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, 2010

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  ¨    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 13, 2010, 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.

 

 

 

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TABLE OF CONTENTS

 

				Page Number
PART I FINANCIAL INFORMATION
Item 1.		Financial Statements:
		Unaudited Interim Statements of Financial Position As of June 30, 2010 and December 31, 2009		4
		Unaudited Interim Statements of Operations and Comprehensive Income Three and Six Months Ended June 30, 2010 and 2009		5
		Unaudited Interim Statement of Equity Six Months Ended June 30, 2010 and 2009		6
		Unaudited Interim Statements of Cash Flows Six Months Ended June 30, 2010 and 2009		7
		Notes to Unaudited Interim Financial Statements		8
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		37
Item 4.		Controls and Procedures		48
PART II OTHER INFORMATION
Item 1.		Legal Proceedings		49
Item 1A.		Risk Factors		50
Item 6.		Exhibits		52
SIGNATURES				53

 

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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 external financing for our operations, which has been affected by the stress experienced by the global financial markets; (3) interest rate fluctuations; (4) reestimates of our reserves for future policy benefits and claims; (5) 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; (6) changes in our assumptions related to deferred policy acquisition costs or valuation of business acquired; (7) changes in our claims-paying or credit ratings; (8) investment losses, defaults and counterparty non-performance; (9) competition in our product lines and for personnel; (10) changes in tax law; (11) regulatory or legislative changes, including the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act; (12) adverse determinations in litigation or regulatory matters and our exposure to contingent liabilities; (13) 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; (14) ineffectiveness of risk management policies and procedures in identifying, monitoring and managing risks; (15) effects of acquisitions, divestitures and restructurings, including possible difficulties in integrating and realizing the projected results of acquisitions; (16) changes in statutory or U.S. GAAP accounting principles, practices or policies; and (17) changes in assumptions for retirement expense. The foregoing risks are even more pronounced in severe adverse market and economic conditions such as those that began in the second half of 2007 and continued into 2009. 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, 2009 and in this Quarterly Report on Form 10-Q for a discussion of certain risks relating to our businesses and investment in our securities.

 

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PART I-FINANCIAL INFORMATION

ITEM 1. Financial Statements

Prudential Annuities Life Assurance Corporation

Unaudited Interim Statements of Financial Position

As of June 30, 2010 and December 31, 2009 (in thousands, except share amounts)

 

 

		June 30, 2010			December 31, 2009
ASSETS
Fixed maturities available for sale, at fair value (amortized cost, 2010: $5,937,904; 2009: $6,056,960)		$	6,551,233		$	6,493,887
Trading account assets, at fair value			78,517			79,892
Equity securities available for sale, at fair value (cost, 2010:$17,086; 2009: $17,085)			19,623			18,612
Commercial mortgage and other loans			366,212			373,080
Policy loans			13,020			13,067
Short-term investments			493,321			705,846
Other long-term investments			100,619			2,995
Total investments			7,622,545			7,687,379
Cash and cash equivalents			111,263			71,548
Deferred policy acquisition costs			1,158,695			1,411,571
Accrued investment income			73,117			77,004
Reinsurance recoverable			677,455			40,597
Income taxes receivable			128,154			230,427
Valuation of business acquired			39,127			52,596
Deferred sales inducements			649,006			801,876
Receivables from parent and affiliates			59,825			119,300
Investment receivable on open trades			1,382			7,984
Other assets			8,252			7,056
Separate account assets			42,698,943			41,448,712
TOTAL ASSETS		$	53,227,764		$	51,956,050
LIABILITIES AND STOCKHOLDER’S EQUITY
LIABILITIES
Policyholders’ account balances		$	6,566,674		$	6,894,651
Future policy benefits and other policyholder liabilities			965,183			292,921
Payables to parent and affiliates			75,161			76,439
Cash collateral for loaned securities			139,808			263,617
Short-term borrowing			28,000			54,585
Long-term borrowing			775,000			775,000
Investment payable on open trades			14,011			11
Other liabilities			145,839			242,205
Separate account liabilities			42,698,943			41,448,712
TOTAL LIABILITIES		$	51,408,619		$	50,048,141
Commitments and Contingent Liabilities (See Note 4)
STOCKHOLDER’S EQUITY
Common stock, $100 par value; 25,000 shares, authorized, issued and outstanding		$	2,500		$	2,500
Additional paid-in capital			992,027			974,921
Retained earnings			638,574			798,170
Accumulated other comprehensive income			186,044			132,318
Total stockholder’s equity		$	1,819,145		$	1,907,909
TOTAL LIABILITIES AND STOCKHOLDER’S EQUITY		$	53,227,764		$	51,956,050

See Notes to Unaudited Interim Financial Statements

 

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Prudential Annuities Life Assurance Corporation

Unaudited Interim Statements of Operations and Comprehensive Income

Three Months and Six Months Ended June 30, 2010 and 2009 (in thousands)

 

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2010				2009				2010				2009
REVENUES
Premiums		$	7,530			$	3,729			$	14,936			$	6,837
Policy charges and fee income			188,954				76,504				373,118				182,687
Net investment income			94,343				130,693				192,903				276,881
Asset administration fees and other income			69,990				43,183				139,079				78,686
Realized investment gains (losses), net:
Other-than-temporary impairments on fixed maturity securities			(13,087	)			(6,419	)			(24,414	)			(21,759	)
Other-than-temporary impairments on fixed maturity securities transferred to Other Comprehensive Income			11,654				3,596				22,325				15,529
Other realized investment gains (losses), net			59,775				24,429				53,574				40,366
Total realized investment gains (losses), net			58,342				21,606				51,485				34,136
Total revenues		$	419,159			$	275,715			$	771,521			$	579,227
BENEFITS AND EXPENSES
Policyholders’ benefits			54,071				(44,016	)			52,115				38,166
Interest credited to policyholders’ account balances			234,500				18,181				356,187				278,584
Amortization of deferred policy acquisition costs			349,786				(206,108	)			442,015				312,663
General administrative and other expenses			100,200				88,870				213,208				175,751
Total benefits and expenses		$	738,557			$	(143,073	)		$	1,063,525			$	805,164
Income (loss) from operations before income taxes		$	(319,398	)		$	418,788			$	(292,004	)		$	(225,937	)
Income tax (benefit) expense			(127,755	)			169,907				(132,408	)			(91,876	)
NET INCOME (LOSS)		$	(191,643	)		$	248,881			$	(159,596	)		$	(134,061	)
Change in net unrealized investment gains (losses), net of taxes (1)			8,781				29,184				53,726				57,654
COMPREHENSIVE INCOME (LOSS)		$	(182,862	)		$	278,065			$	(105,870	)		$	(76,407	)

 

(1)	Amounts are net of tax benefits (expense) of $(4.8) million and $(16.0) million for the three months ended June 30, 2010 and 2009, respectively; and $(29.4) and $(31.6) million for the six months ended June 30, 2010 and 2009, respectively.

See Notes to Unaudited Interim Financial Statements

 

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Prudential Annuities Life Assurance Corporation

Unaudited Interim Statement of Equity

Six Months Ended June 30, 2010 and 2009 (in thousands)

 

 

		Common Stock			Additional paid-in capital			Retained earnings				Accumulated other comprehensive income			Total equity
Balance, December 31, 2009		$	2,500		$	974,921		$	798,170			$	132,318		$	1,907,909
Net loss			—			—			(159,596	)			—			(159,596	)
Distribution from/(to) parent			—			17,106			—				—			17,106
Other comprehensive income, net of taxes			—			—			—				53,726			53,726
Balance, June 30, 2010		$	2,500		$	992,027		$	638,574			$	186,044		$	1,819,145

 

		Common Stock			Additional paid-in capital			Retained earnings				Accumulated other comprehensive income (loss)				Total equity
Balance, December 31, 2008		$	2,500		$	974,921		$	729,100			$	(5,946	)		$	1,700,575
Net loss			—			—			(134,061	)			—				(134,061	)
Impact of adoption of new guidance for other-than-temporary impairments of debt securities, net of taxes			—			—			8,706				(8,706	)			—
Distribution from/(to) parent			—			—			(10,258	)			—				(10,258	)
Other comprehensive income, net of taxes			—			—			—				57,654				57,654
Balance, June 30, 2009		$	2,500		$	974,921		$	593,487			$	43,002			$	1,613,910

See Notes to Unaudited Interim Financial Statements

 

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Prudential Annuities Life Assurance Corporation

Unaudited Interim Statements of Cash Flows

Six Months Ended June 30, 2010 and 2009 (in thousands)

 

 

		Six months ended June 30, 2010				Six months ended June 30, 2009
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
Net loss		$	(159,596	)		$	(134,061	)
Adjustments to reconcile net income to net cash provided by operating activities:
Policy charges and fee income			41,983				57,051
Realized investment (gains) losses, net			(51,485	)			(34,136	)
Amortization and depreciation			(2,665	)			(3,139	)
Interest credited to policyholders’ account balances			136,100				174,437
Change in:
Future policy benefit reserves			106,327				19,887
Accrued investment income			3,117				(2,558	)
Trading account assets			1,015				(8,097	)
Net receivable (payable) to affiliates			58,126				(38,773	)
Deferred sales inducements			130,048				18,184
Deferred policy acquisition costs			182,207				88,871
Income taxes payable (receivable)			72,826				(78,888	)
Reinsurance recoverable			(105,038	)			(45,126	)
Other, net			(39,797	)			(65,438	)
Cash Flows From (Used In) Operating Activities		$	373,168			$	(51,786	)
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
Proceeds from the sale/maturity of:
Fixed maturities, available for sale		$	670,176			$	5,099,594
Equity Securities, available for sale			4,633				11,588
Commercial mortgage and other loans			6,824				75,916
Trading account assets			4,192				4,595
Policy loans			822				44
Other long-term investments			347				326
Short-term investments			2,936,759				3,166,498
Payments for the purchase/origination of:
Fixed maturities, available for sale			(530,631	)			(3,067,469	)
Equity Securities, available for sale			(5,000	)			(17,500	)
Commercial mortgage and other loans			—				(447	)
Trading account assets			(2,475	)			(22,656	)
Policy loans			(333	)			(207	)
Other long-term investments			(29,405	)			(542	)
Short-term investments			(2,724,392	)			(3,373,654	)
Notes receivable from parent and affiliates, net			17,143				—
Cash Flows From Investing Activities		$	348,660			$	1,876,086
CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES:
Capital contribution from (to) Parent		$	17,106			$	(10,258	)
Decrease in future fees payable to PAI, net			—				(691	)
Cash collateral for loaned securities			(123,809	)			143,329
Securities sold under agreement to repurchase			(602	)			—
Repayments of debt (maturities longer than 90 days)			—				(4,547	)
Net increase (decrease) in short-term borrowing			(26,585	)			(175,511	)
Drafts outstanding			22,045				49,611
Policyholders’ account balances
Deposits			1,865,603				2,102,145
Withdrawals			(2,435,871	)			(3,902,614	)
Cash Flows Used in Financing Activities		$	(682,113	)		$	(1,798,536	)
Net increase in cash and cash equivalents			39,715				25,764
Cash and cash equivalents, beginning of period			71,548				26,549
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	111,263			$	52,313

See Notes to Unaudited Interim Financial Statements

 

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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 direct 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, we began the process of changing the Company’s name and the names of various legal entities that include the “American Skandia” name, as required by the terms of the Acquisition. 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, Inc., which is a wholly owned subsidiary of PAI. The Company currently issues variable and fixed deferred and immediate annuities for individuals and groups in the United States of America.

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 insurance products, and individual and group annuities.

Beginning in March 2010, with very limited exceptions, the Company has ceased offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product in 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 purchase payments on inforce contracts under existing annuity products. These initiatives are being 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 image in the marketplace.

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, 2009.

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; valuation 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; reserves for contingent liabilities, including reserves for losses in connection with unresolved legal matters.

During the first quarter of 2010, policy charges and fee income included a $19 million benefit related to an unaffiliated reinsurance payable recorded in prior periods.

Reclassifications

Certain amounts in prior periods have been reclassified to conform to the current period presentation.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

3. ACCOUNTING POLICIES AND ACCOUNTING PRONOUNCEMENTS

Investments in Debt and Equity Securities

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 are as follows:

Fixed maturities are comprised of bonds, notes and redeemable preferred stock. Fixed maturities classified as “available for sale” are carried at fair value. See Note 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 as well as the impact of the Company’s adoption on January 1, 2009 of new authoritative guidance for the recognition and presentation of other-than-temporary impairments for debt securities. Unrealized gains and losses on fixed maturities classified as “available for sale,” net of tax, and the effect on deferred policy acquisition costs, valuation of business acquired, deferred sales inducements and policyholders’ dividends 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 investments. 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 are reported in “Net investment income.”

Equity securities, available for sale are comprised of common stock, and non-redeemable preferred stock, and are carried at fair value. The associated unrealized gains and losses, net of tax, and the effect on deferred policy acquisition costs, deferred sales inducements, valuation of business acquired, 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.

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, provisions 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.

In addition, in April 2009, the Financial Accounting Standards Board (FASB) revised the authoritative guidance for the recognition and presentation of other-than-temporary impairments for debt securities. The Company early adopted this guidance on January 1, 2009. Prior to the adoption of this guidance the Company was required to record an other-than-temporary impairment for a debt security unless it could assert that it had both the intent and ability to hold the security for a period of time sufficient to allow for a recovery in its fair value to its amortized cost basis. This revised guidance indicates that 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

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

3. ACCOUNTING POLICIES AND ACCOUNTING PRONOUNCEMENTS (continued)

 

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. In addition to the above mentioned circumstances, the Company also recognizes an other-than-temporary impairment in earnings when a foreign currency denominated security in an unrealized loss position approaches maturity.

