 | ||||||
Other long-term investments | 82,684 | 75,476 | ||||||
|
|
|
| |||||
Total investments | 5,726,143 | 6,302,609 | ||||||
|
|
|
| |||||
Cash and cash equivalents | 4,120 | 487 | ||||||
Deferred policy acquisition costs | 1,393,177 | 1,540,028 | ||||||
Accrued investment income | 56,188 | 62,392 | ||||||
Reinsurance recoverable | 119,152 | 187,062 | ||||||
Valuation of business acquired | 38,234 | 32,497 | ||||||
Deferred sales inducements | 742,565 | 796,507 | ||||||
Receivables from parent and affiliates | 50,154 | 51,221 | ||||||
Investment receivable on open trades | 1,201 | 8,435 | ||||||
Other assets | 10,294 | 10,355 | ||||||
Separate account assets | 48,566,524 | 48,275,343 | ||||||
|
|
|
| |||||
TOTAL ASSETS | $ | 56,707,752 | $ | 57,266,936 | ||||
|
|
|
| |||||
LIABILITIES AND EQUITY | ||||||||
Policyholders’ account balances | $ | 4,589,050 | $ | 5,319,359 | ||||
Future policy benefits and other policyholder liabilities | 355,090 | 412,872 | ||||||
Payables to parent and affiliates | 105,658 | 127,502 | ||||||
Cash collateral for loaned securities | 129,871 | 87,210 | ||||||
Securities sold under agreements to repurchase | 40,644 | — | ||||||
Income tax payable | 162,476 | 132,455 | ||||||
Short-term debt | 197,580 | 205,054 | ||||||
Long-term debt | 600,000 | 600,000 | ||||||
Other liabilities | 201,255 | 198,757 | ||||||
Separate account liabilities | 48,566,524 | 48,275,343 | ||||||
|
|
|
| |||||
TOTAL LIABILITIES | 54,948,148 | 55,358,552 | ||||||
|
|
|
| |||||
Commitments and Contingent Liabilities (See Note 4) | ||||||||
EQUITY | ||||||||
Common stock, $100 par value; 25,000 shares, authorized, issued and outstanding | 2,500 | 2,500 | ||||||
Additional paid-in capital | 974,921 | 974,921 | ||||||
Retained earnings | 623,980 | 749,751 | ||||||
Accumulated other comprehensive income | 158,203 | 181,212 | ||||||
|
|
|
| |||||
Total equity | 1,759,604 | 1,908,384 | ||||||
|
|
|
| |||||
|
|
|
| |||||
TOTAL LIABILITIES AND EQUITY | $ | 56,707,752 | $ | 57,266,936 | ||||
|
|
|
|
See Notes to Unaudited Interim Financial Statements
4
Table of Contents
Prudential Annuities Life Assurance Corporation
Unaudited Interim Statements of Operations
Three Months and Six Months Ended June 30, 2011 and 2010 (in thousands)
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
REVENUES | ||||||||||||||||
Premiums | $ | 6,934 | $ | 7,530 | $ | 15,446 | $ | 14,936 | ||||||||
Policy charges and fee income | 211,071 | 188,954 | 415,573 | 373,118 | ||||||||||||
Net investment income | 76,587 | 94,343 | 157,718 | 192,903 | ||||||||||||
Asset administration fees and other income | 78,453 | 69,990 | 157,029 | 139,079 | ||||||||||||
Realized investment gains (losses), net: | ||||||||||||||||
Other-than-temporary impairments on fixed maturity securities | (6,243 | ) | (13,087 | ) | (15,328 | ) | (24,414 | ) | ||||||||
Other-than-temporary impairments on fixed maturity securities transferred to | ||||||||||||||||
Other Comprehensive Income | 6,104 | 11,654 | 15,029 | 22,325 | ||||||||||||
Other realized investment gains (losses), net | 30,013 | 59,775 | 28,313 | 53,574 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total realized investment gains (losses), net | 29,874 | 58,342 | 28,014 | 51,485 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total revenues | 402,919 | 419,159 | 773,780 | 771,521 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
BENEFITS AND EXPENSES | ||||||||||||||||
Policyholders’ benefits | 27,277 | 54,071 | 41,469 | 52,115 | ||||||||||||
Interest credited to policyholders’ account balances | 104,127 | 234,500 | 170,611 | 356,187 | ||||||||||||
Amortization of deferred policy acquisition costs | 132,096 | 349,786 | 162,258 | 442,015 | ||||||||||||
General administrative and other expenses | 108,499 | 100,200 | 214,792 | 213,208 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total benefits and expenses | 371,999 | 738,557 | 589,130 | 1,063,525 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
|
|
|
|
|
|
|
| |||||||||
Income (loss) from operations before income taxes | 30,920 | (319,398 | ) | 184,650 | (292,004 | ) | ||||||||||
|
|
|
|
|
|
|
| |||||||||
Income tax (benefit) expense | 5,863 | (127,755 | ) | 40,421 | (132,408 | ) | ||||||||||
|
|
|
|
|
|
|
| |||||||||
NET INCOME/ (LOSS) | $ | 25,057 | $ | (191,643 | ) | $ | 144,229 | $ | (159,596 | ) | ||||||
|
|
|
|
|
|
|
| |||||||||
Change in net unrealized investment gains (losses), net of taxes (1) | 10,337 | 8,781 | (23,009 | ) | 53,726 | |||||||||||
|
|
|
|
|
|
|
| |||||||||
COMPREHENSIVE INCOME/(LOSS) | $ | 35,394 | $ | (182,862 | ) | $ | 121,220 | $ | (105,870 | ) | ||||||
|
|
|
|
|
|
|
|
(1) | Amounts are net of tax benefits (expense) of $(5.6) million and $(4.8) million for the three months ended June 30, 2011 and 2010, respectively and $12.4 million and $(29.4) million for the six months ended June 30, 2011 and 2010, respectively. |
See Notes to Unaudited Interim Financial Statements
5
Table of Contents
Prudential Annuities Life Assurance Corporation
Unaudited Interim Statements of Equity
Six Months Ended June 30, 2011 and 2010 (in thousands)
Common stock | Additional paid-in capital | Retained earnings | Accumulated other comprehensive income (loss) | Total equity | ||||||||||||||||
Balance, December 31, 2010 | $ | 2,500 | $ | 974,921 | $ | 749,751 | $ | 181,212 | $ | 1,908,384 | ||||||||||
Net income | — | — | 144,229 | — | 144,229 | |||||||||||||||
Distribution from/(to) parent | — | — | (270,000 | ) | — | (270,000 | ) | |||||||||||||
Other comprehensive income (loss), net of taxes | — | — | — | (23,009 | ) | (23,009 | ) | |||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, June 30, 2011 | $ | 2,500 | $ | 974,921 | $ | 623,980 | $ | 158,203 | $ | 1,759,604 | ||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Common stock | Additional paid-in capital | Retained earnings | Accumulated other comprehensive income (loss) | Total equity | ||||||||||||||||
Balance, December 31, 2009 | $ | 2,500 | $ | 974,921 | $ | 798,170 | $ | 132,318 | $ | 1,907,909 | ||||||||||
Net loss | — | — | (159,596 | ) | — | (159,596 | ) | |||||||||||||
Contribution from/(to) parent | — | 17,106 | — | — | 17,106 | |||||||||||||||
Other comprehensive income (loss), net of taxes | — | — | — | 53,726 | 53,726 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Balance, June 30, 2010 | $ | 2,500 | $ | 992,027 | $ | 638,574 | $ | 186,044 | $ | 1,819,145 | ||||||||||
|
|
|
|
|
|
|
|
|
|
See Notes to Unaudited Interim Financial Statements
6
Table of Contents
Prudential Annuities Life Assurance Corporation
Unaudited Interim Statements of Cash Flows
Six Months Ended June 30, 2011 and 2010 (in thousands)
2011 | 2010 | |||||||
CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||
Net lncome (Loss) | $ | 144,229 | $ | (159,596 | ) | |||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Policy charges and fee income | 35,621 | 41,983 | ||||||
Realized investment (gains) losses, net | (28,014 | ) | (51,485 | ) | ||||
Amortization and depreciation | (3,101 | ) | (2,665 | ) | ||||
Interest credited to policyholders’ account balances | 65,836 | 136,100 | ||||||
Change in: | ||||||||
Future policy benefit reserves | 121,976 | 106,327 | ||||||
Accrued investment income | 4,871 | 3,117 | ||||||
Trading account assets | 463 | 1,015 | ||||||
Net receivable (payable) to affiliates | (20,990 | ) | 58,126 | |||||
Deferred sales inducements | 68,362 | 130,048 | ||||||
Deferred policy acquisition costs | 134,658 | 182,207 | ||||||
Income taxes payable | 42,411 | 72,826 | ||||||
Reinsurance recoverable | (122,212 | ) | (105,038 | ) | ||||
Other, net | (23,001 | ) | (39,797 | ) | ||||
|
|
|
| |||||
Cash Flows From Operating Activities | $ | 421,109 | $ | 373,168 | ||||
|
|
|
| |||||
CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||
Proceeds from the sale/maturity of: | ||||||||
Fixed maturities, available for sale | $ | 782,515 | $ | 670,176 | ||||
Equity securities, available for sale | 750 | 4,633 | ||||||
Commercial mortgage and other loans | 80,631 | 6,824 | ||||||
Trading account assets | 43,629 | 4,192 | ||||||
Policy loans | 585 | 822 | ||||||
Other long-term investments | 1,499 | 347 | ||||||
Short-term investments | 2,222,012 | 2,936,759 | ||||||
Payments for the purchase/origination of: | ||||||||
Fixed maturities, available for sale | (166,461 | ) | (530,631 | ) | ||||
Equity securities, available for sale | (2,644 | ) | (5,000 | ) | ||||
Commercial mortgage and other loans | (42,539 | ) | — | |||||
Trading account assets | (2,352 | ) | (2,475 | ) | ||||
Policy loans | (569 | ) | (333 | ) | ||||
Other long-term investments | (9,397 | ) | (29,405 | ) | ||||
Short-term investments | (2,279,223 | ) | (2,724,392 | ) | ||||
Notes receivable from parent and affiliates, net | 6,727 | 17,143 | ||||||
Other, net | (217 | ) | — | |||||
|
|
|
| |||||
Cash Flows From Investing Activities | $ | 634,946 | $ | 348,660 | ||||
|
|
|
| |||||
CASH FLOWS USED IN FINANCING ACTIVITIES: | ||||||||
Capital contribution from/(Distribution to) Parent | $ | (270,000 | ) | $ | 17,106 | |||
Cash collateral for loaned securities | 42,661 | (123,809 | ) | |||||
Securities sold under agreement to repurchase | 40,644 | (602 | ) | |||||
Net decrease in short-term borrowing | (7,474 | ) | (26,585 | ) | ||||
Drafts outstanding | (16,231 | ) | 22,045 | |||||
Policyholders’ account balances | ||||||||
Deposits | 719,496 | 1,865,603 | ||||||
Withdrawals | (1,561,518 | ) | (2,435,871 | ) | ||||
|
|
|
| |||||
Cash Flows Used in Financing Activities | $ | (1,052,422 | ) | $ | (682,113 | ) | ||
|
|
|
| |||||
Net increase in cash and cash equivalents | 3,633 | 39,715 | ||||||
Cash and cash equivalents, beginning of period | 487 | 71,548 | ||||||
|
|
|
| |||||
CASH AND CASH EQUIVALENTS, END OF PERIOD | $ | 4,120 | $ | 111,263 | ||||
|
|
|
|
See Notes to Unaudited Interim Financial Statements
7
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
1. | BUSINESS |
Prudential Annuities Life Assurance Corporation (the “Company”, “we”, or “our”), formerly known as American Skandia Life Assurance Corporation, with its principal offices in Shelton, Connecticut, is an indirect wholly-owned subsidiary of Prudential Financial, Inc. (“Prudential Financial”), a New Jersey corporation. The Company is a wholly owned subsidiary of Prudential Annuities, Inc. (“PAI”), formerly known as American Skandia, Inc., which in turn is an indirect wholly owned subsidiary of Prudential Financial. On December 19, 2002, Skandia Insurance Company Ltd. (publ) (“Skandia”), an insurance company organized under the laws of the Kingdom of Sweden, and the ultimate parent company of the Company prior to May 1, 2003, entered into a definitive purchase agreement (the “Acquisition Agreement”) with Prudential Financial, whereby Prudential Financial would acquire the Company and certain of its affiliates (the “Acquisition”) and would be authorized to use the American Skandia name through April, 2008. On May 1, 2003, the Acquisition was consummated. Thus, the Company is now an indirect wholly owned subsidiary of Prudential Financial. During 2007, the Company began the process of changing its name and names of various legal entities that include the “American Skandia” name, as required by the terms of the Acquisition agreement. The Company’s name was changed effective January 1, 2008.
The Company develops long-term savings and retirement products, which are distributed through its affiliated broker/dealer company, Prudential Annuities Distributors, Incorporated. (“PAD”), formerly known as American Skandia Marketing, Incorporated. The Company issued variable deferred and immediate annuities for individuals and groups in the United States of America and its territories.
Beginning in March 2010, 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 each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company within the Prudential Annuities business unit of Prudential Financial). 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. However, subject to applicable contractual provisions and administrative rules, the Company will continue to accept subsequent purchase payments on inforce contracts under existing annuity products.
The Company is engaged in a business that is highly competitive because of the large number of stock and mutual life insurance companies and other entities engaged in marketing long-term savings and retirement products, including insurance products, and individual and group annuities.
2. | BASIS OF PRESENTATION |
The unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and on a basis consistent with reporting interim financial information in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X of the U.S. Securities and Exchange Commission (the “SEC”).
These interim financial statements are unaudited but reflect all adjustments that, in the opinion of management, are necessary to provide a fair presentation of the results of operations and financial condition of the Company for the interim periods presented. All such adjustments are of a normal recurring nature. The results of operations for any interim period are not necessarily indicative of results that may be expected for the full year. These unaudited interim financial statements should be read in conjunction with the audited financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
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; value of business acquired and its amortization; amortization of sales inducements; valuation of investments including derivatives and the recognition of other-than-temporary impairments; future policy benefits including guarantees; 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.
3. | ACCOUNTING POLICIES AND PRONOUNCEMENTS |
Investments in Debt and Equity Securities and Commercial Mortgage and Other Loans
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:
8
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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 7 for additional information regarding the determination of fair value. The amortized cost of fixed maturities is adjusted for amortization of premiums and accretion of discounts to maturity. 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 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, value of business acquired, 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).”
Trading account assets,at fair value, represents the equity securities held in support of a deferred compensation plan and other fixed maturity securities. These instruments are carried at fair value. Realized and unrealized gains and losses on trading account assets are reported in “Asset administration fees and other income.” Interest and dividend income from these investments is reported in “Net investment income.”
Equity securities available for saleare 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, value of business acquired, 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.
Commercial mortgage and other loansconsist 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.
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 6 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 and other loan portfolio 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.