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 two 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).” Prior to the adoption of this guidance in 2009, an other-than-temporary impairment recognized in earnings for debt securities was equal to the total difference between amortized cost and fair value at the time of impairment.

For debt securities, the split between the amount of an other-than-temporary impairment recognized in other comprehensive income and the net amount recognized in earnings is driven principally by assumptions regarding the amount and timing of projected cash flows. For mortgage-backed and asset-backed securities, cash flow estimates consider the payment terms of the underlying assets backing a particular security, including prepayment assumptions, and are based on data from widely accepted third-party data sources or internal estimates. In addition to prepayment assumptions, cash flow estimates include assumptions regarding the underlying collateral including default rates and recoveries which vary based on the asset type and geographic location, as well as the vintage year of the security. For structured securities, the payment priority within the tranche structure is also considered. For all other debt securities, cash flow estimates are driven by assumptions regarding probability of default and estimates regarding timing and amount of recoveries associated with a default. The Company has developed these estimates using information based on its historical experience as well as using market observable data, such as industry analyst reports and forecasts, sector credit ratings and other data relevant to the collectability of a security, such as the general payment terms of the security and the security’s position within the capital structure of the issuer.

The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. In periods subsequent to the recognition of an other-than-temporary impairment, the impaired security is accounted for as if it had been purchased on the measurement date of the impairment. For debt securities, the discount (or reduced premium) based on the new cost basis may be accreted into net investment income in future periods, including increases in cash flow on a prospective basis.

Derivative Financial Instruments

Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or the values of securities. Derivative financial instruments we generally use include swaps, 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. Values can be affected by changes in interest rates, foreign exchange rates, credit spreads, market volatility and liquidity. Values can also be affected by changes in estimates and assumptions including those related to counterparty behavior and non-performance risk used in valuation models.

Derivatives are used to manage the characteristics of the Company’s asset/liability mix, and manage the interest rate and currency characteristics of assets or liabilities. Additionally, derivatives may be used to seek to reduce exposure to interest rate and foreign currency risks associated with assets held or expected to be purchased or sold, and liabilities incurred or expected to be incurred.

Derivatives are recorded as assets, within “Other long-term investments, at fair value” 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 counterparties for which a master netting arrangement has been executed. As discussed in detail 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 Unaudited Interim Statements of Cash Flows.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

3. ACCOUNTING POLICIES AND ACCOUNTING PRONOUNCEMENTS (continued)

 

The Company designates derivatives as either (1) a hedge of the fair value of a recognized asset or liability or unrecognized firm commitment (“fair value” hedge), (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge), (3) a foreign currency fair value or cash flow hedge (“foreign currency” hedge), (4) a hedge of a net investment in a foreign operation, or (5) a derivative entered into as an economic hedge 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 fair value, cash flow, or foreign currency, hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or 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 amortized 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, the identification of which involves judgment. At inception, the Company assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the financial instrument (i.e., the host contract) and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the embedded 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 “Trading account assets,” at fair value. The Company has sold and in certain limited instances continues to sell 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 embedded derivative.

Adoption of New Accounting Pronouncements

In January 2010, the FASB issued updated guidance that requires new fair value disclosures about significant transfers between Level 1 and 2 measurement categories and separate presentation of purchases, sales, issuances, and settlements within the roll forward of Level 3 activity. Also, this updated fair value guidance clarifies the disclosure requirements about level of disaggregation and valuation techniques and inputs. This new guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of Level 3 activity, which are effective for interim and annual reporting periods beginning after December 15, 2010. The Company adopted the effective portions of this guidance on January 1, 2010. The required disclosures are provided in Note 7 and Note 8.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

3. ACCOUNTING POLICIES AND ACCOUNTING PRONOUNCEMENTS (continued)

 

In June 2009, the FASB issued authoritative guidance which changes the analysis required to determine whether or not an entity is a variable interest entity (“VIE”). In addition, the guidance changes the determination of the primary beneficiary of a VIE from a quantitative to a qualitative model. Under the new qualitative model, the primary beneficiary must have both the ability to direct the activities of the VIE and the obligation to absorb either losses or gains that could be significant to the VIE. This guidance also changes when reassessment is needed, as well as requires enhanced disclosures, including the effects of a company’s involvement with a VIE on its financial statements. This guidance is effective for interim and annual reporting periods beginning after November 15, 2009. In February 2010, the FASB issued updated guidance which defers, except for disclosure requirements, the impact of this guidance for entities that (1) possess the attributes of an investment company, (2) do not require the reporting entity to fund losses, and (3) are not financing vehicles or entities that were formerly classified as qualified special purpose entities (“QSPE’s”). The Company’s adoption of this guidance effective January 1, 2010 did not have a material effect on the Company’s financial position, results of operations, and financial statement disclosures.

In June 2009, the FASB issued authoritative guidance which changes the accounting for transfers of financial assets, and is effective for transfers of financial assets occurring in interim and annual reporting periods beginning after November 15, 2009. It removes the concept of a QSPE from the guidance for transfers of financial assets and removes the exception from applying the guidance for consolidation of variable interest entities to qualifying special-purpose entities. It changes the criteria for achieving sale accounting when transferring a financial asset and changes the initial recognition of retained beneficial interests. The guidance also defines “participating interest” to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale. The Company’s adoption of this guidance effective January 1, 2010 did not have a material effect on the Company’s financial position, results of operations, and financial statement disclosures.

Future 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 disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The Company is currently assessing the impact of this guidance on the Company’s financial statement disclosures.

In April 2010, the FASB issued guidance that amends the accounting for modification of loans that are part of a pool accounted for as a single asset. Under this guidance, modification of loans accounted for within a pool under provisions for loans acquired with deteriorated credit quality, does not result in removal of such loans from the pool even if the modification would otherwise be considered a troubled debt restructuring. An entity must continue to consider whether the pool of assets in which the modified loan is included is impaired if expected cash flows for the pool change. This guidance does not affect the accounting for loans acquired with deteriorated credit quality that are not accounted for within a pool. Loans accounted for individually that were acquired with deteriorated credit quality continue to be subject to the accounting provisions for troubled debt restructuring by creditors. This amended guidance is effective for modifications of loans accounted for within a pool that occur in the first interim or annual reporting period ending on or after July 15, 2010. The amended guidance is to be applied prospectively, with early application permitted. The Company’s adoption of this guidance effective July 1, 2010, is not expected to have a material effect on the Company’s financial position, results of operations, and financial statement disclosures.

In April 2010, the FASB issued 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 is not expected to have a material effect on the Company’s financial position, results of operations, and financial statement disclosures.

In March 2010, the FASB issued updated guidance that amends and clarifies the accounting for credit derivatives embedded in interests in securitized financial assets. This new guidance eliminates the scope exception for embedded credit derivatives (except for those that are created solely by subordination) and provides new guidance on how the evaluation of embedded credit derivatives is to be performed. This new guidance is effective for the first interim reporting period beginning after June 15, 2010, with early adoption permitted. The Company’s adoption of this guidance effective with the interim reporting period ending September 30, 2010 is not expected to have a material effect on the Company’s financial position, results of operations, and financial statement disclosures.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

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.

Litigation and Regulatory Matters

The Company is 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 a litigation or regulatory matter, and the amount or range of potential loss at any particular time, is often inherently uncertain. The following is a summary of certain pending proceedings:

Commencing in 2003, the Company received formal requests for information from the SEC and the New York Attorney General’s Office (“NYAG”) relating to market timing in variable annuities by certain American Skandia entities. In connection with these investigations, with the approval of Skandia, an offer was made by American Skandia to the SEC and NYAG, to settle these matters by paying restitution and a civil penalty. In April 2009, AST Investment Services, Inc., formerly named American Skandia Investment Services, Inc. (“ASISI”), reached a resolution of these previously disclosed investigations by the SEC and the NYAG into market timing related misconduct involving certain variable annuities. The settlements relate to conduct that generally occurred between January 1998 and September 2003. Prudential Financial acquired ASISI from Skandia Insurance Company Ltd (publ) (“Skandia”) in May 2003. Subsequent to the acquisition, the Company implemented controls, procedures and measures designed to protect customers from the types of activities involved in these investigations. These settlements resolve the investigations by the above named authorities into these matters, subject to the settlement terms. Under the terms of the settlements, ASISI has paid a total of $34 million in disgorgement and an additional $34 million as a civil money penalty into a Fair Fund administered by the SEC to compensate those harmed by the market timing related activities. Pursuant to the settlements, ASISI has retained, at its ongoing cost and expense, the services of an Independent Distribution consultant acceptable to the Staff of the SEC to develop a proposed plan for the distribution of Fair Fund amounts according to a methodology developed in consultation with and acceptable to the Staff. As part of these settlements, ASISI hired an independent third party which conducted a compliance review and issued a report of its findings and recommendations to ASISI’s Board of Directors, the Audit Committee of the Advanced Series Trust Board of Trustees and the Staff of the SEC. In addition, ASISI has agreed, among other things, to continue to cooperate with the SEC and NYAG in any litigation, ongoing investigations or other proceedings relating to or arising from their investigations into these matters. Under the terms of the Acquisition Agreement pursuant to which Prudential Financial acquired ASISI from Skandia, Prudential Financial was indemnified for the settlements.

During the third quarter of 2004, the Company identified a system-generated calculation error in its annuity contract administration system that existed prior to the Acquisition. This error related to the calculation of amounts due to customers for certain transactions subject to a market value adjustment upon the surrender or transfer of monies out of their annuity contract’s fixed allocation options. The error resulted in an underpayment to policyholders, as well as additional anticipated costs to the Company associated with remediation, breakage and other losses. The Company’s consultants have developed the systems functionality to compute remediation amounts and are in the process of running the computations on affected contracts. The Company contacted state insurance regulators and commenced Phase I of its outreach to customers on November 12, 2007. Phase II commenced on June 6, 2008. Phase III commenced December 5, 2008. Phase IV commenced June 12, 2009. Phase V commenced July 9, 2010. Remaining contracts will require manual calculations and we expect these to be remediated by end of year. Prudential Financial previously advised Skandia that a portion of the remediation and related administrative costs are subject to the indemnification provisions of the Acquisition Agreement. The Company resolved its indemnification claims with Skandia.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

4. CONTINGENT LIABILITIES AND LITIGATION (continued)

 

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.

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 $1.4 million and $1.4 million for the three months ended June 30, 2010 and 2009, respectively and $2.7 million and $2.7 million for the six months ended June 30, 2010 and 2009, 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 $0.7 million and $0.8 million for the three months ended June 30, 2010 and 2009, respectively and $1.3 million and $1.5 million for the six months ended June 30, 2010 and 2009, 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 an 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 an 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, 2010 and December 31, 2009, $28.0 million and $54.6 million, respectively, was outstanding under this credit facility.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

5. RELATED PARTY TRANSACTIONS (continued)

 

Reinsurance Agreements

The Company uses reinsurance as part of its risk management and capital management strategies for certain of its optional living benefit features.

During 2009, the Company entered into two reinsurance agreements with an affiliate as part of its risk management and capital management strategies. 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, included in “Realized investments (losses) gains, net” on the financial statements, were $11.1 million and $16.2 million for the three and six months ended June 30, 2010. 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, included in “Realized investments (losses) gains, net" on the financial statements, were $16.6 million and $1.0 for the three months ended June 30, 2010 and 2009, respectively; and $32.4 million and $1.0 million for the six months ended June 30, 2010 and 2009 respectively.

During 2008, the Company entered into three reinsurance agreements with an affiliate as part of its risk management and capital management strategies. Effective January 28, 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, included in “Realized investments (losses) gains, net” on the financial statements, were $9.2 million and $8.3 million for the three months ended June 30, 2010 and 2009, respectively; and $18.3 million and $15.3 million for the six months ended June 30, 2010 and 2009 respectively. Effective January 28, 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 form of the GRO Plus benefit feature (“GRO Plus II”) on business issued after November 16, 2009. Fees ceded on this agreement, included in “Realized investments (losses) gains, net” on the financial statements, were $3.0 million and $641 thousand for the three months ended June 30, 2010 and 2009, respectively; and $6.0 million and $1.0 million for the six months ended June 30, 2010 and 2009 respectively. Effective January 28, 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, included in “Realized investments (losses) gains. net” on the financial statements, were $1.3 million and $483 thousand for the three months ended June 30, 2010 and 2009, respectively; and $2.4 million and $873 thousand for the six months ended June 30, 2010 and 2009 respectively.

During 2007, the Company amended the reinsurance agreements it entered into in 2005 covering its Lifetime Five benefit (“LT5”). The coinsurance agreement entered into with Prudential Insurance in 2005 provided for the 100% reinsurance of its LT5 feature sold on business prior to May 6, 2005. This agreement was recaptured effective August 1, 2007. Effective July 1, 2005, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its LT5 feature sold on business after May 5, 2005 as well as for riders issued on or after March 15, 2005 forward on business in-force before March 15, 2005. This agreement was amended effective August 1, 2007 to include the reinsurance of business sold prior to May 6, 2005 that was previously reinsured to Prudential Insurance. Fees ceded under these agreements, included in “Realized investments (losses) gains, net” on the financial statements, were $8.9 million and $7.9 million for the three months ended June 30, 2010 and 2009, respectively; and $17.9 million and $15.3 million for the six months ended June 30, 2010 and 2009 respectively.