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
9
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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 6 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 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 and other 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. Historical credit migration, loss rates and loss severity factors are updated each quarter based on the Company’s actual loan experience, and are considered together with other relevant qualitative factors in making the final portfolio reserve calculations.
The allowance for losses on commercial mortgage and other 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.
Short-term investments primarily consist of investments in certain money market funds as well as 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.
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, recoveries of principal on previously impaired 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, the difference is recorded as an other-than-temporary impairment.
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 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
10
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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.
Derivative Financial Instruments
Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or the values of securities, credit spreads, market volatility, expected returns, 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.
Derivative financial instruments generally used by the Company include swaps, options, and futures and may be exchange-traded or contracted in the over-the-counter market. Derivative positions are carried at fair value, generally by obtaining quoted market prices or through the use of valuation models.
Derivatives are used to manage the characteristics of the Company’s asset/liability mix, and 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. As discussed below and in Note 8, 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.
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 Prudential Global Funding, LLC, with which a master netting arrangement has been executed.
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 specific 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.” The 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.
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 derivative are clearly and closely related to the economic characteristics
11
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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 derivative 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 derivative 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 “Other trading account assets, at fair value.” The Company has sold variable annuity products, which may include guaranteed benefit features that are accounted for as embedded derivatives. The Company has entered into reinsurance agreements to transfer the risk related to the embedded derivatives contained in certain insurance product to affiliates. These reinsurance agreements are derivatives and have been accounted in the same manner as the guaranteed benefit feature.
Adoption of New Accounting Pronouncements
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 6. In January 2011, the FASB deferred the disclosures required by this guidance related to troubled debt restructurings. The disclosures will be 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.
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 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 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 this guidance effective for interim and annual reporting periods beginning after December 15, 2010 on January 1, 2011. The required disclosures are provided in Note 7 and Note 8.
Future Adoption of New Accounting Pronouncements
In June 2011, the FASB issued 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. This new guidance is effective for the first interim or annual reporting period beginning after December 15, 2011 and should be applied retrospectively. The Company expects this guidance to have a significant impact on its financial statement presentation but no impact on the Company’s financial position or results of operations.
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 a significant 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 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 is currently assessing the impact of the guidance on the Company’s financial position, results of operations, and financial statement disclosures.
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 is currently assessing the impact of the guidance on the Company’s financial position, results of operations, and financial statement disclosures.
12
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
In October 2010, the FASB issued 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 new 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 that are incurred in transactions with independent third parties or employees as well as the portion of employee compensation and other costs directly related to underwriting, policy issuance and processing, medical inspection, and contract selling for successfully negotiated contracts. Additionally, an entity may capitalize as a deferred acquisition cost only those advertising costs meeting the capitalization criteria for direct-response advertising. The new guidance is expected to result in a lower level of costs relating to the acquisition of new or renewal insurance contracts qualifying for deferral than would have qualified under the prior guidance. This change is effective for fiscal years beginning after December 15, 2011 and interim periods within those years. Early adoption as of the beginning of a fiscal year is permitted. The guidance is to be applied prospectively upon the date of adoption, with retrospective application permitted, but not required. The Company will adopt this guidance effective January 1, 2012. If the Company chooses to adopt the new guidance through retrospective application, upon adoption, the amount of the “deferred policy acquisition costs” asset would be reduced with a corresponding reduction to retained earnings (and total equity), on an after-tax basis, as a result of acquisition costs previously deferred that are not eligible for deferral under the new guidance. The Company is currently assessing the impact of the guidance on the Company’s financial position, results of operations, and financial statement disclosures.
4. | CONTINGENT LIABILITIES AND LITIGATION |
Contingent Liabilities
On an ongoing basis, our internal supervisory and control functions review the quality of our sales, marketing, administration and servicing, 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 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, we may offer customers appropriate 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. The Company is currently being examined by a third party auditor on behalf of 33 U.S. jurisdictions for compliance with the unclaimed property laws of these jurisdictions. Significant attention has been focused on life insurance companies’ processes and procedures used to identify unreported death claims and whether life insurance companies use the Social Security Master Death File (“SSMDF”) to identify deceased policy and contract holders. 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 Company has received market conduct exam notices and additional inquiries from insurance regulators in states not participating in the third party audit described above. Additionally, regulators and state legislators are considering proposals that would require life insurance companies to take additional steps to identify unreported deceased policy and contract holders. If implemented, the proposals under consideration and any escheatable property identified as a result of the audits will result in: (1) additional payments of previously unreported death claims; (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, which will impact claim payments and reserves, among other consequences. There does not appear to be a consensus among state insurance regulators and state unclaimed property administrators regarding a life insurer’s obligations in connection with identifying unreported deaths of its policy and contract holders.
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’s litigation and regulatory matters are subject to many uncertainties, and given their complexity and scope, the outcomes cannot be predicted. 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 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 our 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 our financial position.
As discussed under “Contingent Liabilities” above, the Company is subject to audits and inquiries concerning its handling of unclaimed property.
13
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
5. | RELATED PARTY TRANSACTIONS |
The Company is a party to numerous transactions and relationships with its affiliate The Prudential Insurance Company of America (“Prudential Insurance”) and other affiliates. 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.
The Company’s general and administrative expenses are charged to the Company using allocation methodologies based on business 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. Since 2003, general and administrative expenses also include allocations of stock compensation expenses related to a stock option program and a deferred compensation program sponsored by Prudential Financial.
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 earnings and length of service. Other benefits 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 $0.8 million and $1.4 million for the three months ended June 30, 2011 and 2010, respectively and $1.5 million and $2.7 million for the six months ended June 30, 2011 and 2010, respectively.
Prudential Insurance sponsors voluntary savings plans for the Company’s employees (“401(k) plans”). The 401(k) plans provide for salary reduction contributions by employees and matching contributions by the Company of up to 4% of annual salary. The expense charged to the Company for the matching contribution to the 401(k) plans was $0.4 million and $0.7 million for the three months ended June 30, 2011 and 2010, respectively and $0.7 million and $1.3 million for the six months ended June 30, 2011 and 2010, respectively.
Debt Agreements
Short-term and Long-term borrowings
On December 29, 2009, the Company obtained a $600 million loan from Prudential Financial. This loan has a fixed interest rate of 4.49% and matures on December 29, 2014.
On December 14, 2006, the Company obtained a $300 million loan from Prudential Financial. This loan has a fixed interest rate of 5.18% and matures on December 14, 2011. A partial payment was made to reduce this loan to $179.5 million on December 29, 2008 with the proceeds received from a capital contribution from PAI. On March 27, 2009, a partial payment of $4.5 million was paid to further reduce this loan to $175 million.
On May 1, 2004, the Company entered into a $500 million credit facility agreement with Prudential Funding, LLC, as the lender. During 2009, the credit facility agreement was increased to $900 million. As of June 30, 2011 and December 31, 2010, $22.6 million and $30.1 million, respectively, were outstanding under this credit facility.
Reinsurance Agreements
The Company uses reinsurance as part of its risk management and capital management strategies for certain of its optional living benefit features. Fees ceded under these agreements are included in “Realized investment (losses) gains, net” on the financial statements.
Effective August 24, 2009, the Company entered into a coinsurance agreement with Pruco Reinsurance, Ltd (“Pruco Re”) providing for the 100% reinsurance of its Highest Daily Lifetime 6 Plus (“HD6 Plus”) and Spousal Highest Daily Lifetime 6 Plus (“SHD6 Plus”) benefit features sold on certain of its annuities. Fees ceded on this agreement were $17.8 million and $11.1 million for the three months ended June 30, 2011 and 2010, respectively and $33.4 million and $16.2 million for the six months ended June 30, 2011 and 2010, respectively.
Effective June 30, 2009, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its Highest Daily Lifetime 7 Plus (“HD7 Plus”) and Spousal Highest Daily Lifetime 7 Plus (“SHD7 Plus”) benefit features sold on certain of its annuities. Fees ceded on this agreement were $19.6 million and $16.6 million for the three months ended June 30, 2011 and 2010, respectively and $38.0 million and $32.4 million for the six months ended June 30, 2011 and 2010, respectively.
Effective March 17, 2008, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its Highest Daily Lifetime Seven (“HD7”) and Spousal Highest Daily Lifetime Seven (“SHD7”) benefit features sold on certain of its annuities. Fees ceded on this agreement were $9.6 million and $9.2 million for the three months ended June 30, 2011 and 2010, respectively and $19.1 million and $18.3 million for the six months ended June 30, 2011 and 2010, respectively.
Effective March 17, 2008, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its Guaranteed Return Option Plus (“GRO Plus”) benefit feature sold on certain of its annuities. This agreement was amended effective January 1, 2010 to include a
14
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
form of the GRO Plus benefit feature (“GRO Plus II”) on business issued after November 16, 2009. Fees ceded on this agreement were $2.3 million and $3.0 million for the three months ended June 30, 2011 and 2010, respectively and $4.3 million and $6.0 million for the six months ended June 30, 2011 and 2010, respectively.
Effective March 17, 2008, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its Highest Daily Guaranteed Return Option (“HD GRO”) benefit feature sold on certain of its annuities. This agreement was amended effective January 1, 2010 to include a form of the HD GRO benefit feature (“HD GRO II”) on business issued after November 16, 2009.Fees ceded on this agreement were $1.7 million and $1.3 million for the three months ended June 30, 2011 and 2010, respectively and $3.4 million and $2.4 million for the six months ended June 30, 2011 and 2010, respectively.
Since 2006, the Company reinsures 100% of the risk on its Highest Daily Lifetime Five (“HDLT5”) benefit feature and its Spousal Lifetime Five (“SLT5”) benefit feature sold on certain of its annuities through an automatic coinsurance agreement with Pruco Re. Fees ceded on the HDLT5 agreement were $3.5 million and $3.5 million for the three months ended June 30, 2011 and 2010, respectively, and $7.1 million and $7.2 million for the six months ended June 30, 2011 and 2010, respectively. Fees ceded on the SLT5 agreement were $2.9 million and $2.7 million for the three months ended June 30, 2011 and 2010, respectively and $5.8 million and $5.4 million for the six months ended June 30, 2011 and 2010, respectively.
Since 2005, the Company reinsures 100% of the risk on its Lifetime Five (“LT5”) benefit feature sold on certain of its annuities through an automatic coinsurance agreement with Pruco Re. Fees ceded under the LT5 agreement were $9.5 million and $8.9 million for the three months ended June 30, 2011 and 2010, respectively and $19.0 million and $17.9 million for the six months ended June 30, 2011 and 2010, respectively.
Since 2004, the Company reinsures 100% of the risk on its Guaranteed Minimum Withdrawal Benefit (“GMWB”) feature sold on certain of its annuities through an automatic coinsurance agreement with Prudential Insurance. Fees ceded on this agreement were $.5 million and $.6 million for the three months ended June 30, 2011 and 2010, respectively and $1.0 million and $1.1 million for the six months ended June 30, 2011 and 2010, respectively. The Company also reinsures 100% of the risk on its guaranteed return option (“GRO”) benefit feature sold on certain of its annuities through an automatic coinsurance agreement with Pruco Re. Fees ceded on this agreement were $1.2 million and $1.1 million for the three months ended June 30, 2011 and 2010, respectively and $2.5 million and $2.7 million for the six months ended June 30, 2011 and 2010, respectively.
Affiliated Asset Administration Fee Income
In accordance with an agreement with AST Investment Services, Inc., formerly known as American Skandia Investment Services, Inc, 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 $64.9 million and $59.1 million, for the three months ended June 30, 2011 and 2010, respectively; and $129.5 and $115.1 for the six months ended June 30, 2011 and 2010, respectively. These revenues are recorded as “Asset administration fees and other income” in the Unaudited Interim Statements of Operations and Comprehensive Income.
Derivative Trades
In its 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 an external counterparty.
Purchase/sale of fixed maturities and commercial mortgage loans from/to an affiliate
In March 2010, the Company sold fixed maturity securities to Prudential Insurance. These securities had an amortized cost of $222.4 million and a fair value of $239.5 million. The net difference between historic amortized cost and the fair value was $17.1 million and was recorded as a capital contribution on the Company’s financial statements.
In May 2011, the Company sold fixed maturity securities to an affiliated company in various transactions. These securities had an amortized cost of $68.3 million and a fair value of $75.7 million. The net difference between historic amortized cost and the fair value was $7.4 million and was recorded as a realized investment gain on the Company’s financial statements. The Company also sold commercial mortgage loans to an affiliated company. These securities had an amortized cost of $48.9 million and a fair value of $54.2 million. The net difference between historic amortized cost and the fair value was $5.3 million and was recorded as a realized gain on the Company’s financial statements.
15
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
6. | 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:
June 30, 2011 | ||||||||||||||||||||
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 | $ | 124,947 | $ | 5,927 | $ | — | $ | 130,874 | $ | — | ||||||||||
Obligations of U.S. states and their political subdivisions | 78,772 | 8,384 | — | 87,156 | — | |||||||||||||||
Foreign government bonds | 121,725 | 14,106 | — | 135,831 | — | |||||||||||||||
Corporate securities | 3,296,879 | 363,304 | 1,781 | 3,658,402 | (236 | ) | ||||||||||||||
Asset-backed securities (1) | 201,388 | 13,177 | 5,610 | 208,955 | (8,596 | ) | ||||||||||||||
Commercial mortgage-backed securities | 407,960 | 29,591 | 133 | 437,418 | — | |||||||||||||||
Residential mortgage-backed securities (2) | 210,967 | 17,639 | 48 | 228,558 | (60 | ) | ||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Total fixed maturities, available for sale | $ | 4,442,638 | $ | 452,128 | $ | 7,572 | $ | 4,887,194 | $ | (8,892 | ) | |||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Equity securities, available for sale | $ | 16,335 | $ | 3,384 | $ | 2 | $ | 19,717 | $ | — | ||||||||||
|
|
|
|
|
|
|
|
|
|
(1) | Includes credit tranched securities collateralized by sub-prime mortgages, 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 $4.0 million of net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date. |
December 31, 2010 | ||||||||||||||||||||
Other-than- | ||||||||||||||||||||
Gross | Gross | temporary | ||||||||||||||||||
Amortized | Unrealized | Unrealized | Fair | impairments | ||||||||||||||||
Cost | Gains | Losses | Value | in AOCI (3) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fixed maturities, available for sale | ||||||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | 187,394 | $ | 5,911 | $ | — | $ | 193,305 | $ | — | ||||||||||
Obligations of U.S. states and their political subdivisions | 69,567 | 7,949 | — | 77,516 | — | |||||||||||||||
Foreign government bonds | 122,152 | 14,361 | — | 136,513 | — | |||||||||||||||
Corporate securities | 3,554,569 | 396,747 | 366 | 3,950,950 | (235 | ) | ||||||||||||||
Asset-backed securities (1) | 207,373 | 14,387 | 7,790 | 213,970 | (12,200 | ) | ||||||||||||||
Commercial mortgage-backed securities | 455,972 | 34,597 | — | 490,569 | — | |||||||||||||||
Residential mortgage-backed securities (2) | 367,237 | 26,161 | — | 393,398 | (76 | ) | ||||||||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Total fixed maturities, available for sale | $ | 4,964,264 | $ | 500,113 | $ | 8,156 | $ | 5,456,221 | $ | (12,511 | ) | |||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||
Equity securities, available for sale | $ | 14,484 | $ | 3,150 | $ | 47 | $ | 17,587 | $ | — | ||||||||||
|
|
|
|
|
|
|
|
|
|
(1) | Includes credit tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, educational 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 $6.0 million of net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date. |
16
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
The amortized cost and fair value of fixed maturities by contractual maturities at June 30, 2011 are as follows:
Available for sale | ||||||||
Amortized | Fair | |||||||
Cost | Value | |||||||
(in thousands) | ||||||||
Due in one year or less | $ | 624,640 | $ | 654,884 | ||||
Due after one year through five years | 1,873,167 | 2,077,174 | ||||||
Due after five years through ten years | 712,860 | 793,341 | ||||||
Due after ten years | 411,656 | 486,864 | ||||||
Asset-backed securities | 201,388 | 208,955 | ||||||
Commercial mortgage-backed securities | 407,960 | 437,418 | ||||||
Residential mortgage-backed securities | 210,967 | 228,558 | ||||||
|
|
|
| |||||
Total | $ | 4,442,638 | $ | 4,887,194 | ||||
|
|
|
|
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.
The following table depicts the sources of fixed maturity proceeds and related gross investment gains (losses), as well as losses on impairments of both fixed maturities and equity securities:
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities, available for sale | ||||||||||||||||
Proceeds from sales | $ | 300,188 | $ | 313,941 | $ | 551,902 | $ | 460,507 | ||||||||
Proceeds from maturities/repayments | 78,882 | 135,470 | 230,106 | 210,942 | ||||||||||||
Gross investment gains from sales, prepayments, and maturities | 30,240 | 7,231 | 45,964 | 8,441 | ||||||||||||
Gross investment losses from sales and maturities | — | (830 | ) | — | (1,423 | ) | ||||||||||
Fixed maturity and equity security impairments | ||||||||||||||||
Writedowns for other-than-temporary impairment losses on fixed maturities recognized in earnings (1) | $ | (140 | ) | $ | (1,433 | ) | $ | (299 | ) | $ | (2,089 | ) | ||||
Writedowns for impairments on equity security | $ | 750 | $ | — | $ | 750 | $ | — |
(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 3, a portion of certain other-than-temporary impairment, (“OTTI”) losses on fixed maturity securities are recognized in “Other comprehensive income (loss),” (“OCI”). For these securities 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.
The following tables depict 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.
Three Months Ended | Six Months Ended | |||||||||
June 30, | June 30, | |||||||||
2011 | 2011 | |||||||||
(in thousands) | ||||||||||
Balance, beginning of period | $ | 14,117 | $ | 14,148 | ||||||
Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period | (3,057 | ) | (3,214 | ) | ||||||
Additional credit loss impairments recognized in the current period on securities previously impaired | 140 | 299 | ||||||||
Increases due to the passage of time on previously recorded credit losses | 130 | 262 | ||||||||
Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected | (129 | ) | (294 | ) | ||||||
|
|
|
| |||||||
Balance, end of period | $ | 11,201 | $ | 11,201 | ||||||
|
|
|
|
17
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Three Months Ended | Six Months Ended | |||||||||
June 30, | June 30, | |||||||||
2010 | 2010 | |||||||||
(in thousands) | ||||||||||
Balance, beginning of period | $ | 13,562 | $ | 13,038 | ||||||
Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period | (249 | ) | (618 | ) | ||||||
Additional credit loss impairments recognized in the current period on securities previously impaired | 640 | 1,296 | ||||||||
Increases due to the passage of time on previously recorded credit losses | 120 | 365 | ||||||||
Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected | (162 | ) | (170 | ) | ||||||
|
|
|
| |||||||
Balance, end of period | $ | 13,911 | $ | 13,911 | ||||||
|
|
|
|
Trading Account Assets
The following table sets forth the composition of the Company’s trading account assets as of the dates indicated:
June 30, 2011 | December 31, 2010 | |||||||||||||||
Amortized | Fair | Amortized | Fair | |||||||||||||
Cost | Value | Cost | Value | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities: | ||||||||||||||||
Asset-backed securities | $ | 30,101 | $ | 31,616 | $ | 66,205 | $ | 70,831 | ||||||||
Equity securities | 6,425 | 7,176 | 8,132 | 8,774 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total trading account assets | $ | 36,526 | $ | 38,792 | $ | 74,337 | $ | 79,605 | ||||||||
|
|
|
|
|
|
|
|
The net change in unrealized gains and losses from trading account assets still held at period end, recorded within “Asset administration fees and other income” was $(0.5) million and $0.8 million during the three months ended June 30, 2011 and 2010, respectively and $(2.7) million and $1.1 million during the six months ended June 30, 2011 and 2010, respectively .
Commercial Mortgage and Other Loans
The Company’s commercial mortgage and other loans are comprised as follows, as of the dates indicated:
June 30, 2011 | December 31, 2010 | |||||||||||||||
% of | % of | |||||||||||||||
Amount | Total | Amount | Total | |||||||||||||
(in thousands) | (in thousands) | |||||||||||||||
Commercial mortgage and other loans by property type: | ||||||||||||||||
Office buildings | $ | 39,360 | 9.8 | % | $ | 49,248 | 11.3 | % | ||||||||
Retail | 38,253 | 9.5 | % | 62,078 | 14.3 | % | ||||||||||
Apartments/Multi-Family | 120,228 | 29.9 | % | 124,709 | 28.7 | % | ||||||||||
Industrial buildings | 146,059 | 36.4 | % | 142,003 | 32.7 | % | ||||||||||
Hospitality | 8,456 | 2.1 | % | 8,524 | 2.0 | % | ||||||||||
|
|
|
|
|
|
|
| |||||||||
Total commercial mortgage loans | 352,356 | 87.7 | % | 386,562 | 89.0 | % | ||||||||||
Agricultural property loans | 49,307 | 12.3 | % | 47,850 | 11.0 | % | ||||||||||
|
|
|
|
|
|
|
| |||||||||
Total commercial mortgage and other loans | 401,663 | 100.0 | % | 434,412 | 100.0 | % | ||||||||||
Valuation allowance | (3,694 | ) | (2,980 | ) | ||||||||||||
|
|
|
| |||||||||||||
Total net commercial mortgage and other loans by property type | $ | 397,969 | $ | 431,432 | ||||||||||||
|
|
|
|
The commercial mortgage and agricultural property loans are geographically dispersed throughout the United States, Canada and Asia with the largest concentrations in California (24%), New York (19%) and Ohio (12%) at June 30, 2011.
18
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Activity in the allowance for losses for all commercial mortgage and other loans, as of the dates indicated, is as follows:
June 30, 2011 | December 31, 2010 | |||||||||
(in thousands) | ||||||||||
Allowance for losses, beginning of year | $ | 2,980 | $ | 2,897 | ||||||
Addition to allowance for losses | 714 | 83 | ||||||||
|
|
|
| |||||||
Total Ending Balance (1) | $ | 3,694 | $ | 2,980 | ||||||
|
|
|
|
(1) | Agricultural loans represent $0.1 million of the ending allowance at both June 30, 2011 and December 31, 2010. |
The following tables set forth the allowance for credit losses and the recorded investment in commercial mortgage and other loans as of dates indicated:
June 30, 2011 | December 31, 2010 | |||||||||
Total Loans | Total Loans | |||||||||
(in thousands) | ||||||||||
Allowance for Credit Losses: | ||||||||||
Ending Balance: individually evaluated for impairment (2) | $ | 473 | $ | 416 | ||||||
Ending Balance: collectively evaluated for impairment (3) | 3,221 | 2,564 | ||||||||
|
|
|
| |||||||
Total ending balance | $ | 3,694 | $ | 2,980 | ||||||
Recorded Investment: (1) | ||||||||||
Ending Balance: individually evaluated for impairment (2) | $ | 3,751 | $ | 3,782 | ||||||
Ending Balance: collectively evaluated for impairment (3) | 397,912 | 430,630 | ||||||||
|
|
|
| |||||||
Total ending balance, gross of reserves | $ | 401,663 | $ | 434,412 | ||||||
|
|
|
|
(1) | Recorded investment reflects the balance sheet carrying value gross of related allowance. |
(2) | There were no agricultural loans individually evaluated for impairments at June 30, 2011 and December 31, 2010. |
(3) | Agricultural loans collectively evaluated for impairment had a recorded investment of $49.0 and $48.0 million and related allowance of $0.1 million and $0.2 million at June 30, 2011 and December 31, 2010, respectively. |
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 shown in the table above, impaired commercial mortgage and other loans identified in management’s specific review of probable loan losses and the related allowance for losses at June 30, 2011 and December 31, 2010 had a recorded investment of $3.8 million and a related allowance of $0.4 million for both periods, all of which related to the hospitality property type. The average recorded investment in impaired loans with an allowance recorded, before the allowance for losses, was $3.8 million at June 30, 2011 and December 31, 2010. Net investment income recognized on these loans totaled $84 thousand for the six months ended June 30, 2011 and $266 thousand for the year ended December 31, 2010. See Note 2 for information regarding the Company’s accounting policies for non-performing loans.
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. The Company had no such loans at June 30, 2011 or December 31, 2010.
19
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
The following table sets forth the credit quality indicators as of June 30, 2011, based upon the recorded investment gross of allowance for credit losses:
Total commercial mortgage and other loans
Debt Service Coverage Ratio - June 30, 2011 | ||||||||||||||||||||||||||||
Greater than 2.0X | 1.8X to 2.0X | 1.5X to <1.8X | 1.2X to <1.5X | 1.0X to <1.2X | Less than 1.0X | Grand Total | ||||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||||||
Loan-to-Value Ratio | ||||||||||||||||||||||||||||
0%-49.99% | $ | 41,633 | $ | 15,650 | $ | 30,642 | $ | 19,894 | $ | 64,481 | $ | 23,020 | $ | 195,320 | ||||||||||||||
50%-59.99% | 14,000 | 18,831 | 1,447 | 5,904 | — | — | 40,182 | |||||||||||||||||||||
60%-69.99% | 4,290 | 4,975 | 12,874 | 29,357 | 34,075 | 2,081 | 87,652 | |||||||||||||||||||||
70%-79.99% | 1,000 | — | — | 4,964 | — | 4,827 | 10,791 | |||||||||||||||||||||
80%-89.99% | — | — | — | — | 49,005 | — | 49,005 | |||||||||||||||||||||
90%-100% | — | — | — | 4,962 | — | 10,000 | 14,962 | |||||||||||||||||||||
Greater than 100% | — | 3,751 | — | — | — | — | 3,751 | |||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||||
Total commercial mortgage and other loans (1) | $ | 60,923 | $ | 43,207 | $ | 44,963 | $ | 65,081 | $ | 147,561 | $ | 39,928 | $ | 401,663 | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) | Agricultural loans had a recorded investment of $49.0 million at June 30, 2011, none of which had a loan to value ratio greater than 100% or debt service payments less than 1.0 times the property’s net operating income. |
See Note 2 for further discussion regarding the credit quality of commercial mortgage and other loans.
The following tables set forth the credit quality indicators as of December 31, 2010, based upon the recorded investment gross of allowance for credit losses:
Total commercial mortgage and other loans
Debt Service Coverage Ratio - December 31, 2010 | ||||||||||||||||||||||||||||
Greater than 2.0X | 1.8X to 2.0X | 1.5X to <1.8X | 1.2X to <1.5X | 1.0X to <1.2X | Less than 1.0X | Grand Total | ||||||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||||||
Loan-to-Value Ratio | ||||||||||||||||||||||||||||
0%-49.99% | $ | 46,286 | $ | 12,127 | $ | 30,887 | $ | 14,121 | $ | 86,754 | $ | 23,736 | $ | 213,911 | ||||||||||||||
50%-59.99% | 6,795 | 12,091 | 2,880 | 11,186 | 1,495 | — | 34,447 | |||||||||||||||||||||
60%-69.99% | — | — | 6,680 | 55,286 | 4,864 | 2,137 | 68,967 | |||||||||||||||||||||
70%-79.99% | — | — | 24,362 | 5,030 | — | 14,782 | 44,174 | |||||||||||||||||||||
80%-89.99% | — | — | — | — | — | 54,175 | 54,175 | |||||||||||||||||||||
90%-100% | — | — | — | — | — | 10,000 | 10,000 | |||||||||||||||||||||
Greater than 100% | — | — | — | 3,782 | — | 4,956 | 8,738 | |||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||||
Total commercial mortgage and other loans (1) | $ | 53,081 | $ | 24,218 | $ | 64,809 | $ | 89,405 | $ | 93,113 | $ | 109,786 | $ | 434,412 | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) | Agricultural loans had a recorded investment of $48.0 million at December 31, 2010, none of which had a loan to value ratio greater than 100% or debt service payments less than 1.0 times the property’s net operating income. |
See Note 2 for further discussion regarding the credit quality of commercial mortgage and other loans.
As of June 30, 2011 and December 31, 2010, all commercial mortgage and other loans were in current status including $5.0 million of office loans and $3.8 million of hospitality loans in non-accrual status at the end of both periods.
For the quarter ended June 30, 2011, there were no commercial mortgage and other loans sold or acquired.