During 2006, the Company entered into two reinsurance agreements with Pruco Re as part of its risk management and capital management strategies. Effective November 20, 2006, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its Highest Daily Lifetime Five benefit (“HDLT5”) feature. Fees ceded on this agreement, included in “Realized investments (losses) gains, net” on the financial statements, were $3.5 million and $3.7 million for the three months ended June 30, 2010 and 2009, respectively; and $7.2 million and $7.4 million for the six months ended June 30, 2010 and 2009 respectively. Effective March 20, 2006, the Company entered into a coinsurance agreement with Pruco Re providing for the 100% reinsurance of its Spousal Lifetime Five benefit (“SLT5”) feature. Fees ceded on this agreement, included in “Realized Investments (losses) gains, net” on the financial statements, were $2.7 million and $2.3 million for the three months ended June 30, 2010 and 2009, respectively; and $5.4 million and $4.5 million for the six months ended June 30, 2010 and 2009 respectively.

During 2004, the Company entered into two reinsurance agreements with affiliates as part of our risk management and capital management strategies. We entered into a 100% coinsurance agreement with Prudential Insurance providing for the reinsurance of its GMWB. Fees ceded on this agreement, included in “Realized investments (losses) gains, net” on the financial statements, were $563 thousand, and $551 thousand for the three months ended June 30, 2010 and 2009, respectively; and $1.1 million and $1.1 million for the six months ended

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

5. RELATED PARTY TRANSACTIONS (continued)

 

June 30, 2010 and 2009, respectively. The Company also entered into a 100% coinsurance agreement with Pruco Re providing for the reinsurance of its guaranteed return option (“GRO”). In prior years, the Company entered into reinsurance agreements to provide additional capacity for growth in supporting the cash flow strain from the Company’s variable annuity and variable life insurance business. Fees ceded on this agreement, included in “Realized investments (losses) gains, net” on the financial statements, were $1.1 million and $870 thousand for the three months ended June 30, 2010 and 2009, respectively; and $2.7 million and $1.3 million for the six months ended June 30, 2010 and 2009 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 $59.1 million and $30.8 million, for the three months ended June 30, 2010 and 2009, respectively; and $115.1 million and $55.6 million for the six months ended June 30, 2010 and 2009 respectively. These revenues are recorded as “Asset administration fees” in the Unaudited Interim Statements of Operations and Comprehensive Income.

Derivative Trades

In the ordinary course of business, the Company enters into over-the-counter (“OTC”) derivative contracts with an affiliate, Prudential Global Funding, LLC. For these OTC derivative contracts, Prudential Global Funding, LLC has a substantially equal and offsetting position with an external counterparty.

Sale of Fixed Maturities to an Affiliate

In March 2010, the Company sold fixed maturity securities to Prudential Insurance. These securities were recorded at 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.

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, 2010
		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Fair Value			Other-than- temporary impairments in AOCI (3)
		(in thousands)
Fixed maturities, available for sale
U.S. Treasury securities and obligations of U.S. government authorities and agencies		$	311,406		$	6,190		$	—		$	317,596		$	—
Obligations of U.S. states and their political subdivisions			69,843			8,053			—			77,896			—
Foreign government bonds			123,725			15,493			—			139,218			—
Corporate securities			4,244,680			513,937			2,303			4,756,314			(236	)
Asset-backed securities (1)			180,318			16,239			12,518			184,039			(13,480	)
Commercial mortgage-backed securities			523,604			35,838			1,393			558,049			—
Residential mortgage-backed securities (2)			484,328			33,835			42			518,121			(80	)
Total fixed maturities, available for sale		$	5,937,904		$	629,585		$	16,256		$	6,551,233		$	(13,796	)
Equity securities, available for sale		$	17,086		$	2,735		$	198		$	19,623		$	—

 

(1)	Includes credit tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, education loans, and other asset types.

(2)	Includes publicly traded agency pass-through securities and collateralized mortgage obligations.

(3)

Represents the amount of other-than-temporary impairment losses in “Accumulated other comprehensive income (loss),” or “AOCI,” which were not included in earnings. Amount excludes $2.8 million of net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

6. INVESTMENTS (continued)

 

		December 31, 2009
		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		$	271,796		$	647		$	9,964		$	262,479		$	—
Obligations of U.S. states and their political subdivisions			68,764			5,352			—			74,116			—
Foreign government bonds			124,134			10,866			—			135,000			—
Corporate securities			4,466,408			395,682			6,788			4,855,302			(236	)
Asset-backed securities (1)			206,996			17,245			10,402			213,839			(14,452	)
Commercial mortgage-backed securities			541,409			15,102			7,929			548,582			—
Residential mortgage-backed securities (2)			377,453			27,193			77			404,569			(88	)
Total fixed maturities, available for sale		$	6,056,960		$	472,087		$	35,160		$	6,493,887		$	(14,776	)
Equity securities, available for sale		$	17,085		$	1,997		$	470		$	18,612		$	—

 

(1)	Includes credit tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, education loans, and other asset types.

(2)	Includes publicly traded agency pass-through securities and collateralized mortgage obligations.

(3)

Represents the amount of other-than-temporary impairment losses in “Accumulated other comprehensive income (loss),” or “AOCI,” which were not included in earnings. Amount excludes $6.2 million of net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.

The amortized cost and fair value of fixed maturities by contractual maturities at June 30, 2010 are as follows:

 

		Available for sale
		Amortized Cost			Fair value
		(in thousands)
Due in one year or less		$	297,915		$	308,540
Due after one year through five years			2,921,203			3,230,005
Due after five years through ten years			1,037,733			1,174,712
Due after ten years			492,803			577,767
Asset backed securities			180,318			184,039
Commercial mortgage backed securities			523,604			558,049
Residential mortgage-backed securities			484,328			518,121
Total		$	5,937,904		$	6,551,233

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.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

6. INVESTMENTS (continued)

 

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 June 30,								Six Months Ended June 30,
		2010				2009				2010				2009
		(in thousands)								(in thousands)
Fixed maturities, available for sale:
Proceeds from sales		$	479,170			$	3,192,876			$	320,489			$	4,805,802
Proceeds from maturities/repayments			135,470				217,781				210,942				443,996
Gross investment gains from sales, prepayments and maturities			7,231				93,746				8,441				142,078
Gross investment losses from sales and maturities			(830	)			(1,172	)			(1,423	)			(1,206	)
Fixed maturity and equity security impairments:
Net writedowns for other-than-temporary impairment losses on fixed maturities recognized in earnings(1)		$	(1,433	)		$	(2,823	)		$	(2,089	)		$	(6,230	)
Writedowns for impairments on equity securities		$	—			$	(533	)		$	—			$	(1,844	)

 

(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 table sets forth the amount of pretax credit loss impairments on fixed maturity securities held by the Company as of the dates indicated, for which a portion of the OTTI loss was recognized in OCI, and the corresponding changes in such amounts.

 

Credit losses recognized in earnings on fixed maturity securities held by the Company for which a portion of the OTTI loss was recognized in OCI		Three Months Ended June 30, 2010				Six Months Ended June 30, 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	)
Credit loss impairments previously recognized on securities impaired to fair value during the period (1)			—				—
Credit loss impairment recognized in the current period on securities not previously impaired			—				—
Additional credit loss impairments recognized in the current period on securities previously impaired			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, June 30, 2010		$	13,911			$	13,911

 

(1)	Represents circumstances where the Company determined in the current period that it intends to sell the security or it is more likely than not that it will be required to sell the security before recovery of the security’s amortized cost.

 

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 June 30, 2009				Six Months Ended June 30, 2009
		(in thousands)
Balance, beginning of period		$	9,749			$	—
Credit losses remaining in retained earnings related to adoption of new authoritative guidance on January 1, 2009			—				6,397
Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period			(161	)			(161	)
Credit loss impairments previously recognized on securities impaired to fair value during the period (1)			—				—
Credit loss impairment recognized in the current period on securities not previously impaired			544				1,638
Additional credit loss impairments recognized in the current period on securities previously impaired			50				2,363
Increases due to the passage of time on previously recorded credit losses			263				263
Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected			—				(55	)
Balance, June 30, 2009		$	10,445			$	10,445

 

(1)	Represents circumstances where the Company determined in the current period that it intends to sell the security or it is more likely than not that it will be required to sell the security before recovery of the security’s amortized cost.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

6. INVESTMENTS (continued)

 

Trading Account Assets

The following table sets forth the composition of the Company’s trading account assets as of the dates indicated:

 

		June 30, 2010						December 31, 2009
		Amortized Cost			Fair Value			Amortized Cost			Fair Value
		(in thousands)						(in thousands)
Fixed maturities:
Asset-backed securities		$	64,767		$	70,813		$	63,410		$	70,198
Total fixed maturities			64,767			70,813			63,410			70,198
Equity securities			8,098			7,704			9,603			9,694
Total trading account assets		$	72,865		$	78,517		$	73,013		$	79,892

The net change in unrealized gains (losses) from trading account assets still held at period end, recorded within “Asset administration fees and other income” was $0.8 million and $5.7 million during the three months ended June 30, 2010 and 2009, respectively, and $1.1 million and $8.8 million during the six months ended June 30, 2010 and 2009, respectively.

Net Investment Income

Net investment income for the three and six months ended June 30, 2010 and 2009 was from the following sources:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2010				2009				2010				2009
		(in thousands)								(in thousands)
Fixed maturities, available for sale		$	89,246			$	127,790			$	181,353			$	268,455
Equity securities, available for sale			206				217				411				434
Policy loans			(539	)			193				(429	)			315
Short-term investments and cash equivalents			385				748				764				1,904
Other long-term investments			(5	)			57				383				85
Trading account assets			822				970				1,628				1,867
Commercial mortgage and other loans			6,322				3,528				13,027				9,595
Gross investment income			96,437				133,503				197,137				282,655
Less investment expenses			(2,094	)			(2,810	)			(4,234	)			(5,774	)
Net investment income		$	94,343			$	130,693			$	192,903			$	276,881

Realized Investment Gains (Losses), Net

Realized investment gains (losses), net, for the three and six months ended June 30, 2010 and 2009 were from the following sources:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2010				2009				2010				2009
		(in thousands)								(in thousands)
Fixed maturities		$	4,968			$	89,751			$	4,930			$	134,643
Equity securities			—				1,054				(368	)			(257	)
Derivatives			53,586				(66,606	)			46,886				(93,557	)
Commercial mortgage and other loans			(232	)			(2,657	)			2				(6,812	)
Other			20				64				35				119
Realized investment gains (losses), net		$	58,342			$	21,606			$	51,485			$	34,136

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

6. INVESTMENTS (continued)

 

Net Unrealized Investment Gains (Losses)

Net unrealized investment gains and losses on securities classified as “available for sale” and certain other long-term investments and other assets are included in the Statements of Financial Position as a component of “Accumulated other comprehensive income (loss),” or “AOCI.” Changes in these amounts include reclassification adjustments to exclude from 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:

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, 2009		$	(8,543	)		$	4,341		$	1,488			$	(2,714	)
Net investment gains (losses) on investments arising during the period			(4,195	)			—			1,485				(2,710	)
Reclassification adjustment for (gains) losses included in net income			1,738				—			(615	)			1,123
Reclassification adjustment for OTTI losses excluded from net income (1)			(11	)			—			4				(7	)
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs, deferred sales inducements and valuation of business acquired			—				1,666			(590	)			1,076
Impact of net unrealized investment (gains) losses on future policy benefits			—				—			—				—
Impact of net unrealized investment (gains) losses on policyholders’ dividends			—				—			—				—
Balance, June 30, 2010		$	(11,011	)		$	6,007		$	1,772			$	(3,232	)

 

(1)	Represents “transfers in” related to the portion of OTTI losses recognized during the period that were not recognized in earnings for securities with no prior OTTI loss.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

6. INVESTMENTS (continued)

 

All Other Net Unrealized Investment Gains and Losses in AOCI

 

		Net Unrealized Gains (Losses) on Investments (2)				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, 2009		$	451,879			$	(242,840	)		$	(74,007	)		$	135,032
Net investment gains (losses) on investments arising during the period			189,011				—				(66,910	)			122,101
Reclassification adjustment for (gains) losses included in net income			(6,301	)			—				2,230				(4,071	)
Reclassification adjustment for OTTI losses excluded from net income (1)			11				—				(4	)			7
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs, deferred sales inducements and valuation of business acquired			—				(98,748	)			34,955				(63,793	)
Impact of net unrealized investment (gains) losses on future policy benefits			—				—				—				—
Impact of net unrealized investment (gains) losses on policyholders’ dividends			—				—				—				—
Balance, June 30, 2010		$	634,600			$	(341,588	)		$	(103,736	)		$	189,276

 

(1)	Represents “transfers out” related to the portion of OTTI losses recognized during the period that were not recognized in earnings for securities with no prior OTTI loss.

(2)	Includes cash flow hedges. See Note 8 to the Unaudited Interim Financial Statements included herein for additional discussion of our cash flow hedges.