20
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Net Investment Income
Net investment income for the three and six months ended June 30, 2011 and 2010 was from the following sources:
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities, available for sale | $ | 69,750 | $ | 89,246 | $ | 142,720 | $ | 181,353 | ||||||||
Equity securities, available for sale | 263 | 206 | 458 | 411 | ||||||||||||
Trading account assets | 411 | 822 | 1,112 | 1,628 | ||||||||||||
Commercial mortgage and other loans | 6,835 | 6,322 | 15,144 | 13,027 | ||||||||||||
Policy loans | 295 | (539 | ) | 406 | (429 | ) | ||||||||||
Short-term investments and cash equivalents | 193 | 385 | 313 | 764 | ||||||||||||
Other long-term investments | 567 | (5 | ) | 1,012 | 383 | |||||||||||
|
|
|
|
|
|
|
| |||||||||
Gross investment income | 78,314 | 96,437 | 161,165 | 197,137 | ||||||||||||
Less investment expenses | (1,727 | ) | (2,094 | ) | (3,447 | ) | (4,234 | ) | ||||||||
|
|
|
|
|
|
|
| |||||||||
Net investment income | $ | 76,587 | $ | 94,343 | $ | 157,718 | $ | 192,903 | ||||||||
|
|
|
|
|
|
|
|
Realized Investment Gains (Losses), Net
Realized investment gains (losses), net, for the three and six months ended June 30, 2011 and 2010 were from the following sources:
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities | $ | 30,100 | $ | 4,968 | $ | 45,665 | $ | 4,930 | ||||||||
Equity securities | (43 | ) | — | (43 | ) | (368 | ) | |||||||||
Commercial mortgage and other loans | 5,149 | (232 | ) | 4,673 | 2 | |||||||||||
Derivatives | (5,332 | ) | 53,586 | (22,281 | ) | 46,886 | ||||||||||
Other | — | 20 | — | 35 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Realized investment gains (losses), net | $ | 29,874 | $ | 58,342 | $ | 28,014 | $ | 51,485 | ||||||||
|
|
|
|
|
|
|
|
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 OCI those items that are included as part of “Net income” for a period that had been part of OCI 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:
21
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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, Deferred Sales Inducements and Valuation of Business Acquired | Deferred Income Tax (Liability) Benefit | Accumulated Other Comprehensive Income (Loss) Related To Net Unrealized Investment Gains (Losses) | |||||||||||||||||
�� | (in thousands) | |||||||||||||||||||
Balance, December 31, 2010 | $ | (6,560 | ) | $ | 2,852 | $ | 1,313 | $ | (2,395 | ) | ||||||||||
Net investment gains (losses) on investments arising during the period | (377 | ) | — | 132 | (245 | ) | ||||||||||||||
Reclassification adjustment for (gains) losses included in net income | 1,967 | — | (687 | ) | 1,280 | |||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs, deferred sales inducements and valuation of business acquired | — | (608 | ) | 213 | (395 | ) | ||||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Balance, June 30, 2011 | $ | (4,970 | ) | $ | 2,244 | $ | 971 | $ | (1,755 | ) | ||||||||||
|
|
|
|
|
|
|
|
All Other Net Unrealized Investment Gains and Losses in AOCI
Net Unrealized Gains/(Losses) on Investments (1) | Deferred Policy Acquisition Costs, Deferred Sales Inducements and Valuation of Business Acquired | Deferred Income Tax (Liability) Benefit | Accumulated Other Comprehensive Income (Loss) Related To Net Unrealized Investment Gains (Losses) | |||||||||||||||||
(in thousands) | ||||||||||||||||||||
Balance, December 31, 2010 | $ | 504,664 | $ | (220,898 | ) | $ | (100,163 | ) | $ | 183,603 | ||||||||||
Net investment gains (losses) on investments arising during the period | (3,057 | ) | — | 1,070 | (1,987 | ) | ||||||||||||||
Reclassification adjustment for (gains) losses included in net income | (47,589 | ) | — | 16,659 | (30,930 | ) | ||||||||||||||
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs, deferred sales inducements and valuation of business acquired | — | 14,266 | (4,993 | ) | 9,273 | |||||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Balance, June 30, 2011 | $ | 454,018 | $ | (206,632 | ) | $ | (87,427 | ) | $ | 159,959 | ||||||||||
|
|
|
|
|
|
|
|
(1) | Includes cash flow hedges. See Note 8 to the Unaudited Interim Financial Statements included herein for additional discussion of our cash flow hedges. |
22
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
The table below presents net unrealized gains (losses) on investments by asset class as of the dates indicated:
June 30, | December 31, | |||||||
2011 | 2010 | |||||||
(in thousands) | ||||||||
Fixed maturity securities on which an OTTI loss has been recognized | $ | (4,970 | ) | $ | (6,560 | ) | ||
Fixed maturity securities, available for sale - all other | 449,526 | 498,517 | ||||||
Equity securities, available for sale | 3,382 | 3,103 | ||||||
Affiliated notes | 5,299 | 5,511 | ||||||
Derivatives designated as cash flow hedges (1) | (4,200 | ) | (2,462 | ) | ||||
Other long-term investments | 11 | (5 | ) | |||||
|
|
|
| |||||
Unrealized gains (losses) on investments and derivatives | $ | 449,048 | $ | 498,104 | ||||
|
|
|
|
(1) | See Note 8 for more information on cash flow hedges. |
Duration of Gross Unrealized Loss Positions for Fixed Maturities and Equity Securities
The following table shows the fair value and gross unrealized losses aggregated by investment category and length of time that individual fixed maturity securities and equity securities have been in a continuous unrealized loss position, as of the dates indicated:
June 30, 2011 | ||||||||||||||||||||||||
Less than twelve months | Twelve months or more | Total | ||||||||||||||||||||||
Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Fixed maturities, available for sale | ||||||||||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||||
Corporate securities | 64,402 | 1,781 | — | — | 64,402 | 1,781 | ||||||||||||||||||
Commercial mortgage-backed securities | 2,123 | 133 | — | — | 2,123 | 133 | ||||||||||||||||||
Asset-backed securities | 18,461 | 224 | 37,645 | 5,386 | 56,106 | 5,610 | ||||||||||||||||||
Residential mortgage-backed securities | 548 | 48 | — | — | 548 | 48 | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | 85,534 | $ | 2,186 | $ | 37,645 | $ | 5,386 | $ | 123,179 | $ | 7,572 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Equity securities, available for sale | $ | 142 | $ | 2 | $ | — | $ | — | $ | 142 | $ | 2 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
December 31, 2010 | ||||||||||||||||||||||||
Less than twelve months | Twelve months or more | Total | ||||||||||||||||||||||
Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Fixed maturities, available for sale | ||||||||||||||||||||||||
U.S. Treasury securities and obligations of U.S. government authorities and agencies | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||||
Corporate securities | 50,071 | 366 | 62 | — | 50,133 | 366 | ||||||||||||||||||
Commercial mortgage-backed securities | 4,992 | — | — | — | 4,992 | — | ||||||||||||||||||
Asset-backed securities | 25,905 | 199 | 42,402 | 7,591 | 68,307 | 7,790 | ||||||||||||||||||
Residential mortgage-backed securities | — | — | — | — | — | — | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | 80,968 | $ | 565 | $ | 42,464 | $ | 7,591 | $ | 123,432 | $ | 8,156 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Equity securities, available for sale | $ | — | $ | — | $ | 746 | $ | 47 | $ | 746 | $ | 47 | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
The gross unrealized losses, related to fixed maturities at June 30, 2011 and December 31, 2010 are composed of $5.9 million and $6.1 million related to high or highest quality securities based on NAIC or equivalent rating and $1.7 million and $2.0 million, respectively, related to other than high or highest quality securities based on NAIC or equivalent rating. At June 30, 2011, $5.1 million of the gross unrealized losses represented declines in value of greater than 20%, $2.6 million of which had been in that position for less than six months, as compared to $4.7 million at December 31, 2010 that represented declines in value of greater than 20%, $.9 million of which had been in that position for less than six months. At June 30, 2011, the $ 5.4 million of gross unrealized losses of twelve months or more were concentrated in asset backed securities. At December 31, 2010, the $7.6 million of gross unrealized losses of twelve months or more were concentrated in asset backed securities.
23
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
In accordance with its policy described in Note 3, the Company concluded that an adjustment to earnings for other-than-temporary impairments for these securities was not warranted at June 30, 2011 or 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 June 30, 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.
At June 30, 2011 and December 31, 2010, there were no gross unrealized losses, related to equity securities that represented declines of greater than 20%. 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 June 30, 2011 and December 31, 2010. In accordance with its policy described in Note 3, the Company concluded that an adjustment for other-than-temporary impairments for these equity securities was not warranted at June 30, 2011 or December 31, 2010.
7. | 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 short term investments, equity securities and derivative contracts that are traded in an active exchange market. 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.), 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, 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 June 30, 2011 and December 31, 2010 these over-rides on a net basis were not material.
24
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Asset 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 June 30, 2011 | ||||||||||||||||
Level 1 | Level 2 | Level 3 | Total | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities, available for sale: | ||||||||||||||||
U.S. government securities | $ | — | $ | 130,874 | $ | — | $ | 130,874 | ||||||||
State and municipal securities | — | 87,156 | — | 87,156 | ||||||||||||
Foreign government securities | — | 135,831 | — | 135,831 | ||||||||||||
Corporate securities | — | 3,564,702 | 93,700 | 3,658,402 | ||||||||||||
Asset-backed securities | — | 155,066 | 53,889 | 208,955 | ||||||||||||
Commercial mortgage-backed securities | — | 437,418 | — | 437,418 | ||||||||||||
Residential mortgage-backed securities | — | 228,558 | — | 228,558 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | — | 4,739,605 | 147,589 | 4,887,194 | ||||||||||||
Trading account assets: | ||||||||||||||||
Asset-backed securities | — | 31,616 | — | 31,616 | ||||||||||||
Equity securities | 7,176 | — | — | 7,176 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | 7,176 | 31,616 | — | 38,792 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Equity securities, available for sale | 19,487 | — | 230 | 19,717 | ||||||||||||
Short-term investments | 285,594 | — | — | 285,594 | ||||||||||||
Cash equivalents | 3,611 | — | — | 3,611 | ||||||||||||
Other long term investments | — | 53,883 | 186 | 54,069 | ||||||||||||
Reinsurance recoverable | — | — | 118,635 | 118,635 | ||||||||||||
Other assets | — | 28,988 | — | 28,988 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total excluding separate account assets | 315,868 | 4,854,092 | 266,640 | 5,436,600 | ||||||||||||
Separate account assets (1) | 1,570,886 | 46,995,638 | — | 48,566,524 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total assets | $ | 1,886,754 | $ | 51,849,730 | $ | 266,640 | $ | 54,003,124 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Future policy benefits | $ | — | $ | — | $ | 95,603 | $ | 95,603 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Total liabilities | $ | — | $ | — | $ | 95,603 | $ | 95,603 | ||||||||
|
|
|
|
|
|
|
|
(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. |
25
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
As of December 31, 2010 | ||||||||||||||||
Level 1 | Level 2 | Level 3 | Total | |||||||||||||
(in thousands) | ||||||||||||||||
Fixed maturities, available for sale: | ||||||||||||||||
U.S. government securities | $ | — | $ | 193,305 | $ | — | $ | 193,305 | ||||||||
State and municipal securities | — | 77,516 | — | 77,516 | ||||||||||||
Foreign government securities | — | 136,513 | — | 136,513 | ||||||||||||
Corporate Securities | — | 3,876,695 | 74,255 | 3,950,950 | ||||||||||||
Asset-backed securities | — | 160,113 | 53,857 | 213,970 | ||||||||||||
Commercial mortgage-backed securities | — | 490,569 | — | 490,569 | ||||||||||||
Residential mortgage-backed securities | — | 393,398 | — | 393,398 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | — | 5,328,109 | 128,112 | 5,456,221 | ||||||||||||
Trading account assets: | ||||||||||||||||
Asset backed securities | — | 70,831 | — | 70,831 | ||||||||||||
Equity Securities | 8,774 | — | — | 8,774 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total | 8,774 | 70,831 | — | 79,605 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Equity securities, available for sale | 16,611 | 976 | — | 17,587 | ||||||||||||
Short-term investments | 228,383 | — | — | 228,383 | ||||||||||||
Cash equivalents | — | — | — | — | ||||||||||||
Other long-term investments | — | 51,000 | — | 51,000 | ||||||||||||
Reinsurance recoverable | — | — | 186,735 | 186,735 | ||||||||||||
Other assets | — | 29,201 | — | 29,201 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Sub-total excluding separate account assets | 253,768 | 5,480,117 | 314,847 | 6,048,732 | ||||||||||||
Separate account assets (1) | 1,488,369 | 46,786,974 | — | 48,275,343 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total assets | $ | 1,742,137 | $ | 52,267,091 | $ | 314,847 | $ | 54,324,075 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Future policy benefits | $ | — | $ | — | $ | 164,283 | $ | 164,283 | ||||||||
|
|
|
|
|
|
|
| |||||||||
Total liabilities | $ | — | $ | — | $ | 164,283 | $ | 164,283 | ||||||||
|
|
|
|
|
|
|
|
(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. |
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 the 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 June 30, 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
26
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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 consist primarily of asset-backed and equity securities whose fair values are determined consistent with similar instruments described under “Fixed Maturity Securities” and under “Equity Securities.”
Equity Securities - Equity securities consist principally of investments in common and preferred stock of publicly traded companies. 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. 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.
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 and liquidity as well as 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. Fair values can also be affected by changes in estimates and assumptions including those related to counterparty behavior used in valuation models.
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 and single name credit default swaps are determined using discounted cash flow models. These models’ key assumptions 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, and are classified as Level 2.
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. 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 and classify these derivative contracts as Level 2.
Derivatives classified as Level 3 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. Other structured options and derivatives are valued using simulation models such as the Monte Carlo technique. Level 3 methodologies are validated through periodic comparison of the Company’s fair values to broker-dealer values. As of June 30, 2011 and December 31, 2010, there were derivatives with the fair value of $186 thousand and $0 classified within Level 3, and all other derivatives were classified within Level 2. See Note 8 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. 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 affiliated bonds within our legal entity whose fair value are determined consistent with similar securities described above under “Fixed Maturity Securities” managed by affiliated asset managers.
Reinsurance Recoverables - Reinsurance recoverables carried at fair value include the reinsurance of our living benefit guarantees on certain of our variable annuities. These guarantees are considered embedded derivatives and are described below in “Future Policy Benefits”. The reinsurance agreements covering these guarantees are derivatives with fair value determined in the same manner as the embedded derivative guarantee.
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
27
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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 in the valuation of the embedded derivatives associated with its optional living benefit features. 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 asset appropriately takes into consideration the Company’s own risk of non-performance. To reflect the market’s perception of its non-performance risk, the Company incorporates an additional spread over LIBOR into the discount rate used in the valuations of the embedded derivatives associated with its optional living benefit features. The additional spread over LIBOR is determined taking into consideration publicly available information relating to the financial strength of the Company, as indicated by the credit spreads associated with funding agreements issued by an affiliated company. The Company adjusts these credit spreads to remove any liquidity risk premium. The additional spread over LIBOR incorporated into the discount rate as of June 30, 2011 generally ranged from 60 to 200 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 embedded derivatives in a liability position and not to those in an asset 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.
Transfers between Levels 1 and 2 –During the three and six months ended June 30, 2011 and 2010, there were no material transfers between Level 1 and Level 2.
28
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
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 three and six months ended June 30, 2011, as well as the portion of gains or losses included in income for the three and six months ended June 30, 2011 attributable to unrealized gains or losses related to those assets and liabilities still held at June 30, 2011.
Three Months Ended June 30, 2011 | |||||||||||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Asset Backed Securities | Equity Securities - Available For Sale | Other Long- Term Investments | Reinsurance Recoverable (3) | |||||||||||||||||||||
(in thousands) | |||||||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | 101,585 | $ | 54,515 | $ | 977 | $ | 244 | $ | (19,884 | ) | ||||||||||||||
Total gains or (losses) (realized/unrealized): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | 10 | — | — | (58 | ) | 84,761 | |||||||||||||||||||
Included in other comprehensive income (loss) | 1,785 | 369 | (1 | ) | — | — | |||||||||||||||||||
Net investment income | 1,124 | 124 | — | — | — | ||||||||||||||||||||
Purchases | 7,302 | — | — | — | 53,758 | ||||||||||||||||||||
Sales | — | — | (746 | ) | — | ||||||||||||||||||||
Settlements | (902 | ) | (1,119 | ) | — | — | — | ||||||||||||||||||
Transfers into Level 3 (1) | 4,308 | — | — | — | — | ||||||||||||||||||||
Transfers out of Level 3 (1) | (21,512 | ) | — | — | — | — | |||||||||||||||||||
|
|
|
|
|
|
|
|
|
| ||||||||||||||||
Fair value, end of period assets/(liabilities) | $ | 93,700 | $ | 53,889 | $ | 230 | $ | 186 | $ | 118,635 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| ||||||||||||||||
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period (2): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | $ | — | $ | — | $ | — | $ | (56 | ) | $ | 85,394 | ||||||||||||||
Asset administration fees and other income | $ | — | $ | — | $ | — | $ | — | $ | — | |||||||||||||||
Included in other comprehensive income (loss) | $ | 1,785 | $ | 369 | $ | (1 | ) | $ | — | $ | — | ||||||||||||||
Three Months Ended June 30, 2011 | |||||||||||||||||||||||||
Future Policy Benefits | |||||||||||||||||||||||||
(in thousands) | |||||||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | 48,529 | |||||||||||||||||||||||
Total gains or (losses) (realized/unrealized): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | (87,815 | ) | |||||||||||||||||||||||
Purchases | (56,317 | ) | |||||||||||||||||||||||
Sales | |||||||||||||||||||||||||
Settlements | — | ||||||||||||||||||||||||
Transfers into Level 3 (1) | — | ||||||||||||||||||||||||
Transfers out of Level 3 (1) | — | ||||||||||||||||||||||||
|
| ||||||||||||||||||||||||
Fair Value, end of period assets/(liabilities) | $ | (95,603 | ) | ||||||||||||||||||||||
|
| ||||||||||||||||||||||||
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period (2): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | $ | (88,232 | ) | ||||||||||||||||||||||
Interest credited to policyholders’ account balances | $ | — | |||||||||||||||||||||||
Included in other comprehensive income (loss) | $ | — |
(1) | 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. |
(2) | 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. |
(3) | Reinsurance Recoverable classified as Other Liabilities at March 31, 2011 were reclassified to Other Assets-Reinsurance Recoverable at June 30, 2011 as they were in a net asset position. |
29
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Transfers –Transfers out of Level 3 were typically 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 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.
Six Months Ended June 30, 2011 | |||||||||||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Asset Backed Securities | Equity Securities - Available For Sale | Other Long- Term Investments | Reinsurance Recoverable | |||||||||||||||||||||
(in thousands) | |||||||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | 74,255 | $ | 53,858 | $ | — | $ | — | $ | 186,735 | |||||||||||||||
Total gains or (losses) (realized/unrealized): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | 35 | — | — | 186 | (174,132 | ) | |||||||||||||||||||
Included in other comprehensive income (loss) | 540 | 1,132 | 1 | — | — | ||||||||||||||||||||
Net investment income | 2,237 | 241 | — | — | — | ||||||||||||||||||||
Purchases | 8,252 | — | — | — | 106,032 | ||||||||||||||||||||
Sales | — | — | (747 | ) | — | ||||||||||||||||||||
Settlements | (1,644 | ) | (1,342 | ) | — | — | — | ||||||||||||||||||
Transfers into Level 3 (1) | 31,537 | — | 976 | — | — | ||||||||||||||||||||
Transfers out of Level 3 (1) | (21,512 | ) | — | — | — | — | |||||||||||||||||||
|
|
|
|
|
|
|
|
|
| ||||||||||||||||
Fair value, end of period assets/(liabilities) | $ | 93,700 | $ | 53,889 | $ | 230 | $ | 186 | $ | 118,635 | |||||||||||||||
|
|
|
|
|
|
|
|
|
| ||||||||||||||||
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period (2): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | $ | — | $ | — | $ | — | $ | 162 | $ | (169,271 | ) | ||||||||||||||
Asset administration fees and other income | $ | — | $ | — | $ | — | $ | — | | $ | — | ||||||||||||||
Included in other comprehensive income (loss) | $ | 534 | $ | 1,132 | $ | 1 | $ | — | $ | — | |||||||||||||||
Six Months Ended June 30, 2011 | |||||||||||||||||||||||||
Future Policy Benefits | |||||||||||||||||||||||||
(in thousands) | |||||||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | (164,283 | ) | ||||||||||||||||||||||
Total gains or (losses) (realized/unrealized): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | 179,758 | ||||||||||||||||||||||||
Purchases | (111,078 | ) | |||||||||||||||||||||||
Sales | |||||||||||||||||||||||||
Settlements | — | ||||||||||||||||||||||||
Transfers into Level 3 (1) | — | ||||||||||||||||||||||||
Transfers out of Level 3 (1) | — | ||||||||||||||||||||||||
|
| ||||||||||||||||||||||||
Fair Value, end of period assets/(liabilities) | $ | (95,603 | ) | ||||||||||||||||||||||
|
| ||||||||||||||||||||||||
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period (2): | |||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||
Realized investment gains (losses), net | $ | 175,186 | |||||||||||||||||||||||
Interest credited to policyholders’ account balances | $ | — | |||||||||||||||||||||||
Included in other comprehensive income (loss) | $ | — |
(1) | 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. |
(2) | 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. |
30
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Transfers– As a 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 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.
The following table provides a summary of the changes in fair value of Level 3 assets and liabilities for the three and six months ended June 30, 2010, as well as the portion of gains or losses included in income for three and six months ended June 30, 2010 attributable to unrealized gains or losses related to those assets and liabilities still held at June 30, 2010.
Three Months Ended June 30, 2010 | ||||||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Foreign Government Bonds | Fixed Maturities Available For Sale - Asset- Backed Securities | Reinsurance Recoverable (3) | |||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | 64,738 | $ | 1,203 | $ | 41,014 | $ | (103,450 | ) | |||||||||||
Total gains or (losses) (realized/unrealized): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | — | — | — | 734,795 | ||||||||||||||||
Included in other comprehensive income (loss) | 3,766 | 4 | — | — | ||||||||||||||||
Net investment income | 973 | (1 | ) | — | — | |||||||||||||||
Purchases, sales, issuances and settlements | — | — | 4,275 | 45,826 | ||||||||||||||||
Transfers into Level 3 (1) | 5,211 | — | — | — | ||||||||||||||||
Transfers out of Level 3 (1) | — | — | (17,422 | ) | — | |||||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Fair value, end of period assets/(liabilities) | $ | 74,688 | $ | 1,206 | $ | 27,867 | $ | 677,171 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period (2): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | $ | — | $ | — | $ | — | $ | 705,955 | ||||||||||||
Asset management fees and other income | $ | — | $ | — | $ | — | $ | — | ||||||||||||
Included in other comprehensive income (loss) | $ | 3,766 | $ | 4 | $ | — | $ | — | ||||||||||||
Three Months Ended June 30, 2010 | ||||||||||||||||||||
Future Policy Benefits | Other Liabilities | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | 135,920 | $ | (31 | ) | |||||||||||||||
Total gains or (losses) (realized/unrealized): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | (757,484 | ) | (21 | ) | ||||||||||||||||
Purchases, sales, issuances and settlements | (48,032 | ) | — | |||||||||||||||||
Transfers into Level 3 (1) | — | — | ||||||||||||||||||
Transfers out of Level 3 (1) | — | — | ||||||||||||||||||
|
|
|
| |||||||||||||||||
Fair value, end of period assets/(liabilities) | $ | (669,596 | ) | $ | (52 | ) | ||||||||||||||
|
|
|
| |||||||||||||||||
Unrealized gains (losses) for the period relating to Level 3 assets that were still held by the Company at the end of the period (2): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | $ | (728,659 | ) | $ | (20 | ) | ||||||||||||||
Interest credited to policyholders’ account balances | $ | — | $ | — | ||||||||||||||||
Included in other comprehensive income (loss) | $ | — | $ | — |
(1) | 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. |
(2) | 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. |
(3) | Reinsurance Recoverable classified as Other Liabilities at March 31, 2010 were reclassified to Other Assets-Reinsurance Recoverable at June 30, 2010 as they were in a net asset position. |
31
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Six Months Ended June 30, 2010 | ||||||||||||||||||||
Fixed Maturities Available For Sale - Corporate Securities | Fixed Maturities Available For Sale - Foreign Government Bonds | Fixed Maturities Available For Sale - Asset- Backed Securities | Reinsurance Recoverable | |||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | 63,634 | $ | 1,219 | $ | 43,795 | $ | 40,351 | ||||||||||||
Total gains or (losses) (realized/unrealized): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | — | — | (1,247 | ) | 548,265 | |||||||||||||||
Included in other comprehensive income (loss) | 4,046 | (12 | ) | (1,215 | ) | — | ||||||||||||||
Net investment income | 1,924 | (1 | ) | (203 | ) | — | ||||||||||||||
Purchases, sales, issuances and settlements | (127 | ) | — | 4,159 | 88,555 | |||||||||||||||
Transfers into Level 3 (1) | 5,211 | — | — | — | ||||||||||||||||
Transfers out of Level 3 (1) | — | — | (17,422 | ) | — | |||||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Fair value, end of period assets/(liabilities) | $ | 74,688 | $ | 1,206 | $ | 27,867 | $ | 677,171 | ||||||||||||
|
|
|
|
|
|
|
| |||||||||||||
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period (2): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | $ | — | $ | — | $ | (654 | ) | $ | 548,398 | |||||||||||
Asset management fees and other income | $ | — | $ | — | $ | — | $ | — | ||||||||||||
Included in other comprehensive income (loss) | $ | 4,046 | $ | (12 | ) | $ | (1,215 | ) | $ | — | ||||||||||
Six Months Ended June 30, 2010 | ||||||||||||||||||||
Future Policy Benefits | Other Liabilities | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||
Fair value, beginning of period assets/(liabilities) | $ | (10,874 | ) | $ | (53 | ) | ||||||||||||||
Total gains or (losses) (realized/unrealized): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | (565,935 | ) | 1 | |||||||||||||||||
Purchases, sales, issuances and settlements | (92,787 | ) | — | |||||||||||||||||
Transfers into Level 3 (1) | — | — | ||||||||||||||||||
Transfers out of Level 3 (1) | — | — | ||||||||||||||||||
|
|
|
| |||||||||||||||||
Fair value, end of period assets/(liabilities) | $ | (669,596 | ) | $ | (52 | ) | ||||||||||||||
|
|
|
| |||||||||||||||||
Unrealized gains (losses) for the period relating to Level 3 assets that were still held by the Company at the end of the period (2): | ||||||||||||||||||||
Included in earnings: | ||||||||||||||||||||
Realized investment gains (losses), net | $ | (565,298 | ) | $ | 1 | |||||||||||||||
Interest credited to policyholders’ account balances | $ | — | $ | — | ||||||||||||||||
Included in other comprehensive income (loss) | $ | — | $ | — |
(1) | 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. |
(2) | 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. |
32
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Fair Value of Financial Instruments– The Company is required by US 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, short-term investments, cash and cash equivalents, separate account assets and long-term and short-term borrowing.
The following table discloses the Company’s financial instruments where the carrying amounts and fair values may differ:
June 30, 2011 | December 31, 2010 | |||||||||||||||
Carrying value | Fair value | Carrying value | Fair value | |||||||||||||
(in thousands) | ||||||||||||||||
Assets: | ||||||||||||||||
Commercial mortgage and other loans | $ | 397,969 | $ | 431,419 | $ | 431,432 | $ | 465,099 | ||||||||
Policy loans | $ | 14,193 | $ | 18,324 | $ | 13,905 | $ | 18,374 | ||||||||
Liabilities: | ||||||||||||||||
Investment Contracts - Policyholders’ Account Balances | $ | 63,880 | $ | 63,775 | $ | 58,549 | $ | 58,679 |
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 the current market spread for similar quality loans.
Policy Loans
The fair value of U.S. insurance 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 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 financial strength ratings, and hence reflects the Company’s own non-performance risk.
8. | 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 a master agreement that provides 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.
Foreign Exchange Contracts
Currency swaps 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
33
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
party. These transactions are entered into pursuant to a master agreement that provides 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 sells credit protection on an identified name, or a basket of names in a first to default structure, and in return receives a quarterly premium. With single name credit default derivatives, this premium or credit spread generally corresponds to the difference between the yield on the referenced name’s public fixed maturity cash instruments and swap rates, at the time the agreement is executed. 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.
Embedded Derivatives
The Company has sold variable annuity contracts that include certain optional living benefit features that are treated, for accounting purposes, as embedded derivatives. The Company has affiliated reinsurance agreements with Pruco Reinsurance, Ltd. (“Pruco Re”) and The Prudential Insurance Company of America (“Prudential Insurance”) to transfer the risk related to certain of these embedded derivatives. 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 fair value of the living benefit feature embedded derivatives included in “Future policy benefits” was a liability of $95.6 million as of June 30, 2011 and liability of $164.3 million as of December 31, 2010. 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 $118.6 million as of June 30, 2011 and an asset of $186.7 million as of December 31, 2010.
Primarily in the reinsurance affiliate, equity options and futures as well as interest rate derivatives are purchased to hedge the living benefit features accounted for as embedded derivatives against changes in equity markets, interest rates, and market volatility. Prior to the third quarter of 2010, the hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by 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 the GAAP value of the embedded derivative liability to be an appropriate measure for determining the hedge target. The new hedge target is grounded in a GAAP/capital markets valuation framework but incorporates modifications to the risk-free return assumption 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 modifications include the removal of a volatility risk margin embedded in the valuation technique used to fair value the embedded derivative liability under GAAP, and the inclusion of a credit spread over the risk-free rate used to estimate future growth of bond investments in the customer separate account funds. This new strategy will result in differences each period between the change in the value of the embedded derivative liability as defined by GAAP and the change in the value of the hedge positions, potentially increasing volatility in GAAP earnings in the Company and the reinsurance affiliate, and increasing volatility in the amortization of deferred acquisition and other costs of the Company as a result of the gross profits impact. In addition, management of the Company and reinsurance affiliates evaluates hedge levels versus the target given the overall capital considerations of our ultimate parent Company, Prudential Financial Inc., and prevailing capital market conditions and may decide to temporarily hedge to an amount that differs from the hedge target definition.
In the second quarter of 2009, the Company began the expansion of our hedging program to include a portion of the market exposure related to our overall capital position including the impact of certain statutory reserve exposures. These capital hedges primarily consisted of equity-based total return swaps that were designed to partially offset changes in our capital position resulting from market driven changes in certain living and death benefit features of our variable annuity products. During the second quarter of 2010, the capital hedge program was terminated in lieu of a new program managed at the Prudential Financial level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial and its subsidiaries, as a whole under stress scenarios. A portion of the derivatives related to the new program were purchased by the Company.
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 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.