The table below presents net unrealized gains (losses) on investments by asset class as of the dates indicated:

 

		June 30, 2010				December 31, 2009
		(in thousands)
Fixed maturity securities on which an OTTI loss has been recognized		$	(11,011	)		$	(8,543	)
Fixed maturity securities, available for sale – all other			624,340				445,470
Equity securities, available for sale			2,537				1,527
Affiliated Notes			6,172				5,522
Derivatives designated as Cash Flow Hedges (1)			1,551				(640	)
Total net unrealized gains (losses) on investments		$	623,589			$	443,336

 

(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, 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
U.S. Treasury securities and obligations of U.S. government authorities and agencies		$	—		$	—		$	—		$	—		$	—		$	—
Corporate securities			57,263			1,441			30,928			862			88,191			2,303
Asset-backed securities			4,284			3			38,929			12,515			43,213			12,518
Commercial mortgage-backed securities			—			—			44,019			1,393			44,019			1,393
Residential mortgage-backed securities			—			—			642			42			642			42
Total		$	61,547		$	1,444		$	114,518		$	14,812		$	176,065		$	16,256
Equity securities, available for sale		$	2,034		$	125		$	720		$	73		$	2,754		$	198

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

6. INVESTMENTS (continued)

 

		December 31, 2009
		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
U.S. Treasury securities and obligations of U.S. government authorities and agencies		$	240,337		$	9,911		$	1,648		$	53		$	241,985		$	9,964
Corporate securities			101,915			1,727			114,094			5,061			216,009			6,788
Asset-backed securities			9,886			4,979			37,384			5,423			47,270			10,402
Commercial mortgage-backed securities			5,104			25			128,593			7,904			133,697			7,929
Residential mortgage-backed securities			646			77			—			—			646			77
Total		$	357,888		$	16,719		$	281,719		$	18,441		$	639,607		$	35,160
Equity securities, available for sale		$	5,090		$	375		$	698		$	95		$	5,788		$	470

The gross unrealized losses, related to fixed maturities at June 30, 2010 and December 31, 2009 are composed of $10.5 million and $30.6 million related to high or highest quality securities based on NAIC or equivalent rating and $5.8 million and $4.5 million, respectively, related to other than high or highest quality securities based on NAIC or equivalent rating. At June 30, 2010, $11.2 million of the gross unrealized losses represented declines in value of greater than 20%, $7.1 million of which had been in that position for less than six months, as compared to $7.3 million at December 31, 2009 that represented declines in value of greater than 20%, $0.4 million of which had been in that position for less than six months. At June 30, 2010, the $14.8 million of gross unrealized losses of twelve months or more were concentrated in asset backed securities and commercial mortgage-backed securities. At December 31, 2009, the $18.4 million of gross unrealized losses of twelve months or more were concentrated in asset backed securities, and in the manufacturing and finance sectors of the Company’s corporate securities. 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, 2010 or December 31, 2009. 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, 2010, 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, 2010 and December 31, 2009, 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, 2010 and December 31, 2009. 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, 2010 or December 31, 2009.

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 used to measure fair value 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

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

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- and mortgage-backed securities, etc.), certain equity securities, short-term investments and certain cash equivalents (primarily commercial paper), and certain over-the-counter derivatives. Valuations are generally obtained from third party pricing services for identical or comparable assets or liabilities or through the use of valuation methodologies using observable market inputs. Prices from services are validated through comparison to trade data and internal estimates of current fair value, generally developed using market observable inputs and economic indicators.

Level 3 – Fair value is based on at least one or more significant unobservable inputs for the asset or liability. These inputs reflect the Company’s assumptions about the assumptions 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, 2010 and December 31, 2009 these over-rides on a net basis were not material.

Inactive Markets – During 2009 and continuing through the first quarter of 2010, the Company observed that the volume and level of activity in the market for asset-backed securities collateralized by sub-prime mortgages remained at historically low levels. This stood in particular contrast to the markets for other structured products with similar cash flow and credit profiles. The Company also observed significant implied relative liquidity risk premiums, yields, and weighting of “worst case” cash flows for asset-backed securities collateralized by sub-prime mortgages in comparison with its own estimates for such securities. In contrast, the liquidity of other spread-based asset classes, such as corporate bonds, high yield and consumer asset-backed securities, such as those collateralized by credit cards or autos, which were previously more correlated with sub-prime securities, improved beginning in the second quarter of 2009. Based on this information, the Company concluded as of June 30, 2009 and continuing through March 31, 2010 that the market for asset-backed securities collateralized by sub-prime mortgages was inactive and also determined the pricing quotes it received were based on limited market transactions, calling into question their representation of observable fair value. As a result, we considered both third-party pricing information and an internally developed price based on a discounted cash flow model in determining the fair value of certain of these securities as of June 30, 2009 through March 31, 2010. Based on the unobservable inputs used in the discounted cash flow model and the limited observable market activity, the Company classified these securities within Level 3 as of June 30, 2009 through March 31, 2010.

In the second quarter of 2010, the Company observed an increasingly active market, as evidence of orderly transactions in asset-backed securities collateralized by sub-prime mortgages became more apparent. Additionally, the valuation based on the pricing the Company received from independent pricing services was not materially different from its internal estimates of current market value for these securities. As a result, where third party pricing information based on observable inputs was used to fair value the security, and based on the assessment that the market has been becoming increasingly active, the Company reported fair values for these asset-backed securities collateralized by sub-prime mortgages in Level 2 beginning with the second quarter of 2010. As of June 30, 2010, the fair value of these securities included in Level 2 was $15.3 million included in Fixed Maturities Available for Sale – Asset-Backed Securities.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

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, 2010
		Level 1			Level 2			Level 3			Total
		(in thousands)
Fixed maturities, available for sale:
U.S. government securities		$	—		$	317,596		$	—		$	317,596
State and municipal securities			—			77,896			—			77,896
Foreign government securities			—			138,012			1,206			139,218
Corporate Securities			—			4,681,626			74,688			4,756,314
Asset-backed securities			—			156,172			27,867			184,039
Commercial mortgage-backed securities			—			558,049			—			558,049
Residential mortgage-backed securities			—			518,121			—			518,121
Sub-total		$	—		$	6,447,472		$	103,761		$	6,551,233
Trading account assets:
Asset backed securities			—			70,813			—			70,813
Equity Securities			7,704			—			—			7,704
Sub-total		$	7,704		$	70,813		$	—		$	78,517
Equity securities, available for sale			18,182			1,441			—			19,623
Short term investments			292,984			200,337			—			493,321
Cash equivalents			—			109,788			—			109,788
Other Long Term Investments			—			80,209			—			80,209
Reinsurance Recoverable			—			—			677,171			677,171
Other Assets			—			33,780						33,780
Sub-total excluding separate account assets		$	318,870		$	6,943,840		$	780,932		$	8,043,642
Separate account assets (1)			1,151,247			41,547,696			—			42,698,943
Total assets		$	1,470,117		$	48,491,536		$	780,932		$	50,742,585
Future policy benefits			—			—			669,596			669,596
Other liabilities			—			—			52			52
Total liabilities		$	—		$	—		$	669,648		$	669,648

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

		As of December 31, 2009(2)
		Level 1			Level 2			Level 3			Total
		(in thousands)
Fixed maturities, available for sale:
U.S. government securities		$	—		$	262,479		$	—		$	262,479
State and municipal securities			—			74,116			—			74,116
Foreign government securities			—			133,781			1,219			135,000
Corporate Securities			—			4,791,668			63,634			4,855,302
Asset-backed securities			—			170,045			43,794			213,839
Commercial mortgage-backed securities			—			548,582			—			548,582
Residential mortgage-backed securities			—			404,569			—			404,569
Sub-total		$	—		$	6,385,240		$	108,647		$	6,493,887
Trading account assets:
Asset backed securities		$	—		$	70,198		$	—		$	70,198
Equity Securities			9,694			—			—			9,694
Sub-total		$	9,694		$	70,198		$	—		$	79,892
Equity securities, available for sale		$	17,230		$	1,382		$	—		$	18,612
Short term investments			393,163			312,683			—			705,846
Cash equivalents			17			68,581			—			68,598
Reinsurance recoverable			—			—			40,351			40,351
Other Assets			—			33,133			—			33,133
Sub-total excluding separate account assets		$	420,104		$	6,871,217		$	148,998		$	7,440,319
Separate account assets (1)			1,008,077			40,440,635			—			41,448,712
Total assets		$	1,428,181		$	47,311,852		$	148,998		$	48,889,031
Future policy benefits		$	—		$	—		$	10,874		$	10,874
Other liabilities			—			8,384			53			8,437
Total liabilities		$	—		$	8,384		$	10,927		$	19,311

 

(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.

(2)	Includes reclassifications to conform to current period presentation.

The methods and assumptions the Company uses to estimate 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 of assets for these categories is ultimately borne by our 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 reasonability, 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, 2010 and December 31, 2009 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 our 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 our 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

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

use observable inputs with a discount rate based upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions, taking into account, among other factors, the credit quality and industry sector of the issuer and the reduced liquidity associated with private placements. Generally, these securities have been reflected within Level 2. For certain private fixed maturities, the discounted cash flow model may also incorporate significant unobservable inputs, which reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset. Accordingly, these securities have been reflected within Level 3. Significant unobservable inputs used include: issue specific credit adjustments, material non-public financial information, management judgment, estimation of future earnings and cash flows, default rate assumptions, and liquidity assumptions. These inputs are usually considered unobservable, as not all market participants will have access to this data.

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 – 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 – 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 and, in order to validate reasonability, are compared with directly observed recent market trades. 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 is traded in the OTC derivative market and is 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, non-binding broker-dealer quotations, third-party pricing vendors and/or recent trading activity. The fair values of most OTC derivatives, including interest rate swaps, 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, yield curves, index dividend yields and nonperformance risk and volatility.

To reflect the market’s perception of its non-performance risk, the Company incorporates an additional spread 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 contracts 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.

Level 3 includes OTC derivatives where the bid-ask spreads are generally wider than derivatives classified within Level 2 thus requiring more judgment in estimating the mid-market price of such derivatives. 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. The input values for look-back equity options are derived from observable market indices such as interest rates, dividend yields, equity indices as well as unobservable model-specific input values such as certain volatility parameters. Level 3 methodologies are validated through periodic comparison of the Company’s fair values to broker-dealer values. As of June 30, 2010, there were derivatives with the fair value of $52 thousand 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.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

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 – Future policy benefits includes embedded derivatives related to guarantees on variable annuity contracts, including GMAB, GMWB and GMIWB. The fair values of the GMAB, GMWB and GMIWB liabilities are calculated as the present value of future expected benefit payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature and could result in an embedded derivative asset or liability. 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 it’s own non-performance in the valuation of the embedded derivatives associated with the 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 appropriately takes into consideration the Company’s own risk of non-performance. 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, 2010 generally ranged from 100 to 200 basis points for the portion of the interest rate curve most relevant to these liabilities.

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, 2010, there were no material transfers between Level 1 and Level 2.

 

27

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

Changes in Level 3 assets and liabilities – The following tables provide a summary of the changes in fair value of Level 3 assets and liabilities for the three and six months ended June 30, 2010, as well as the portion of gains or losses included in income for the 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		$	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		$	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 administration 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		$	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		$	(669,596	)		$	(52	)
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		$	(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.

Transfers – Transfers out of Level 3 for Fixed Maturities Available for Sale – Asset-Backed Securities includes $17.4 million for the three months ended June 30, 2010 resulting from the Company’s conclusion that the market for asset-backed securities collateralized by sub-prime mortgage has been becoming increasingly active, as evidenced by orderly

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

transactions. The pricing received from independent pricing services could be validated by the Company, as discussed in detail above. Other 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, 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		$	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		$	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 administration 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		$	(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		$	(669,596	)		$	(52	)
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		$	(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.

Transfers – Transfers out of Level 3 for Fixed Maturities Available for Sale – Asset-Backed Securities includes $17.4 million for the six months ended June 30, 2010 resulting from the Company’s conclusion that the market for asset-backed securities collateralized by sub-prime mortgages has been becoming increasingly active, as evidenced by orderly transactions. The pricing received from independent pricing services could be validated by the Company, as discussed in detail above. Other transfers out of Level 3 were

 

29

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

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.

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, 2009, as well as the portion of gains or losses included in income for three and six months ended June 30, 2009 attributable to unrealized gains or losses related to those assets and liabilities still held at June 30, 2009.

 

		Three Months Ended June 30, 2009
		Fixed Maturities, Available For Sale –  Foreign Government Bonds			Fixed Maturities, Available For Sale – Corporate Securities				Fixed Maturities, Available For Sale – Asset- Backed Securities				Other Long- Term Investments				Reinsurance Recoverable
		(in thousands)
Fair value, beginning of period		$	995		$	60,788			$	21,772			$	(1,769	)		$	1,168,198
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net:			—			(10	)			—				933				(684,187	)
Included in other comprehensive income (loss)			149			438				1,666				—				—
Net investment income			—			900				(14	)			—				—
Purchases, sales, issuances, and settlements			—			—				—				—				19,988
Transfers into Level 3 (1)			—			4,459				—				—				—
Transfers out of Level 3 (1)			—			—				—				—				—
Fair value, end of period		$	1,144		$	66,575			$	23,424			$	(836	)		$	503,999
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:		$	—		$	—			$	—			$	934			$	(638,223	)
Asset administration fees and other income			—			—				—				—				—
Included in other comprehensive income (loss)		$	149		$	438			$	1,666			$	—			$	—

 

		Three Months Ended June 30, 2009
		Future Policy Benefits
		(in thousands)
Fair value, beginning of period		$	(1,165,772	)
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net:			693,029
Purchases, sales, issuances, and settlements			(20,255	)
Transfers into Level 3 (1)			—
Transfers out of Level 3 (1)			—
Fair value, end of period		$	(492,998	)
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:		$	641,209
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.