34
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
June 30, 2011 | December 31, 2010 | |||||||||||||||||||||||
Notional | Fair Value | Notional | Fair Value | |||||||||||||||||||||
Amount | Assets | Liabilities | Amount | Assets | Liabilities | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Qualifying Hedge Relationships | ||||||||||||||||||||||||
Currency/Interest Rate | $ | 36,071 | $ | — | $ | (4,223 | ) | $ | 36,072 | $ | 152 | $ | (2,606 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total Qualifying Hedge Relationships | $ | 36,071 | $ | — | $ | (4,223 | ) | $ | 36,072 | $ | 152 | $ | (2,606 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Non-qualifying Hedge Relationships | ||||||||||||||||||||||||
Interest Rate | $ | 1,685,450 | $ | 70,557 | $ | (14,060 | ) | $ | 913,700 | $ | 56,896 | $ | (6,727 | ) | ||||||||||
Credit | 399,050 | 2,547 | (2,688 | ) | 350,050 | 2,810 | (3,104 | ) | ||||||||||||||||
Currency/Interest Rate | 58,150 | 72 | (6,825 | ) | 60,439 | 1,622 | (6,829 | ) | ||||||||||||||||
Equity | 13,142,043 | 27,435 | (18,746 | ) | 10,374,514 | 30,278 | (21,492 | ) | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total Non-Qualifying Hedge Relationships | $ | 15,284,693 | $ | 100,611 | $ | (42,319 | ) | $ | 11,698,703 | $ | 91,606 | $ | (38,152 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total Derivatives (1) | $ | 15,320,764 | $ | 100,611 | $ | (46,542 | ) | $ | 11,734,775 | $ | 91,758 | $ | (40,758 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
(1) | Excludes embedded derivatives which contain multiple underlyings. The fair value of these embedded derivatives was a liability of $97.8 million as of June 30, 2011 and a liability of $166.8 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, options, 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:
Three Months Ended | ||||||||
June 30, | ||||||||
2011 | 2010 | |||||||
(in thousands) | ||||||||
Qualifying | ||||||||
Cash Flow Hedges | ||||||||
Currency/Interest Rate | ||||||||
Net investment income | $ | (31 | ) | $ | 17 | |||
Other income | (15 | ) | 26 | |||||
Accumulated other comprehensive income (loss) (1) | (674 | ) | 2,460 | |||||
|
|
|
| |||||
Total cash flow hedges | $ | (720 | ) | $ | 2,503 | |||
|
|
|
| |||||
Non-qualifying hedges | ||||||||
Realized investment gains (losses), net | ||||||||
Interest Rate | $ | 17,592 | $ | 47,870 | ||||
Currency/Interest Rate | (1,019 | ) | 6,881 | |||||
Credit | 323 | (183 | ) | |||||
Equity | (4,311 | ) | 34,367 | |||||
Embedded Derivatives (2) | (17,917 | ) | (35,349 | ) | ||||
|
|
|
| |||||
Total non-qualifying hedges | $ | (5,332 | ) | $ | 53,586 | |||
|
|
|
| |||||
Total Derivative Impact | $ | (6,052 | ) | $ | 56,089 | |||
|
|
|
|
(1) | Amounts deferred in Equity |
(2) | Primarily includes the following: 1) mark-to-market on embedded derivatives of $144.1 million; 2) fees ceded of $68.7 million; offset by 3) change in reinsurance recoverable of $138.5 million; and 4) fees attributed to embedded derivative of $56.3 million as of June 30, 2011. |
35
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Six Months Ended June 30, | ||||||||
2011 | 2010 | |||||||
(in thousands) | ||||||||
Qualifying | ||||||||
Cash Flow Hedges | ||||||||
Currency/Interest Rate | ||||||||
Net investment income | $ | (39 | ) | $ | 24 | |||
Other income | (51 | ) | 24 | |||||
Accumulated other comprehensive income (loss) (1) | (1,738 | ) | 2,191 | |||||
|
|
|
| |||||
Total cash flow hedges | $ | (1,828 | ) | $ | 2,239 | |||
|
|
|
| |||||
Non-qualifying hedges | ||||||||
Realized investment gains (losses), net | ||||||||
Interest Rate | $ | 15,428 | $ | 59,852 | ||||
Currency/Interest Rate | (2,795 | ) | 7,411 | |||||
Credit | 611 | (222 | ) | |||||
Equity | (13,916 | ) | 18,648 | |||||
Embedded Derivatives (2) | (21,608 | ) | (38,803 | ) | ||||
|
|
|
| |||||
Total non-qualifying hedges | $ | (22,280 | ) | $ | 46,886 | |||
|
|
|
| |||||
Total Derivative Impact | $ | (24,108 | ) | $ | 49,125 | |||
|
|
|
|
(1) | Amounts deferred in Equity |
(2) | Primarily includes the following: 1) mark-to-market on embedded derivatives of $(68.7) million; 2) fees ceded of $125.1 million; offset by 3) change in reinsurance recoverable of $(68.1) million; and 4) fees attributed to embedded derivative of $111.1 million as of June 30, 2011. |
For the three and six months ended June 30, 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 | $ | (2,462 | ) | |
Net deferred gains on cash flow hedges from January 1 to June 30, 2011 | (1,828 | ) | ||
Amount reclassified into current period earnings | 90 | |||
|
| |||
Balance, June 30, 2011 | $ | (4,200 | ) | |
|
|
As of June 30, 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 6 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.
36
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Credit Derivatives Written
The following tables set forth the Company’s exposure from credit derivatives where the Company has written credit protection, excluding embedded derivatives contained in externally-managed investments in European markets, by NAIC rating of the underlying credits as of the dates indicated.
NAIC | Rating Agency Equivalent | June 30, 2011 | ||||||||
Single Name | ||||||||||
Notional | Fair Value | |||||||||
(in thousands) | ||||||||||
1 | Aaa, Aa, A | $ | 344,000 | $ | 2,223 | |||||
2 | Baa | 25,000 | 310 | |||||||
|
|
|
| |||||||
Subtotal Investment Grade | 369,000 | 2,533 | ||||||||
|
|
|
| |||||||
3 | Ba | — | — | |||||||
4 | B | — | — | |||||||
5 | C and Lower | — | — | |||||||
6 | In or near default | — | — | |||||||
|
|
|
| |||||||
Subtotal Below Investment Grade | — | — | ||||||||
|
|
|
| |||||||
Total | $ | 369,000 | $ | 2,533 | ||||||
|
|
|
|
(1) | First-to-default credit swap baskets, which may include credits of varying qualities, are grouped above based on the lowest credit in the basket. However, such basket swaps may entail greater credit risk than the rating level of the lowest credit. |
NAIC Designation (1) | Rating Agency Equivalent | December 31, 2010 | ||||||||
Single Name | ||||||||||
Notional | Fair Value | |||||||||
(in thousands) | ||||||||||
1 | Aaa, Aa, A | $ | 290,000 | $ | 2,297 | |||||
2 | Baa | 25,000 | 374 | |||||||
|
|
|
| |||||||
Subtotal Investment Grade | 315,000 | 2,671 | ||||||||
|
|
|
| |||||||
3 | Ba | — | — | |||||||
4 | B | — | — | |||||||
5 | C and Lower | — | — | |||||||
6 | In or near default | — | — | |||||||
|
|
|
| |||||||
Subtotal Below Investment Grade | — | — | ||||||||
|
|
|
| |||||||
Total | $ | 315,000 | $ | 2,671 | ||||||
|
|
|
|
(1) | First-to-default credit swap baskets, which may include credits of varying qualities, are grouped above based on the lowest credit in the basket. However, such basket swaps may entail greater credit risk than the rating level of the lowest credit. |
37
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
The following table sets forth the composition of the Company’s credit derivatives where it has written credit protection, excluding embedded derivatives contained in externally-managed investments in European markets, by industry category as of the dates indicated.
June 30, 2011 | December 31, 2010 | |||||||||||||||
Industry | Notional | Fair Value | Notional | Fair Value | ||||||||||||
(in thousands) | ||||||||||||||||
Corporate Securities: | ||||||||||||||||
Manufacturing | $ | 40,000 | $ | 258 | $ | 40,000 | $ | 249 | ||||||||
Finance | 54,000 | 186 | — | — | ||||||||||||
Services | 20,000 | 96 | 20,000 | 101 | ||||||||||||
Energy | 20,000 | 186 | 20,000 | 220 | ||||||||||||
Transportation | 25,000 | 157 | 25,000 | 203 | ||||||||||||
Retail and Wholesale | 20,000 | 162 | 20,000 | 189 | ||||||||||||
Other | 190,000 | 1,488 | 190,000 | 1,709 | ||||||||||||
First to Default Baskets (1) | — | — | — | — | ||||||||||||
|
|
|
|
|
|
|
| |||||||||
Total Credit Derivatives | $ | 369,000 | $ | 2,533 | $ | 315,000 | $ | 2,671 | ||||||||
|
|
|
|
|
|
|
|
(1) | Credit default baskets may include various industry categories. |
The Company writes credit derivatives under which the Company is obligated to pay a related party 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 $369.0 million notional of credit default swap (“CDS”) selling protection at June 30, 2011. These credit derivatives generally have maturities of five years or less.
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 Stockholders’ Equity under the heading “Accumulated Other Comprehensive Income (Loss)” 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 investments was $7.8 million and $7.5 million at June 30, 2011 and December 31, 2010, respectively.
In addition to selling 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 June 30, 2011 the Company had $30.0 million of outstanding notional amounts reported at fair value as a liability of $2.7 million.
Credit Risk
The Company is exposed to credit-related losses in the event of non-performance by counterparties 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.
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, see Note 5.
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.
38
Table of Contents
Prudential Annuities Life Assurance Corporation
Notes to Unaudited Interim Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Prudential Annuities Life Assurance Corporation meets the conditions set forth in General Instruction H(1)(a) and (b) on Form 10-Q and is therefore filing this form with the reduced disclosure format.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of Prudential Annuities Life Assurance Corporation (“PALAC” or the “Company”), formerly known as American Skandia Life Assurance Corporation, as of June 30, 2011 compared with December 31, 2010, and its results of operations for the three months and six months ended June 30, 2011 and 2010. You should read the following analysis of our financial condition and results of operations in conjunction with the audited Financial Statements, and the “Risk Factors” section included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, the statements under “Forward Looking Statements”, and the Unaudited Interim Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.
General
The Company was established in 1988 and has been a significant provider of variable annuity contracts for the individual market in the United States. The Company’s products have been sold primarily to individuals to provide for long-term savings and retirement needs and to address the economic impact of premature death, estate planning concerns and supplemental retirement income. The investment performance of the registered investment companies supporting the variable annuity contracts, which is principally correlated to equity market performance, can significantly impact the market for the Company’s products.
Products
The Company has sold a wide array of annuities, including deferred and immediate variable annuities that are registered with the United States Securities and Exchange Commission (the “SEC”), which may also include (1) fixed interest rate allocation options, subject to a market value adjustment, and registered with the SEC, and (2) fixed-rate allocation options not subject to a market value adjustment and not registered with the SEC. In addition, the Company has a relatively small in force block of variable life insurance policies, but it no longer actively sells such policies.
Beginning in March 2010, the Company ceased offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product line in each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company within the Prudential Annuities business unit of Prudential Financial). 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. However, subject to applicable contractual provisions and administrative rules, the Company will continue to accept subsequent purchase payments on inforce 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 one insurer (and its affiliate, for New York sales), the Prudential Annuities business unit of Prudential Financial expects to convey a more focused, cohesive brand in the marketplace.
The Company’s variable annuities provide its customers with tax-deferred asset accumulation together with a base death benefit and a suite of optional guaranteed death and living benefits. The benefit features contractually guarantee the contractholder a return of no less than (1) total deposits made to the contract less any partial withdrawals (“return of net deposits”), (2) total deposits made to the contract less any partial withdrawals plus a minimum return (“minimum return”), and/or (3) the highest contract value on a specified date minus any withdrawals (“contract value”). These guarantees may include benefits that are payable in the event of death, annuitization or at specified dates during the accumulation period and withdrawal and income benefits payable during specified periods. Our latest optional living benefits guarantee, among other features, the ability to make withdrawals based on the highest daily contract value plus a minimum return, credited for a period of time. This highest daily guaranteed contract value is accessible through periodic withdrawals for the life of the contractholder, and not as a lump-sum surrender value.
Our variable annuity investment options provide our customers with the opportunity to invest in proprietary and non-proprietary mutual funds, frequently under asset allocation programs, and fixed-rate accounts. The investments made by customers in the proprietary and non-proprietary mutual funds generally represent separate account interests that provide a return linked to an underlying investment portfolio. The general account investments made in the fixed-rate accounts are credited with interest at rates we determine, subject to certain minimums. We also have offered fixed annuities that provide a guarantee of principal and interest credited at rates we determine, subject to certain contractual minimums. Certain investments made in the fixed-rate accounts of our variable annuities and certain fixed annuities impose a market value adjustment if the invested amount is not held to maturity. Based on the contractual terms the market value adjustment can be positive, resulting in an additional amount for the contractholder, or negative, resulting in a deduction from the contractholder’s account value or redemption proceeds.
The primary risk exposures of our variable annuity contracts relate to actual deviations from, or changes to, the assumptions used in the original pricing of these products, including equity market returns, interest rates, market volatility, timing of annuitization and withdrawals, contract lapses and contractholder mortality. The rate of return we realize from our variable annuity contracts will vary based on the extent of the differences between our actual experience and the assumptions used in the original pricing of these products. As part of our risk management strategy we hedge or limit our exposure to certain of these risks primarily through a combination of product design elements, such as an asset transfer feature, externally purchased hedging instruments and affiliated reinsurance arrangements with Pruco Reinsurance, Ltd. (“Pruco Re”) and The Prudential Insurance Company of America (“Prudential Insurance”). Our returns can also vary by contract based on our risk management strategy, including the impact of
39
Table of Contents
any capital markets movements that we may hedge in the affiliate, the impact on that portion of our variable annuity contracts that benefit from an asset transfer feature and the impact of risks that are not able to be hedged.
The asset transfer feature, included in the design of certain optional living benefits, transfers assets between the variable investments selected by the annuity contractholder and, depending on the benefit feature, a fixed rate account in the general account or a bond portfolio within the separate account. The potential transfers are based on the static mathematical formula used with the particular optional benefit which considers a number of factors, including the impact of investment performance on the contractholder’s total account value. In general, negative investment performance may result in transfers to either a fixed rate account in the general account or a bond portfolio within the separate account, and positive investment performance may result in transfers back to contractholder-selected investments. Overall, the asset transfer feature is designed to help mitigate our exposure to equity market risk and market volatility. Beginning in 2009, our offerings of optional living benefit features associated with variable annuity products all included an asset transfer feature, and in 2009 we discontinued any new sales of optional living benefit features without an asset transfer feature. Other product design elements we utilize for certain products to manage these risks include investment option restrictions and minimum issuance age requirements. As of June 30, 2011 approximately $42.2 billion or 80% of total variable annuity account values contain a living benefit feature, compared to approximately $42.1billion or 79% as of December 31, 2010. As of June 30, 2011 approximately $30.8 billion or 73% of variable annuity account values with living benefit features included an asset transfer feature in the product design, compared to approximately $29.0 billion or 69% as of December 31, 2010.