Transfers – Transfers into level 3 for Fixed Maturities Available for Sale – Corporate securities for the three months ended June 30, 2009 was primarily due to use of unobservable inputs within valuation methodologies when previously, a discounted cash flow model with observable inputs was utilized.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

 

		Six Months Ended June 30, 2009
		Fixed Maturities, Available For Sale –  Foreign Government Bonds				Fixed Maturities, Available For Sale  – Corporate Securities				Fixed Maturities, Available For Sale – Asset- Backed Securities				Other Long- Term Investments				Reinsurance Recoverable
		(in thousands)
Fair value, beginning of period		$	977			$	68,559			$	21,188			$	(1,496	)		$	2,110,146
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net:							(433	)							660				(1,641,358	)
Included in other comprehensive income (loss)			168				(7,794	)			2,264				—				—
Net investment income			(1	)			1,784				(28	)			—				—
Purchases, sales, issuances, and settlements			—				—				—				—				35,211
Transfers into Level 3 (1)			—				4,459				—				—				—
Transfers out of Level 3 (1)			—				—				—				—				—
Fair value, end of period		$	1,144			$	66,575			$	23,424			$	(836	)		$	503,999
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:		$	—			$	433			$	—			$	660			$	(1,602,771	)
Asset administration fees and other income		$	—			$	—			$	—			$	—			$	—
Included in other comprehensive income (loss)		$	168			$	(7,794	)		$	2,264			$	—			$	—

 

		Six Months Ended June 30, 2009
		Future Policy Benefits
		(in thousands)
Fair value, beginning of period		$	(2,111,242	)
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net:			1,654,021
Purchases, sales, issuances, and settlements			(35,777	)
Transfers into Level 3 (1)			—
Transfers into (out of) Level 3 (1)			—
Fair value, end of period		$	(492,998	)
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:		$	1,614,269
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.

Transfers – Transfers into level 3 for Fixed Maturities Available for Sale – Corporate securities for the six months ended June 30, 2009 was primarily due to use of unobservable inputs within valuation methodologies when previously, a discounted cash flow model with observable inputs was utilized.

Fair Value of Financial Instruments –The Company is required 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.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

7. FAIR VALUE OF ASSETS AND LIABILITIES (continued)

 

The following table discloses the Company’s financial instruments where the carrying amounts and fair values may differ:

 

		June 30, 2010						December 31, 2009
		Carrying value			Fair value			Carrying value			Fair value
		(in thousands)
Assets:
Commercial Mortgage and other Loans		$	366,212		$	394,886		$	373,080		$	381,557
Policy loans		$	13,020		$	16,533		$	13,067		$	14,796
Liabilities:
Investment Contracts - Policyholders’ Account Balances		$	56,421		$	56,353		$	53,599		$	52,960

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 swaps are used by the Company to manage interest rate exposures arising from mismatches between assets and liabilities (including duration mismatches) and to hedge against changes in the value of assets it anticipates acquiring and other anticipated transactions and commitments. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed rate and floating rate interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the contract and no principal payments are made by either party. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty at each due date.

Exchange-traded futures are used by the Company to reduce risks from changes in interest rates, to alter mismatches between the duration of assets in a portfolio and the duration of liabilities supported by those assets, and to hedge against changes in the value of securities it owns or anticipates acquiring or selling. In exchange-traded futures transactions, the Company agrees to purchase or sell a specified number of contracts, the values of which are determined by the values of underlying referenced investments, and to post variation margin on a daily basis in an amount equal to the difference in the daily market values of those contracts. The Company enters into exchange-traded futures and options with regulated futures commission merchants who are members of a trading exchange.

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.

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 party. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty for payments made in the same currency at each due date.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

8. DERIVATIVE INSTRUMENTS (continued)

 

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.

The Company has sold and in certain limited instances continues to sell 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 to affiliates. These embedded derivatives are marked to market through “Realized investment gains (losses), net” based on the change in value of the underlying contractual guarantees, which are determined using valuation models. The affiliates maintain a portfolio of derivative instruments that is intended to economically hedge many of the risks related to the above products’ features. The derivatives may include, but are not limited to equity options, total return swaps, interest rate swap options, caps, floors, and other instruments. Also, some variable annuity products’ optional living benefits feature an automatic rebalancing element, also referred as an asset transfer feature, to minimize risks inherent in the Company’s guarantees which reduces the need for hedges.

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, we terminated the capital hedge program 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. 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.

 

		June 30, 2010										December 31, 2009
		Notional			Fair Value							Notional			Fair Value
		Amount			Assets			Liabilities				Amount			Assets			Liabilities
		(in thousands)
Qualifying Hedge Relationships
Currency/Interest Rate			33,389			2,015			(395	)			5,058			—			(642	)
Total Qualifying Hedge Relationships		$	33,389		$	2,015		$	(395	)		$	5,058		$	—		$	(642	)
Non-qualifying Hedge Relationships
Interest Rate		$	1,068,700		$	64,864		$	(3,929	)		$	978,700		$	28,741		$	(18,083	)
Currency			—			—			—				—			—			—
Credit			353,350			2,099			(3,192	)			358,350			3,428			(3,995	)
Currency/Interest Rate			66,964			4,993			(3,687	)			78,553			426			(7,784	)
Equity			4,019,857			71,909			(54,520	)			335,411			4,273			(14,802	)
Total Non-qualifying Hedge Relationships		$	5,508,871		$	143,865		$	(65,328	)		$	1,751,014		$	36,868		$	(44,664	)
Total Derivatives (1)		$	5,542,260		$	145,880		$	(65,723	)		$	1,756,072		$	36,868		$	(45,306	)

 

(1)

Excludes embedded derivatives which contain multiple underlyings. The fair value of these embedded derivatives was a liability of $672.6 million as of June 30, 2010 and a liability of $14.0 million as of December 31, 2009, included in “Future policy benefits” and “Fixed maturities available for sale.”

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

8. DERIVATIVE INSTRUMENTS (continued)

 

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,
		2010				2009
		(in thousands)
Qualifying Cash Flow Hedges
Currency /Interest Rate
Net Investment Income		$	17			$	4
Other Income			26				(1	)
Accumulated Other Comprehensive Income (Loss)(1)			2,460				(63	)
Total Cash Flow Hedges		$	2,503			$	(60	)
Non- qualifying hedges
Realized investment gains (losses), net
Interest Rate		$	47,870			$	(76,764	)
Currency/Interest Rate			6,881				2,361
Credit			(183	)			4,343
Equity			34,367				(509	)
Embedded Derivatives (Interest/Equity/Credit)			(35,349	)			3,963
Total non-qualifying hedges		$	53,586			$	(66,606	)
Total Derivative Impact		$	56,089			$	(66,666	)

 

(1)

Amounts deferred in Equity

 

		Six Months ended June 30,
		2010				2009
		(in thousands)
Qualifying Cash Flow Hedges
Currency /Interest Rate
Net Investment Income		$	24			$	4
Other Income			24				(1	)
Accumulated Other Comprehensive Income (Loss)(1)			2,191				(63	)
Total Cash Flow Hedges		$	2,239			$	(60	)
Non- qualifying hedges
Realized investment gains (losses), net
Interest Rate		$	59,852			$	(104,150	)
Currency/Interest Rate			7,411				2,387
Credit			(222	)			8,316
Equity			18,648				(509	)
Embedded Derivatives (Interest/Equity/Credit)			(38,803	)			399
Total non-qualifying hedges		$	46,886			$	(93,557	)
Total Derivative Impact		$	49,125			$	(93,617	)

 

(1)

Amounts deferred in Equity

For the period ending June 30, 2010 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.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

8. DERIVATIVE INSTRUMENTS (continued)

 

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, 2009		$	(640	)
Net deferred gains on cash flow hedges from January 1 to June 30, 2010			2,167
Amount reclassified into current period earnings			24
Balance, June 30, 2010		$	1,551

As of June 30, 2010, 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 7 years. Income amounts deferred in “Accumulated other comprehensive income (loss)” as a result of cash flow hedges are included in “Net unrealized investment gains (losses)” in the Statements of Equity.

Credit Derivatives Written

The 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.

 

				June 30, 2010
				Single Name						First To Default Basket							Total
NAIC Designation (1)		Rating Agency Equivalent		Notional			Fair Value			Notional			Fair Value				Notional			Fair Value
				(in thousands)
1		Aaa, Aa, A		$	290,000		$	1,631		$	1,000		$	(6	)		$	291,000		$	1,625
2		Baa			25,000			429			—			—				25,000			429
		Subtotal Investment Grade		$	315,000		$	2,060		$	1,000		$	(6	)		$	316,000		$	2,054
3		Ba		$	—		$	—		$	3,500		$	(46	)		$	3,500		$	(46	)
		Subtotal Below Investment Grade		$	—		$	—		$	3,500		$	(46	)		$	3,500		$	(46	)
Total				$	315,000		$	2,060		$	4,500		$	(52	)		$	319,500		$	2,008

 

(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.

 

				December 31, 2009
				Single Name						First To Default Basket							Total
NAIC Designation (1)		Rating Agency Equivalent		Notional			Fair Value			Notional			Fair Value				Notional			Fair Value
				(in thousands)
1		Aaa, Aa, A		$	295,000		$	2,868		$	1,000		$	(4	)		$	296,000		$	2,864
2		Baa			25,000			541			—			—				25,000			541
		Subtotal Investment Grade		$	320,000		$	3,409		$	1,000		$	(4	)		$	321,000		$	3,405
3		Ba		$	—		$	—		$	3,500		$	(49	)		$	3,500		$	(49	)
		Subtotal Below Investment Grade		$	—		$	—		$	3,500		$	(49	)		$	3,500		$	(49	)
Total				$	320,000		$	3,409		$	4,500		$	(53	)		$	324,500		$	3,356

 

(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.

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.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

8. DERIVATIVE INSTRUMENTS (continued)

 

 

		June 30, 2010							December 31, 2009
Industry		Notional			Fair Value				Notional			Fair Value
		(in thousands)
Corporate Securities:
Manufacturing		$	40,000		$	251			$	40,000		$	395
Services			20,000			67				20,000			130
Energy			20,000			28				20,000			290
Transportation			25,000			176				30,000			270
Retail and Wholesale			20,000			158				20,000			248
Other			190,000			1,380				190,000			2,076
First to Default Baskets(1)			4,500			(52	)			4,500			(53	)
Total Credit Derivatives		$	319,500		$	2,008			$	324,500		$	3,356

 

(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 $319.5 million notional of credit default swap (“CDS”) selling protection at June 30, 2010. 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” 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 $7.0 million and $7.0 million at June 30, 2010 and December 31, 2009, 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, 2010 the Company had $33.8 million of outstanding notional amounts reported at fair value as an asset of $3.1 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.

 

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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, 2010 compared with December 31, 2009, and its results of operations for the three and six months ended June 30, 2010 and 2009. 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, 2009, and “Risk Factors”, 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 and, as discussed below, in certain limited instances continues to sell 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 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, with very limited exceptions, the Company has ceased offering its existing variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product in each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company within Prudential Financial, Inc.’s (“Prudential Financial”) Annuities business unit). 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, regulatory requirements and administrative rules, the Company will continue to accept purchase payments on inforce contracts under existing annuity products. These initiatives are being implemented to create operational and administrative

 

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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 image in the marketplace.

The Company’s variable annuities provide its customers with tax-deferred asset accumulation together with a base death benefit and a full 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”), including a highest daily contract value in certain of our latest optional living benefits. 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. This highest daily guaranteed contract value offered with certain optional living benefits is generally 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 portfolios, and fixed-rate options. 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 investments made in the general account are credited with interest at rates we determine, subject to certain minimums. We also offer fixed annuities that provide a guarantee of principal and interest credited at rates we determine, subject to certain contractual minimums. Certain investments made in the fixed-rate options 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 automatic rebalancing element, also referred to 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 affiliated reinsurance arrangements, and the impact on that portion of our variable annuity contracts that benefit from the automatic rebalancing element.

The automatic rebalancing element, included in the design of certain optional living benefits, may transfer assets between the variable investments selected by the annuity contractholder and, depending on the benefit feature, to either the general account or a separate account bond portfolio. The potential transfers are based on a static mathematical formula which considers a number of factors, including the impact of investment performance on the contractholders’ account value. In general, negative investment performance may result in transfers to fixed income investments backed by our general account or a separate account bond portfolio, and positive investment performance may result in transfers back to contractholder-selected investments. Overall, the automatic rebalancing element is designed to help limit our exposure, and the exposure of the contractholders’ account value, to equity market risk and market volatility. Beginning in 2009, our offerings of optional living benefit features associated with variable annuity products all include an automatic rebalancing element, and in 2009 we discontinued any new sales of optional living benefit features without an automatic rebalancing element. 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, 2010 approximately $30.3 billion or 79% of variable annuity account values with living benefit features included an automatic rebalancing element in the product design, compared to $27.6 billion or 76% as of December 31, 2009. As of June 30, 2010 approximately $8.1 billion or 21% of variable annuity account values with living benefit features did not include an automatic rebalancing element in the product design, compared to $8.7 billion or 24% as of December 31, 2009.

As mentioned above, in addition to our automatic rebalancing element, we also manage certain risks associated with our variable annuity products through hedging programs and affiliated reinsurance arrangements. In the reinsurance affiliate, we manage the risks associated with our optional living benefits through purchases of equity options and futures as well as interest rate derivatives, which hedge certain optional living benefit features accounted for as embedded derivatives against changes in equity markets, interest rates, and market volatility. In the second quarter of 2009, we 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 consist of equity-based total return swaps that are 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 level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial and its subsidiaries, as whole as discussed further under “—Liquidity and Capital Resources— General Liquidity”. A portion of the derivatives related to the new program were purchased by the Company.

Marketing and Distribution

The Company has sold and, as discussed above, in certain limited instances continues to sell its annuity products through multiple distribution channels, including (1) independent broker-dealer firms and financial planners; (2) broker-dealers that are members of the New York Stock Exchange, including “wirehouse” and regional broker-dealer firms; and (3) broker-dealers affiliated with banks

 

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or that specialize in marketing to customers of banks. Although the Company has sold in each of those distribution channels, the majority of the Company’s sales have come from the independent broker-dealer firms and financial planners. The Company has selling agreements with over eight hundred broker-dealer firms and financial institutions.

The Company’s Changes in Financial Position and Results of Operations are described below.

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, 2009.

Changes in Financial Position

2010 versus 2009

Total assets increased by $1.3 billion, from $51.9 billion at December 31, 2009 to $53.2 billion at June 30, 2010. Separate account assets increased by $1.3 billion, primarily driven by positive net flows and transfers of balances from the general account to the separate accounts primarily as a result of transfers from a customer elected dollar cost averaging (“DCA”) program partially offset by decreases in market value. Additionally, reinsurance recoverables increased by $636.9 million driven by an increase in the reinsured liability for living benefit embedded derivatives reflecting an increase in the present value of future expected benefit payments, resulting from a decrease in policyholder account balances due to unfavorable market conditions, partially offset by a benefit related to updates of the inputs used in the valuation of the embedded derivatives for the market perceived risk of our non-performance. Partially offsetting the above increases was a decrease in short term investments of $212.5 million driven by lower general account balances due to the aforementioned DCA transfers. Also, deferred policy acquisition costs (“DAC”) and deferred sales inducements (“DSI”) decreased from December 31, 2009 to June 30, 2010 by $252.9 million and $152.9 million, respectively, mainly due to increased amortization resulting from the aforementioned impact of the change in non-performance risk in the valuation of embedded derivatives.

During the period, total liabilities increased by $1.3 billion, from $50.1 billion at December 31, 2009 to $51.4 billion at June 30, 2010. Separate account liabilities increased by $1.3 billion offsetting the increase in separate accounts assets above. Additionally, future policy benefits and other policyholder liabilities increased by $672.3 million driven by an increase in the liability for living benefit embedded derivatives, as discussed above. Partially offsetting the above increases was a decrease in policyholders’ account balances of $328.0 million primarily driven by transfers of customer account values to the separate account from the general account as a result of transfers from a customer elected DCA program.

Results of Operations

2010 versus 2009 Three Month Comparison

Net Income

Net income decreased $440.5 million from a gain of $248.9 million for the three months ended June 30, 2009 to a loss of $191.6 million for the three months ended June 30, 2010. The loss is driven by a $738.2 million decrease in income from operations before income taxes, as discussed below, partially offset by a $297.7 million decrease in income tax expense.

The loss from operations for the three months ended June 30, 2010 included a $727.2 million unfavorable variance in the amortization of deferred policy acquisition and other costs from the impact of updates to the inputs used in the valuation of the

 

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reinsured liability for living benefit embedded derivatives and its impact on actual gross profits. Beginning in the first quarter of 2009, in light of developments including rating agency downgrades to the financial strength ratings of our insurance subsidiaries, we incorporated an additional spread over LIBOR into the discount rate used in the valuation of the embedded derivative liabilities to reflect an increase in the market-perceived risk of our non-performance, thereby reducing the value of the embedded derivative liabilities. The three months ended June 30, 2010 includes a benefit related to this update primarily resulting from an increase in the fair value of embedded derivative liabilities reflecting an increase in the present value of future expected benefit payments resulting from a decrease in policyholder account balances due to unfavorable market conditions in the three months ended June 30, 2010, as well as an increase in the additional spread over LIBOR, reflecting general credit spread widening. The amortization of deferred policy acquisition and other costs for the three months ended June 30, 2010 related to this benefit was a $393.7 million charge. The three months ended June 30, 2009 included an increase in the embedded derivative liability related to this update resulting from an overall lower level of embedded derivative liabilities, resulting from the impact of improved market conditions as well as a decrease in the additional spread over LIBOR. The amortization of deferred policy acquisition and other costs for the three months ended June 30, 2009 related to this charge was a $333.5 million benefit. We amortize deferred policy acquisition 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 loss from operations for the three months ended June 30, 2010 also included $82.3 million of charges related to adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, compared to $139.0 million of benefits included in the three months ended June 30, 2009, resulting in a $221.4 million unfavorable variance, as shown in the table below. This variance primarily reflects the market conditions that existed in the respective periods and are discussed individually in more detail below.

 

		Three months Ended June 30, 2010												Three months Ended June 30, 2009
		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
Quarterly market performance adjustment		$	(48,211	)		$	(39,955	)		$	(88,166	)		$	49,807		$	56,755		$	106,562
Annual review / assumption updates			—				—				—				—			—			—
Quarterly adjustment for current period experience			(4,897	)			10,725				5,828				19,312			13,165			32,477
Total		$	(53,108	)		$	(29,230	)		$	(82,338	)		$	69,119		$	69,920		$	139,039

 

(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.

Also included within the decrease in income from operations before income taxes was lower net investment income less interest credited of $9.9 million due to lower average annuity account values in the general account resulting from both transfers from a customer elected DCA program and from the automatic rebalancing element. Partially offsetting the decrease in pre-tax income was an increase in policy charges and fee income and asset administration fees and other income of $139.3 million driven by higher average variable annuity asset balances invested in separate accounts. The increase in average separate account assets was due to positive net flows, net market appreciation, and net transfers of balances from the general account to the separate accounts between June 30, 2009 and June 30, 2010. The net transfer of balances from the general account to the separate accounts relates to both transfers from a customer elected DCA program of approximately $1.1 billion and transfers from the automatic rebalancing element in some of our optional living benefit features, which, as part of the overall product design, transferred approximately $1.5 billion out of the general account to the separate accounts from July 1, 2009 through June 30, 2010 due to overall market improvements. Also serving as a partial offset to the decrease in income from operations were lower amortization of deferred policy acquisition and other costs of $41.1 million due to lower levels of actual gross profits primarily from unfavorable variance in embedded derivative breakage and a $30.7 million favorable variance in the mark-to-market on derivative positions associated with our capital hedging program. In the second quarter of 2009, we 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 consist of equity-based total return swaps that are 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 level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial and its subsidiaries, as whole as discussed further under “—Liquidity and Capital Resources— General Liquidity”. A portion of the derivatives related to the new program were purchased by the Company.

 

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The $88.2 million of charges in the three months ended June 30, 2010 relating to the quarterly market performance adjustments shown in the table above are attributable to changes to our estimate of total gross profits to reflect actual fund performance. The actual rate of return on annuity account values for the three months ended June 30, 2010 was a decrease of 4.6% compared to our expected rate of return of 1.8%. The lower than expected market returns decreased our estimates of total gross profits and increased our estimate of future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products, by establishing a new, lower starting point for the variable annuity account values used in estimating those items for future periods. The expected rates of return for the three months ended June 30, 2010, for some contract groups, was based upon our maximum future rate of return assumption under the reversion to the mean approach, as discussed below. The decrease in our estimate of total gross profits and increase in our estimate of future expected claims costs results in a higher required rate of amortization and higher required reserve provisions, which are applied to all prior periods. The resulting cumulative adjustment to prior amortization and reserve provisions are recognized in the current period. In addition, the higher rate of amortization and reserve provisions will also be applied in calculating amortization and the provision for reserves in future periods.

The $106.6 million benefit in the three months ended June 30, 2009 is attributable to a similar but opposite impact on gross profits of market value increases in the underlying assets associated with our variable annuity products, reflecting financial market conditions during that period. The actual rate of return on annuity account values for the three months ended June 30, 2009 was 12.7% compared to our previously expected rate of return of 2.5%.

As mentioned above, 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 grow at the long-term expected rate of return for the entire period. The near-term future projected return across all contract groups is 8.4% per annum as of June 30, 2010. Beginning in the fourth quarter of 2008 and continuing through the second quarter of 2010, the projected near-term future annual rate of return calculated using the reversion to the mean approach for some contract groups 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 9.5% at the end of the second quarter of 2010. Included in the blended maximum future rate are assumptions for returns on various asset classes, including a 13% annual maximum rate of return on equity investments. Further or continued market volatility could result in additional market value changes within our separate account assets and corresponding changes to our gross profits, as well as additional adjustments to the amortization of deferred policy acquisition and other costs, and the costs relating to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products. Given that the estimates of future gross profits are based upon our maximum future rate of return assumption for some contract groups, all else being equal, future rates of return higher than the above mentioned future projected four year return of 8.4%, but less than the maximum future rate of return of 9.5%, may still result in increases in the amortization of deferred policy acquisition and other costs, and the costs relating to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products.

The quarterly adjustments for current period experience shown in the table above primarily reflect the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as an update for current and future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products. To the extent each period’s actual experience differs from the previous estimate for that period, the assumed level of total gross profits may change, and a cumulative adjustment to previous periods’ amortization and reserve provisions, also referred to as an experience true-up adjustment, may be required in the current period. This adjustment to previous periods’ amortization is in addition to the direct impact of actual gross profits on current period amortization and the market performance related adjustment to our estimates of gross profits for future periods. The experience true-up adjustments for deferred policy acquisition and other costs in the three months ended June 30, 2010 reflect an increase in amortization due to less favorable than expected gross profits, resulting primarily from the charges related to the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features. The experience true-up adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in the three months ended June 30, 2010 primarily reflects a reserve release for a large group of inforce contracts where the death benefit guarantee expired in the current quarter. The experience true-up adjustments for deferred policy acquisition and other costs in the three months ended June 30, 2009 reflect a reduction in amortization due to better than expected gross profits, resulting primarily from the net benefit in the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features excluding the adjustment for non-performance risk as discussed above, and better than expected lapses. The experience true-up adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in the three months ended June 30, 2009 primarily reflects higher than expected fee income as well as lower than expected actual contract guarantee claims costs.

Revenues

Revenues increased $143.5 million, from $275.7 million for the three months ended June 30, 2009 to $419.2 million for the three months ended June 30, 2010. Premiums increased $3.8 million, from $3.7 million for the three months June 30, 2009 to $7.5 million for the three months June 30, 2010, reflecting an increase in funds from customers electing to enter into the payout phase of their annuity contracts.

 

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Policy charges and fee income increased $112.5 million, from $76.5 million for the three months ended June 30, 2009 to $189.0 million for the three months ended June 30, 2010 driven by higher mortality and expense (“M&E”) fees of $69.7 million and an increase in optional benefit charges on our living and death benefit features of $11.0 million, primarily driven by higher average variable annuity asset balances invested in separate accounts. The increase in average separate account assets was due to positive net flows, net market appreciation, and net transfers of balances from the general account to the separate accounts between the three months ended June 30, 2009 and the three months ended June 30, 2010, as discussed above. The increase in optional benefit charges was primarily offset in realized investment gains, net as these features are reinsured with affiliates. Also included in the above increases was an increase of $21.7 million from market value adjustments related to the Company’s market value adjusted investment option (the “MVA option”) driven by market conditions and transfer of assets to the separate account primarily due to the automatic rebalancing element.

Net investment income decreased $36.4 million from $130.7 million for the three months ended June 30, 2009 to $94.3 million for the three months ended June 30, 2010 as a result of lower average annuity account values in our general account, as previously discussed.

Asset administration fees and other income increased $26.8 million, from $43.2 million for the three months ended June 30, 2009 to $70.0 million for the three months ended June 30, 2010 as a result of higher average variable annuity asset balances invested in separate accounts, as discussed above.

Realized investment gains, net, increased by $36.7 million from $21.6 million for the three months ended June 30, 2009 to $58.3 million for the three months ended June 30, 2010. This increase was primarily driven by $30.7 million of favorable variance in the mark-to-market on derivative positions associated with our capital hedging program. Additionally, realized investment gains increased driven by increased gains on our MVA and general account portfolios of $7.4 million.

Benefits and Expenses

Benefits and expenses increased $881.7 million from a benefit of $143.1 million for the three months ended June 30, 2009 to an expense $738.6 million for the three months ended June 30, 2010. The overall increase in benefits and expenses included $727.2 million of higher amortization of deferred acquisition cost and other cost related to the impact of the change in non-performance risk in the valuation of embedded derivatives, as previously discussed. The overall increase in benefits and expenses also included a charge of $221.4 million related to the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, as previously discussed. Absent the effect of the change in non-performance risk in the valuation of embedded derivatives and the quarterly adjustments and assumption updates, benefits and expenses for the three months ended June 30, 2010 decreased $67.0 million from the three months ended June 30, 2009.

Policyholders’ benefits increased $98.1 million, from a benefit of $44.0 million for the three months ended June 30, 2009 to an expense of $54.1 million for the three months ended June 30, 2010, primarily driven by the impact of the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, as previously discussed.

Interest credited to policyholders’ account balances increased $216.3 million, from $18.2 million for the three months ended June 30, 2009 to $234.5 million for the three months ended June 30, 2010, primarily due to $209.3 million from higher DSI amortization from the impact of the change in non-performance risk in the valuation of embedded derivatives, as previously discussed. Also contributing to the increase was $32.6 million relating the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing DSI, as discussed above. Partially offsetting the above increases was a decrease in interest credited to policyholders’ account balances of $26.5 million driven by lower average annuity account values in our general account, as previously discussed.

Amortization of deferred policy acquisition costs increased by $555.9 million, from a benefit of $206.1 million for the three months ended June 30, 2009 to an expense of $349.8 million for the three months ended June 30, 2010, primarily due to an increase of $517.1 million from higher DAC amortization from the impact of the change in non-performance risk in the valuation of embedded derivatives and an increase of $84.0 million from the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing DAC, as previously discussed. Partially offsetting the above increases was a decrease in DAC amortization of $45.2 million driven by lower level of actual gross profits from an unfavorable variance in embedded derivative breakage.