As mentioned above, in addition to our asset transfer feature, we also manage certain risks associated with our variable annuity products through hedging programs and affiliated reinsurance arrangements. Primarily in the reinsurance affiliate, equity options and futures as well as interest rate derivatives are purchased to hedge certain living benefit features accounted for as embedded derivatives against changes in equity markets, interest rates, and market volatility. Prior to the third quarter of 2010, the hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by GAAP, excluding the impact of the market-perceived risk of non-performance (“NPR”), 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 the GAAP value of the embedded derivative liability to be an appropriate measure for determining the hedge target. The new hedge target is grounded in a GAAP/capital markets valuation framework but incorporates modifications to the risk-free return assumption 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 modifications include the removal of a volatility risk margin embedded in the valuation technique used to fair value the embedded derivative liability under GAAP, and the inclusion of a credit spread over the risk-free rate used to estimate future growth of bond investments in the customer separate account funds. This new strategy will result in differences each period between the change in the value of the embedded derivative liability as defined by GAAP and the change in the value of the hedge positions, potentially increasing volatility in GAAP earnings in the Company and the reinsurance affiliate, and increasing volatility in the amortization of deferred acquisition and other costs of the Company as a result of the gross profits impact. In addition, management of the company and reinsurance affiliates evaluates hedge levels versus the target given the overall capital considerations of our ultimate parent Company, Prudential Financial Inc., and prevailing capital market conditions and may decide to temporarily hedge to an amount that differs from the hedge target definition.
In the second quarter of 2009, we began the expansion of our hedging program to include a portion of the market exposure related to the overall capital position of our variable annuity business, including the impact of certain statutory reserve exposures. These capital hedges primarily consisted of equity-based total return swaps that were designed to partially offset changes in our capital position resulting from market driven changes in certain living and death benefit features of our variable annuity products. During the second quarter of 2010, we terminated the capital hedge program in lieu of a new program managed at the Prudential Financial parent company level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial as a whole, under stress scenarios.
Significant Accounting Policies
For information on the Company’s significant accounting policies, see Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
The Company’s Changes in Financial Position and Results of Operations are described below.
40
Table of Contents
Changes in Financial Position
2011 versus 2010
Total assets decreased by $559 million, from $57.3 billion at December 31, 2010 to $56.7 billion at June 30, 2011. Total investments decreased $576 million primarily driven by transfers of balances from the general account to the separate accounts primarily as a result of the asset transfer feature embedded, in some of our optional living benefit features, as discussed above and transfers from customer elected dollar cost averaging (“DCA”) program. In addition, the Company issued a $270 million dividend to Prudential Financial in the second quarter of 2011. Deferred policy acquisition costs (“DAC”) and Deferred sales inducements (“DSI”) decreased by $147 million and $54 million, respectively, primarily due to expected amortization. Additionally, reinsurance recoverables decreased by $68 million driven by mark-to-market decreases in the reinsured liability for living benefit embedded derivatives primarily resulting from a decrease in the present value of future expected benefit payments driven by favorable market conditions. Partially offsetting the above decreases, separate account assets increased by $291 million, primarily driven by market appreciation and the aforementioned transfers related to the asset transfer feature and DCA program, partially offset by net outflows driven by the change in sales strategy discussed above.
During the period, total liabilities decreased by $410 million, from $55.4 billion at December 31, 2010 to $54.9 billion at June 30, 2011. Policyholders’ account balances decreased $730 million primarily driven by transfers of customer account values to the separate account from the general account as discussed above. Additionally, future policy benefits and other policyholder liabilities decreased by $58 million primarily driven by a decrease in the liability for living benefit embedded derivatives, as discussed above. Partially offsetting the above decreases, separate account liabilities increased by $291 million offsetting the increase in separate accounts assets above.
Results of Operations
2011 versus 2010 Three Month Comparison
Net Income
Net income increased $217 million from a loss of $192 million in the second quarter of 2010 to income of $25 million in the second quarter of 2011. The gain is driven by a $350 million increase in income from operations before income taxes, as discussed below, partially offset by a $134 million increase in income tax expense.
The increase in income from operations before taxes was driven by a favorable variance from lower amortization of DAC and other costs primarily related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions, as discussed in more detail below. Also contributing to the increase was a favorable variance related to adjustments to the reserves for the guaranteed minimum death (“GMDB”) and income benefit (“GMIB”) features of our variable annuity products and to the increase in our deferred policy acquisition and other costs. These adjustments are discussed in more detail below. Additionally, fee income, net of higher distribution costs, increased due to higher average separate account balances driven by net market appreciation and net transfers of balances from the general account to the separate accounts over the past twelve months. Partially offsetting these items was an unfavorable variance related to $30 million in mark-to-market gains in the second quarter of 2010 from derivative positions associated with our capital hedging program. As discussed above, the capital hedging program was terminated at the end of the second quarter of 2010.
We amortize DAC and other costs over the expected lives of the contracts based on the level and timing of gross profits on the underlying product. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and include profits and losses related to these contracts that are reported in affiliated legal entities other than the Company as a result of, for example, reinsurance agreements with those affiliated entities. The Company is an indirect subsidiary of Prudential Financial (an SEC registrant) and has extensive transactions and relationships with other subsidiaries of Prudential Financial, including reinsurance agreements, as discussed in Note 5 to the Unaudited Interim Financial Statements. Incorporating all product-related profits and losses in gross profits, including those that are reported in affiliated legal entities, produces a DAC and other costs amortization pattern representative of the economics of the products.
As mentioned above, included in the favorable variance from lower amortization of DAC and other costs, was a $279 million favorable variance in amortization related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions. This impact primarily relates to changes in NPR in the valuation of the reinsured living benefit liabilities. We incorporate the NPR of our affiliates’ in the valuation of the embedded derivatives associated with our living benefit features on our variable annuity contracts. 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 second quarter of both 2010 and 2011, positive NPR adjustments in the reinsurance affiliate, were driven by increases in the reinsured living benefit liabilities due to unfavorable market conditions and widening of the NPR spreads. The NPR gain was smaller in the second quarter of 2011 compared to the second quarter of 2010 due to smaller market and interest rate declines resulting in a favorable variance from lower amortization of DAC and other costs.
As shown in the following table, income from operations for the second quarter of 2011 included $20 million of losses related to adjustments to the GMDB and GMIB reserves and amortization of DAC and other costs, compared to losses of $86 million included in the second quarter of 2010, resulting in a $66 million favorable variance.
41
Table of Contents
Three Months Ended June 30, 2011 | Three Months Ended June 30, 2010 | |||||||||||||||||||||||
Amortization of DAC and Other Costs (1) | Reserves for GMDB / GMIB (2) | Total | Amortization of DAC and Other Costs (1) | Reserves for GMDB / GMIB (2) | Total | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Quarterly market performance adjustment | $ | (7,588 | ) | $ | (2,387 | ) | $ | (9,975 | ) | $ | (48,211 | ) | $ | (39,955 | ) | $ | (88,166 | ) | ||||||
Quarterly adjustment for current period experience | (9,615 | ) | (231 | ) | (9,846 | ) | (8,453 | ) | 10,725 | 2,272 | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | (17,203 | ) | $ | (2,618 | ) | $ | (19,821 | ) | $ | (56,664 | ) | $ | (29,230 | ) | $ | (85,894 | ) | ||||||
|
|
|
|
|
|
|
|
|
|
|
|
(1) | Amounts reflect (charges) or benefits for (increases) or decreases, respectively, in the amortization of deferred policy acquisition, or DAC, and other costs. |
(2) | Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the guaranteed minimum death and income benefit, or GMDB / GMIB, features of our variable annuity products. |
As shown in the table above, results for both periods include quarterly updates for the impact of fund performance on our amortization of DAC and other costs and GMDB/GMIB reserves for our variable annuity products. Results for the second quarter of 2011 included $10 million of losses associated with these quarterly updates due to overall less favorable than expected market performance. The actual rates of return on annuity account values for the second quarter of 2011 was 0.8% compared to our expected rate of return of 1.5%. The second quarter of 2010 updates resulted in losses of $88 million of losses due to unfavorable market performance. The actual rate of return on annuity account values for the second quarter of 2010 was (4.6)% compared to our previously expected rate of return of 1.8%.
We derive our near-term future rate of return assumptions using a reversion to the mean approach, a common industry practice. Under this approach, we consider actual returns over a period of time and initially adjust future projected returns over a four year period so that the assets are projected to grow at the long-term expected rate of return for the entire period. The near-term future projected return across all contract groups is 6.0% per annum as of June 30, 2011, or approximately 1.5% per quarter.
For some contract groups, the projected near-term future annual rate of return calculated using the reversion to the mean approach was greater than our maximum future rate of return assumption across all asset types for this business. In those cases, we utilize the maximum future rate of return over the four year period, thereby limiting the impact of the reversion to the mean on our estimate of total gross profits. The near-term blended maximum future rate of return, for these impacted contract groups, under the reversion to the mean approach is 9.3% as of June 30, 2011. Included in the blended maximum future rate are assumptions for returns on various asset classes, including a 5.7% annual weighted average rate of return on fixed income investments and a 13% annual maximum rate of return on equity investments.
The $10 million charge in the second quarter of 2011 and the $3 million benefit in the second quarter of 2010 shown in the table above, reflect the quarterly adjustments for current period experience, also referred to as experience true-up adjustments. 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 second quarter of 2010 compared to second quarter of 2011.
Revenues
Revenues decreased $16 million, from $419 million in the second quarter of 2010 to $403 million in the second quarter of 2011.
Policy charges and fee income increased $22 million, from $189 million in the second quarter of 2010 to $211 million in the second quarter of 2011 driven by higher fee income primarily driven by an increase in average variable annuity asset balances invested in separate accounts as discussed above.
Net investment income decreased $17 million from $94 million in the second quarter 2010 to $77 million in the second quarter of 2011 as a result of lower average annuity account values in the general account primarily resulting from transfers from the fixed-rate option in the general account to the separate accounts relating to the asset transfer feature and DCA program, as discussed above.
Asset administration fees and other income increased $8 million, from $70 million in the second quarter of 2010 to $78 million in the second quarter of 2011 as a result of higher average variable annuity asset balances invested in separate accounts, as discussed above.
Realized investment gains/losses, net, decreased by $29 million from $58 million in the second quarter of 2010 to $29 million in the second quarter of 2011. This decrease was driven by a $30 million unfavorable variance in the mark-to-market gains in the second quarter of 2010 from derivative positions associated with our terminated capital hedging program. As discussed above, the capital hedging program was terminated at the end of the second quarter of 2010.
42
Table of Contents
Benefits and Expenses
Benefits and expenses decreased $368 million from $739 million in the second quarter of 2010 to $371 million in the second quarter of 2011.
Policyholders’ benefits decreased $27 million, from $54 million in the second quarter of 2010 to $27 million in the second quarter of 2011, primarily due to the adjustments to the reserves for the GMDB/GMIB features of our variable annuity products related to our quarterly adjustments to reflect current period experience and market performance, as discussed above.
Interest credited to policyholders’ account balances decreased $131 million, from $235 million in the second quarter of 2010 to $104 million in the second quarter of 2011, due to lower DSI amortization primarily related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions and quarterly adjustments to reflect current period experience and market performance, as discussed above. Also contributing to the decrease was lower interest credited to policyholders’ account balances due to lower average annuity account values in the fixed-rate option of the general account, primarily due to the asset transfer feature and DCA program discussed above.
Amortization of deferred policy acquisition costs decreased by $218 million, from $350 million in the second quarter of 2010 to $132 million in the second quarter of 2011, primarily due to lower DAC amortization related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions and quarterly adjustments to reflect current period experience and market performance, as discussed above.
General, administrative and other expenses increased $8 million, from $100 million in the second quarter of 2010 to $108 million in the second quarter of 2011, primarily driven by higher asset based commissions due to higher average separate account asset values.
2011 versus 2010 Six Month Comparison
Net Income
Net income increased $304 million from a loss of $160 million for the six months ended June 30, 2010 to income of $144 million for the six months ended June 30, 2011. The increase is driven by a $477 million higher income from operations before income taxes, as discussed below, partially offset by a $174 million increase in income tax expense.
The increase in income from operations before taxes was driven by a favorable variance from lower amortization of DAC and other costs primarily related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions, as discussed in more detail below. Also contributing to the increase was a favorable variance related to adjustments to the reserves for the guaranteed minimum death (“GMDB”) and income benefit (“GMIB”) features of our variable annuity products and to the increase in our deferred policy acquisition and other costs. These adjustments are discussed in more detail below. Additionally, fee income, net of higher distribution costs, increased due to higher average separate account balances driven by net market appreciation and net transfers of balances from the general account to the separate accounts over the past twelve months.
We amortize DAC and other costs over the expected lives of the contracts based on the level and timing of gross profits on the underlying product. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and include profits and losses related to these contracts that are reported in affiliated legal entities other than the Company as a result of, for example, reinsurance agreements with those affiliated entities. The Company is an indirect subsidiary of Prudential Financial (an SEC registrant) and has extensive transactions and relationships with other subsidiaries of Prudential Financial, including reinsurance agreements, as discussed in Note 5 to the Unaudited Interim Financial Statements. Incorporating all product-related profits and losses in gross profits, including those that are reported in affiliated legal entities, produces a DAC and other costs amortization pattern representative of the economics of the products.
As mentioned above, included in the favorable variance from lower amortization of DAC and other costs, was a $382 million favorable variance in amortization related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions. This impact primarily relates to changes in NPR in the valuation of the reinsured living benefit liabilities. In both 2010 and 2011, positive NPR adjustments in the reinsurance affiliate, were driven by increases in the reinsured living benefit liabilities due to unfavorable market conditions and widening of the NPR spreads. The NPR gain was smaller for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 due to smaller market and interest rate declines resulting in a favorable variance from lower amortization of DAC and other costs.
As shown in the following table, income from operations for the six months ended June 30, 2011 included $6 million of losses related to adjustments to the GMDB and GMIB reserves and amortization of DAC and other costs, compared to losses of $64 million for the six months ended June 30, 2010, resulting in a $58 million favorable variance.
43
Table of Contents
Six Months Ended June 30, 2011 | Six Months Ended June 30, 2010 | |||||||||||||||||||||||
Amortization of DAC and Other Costs (1) | Reserves for GMDB / GMIB (2) | Total | Amortization of DAC and Other Costs (1) | Reserves for GMDB / GMIB (2) | Total | |||||||||||||||||||
(in thousands) | ||||||||||||||||||||||||
Quarterly market performance adjustment | $ | 2,982 | $ | 4,835 | $ | 7,817 | $ | (41,372 | ) | $ | (34,424 | ) | $ | (75,796 | ) | |||||||||
Quarterly adjustment for current period experience | (18,714 | ) | 4,600 | (14,114 | ) | (16,281 | ) | 28,320 | 12,039 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||||||||
Total | $ | (15,732 | ) | $ | 9,435 | $ | (6,297 | ) | $ | (57,653 | ) | $ | (6,104 | ) | $ | (63,757 | ) | |||||||
|
|
|
|
|
|
|
|
|
|
|
|
(1) | Amounts reflect (charges) or benefits for (increases) or decreases, respectively, in the amortization of deferred policy acquisition, or DAC, and other costs. |
(2) | Amounts reflect (charges) or benefits for reserve (increases) or decreases, respectively, related to the guaranteed minimum death and income benefit, or GMDB / GMIB, features of our variable annuity products. |
As shown in the table above, results for both periods include quarterly updates for the impact of fund performance on our amortization of DAC and other costs and GMDB/GMIB reserves for our variable annuity products. Results for the six months ended June 30, 2011 included $7 million of benefits associated with these quarterly updates due to favorable market performance. Results for the six months ended June 30, 2010 resulted in losses of $75 million due to unfavorable market 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 | First Quarter | Second Quarter | |||||||||||||
Actual rate of return | 3.6 | % | 0.8 | % | 3.3 | % | (4.6 | )% | ||||||||
Expected rate of return | 1.5 | % | 1.5 | % | 1.8 | % | 1.8 | % |
The $14 million charge for the six months ended June 30, 2011 and the $12 million benefit for the six months ended June 30, 2010 shown in the table above reflect the quarterly adjustments for current period experience, also referred to as actual experience true-up adjustments. 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 the six months ended June 30, 2011 compared to the six months ended June 30, 2010.