General, administrative and other expenses increased by $11.3 million, from $88.9 million for the three months ended June 30, 2009 to $100.2 million for the three months ended June 30, 2010, primarily due to $6.7 million of higher interest expense driven by increased borrowings to fund new business sales, and an increase of $5.7 million from the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing value of business acquired (“VOBA”), as previously discussed. Also contributing to the increase was $5.0 million of higher commission expense, net of capitalization, driven by higher asset based commission from higher average variable annuity asset balances invested in separate accounts. Partially offsetting the above increases were lower general administrative expenses resulting from lower allocation of sales to the Company due to the launch of a new single product line in each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey, as previously discussed.

 

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2010 versus 2009 Six Month Comparison

Net Income

Net loss increased $25.5 million from a loss of $134.1 million for the six months ended June 30, 2009 to a loss of $159.6 million for the six months ended June 30, 2010. The greater loss is driven by a $66.0 million increase in loss from operations before income taxes, as discussed below, partially offset by a $40.5 million increase in income tax benefit.

The loss from operations for the six months ended June 30, 2010 included a $163.7 million unfavorable variance in the amortization of deferred policy acquisition and other costs from the impact of updates to the inputs used in the valuation of the reinsured liability for living benefit embedded derivatives and its impact on actual gross profits Beginning in the first quarter of 2009, in light of developments including rating agency downgrades to the financial strength ratings of our insurance subsidiaries, we incorporated an additional spread over LIBOR into the discount rate used in the valuation of the embedded derivative liabilities to reflect an increase in the market-perceived risk of our non-performance, thereby reducing the value of the embedded derivative liabilities. The first six months of 2010 includes a benefit related to this update primarily driven by an increase in the fair value of the embedded derivative liabilities reflecting an increase in the present value of future expected benefit payments, resulting from a decrease in policyholder account balances due to unfavorable markets, as well as an increase in the additional spread over LIBOR, reflecting general spread widening. The amortization of deferred policy acquisition and other costs for the six months ended June 30, 2010 related to this benefit was a $414.1 million charge. The decrease in the embedded derivative liability for the first six months of 2009 included a benefit from an increase in the market-perceived risk of our non-performance and a benefit driven by an update of the equity volatility assumption to better match the actual equity indices referenced. The amortization of deferred policy acquisition and other costs for the six months ended June 30, 2009 related to this benefit was a $250.4 million charge. We amortize deferred policy acquisition 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 loss from operations for the six months ended June 30, 2010 also included $48.2 million of charges related to adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, compared to $65.3 million of benefits included in the six months ended June 30, 2009, resulting in a $113.5 million unfavorable variance, as shown in the table below. This variance primarily reflects the market conditions that existed in the respective periods and are discussed individually in more detail below.

 

		Six months Ended June 30, 2010												Six months Ended June 30, 2009
		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
Quarterly market performance adjustment		$	(41,372	)		$	(34,424	)		$	(75,796	)		$	17,266		$	16,724			$	33,990
Annual review / assumption updates			—				—				—				—			—				—
Quarterly adjustment for current period experience			(737	)			28,320				27,583				35,530			(4,176	)			31,354
Total		$	(42,109	)		$	(6,104	)		$	(48,213	)		$	52,796		$	12,548			$	65,344

 

(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.

Also included within the increase in loss from operations before income taxes was lower net investment income less interest credited of $27.1 million due to lower average annuity account values in the general account resulting from both transfers from a customer elected DCA program and from the automatic rebalancing element and $26.4 million of higher commission expense, net of capitalization, driven by higher asset based commission from higher average variable annuity asset balances invested in separate accounts and higher sales. Partially offsetting the increases in pre-tax loss was an increase in policy charges and fee income and asset administration fees and other income of $250.8 million driven by higher average variable annuity asset balances invested in separate accounts. The increase in average separate account assets was due to positive net flows, net market appreciation, and net transfers of balances from the general account to the separate accounts between June 30, 2009 and June 30, 2010. The transfer of balances from the general account relates to both transfers from a customer elected DCA program of approximately $1.1 billion and transfers from the automatic rebalancing element, also referred to as an asset transfer feature, in some of our optional living benefit features, which, as part of the overall product design, transferred approximately $1.5 billion out of the general account to the separate accounts from July 1, 2009 through June 30, 2010 due to market improvements. In addition, results for the first six months of 2010 include a net benefit of $25 million from refinements based on review and settlement of unaffiliated reinsurance contracts and a $16.6 million favorable variance in the mark-to-market on derivative positions associated with our capital hedging program. In the second quarter of 2009, we 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 consist of equity-based total

 

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return swaps that are 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 level that more broadly addresses equity market exposure of the overall 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 as discussed further under “—Liquidity and Capital Resources— General Liquidity”

The $75.8 million of charges for the six months ended June 30, 2010 relating to the quarterly market performance adjustments shown in the table above are attributable to changes to our estimate of total gross profits to reflect actual fund performance. The actual rates of return on annuity account values was 3.3% for the three months ended March 31, 2010 and a decline of 4.6% for the three months ended June 30, 2010 compared to our expected rates of return of 1.8% for the three months ended March 31, 2010 and 1.8% for the three months ended June 30, 2010. The overall lower than expected market returns for the six months ended June 30, 2010 decreased our estimates of total gross profits and increased our estimate of future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products, by establishing a new, lower starting point for the variable annuity account values used in estimating those items for future periods. The expected rates of return for the first and second quarters of 2010, for some contract groups, was based upon our maximum future rate of return assumption under the reversion to the mean approach. The decrease in our estimate of total gross profits and increase in our estimate of future expected claims costs results in a higher required rate of amortization and higher required reserve provisions, which are applied to all prior periods. The resulting cumulative adjustment to prior amortization and reserve provisions are recognized in the current period. In addition, the higher rate of amortization and reserve provisions will also be applied in calculating amortization and the provision for reserves in future periods.

The $34.0 million of benefits in the six months ended June 30, 2009 is attributable to a similar but opposite impact of market value increases in the underlying assets associated with our variable annuity products, reflecting financial market conditions during the period. Market value appreciation in the six months ended June 30, 2009 increased our estimates of total gross profits by establishing a new, higher starting point for the annuity account values used in estimating gross profits for future periods. The increase in our estimate of total gross profits resulted in a lower required rate of amortization, which was applied to all prior periods’ gross profits.

The $27.6 million benefit for the six months ended June 30, 2010 and the $31.4 million benefit for the six months ended June 30, 2009 for the quarterly adjustments for current period experience and other updates shown in the table above primarily reflect the impact of differences between actual gross profits for the period and the previously estimated expected gross profits for the period, as well as an update for current and future expected claims costs associated with the guaranteed minimum death and income benefit features of our variable annuity products. To the extent each period’s actual experience differs from the previous estimate for that period, the assumed level of total gross profits may change, and a cumulative adjustment to previous periods’ amortization and reserve provisions, also referred to as an experience true-up adjustment, may be required in the current period. This adjustment to previous periods’ amortization is in addition to the direct impact of actual gross profits on current period amortization and the market performance related adjustment to our estimates of gross profits for future periods. The experience true-up adjustments for deferred policy acquisition and other costs in the six months ended June 30, 2010 reflect an increase in amortization due to less favorable than expected gross profits, resulting primarily from the charges related to the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features. The experience true-up adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products in the six months ended June 30, 2010 primarily reflects a reserve release for a large group of inforce contracts where the death benefit guarantee expired in the current quarter. The experience true-up adjustment for deferred policy acquisition and other costs for the six months ended June 30, 2009 reflect a reduction in amortization due to better than expected gross profits, resulting primarily from a net benefit in the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features and better than expected lapse experience. The adjustment for the reserves for the guaranteed minimum death and income benefit features of our variable annuity products primarily reflects higher than expected actual contract guarantee claims costs in the six months ended June 30, 2009 due to lower than expected lapses, partially offset by higher than expected fee income.

Revenues

Revenues increased $192.3 million, from $579.2 million for the six months ended June 30, 2009 to $771.5 million for the six months ended June 30, 2010. Premiums increased $8.1 million, from $6.8 million for the six months June 30, 2009 to $14.9 million for the six months June 30, 2010, reflecting an increase in funds from customers electing to enter into the payout phase of their annuity contracts.

Policy charges and fee income increased $190.4 million, from $182.7 million for the six months ended June 30, 2009 to $373.1 million for the six months ended June 30, 2010 driven by higher mortality and expense (“M&E”) fees of $145.5 million and an increase in optional benefit charges on our living and death benefit features of $16.7 million, primarily driven by higher average variable annuity asset balances invested in separate accounts. The increase in average separate account asset balances was due to positive net flows, net market appreciation, and net transfers of balances from the general account to the separate accounts over the past twelve months relating to both a customer elected dollar cost averaging program and an automatic rebalancing element in some of our optional living benefit features. The increase in optional benefit charges was primarily offset in realized investment gains, net as these features are reinsured with affiliates. Also included in the above increases was a $27 million benefit in the six months ended June 30, 2010 from refinements based on review and settlement of reinsurance contracts. Partially offsetting the above increases was $15.6 million of higher charges from market value adjustments related to the Company’s market value adjusted investment option (the “MVA option”) driven by market conditions and transfer of assets to the separate account primarily due to the automatic rebalancing element.

 

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Net investment income decreased $84.0 million from $276.9 million for the six months ended June 30, 2009 to $192.9 million for the six months ended June 30, 2010 as a result of lower average annuity account values in the general account, as previously discussed.

Asset administration fees and other income increased $60.4 million, from $78.7 million for the six months ended June 30, 2009 to $139.1 million for the six months ended June 30, 2010 as a result of higher average variable annuity asset balances invested in separate accounts, as discussed above.

Realized investment gains, net, increased by $17.4 million from $34.1 million for the six months ended June 30, 2009 to $51.5 million for the six months ended June 30, 2010. This increase was primarily driven by a favorable variance in the mark-to-market on derivative positions associated with our capital hedging program.

Benefits and Expenses

Benefits and expenses increased $258.3 million from $805.2 million for the six months ended June 30, 2009 to $1,063.5 million for the six months ended June 30, 2010. The overall increase in benefits and expenses included $163.7 million of higher amortization of deferred acquisition cost and other cost related to the impact of the change in non-performance risk in the valuation of embedded derivatives, as previously discussed. The overall increase in benefits and expenses also included a charge of $113.5 million related to the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products and to our estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs, as previously discussed. Absent the effect of the change in non-performance risk in the valuation of embedded derivatives and the quarterly adjustments and assumption updates, benefits and expenses for the six months ended June 30, 2010 decreased $18.9 million from the six months ended June 30, 2009.

Policyholders’ benefits increased $13.9 million, from $38.2 million for the six months ended June 30, 2009 to $52.1 million for the six months ended June 30, 2010, primarily driven by the impact of the adjustments to the reserves for the guaranteed minimum death and income benefit features of our variable annuity products, as previously discussed.

Interest credited to policyholders’ account balances increased $77.6 million, from $278.6 million for the six months ended June 30, 2009 to $356.2 million for the six months ended June 30, 2010, primarily due to $79.6 million from higher DSI amortization from the impact of the change in non-performance risk in the valuation of embedded derivatives, as previously discussed. Also contributing to the increase was $23.5 million relating the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing DSI, as discussed above. Additionally, DSI amortization increased by $30.6 driven by higher level of actual gross profits. Partially offsetting the above increases was a decrease in interest credited to policyholders’ account balances of $56.9 million driven by lower average annuity account values in the general account.

Amortization of deferred policy acquisition costs increased by $129.4 million, from $312.7 million for the six months ended June 30, 2009 to $442.0 million for the six months ended June 30, 2010, primarily due to an increase of $84.5 million from higher DAC amortization from the impact of the change in non-performance risk in the valuation of embedded derivatives and an increase of $73.9 million from the impact of the adjustments to our estimate of total gross profits used as a basis for amortizing DAC, as previously discussed. Partially offsetting the above increases was a decrease in DAC amortization of $29.0 million driven by lower level of actual gross profits from an unfavorable variance in embedded derivative breakage

General, administrative and other expenses increased by $37.5 million, from $175.7 million for the six months ended June 30, 2009 to $213.2 million for the six months ended June 30, 2010, primarily due to $26.4 million of higher commission expense, net of capitalization, driven by higher asset based commission from higher average variable annuity asset balances invested in separate accounts and higher sales. Also contributing to the increase was $12.3 million of higher interest expense driven by increased borrowings.

Income Taxes

The Company determines its interim tax provision using the annual effective tax rate methodology as required by Accounting Standards Codification 740-270. The Company has utilized a discrete effective tax rate method to calculate taxes for the second quarter and first 6 months of 2010. The Company believes that, at this time, the use of this discrete method is more appropriate than the full year effective tax rate method applied in the first quarter. As a result of the forecasted level of pre-tax earnings the full year effective tax rate is unreliable.

Our income tax provision amounted to an income tax benefit of $132.4 million for the six months ended June 30, 2010 compared to income tax benefit of $91.9 million for the six months ended June 30, 2009. The increase in income tax benefit was primarily driven by the decrease in pretax income, as discussed above.

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 2009, 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.

 

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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 1, 2010, 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. The IRS recently issued an Industry Director Directive (“IDD”) stating that the methodology for calculating the DRD set forth in Revenue Ruling 2007-54 should not be followed. The IDD also confirmed that the IRS guidance issued before Revenue Ruling 2007-54, which guidance the Company relied upon in calculating its DRD, should be used to determine the DRD. These activities had no impact on the Company’s 2009 or the first six months of 2010 results.

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.

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 “Risk Factors” in Part II, Item IA for information regarding the potential effects of the Dodd-Frank bill on the Company and its affiliates.

General Liquidity

Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of 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 annuity considerations, 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

 

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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, with very limited exceptions, the Company has ceased offering its existing variable annuity products to new investors upon the launch of a new product 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.

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, 2010 and December 31, 2009, the Company had liquid assets of $7.2 billion and $7.3 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 $0.6 billion and $0.8 billion as of June 30, 2010 and December 31, 2009, 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 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 Connecticut Insurance Department. 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 ratio to a level consistent with an “AA” ratings target 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.

 

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Prudential Financial recently changed the focus of its capital hedge program from the equity price risk associated with the annuities business to a broader view of equity market exposure of the statutory capital of Prudential Financial and its subsidiaries, as a whole. In the second quarter of 2010, the capital hedge program was terminated as described under “—Results of Operations” and equity index-linked derivative transactions were entered into that are designed to mitigate the overall impact on statutory capital of a severe equity market stress event on Prudential Financial and its subsidiaries, as whole. A portion of the derivatives related to the new program were purchased by the Company. The program now focuses on tail risk rather than general equity market declines in order to protect statutory capital in a more 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.

The implementation of VACARVM, a new statutory reserve methodology for variable annuities with guaranteed benefits, effective December 31, 2009 had an impact of approximately $61 million benefit on the statutory surplus of the Company. Certain of the Company’s statutory reserves are ceded to an affiliated offshore captive reinsurance company. A reinsurance trust is established by the affiliated offshore captive reinsurance company to satisfy reinsurance reserve credit requirements. These reserve credits allow the Company to reduce the level of statutory capital it is required to hold. The reinsurance reserve credit requirements and the value of the reinsurance trust assets are reviewed on a quarterly basis. Since the exact requirements cannot be known for certain until after the close of the accounting period, the reserve credit requirements are estimated to determine if the value of the reinsurance trust assets are expected to be sufficient. If it is determined that the value of the reinsurance trust assets are not sufficient to meet the reinsurance reserve credit requirements, we expect Prudential Financial would satisfy those additional needs through a combination of funding the reinsurance credit trusts with available cash, certain hedge assets, 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. In 2009, we satisfied the reinsurance reserve credit requirement through a combination of funding statutory reserve credit trusts with available cash of the captive reinsurer and cash proceeds from an inter-company loan to the captive reinsurer from Prudential Insurance. For the second quarter of 2010, we provided additional funding to the reinsurance trusts of $178 million to meet increased reserve credit requirements due to unfavorable market conditions.

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, 2010. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2010, 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, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II		OTHER INFORMATION

Item 1. Legal Proceedings

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 a 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 the Unaudited Interim Financial Statements included herein for additional discussion of our litigation and regulatory matters.

 

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Item 1A. Risk Factors

The following should be read in conjunction with and supplements and amends the section titled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009. These risks could materially affect our 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.

The enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act will subject the Company, our parent and our affiliates to substantial additional federal regulation and we cannot predict the effect on our business, results of operations, cash flows or financial condition.

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which effects comprehensive changes to the regulation of financial services in the United States and will subject the Company, our parent and our affiliates to substantial additional federal regulation. Dodd-Frank directs existing and newly-created government agencies and bodies to promulgate regulations implementing the law, a process anticipated to occur over the next few years. We cannot predict with any certainty the requirements of the regulations ultimately adopted or how Dodd-Frank and such regulations will affect the financial markets generally or impact our business, financial strength ratings, results of operations, cash flows or financial condition.

Key aspects we have identified to date of Dodd-Frank’s potential impact on the Company, our parent and our affiliates include:

 

•

Prudential Financial, Inc. will become subject, as a savings and loan holding company, to the examination, enforcement and supervisory authority of the Board of Governors of the Federal Reserve System (“FRB”) after the transfer to the FRB of the existing authority of the Office of Thrift Supervision (expected to occur within a year of Dodd-Frank’s enactment). The FRB will have authority to impose capital requirements on Prudential Financial and its subsidiaries (including the Company) after the transfer date. Pursuant to the “Collins Amendment” included in Dodd-Frank, the FRB must establish minimum leverage and risk-based capital requirements for savings and loan holding companies (including Prudential Financial, Inc.) and other institutions that are not less than those applicable to insured depository institutions. These requirements will become generally applicable to Prudential Financial, Inc. five years after Dodd-Frank’s enactment except, for purposes of calculating Tier 1 capital, new issuances of debt and equity capital will be immediately subject to the requirements. We cannot predict what capital regulations the FRB will promulgate under these authorizations, either generally or as applicable to insurance-based organizations. We cannot predict how the FRB will exercise general supervisory authority over Prudential Financial and its subsidiaries (including the Company) as to business practices.

 

•

Dodd-Frank establishes a Financial Stability Oversight Council (“Council”) which is authorized to subject non-bank financial companies such as Prudential Financial, Inc. to stricter prudential standards (a “Designated Financial Company”) if the Council determines that material financial distress at the company or the scope of the company’s activities could pose a threat to financial stability of the U.S. If so designated, Prudential Financial, Inc. and/or its subsidiaries (including the Company) would become subject to unspecified stricter prudential standards, including stricter requirements and limitations relating to risk-based capital, leverage, liquidity and credit exposure, as well as overall risk management requirements, management interlock prohibitions and a requirement to maintain a plan for rapid and orderly dissolution in the event of severe financial distress. The “Collins Amendment” capital requirements referred to above would apply when adopted by the FRB (i.e., the 5-year grandfathering would no longer be available). The FRB could also require the issuance of capital securities automatically convertible to equity in the event of financial distress, require enhanced public disclosures to support market evaluation of risk profile and impose short-term debt limits. If Prudential Financial, Inc. or a subsidiary (such as the Company) were so designated, failure to meet defined measures of financial condition could result in: limits on capital distributions, acquisitions and/or asset growth; requirements for a capital restoration plan and capital raising, limitations on transactions with affiliates, management changes and asset sales; and, if the FRB and the Council determined Prudential Financial, Inc. (or the designated subsidiary) posed a grave threat to the financial stability of the U.S., further limits on acquisitions or combinations, restrictions on product offerings and/or requirements to sell assets. We cannot predict whether Prudential Financial, Inc. or a subsidiary will be designated as a Designated Financial Company.

 

•

Prudential Financial, Inc. will become, as a savings and loan holding company (and if designated, as a Designated Financial Company), subject to stress tests to be promulgated by the FRB in consultation with the newly-created Federal Insurance Office (discussed below) to determine whether, on a consolidated basis, Prudential Financial, Inc. has the capital necessary to absorb losses as a result of adverse economic conditions. We cannot predict how the stress tests will be designed or conducted or whether the results thereof will cause Prudential Financial, Inc. or a subsidiary (such as the Company) to alter business practices or affect the perceptions of regulators, rating agencies, customers, counterparties or investors of our financial strength.

 

•

The Council may recommend that state insurance regulators or other regulators apply new or heightened standards and safeguards for activities or practices we and other insurers or other financial services companies engage in that could create or increase the risk that significant liquidity, credit or other problems spread among financial companies. We cannot predict whether any such recommendations will be made or their effect on our business, results of operations, cash flows or financial condition.

 

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•

As a savings and loan holding company, Prudential Financial, Inc. and its subsidiaries will become subject to the “Volcker Rule” provisions of Dodd-Frank prohibiting, subject to the rule’s exceptions, “proprietary trading” and the sponsorship of, and investment in funds referred to in Dodd-Frank as hedge funds or private equity funds that rely on certain exceptions from the Investment Company Act of 1940 as amended. The Council is to provide recommendations on the implementation of the Volcker Rule within six months of Dodd-Frank’s enactment, and the FRB is to promulgate regulations thereunder within nine months thereafter, and substantial uncertainty as to the rule’s application to our business may exist over this period. The rule becomes effective on the earlier of one year after adoption of regulations or two years after Dodd-Frank’s enactment, and activities and investments must be brought into compliance within two years thereafter, subject to exceptions. We presently believe that the “permitted activities” exceptions to the rule should be interpreted in a manner that does not require us to materially alter our securities trading or investing practices, but there can be no assurance that the regulations promulgated will so provide.

 

•

Dodd-Frank creates a new framework for regulation of the over-the-counter (“OTC”) derivatives markets which could impact various activities of our affiliate Prudential Global Funding, LLC (“PGF”), Prudential Financial, Inc. and its insurance subsidiaries (including the Company), which use derivatives for various purposes (including hedging interest rate, foreign currency and equity market exposures). Dodd-Frank generally requires swaps, subject to a determination by the CFTC or SEC as to which swaps are covered, with all counterparties except non-financial end users to be executed through a centralized exchange or regulated facility and to be cleared through a regulated clearinghouse. Swap dealers and major swap participants (“MSPs”) are subject to capital and margin (i.e., collateral) requirements that will be imposed by the applicable prudential regulator or the CFTC or SEC, as well as business conduct rules and reporting requirements. While we believe Prudential Financial, Inc. and PGF should not be considered dealers or MSPs subject to the capital and margin requirements, the final regulations adopted could provide otherwise, which could substantially increase the cost of hedging and the related operations. A determination by the Secretary of the Treasury not to exclude foreign currency swaps and forwards from the foregoing requirements also could have that result. PGF intermediates swaps between Prudential entities and third parties, and it is possible that PGF’s standardized intra-Company transactions might be required to be executed through an exchange, clear centrally and post margin, potentially defeating PGF’s key function; if so, Prudential entities, including the Company, might directly enter into swaps with third parties, potentially increasing the economic costs of hedging. The SEC and CFTC are required to determine whether and how “stable value contracts” should be treated as swaps and, although we believe otherwise, various other insurance products might be treated as swaps; if regulated as swaps, we cannot predict how the rules would be applied to such products or the effect on their profitability or attractiveness to our clients. Finally, the new regulatory scheme imposed on all market participants may increase the costs of hedging generally and banking institutions (with which we enter into a substantial portion of our derivatives) may be required to conduct at least a portion of their OTC derivatives businesses outside their depositary institutions. The affiliates through which these institutions will conduct their OTC derivatives businesses might be less creditworthy than the depository institutions themselves, and “netting” of counterparty exposures with non-banks will not be allowed, potentially affecting the credit risk these counterparties pose to us and the degree to which we are able to enter into transactions with these counterparties. We cannot predict the effect of the foregoing on our hedging costs, our hedging strategy or implementation thereof or whether we will need or choose to increase and/or change the composition of the risks we do not hedge.

 

•

Dodd-Frank establishes a Federal Insurance Office within the Department of the Treasury to be headed by a director appointed by the Secretary of the Treasury. While not having a general supervisory or regulatory authority over the business of insurance, the director of this office will perform various functions with respect to insurance (other than health insurance), including serving as a non-voting member of the Council and making recommendations to the Council regarding insurers to be designated for stricter regulation. The director is also required to conduct a study on how to modernize and improve the system of insurance regulation in the United States, including by increased national uniformity through either a federal charter or effective action by the states.

 

•

Title II of Dodd-Frank provides that a financial company may be subject to a special orderly liquidation process outside the federal bankruptcy code, administered by the FDIC as receiver, upon a determination (with the approval of the director of the Federal Insurance Office if – as is true with respect to Prudential Financial, Inc. – the largest United States subsidiary is an insurer) that the company is in default or in danger of default and presents a systemic risk to U.S. financial stability. Were Prudential Financial, Inc. subject to such a proceeding, the Company would remain subject to rehabilitation and liquidation proceedings under state law, although the FDIC has discretion and authority to initiate resolution of an insurer under state law if its state insurance regulator has not filed the appropriate judicial action within 60 days of a systemic risk determination. We cannot predict how our creditors or creditors of Prudential Financial, Inc. or its other insurance and non-insurance subsidiaries, including the holders of Prudential Financial debt, will evaluate this potential or whether it will impact the Company’s or its affiliates’ financing or hedging costs.

 

•

Dodd-Frank establishes the Bureau of Consumer Financial Protection (“BCFP”) as an independent agency within the FRB to regulate consumer financial products and services offered primarily for personal, family or household purposes, with rule-making and enforcement authority over unfair, deceptive or abusive practices. Insurance products and services are not within the BCFP’s general jurisdiction, and broker-dealers and investment advisers are not subject to the BCFP’s jurisdiction when acting in their registered capacity. Retirement service providers (which may include certain of our affiliates) could become subject to the BCFP’s jurisdiction, but only if the Department of Labor and the Department of the Treasury agree. Otherwise, we believe that the Company and its affiliates offer a very limited number of products subject to BCFP regulation and the impact of Dodd-Frank on their operations in this regard should not be material; however, it is possible that the regulations promulgated by the BCFP will assert jurisdiction more expansively than we anticipate.

 

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•

Dodd-Frank includes various securities law reforms that may affect business practices of the Company and its affiliates and the liabilities and/or exposures associated therewith, including:

 

¡

The SEC is to conduct a study and may impose on registered broker-dealers that provide retail investors personalized investment advice about securities a new standard of conduct the same or similar as the overall standard for investment advisers (i.e., a fiduciary standard). The SEC may also require broker-dealers selling proprietary or a limited range of products to make certain disclosures and obtain customer consents or acknowledgements.

 

•

Dodd-Frank imposes various assessments on financial companies, including (as applicable to Prudential Financial, Inc. and its subsidiaries) ex-post assessments to provide funds necessary to repay any borrowing and to cover the costs of any special resolution of a financial company conducted under Title II (although the FDIC is to take into account assessments otherwise imposed under state insurance guaranty funds); if Prudential Financial, Inc. and/or one of its subsidiaries (such as the Company) were to become a Designated Financial Company, assessments to fund a newly-created Office of Financial Research which, among other things, assists the Council; and the costs of the new regulation by the FRB. We are unable to estimate these costs at this time.

 

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Item 6. Exhibits

 

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.

Schedules are omitted because they are either inapplicable or the information required therein is included in the notes to the Unaudited Interim Financial Statements included herein.

 

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SIGNATURES

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 13, 2010

 

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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.

 

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