Revenues
Revenues increased $2 million, from $772 million for the six months ended June 30, 2010 to $774 million for the six months ended June 30, 2011.
Policy charges and fee income increased $42 million, from $373 million for the six months ended June 30, 2010 to $415 million for the six months ended June 30, 2011 driven by higher fee income primarily driven by an increase in average variable annuity asset balances invested in separate accounts as discussed above. Also included in the above increases was a favorable variance of $14 million from lower market value adjustments related to the Company’s market value adjusted investment option (the “MVA option”) driven by differences in market conditions and transfers of assets to the separate account primarily due to the asset transfer feature. Partially offsetting the above increases was a $27 million benefit in fee income in the prior year from refinements based on a review and settlement of reinsurance contracts related to acquire business.
Net investment income decreased $35 million from $193 million for the six months ended June 30, 2010 to $158 million for the six months ended June 30, 2011 as a result of lower average annuity account values in the general account primarily resulting from transfers from the fixed-rate option in the general account to the separate accounts relating to the asset transfer feature and DCA program, as discussed above.
Asset administration fees and other income increased $18 million, from $139 million for the six months ended June 30, 2010 to $157 million for the six months ended June 30, 2011 as a result of higher average variable annuity asset balances invested in separate accounts, as discussed above.
Realized investment gains/losses, net, decreased by $23 million from $51 million for the six months ended June 30, 2010 to $28 million for the six months ended June 30, 2010. This decrease was driven by a $17 million unfavorable variance in the mark-to-market gains for the six months ended 2010 from derivative positions associated with our terminated capital hedging program. As discussed above, the capital hedging program was terminated at the end of the second quarter of 2010.
44
Table of Contents
Benefits and Expenses
Benefits and expenses decreased $474 million from $1,063 million for the six months ended June 30, 2010 to $589 million for the six months ended June 30, 2011.
Policyholders’ benefits decreased $11 million, from $52 million for the six months ended June 30, 2010 to $41 million for the six months ended June 30, 2011, primarily due to the adjustments to the reserves for the GMDB/GMIB benefit features of our variable annuity products related to our quarterly adjustments to reflect current period experience and market performance, as discussed above.
Interest credited to policyholders’ account balances decreased $185 million, from $356 million for the six months ended June 30, 2010 to $171 million for the six months ended June 30, 2011, due to lower DSI amortization primarily related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions and quarterly adjustments to reflect current period experience and market performance, as discussed above. Also contributing to the decrease was lower interest credited to policyholders’ account balances due to lower average annuity account values in the fixed-rate option of the general account, primarily due to the asset transfer feature and DCA program discussed above.
Amortization of deferred policy acquisition costs decreased by $280 million, from $442 million for the six months ended June 30, 2010 to $162 million for the six months ended June 30, 2011, primarily due to lower DAC amortization related to the impact of the mark-to-market of the reinsured liability for living benefit embedded derivatives and related hedge positions and quarterly adjustments to reflect current period experience and market performance, as discussed above.
General, administrative and other expenses increased $2 million, from $213 million for the six months ended June 30, 2010 to $215 million for the six months ended June 30, 2011, primarily driven by higher asset based commissions due to higher average separate account asset values.
Income Taxes
Our income tax provision amounted to an income tax expense of $40.4 million for the six months ended June 30, 2011 compared to income tax benefit of $132.4 million for the six months ended June 30, 2010. The increase in income tax expense was primarily driven by the increase in pretax income.
The Company’s liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the Internal Revenue Service (“IRS”) or other taxing authorities. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards (“tax attributes”), the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the liability for income taxes. The statute of limitations for the 2002 tax year expired on April 30, 2009. The statute of limitations for the 2003 tax year expired on July 31, 2009. The statute of limitations for the 2004 through 2007 tax years will expire in February 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.
The dividends received deduction (“DRD”) reduces the amount of dividend income subject to U.S. tax and is a significant component of the difference between the Company’s effective tax rate and the federal statutory tax rate of 35%. The DRD for the current period was estimated using information from 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 regulations 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 14, 2011, the Obama Administration released the “General Explanations of the Administration’s Revenue Proposals.” Although the Administration has not released proposed statutory language, 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 regulation or legislation, could increase actual tax expense and reduce the Company’s consolidated net income. These activities had no impact on the Company’s 2010 or second quarter 2011 results.
The Company is not currently under audit by the IRS or any state or local jurisdiction for the years prior to 2009.
In 2009, the Company joined in filing the consolidated federal tax return with its parent, Prudential Financial. For tax years 2009 through 2010, 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.
45
Table of Contents
Liquidity and Capital Resources
Overview
Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long term financial resources available to support the operation of our business, fund business growth, and provide a cushion to withstand adverse circumstances. The ability to generate and maintain sufficient liquidity and capital depends on the profitability of our business, general economic conditions and our access to the capital markets through our 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, Prudential Insurance 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, equity derivatives and other contingent sources of capital.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, could result in the imposition of new capital, liquidity and other requirements on Prudential Financial and the Company. See Item 1. Business -“Regulatory Environment” in our 2010 Annual Report on Form 10-K for information regarding the potential effects of the Dodd-Frank Act on the Company and its affiliates.
On June 30, 2011, the Company paid an extra-ordinary dividend of $270 million to Prudential Financial.
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 our operations. We segment our investment portfolios and employ an asset/liability management approach specific to the requirements of our product lines. This enhances the discipline applied in managing the liquidity, as well as the interest rate and credit risk profiles, of each portfolio in a manner consistent with the unique characteristics of the product liabilities. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact of Prudential Funding, LLC’s financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company.
Liquidity is measured against internally developed benchmarks that take into account the characteristics of both the asset portfolio and the liabilities that they support. The results are affected substantially by the overall asset type and quality of our investments.
Cash Flow
The principal sources of the Company’s liquidity are investment and fee income, and investment maturities and sales, as well as internal borrowings. The principal uses of that liquidity include benefits, claims, and payments to policyholders and contractholders in connection with surrenders, withdrawals and net policy loan activity. Other uses of liquidity include commissions, general and administrative expenses, purchases of investments, and payments in connection with financing activities. As discussed above, in March 2010, the Company ceased offering its existing variable annuity products to new investors upon the launch of a new product line by certain affiliates. Therefore, the Company expects its overall level of cash flows to decrease going forward.
We believe that the cash flows from our 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, policyholder perceptions of our financial strength, and the relative safety of competing products, each of which could lead to reduced cash inflows or increased cash outflows. In addition, market volatility can impact the level of capital required to support our businesses. Our cash flows from investment activities result from repayments of principal, proceeds from maturities and sales of invested assets, net of amounts reinvested. The primary liquidity risks with respect to these cash flows are the risk of default by debtors or bond insurers, our counterparties’ willingness to extend repurchase and/or securities lending arrangements, commitments to invest and market volatility. We closely manage these risks through our credit risk management process and regular monitoring of our liquidity position.
In managing our liquidity, we also consider the risk of policyholder and contractholder withdrawals of funds earlier than our assumptions when selecting assets to support these contractual obligations. We use surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of withdrawals of funds by customers from annuity contracts and deposit liabilities.
46
Table of Contents
Liquid Assets
Liquid assets include cash, cash equivalents, short-term investments, most fixed maturities that are not designated as held to maturity and public equity securities. As of June 30, 2011 and December 31, 2010, the Company had liquid assets of $5.3 billion and $5.8 billion, respectively, which includes a portion financed with asset-based financing. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $0.3 billion and $0.2 billion as of June 30, 2011 and December 31, 2010, respectively. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures in order to evaluate the adequacy of our operations’ liquidity under a variety of stress scenarios. We believe that the liquidity profile of our assets is sufficient to satisfy current liquidity requirements, including under reasonably foreseeable stress scenarios.
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.
Our liquidity is managed through access to substantial investment portfolios as well as a variety of instruments available for funding and/or managing 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 our liquidity. 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 up to limits established with the applicable insurance regulators. Prudential Funding borrows funds in the capital markets primarily through the direct issuance of commercial paper.
Capital
The Risk Based Capital, or RBC, ratio is a primary measure by which we evaluate the capital adequacy of the Company. Prudential Financial manages its domestic insurance subsidiaries’ RBC ratios including the Company’s to a level that is consistent with the ratings targets for those subsidiaries and in excess of the minimum levels required by applicable insurance regulations. RBC is determined by statutory guidelines and formulas that consider, among other things, risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products, interest rate risks and general business risks. The RBC ratio calculations are intended to assist insurance regulators in measuring the adequacy of an insurer’s statutory capitalization. The 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 “—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. A portion of the derivatives related to the new program were purchased by the Company. The program focuses on tail risk in order to protect statutory capital in a cost-effective manner under stress scenarios. Prudential Financial assesses the composition of the hedging program on an ongoing basis and may change it from time to time based on an evaluation of its risk position or other factors.
In addition to hedging the equity market exposure as mentioned above, we also manage certain risks associated with our variable annuity products through hedging programs and affiliated reinsurance arrangements. Primarily in the reinsurance affiliate, we purchase equity options and futures as well as interest rate derivatives are purchased to hedge certain optional living benefit features accounted for as embedded derivatives against changes in equity markets, interest rates, and market volatility. Historically, the hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by 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 the 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 “Products”.
Certain of the Company’s living benefit guarantees are ceded to an affiliated offshore captive reinsurance company, Pruco Re. A reinsurance trust is established by Pruco Re to satisfy reinsurance reserve credit requirements. These reserve credits allow the Company to reduce the level of statutory
47
Table of Contents
capital it is required to hold. As of July 1, 2011 Pruco Re was redomiciled from Bermuda to Arizona. At this time, Pruco Re continues to maintain the statutory reserve credit trust for business reinsured from the Company.
Reinsurance credit reserve requirements can move materially in either direction due to changes in equity markets and interest rates, actuarial assumptions and other factors. Higher reinsurance credit reserve requirements would necessitate depositing additional assets in the statutory reserve credit trusts, 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 interest rates in the second quarter of 2011 led to an increase in the need to fund the captive reinsurance trusts by an amount of $53 million.
Item 4. Controls and Procedures
In order to ensure that the information we must disclose in our filings with the SEC is recorded, processed, summarized and reported on a timely basis, the Company’s management, including our Chief Executive Officer and Chief Financial Officer, have reviewed and evaluated the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934, as amended, or the “Exchange Act”, as of June 30, 2011 .. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2011, our disclosure controls and procedures were effective. No change in our internal control over financial reporting, as defined in Exchange Act Rules 13a-15(f) and 15d-15(f), occurred during the quarter ended June 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
48
Table of Contents
OTHER INFORMATION |
We are subject to legal and regulatory actions in the ordinary course of our businesses, including class action lawsuits. Our pending legal and regulatory actions include proceedings specific to the Company and proceedings generally applicable to business practices in the industry in which we operate. We may be subject to class action lawsuits and other litigation alleging, among other things, that we made improper or inadequate disclosures in connection with the sale of annuity products or charged excessive or impermissible fees on these products, recommended unsuitable products to customers, mishandled customer accounts or breached fiduciary duties to customers. We are also subject to litigation arising out of our general business activities, such as our investments and contracts, and could be exposed to claims or litigation concerning certain business or process patents. Regulatory authorities from time to time make inquiries and conduct investigations and examinations relating particularly to us and our products. In addition, we, along with other participants in the business in which we engage, 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 our pending legal and regulatory actions, parties are seeking large and/or indeterminate amounts, including punitive or exemplary damages. The outcome of litigation or regulatory matter, and the amount or range of potential loss at any particular time, is inherently uncertain.
Summary
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 results of operations or cash flow of the Company 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. See Note 4 to Financial Statements included herein for additional discussion of our litigation and regulatory matters and audits and inquiries concerning the Company’s handling of unclaimed property.
The Company is an indirectly owned subsidiary of Prudential Financial. You should carefully consider the risks described under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010. These risks could materially affect Prudential Financial’s and/or the Company’s business, results of operations or financial condition or cause our actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company. These risks are not exclusive, and additional risks to which we are subject include, but are not limited to, the factors mentioned under “Forward-Looking Statements” above and the risks of our businesses described elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2010.
49
Table of Contents
31.1 | Section 302 Certification of the Chief Executive Officer. | |
31.2 | Section 302 Certification of the Chief Financial Officer. | |
32.1 | Section 906 Certification of the Chief Executive Officer. | |
32.2 | Section 906 Certification of the Chief Financial Officer. | |
101.INS - XBRL | Instance Document. | |
101.SCH - XBRL | Taxonomy Extension Schema Document. | |
101.CAL - XBRL | Taxonomy Extension Calculation Linkbase Document. | |
101.LAB - XBRL | Taxonomy Extension Label Linkbase Document. | |
101.PRE - XBRL | Taxonomy Extension Presentation Linkbase Document. | |
101.DEF - XBRL | Taxonomy Extension Definition Linkbase Document. |
In accordance with Rule 406T of Regulation S-T, the XBRL related information in Exhibit 101 to the Quarterly Report on Form 10-Q shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.
50
Table of Contents
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PRUDENTIAL ANNUITIES LIFE ASSURANCE CORPORATION | ||
By: | /s/ Thomas J. Diemer | |
Thomas J. Diemer | ||
Executive Vice President and Chief Financial Officer | ||
(Principal Financial Officer and Principal Accounting Officer) |
August 12, 2011
51
Table of Contents
Exhibit Index
Exhibit Number and Description
31.1 | Section 302 Certification of the Chief Executive Officer. | |
31.2 | Section 302 Certification of the Chief Financial Officer. | |
32.1 | Section 906 Certification of the Chief Executive Officer. | |
32.2 | Section 906 Certification of the Chief Financial Officer. | |
101.INS | XBRL Instance Document. | |
101.SCH | XBRL Taxonomy Extension Schema Document. | |
101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document. | |
101.LAB | XBRL Taxonomy Extension Label Linkbase Document. | |
101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document. | |
101.DEF | XBRL Taxonomy Extension Definition Linkbase Document. |
52