Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(MARK ONE)

x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2014

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)

 

Arizona		06-1241288
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)

One Corporate Drive

Shelton, Connecticut 06484

(203) 926-1888

(Address and Telephone Number of Registrant’s Principal Executive Offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of the Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		x		Smaller reporting company		¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 13, 2014, 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., 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
PART I		FINANCIAL INFORMATION
		Item 1.		Financial Statements:
				Unaudited Interim Statements of Financial Position As of September 30, 2014 and December 31, 2013			4
				Unaudited Interim Statements of Operations and Comprehensive Income Three and Nine Months Ended September 30, 2014 and 2013			5
				Unaudited Interim Statements of Equity Nine Months Ended September 30, 2014 and 2013			6
				Unaudited Interim Statements of Cash Flows Nine Months Ended September 30, 2014 and 2013			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			43
PART II		OTHER INFORMATION					44
		Item 1.		Legal Proceedings			44
		Item 1A.		Risk Factors			44
		Item 6.		Exhibits			45
SIGNATURES							46

 

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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 additional debt or equity capital or external financing for our operations; (3) interest rate fluctuations or prolonged periods of low interest rates; (4) the degree to which we choose not to hedge risks, or the potential ineffectiveness or insufficiency of hedging or risk management strategies we do implement, with regard to variable annuity or other product guarantees; (5) any inability to access our credit facilities; (6) reestimates of our reserves for future policy benefits and claims; (7) differences between actual experience regarding mortality, longevity, morbidity, persistency, surrender experience, interest rates, or market returns and the assumptions we use in pricing our products, establishing liabilities and reserves or for other purposes; (8) changes in our assumptions related to deferred policy acquisition costs or value of business acquired; (9) changes in our financial strength or credit ratings; (10) investment losses, defaults and counterparty non-performance; (11) competition in our product lines and for personnel; (12) changes in tax law; (13) regulatory or legislative changes, including the Dodd-Frank Wall Street Reform and Consumer Protection Act; (14) inability to protect our intellectual property rights or claims of infringement of the intellectual property rights of others; (15) adverse determinations in litigation or regulatory matters and our exposure to contingent liabilities; (16) domestic or international military actions, natural or man-made disasters including terrorist activities or pandemic disease, or other events resulting in catastrophic loss of life; (17) ineffectiveness of risk management policies and procedures in identifying, monitoring and managing risks; (18) interruption in telecommunication, information technology or other operational systems or failure to maintain the security, confidentiality or privacy of sensitive data on such systems; and (19) changes in statutory or accounting principles generally accepted in the United States of America (“U.S. GAAP”), practices or policies. Prudential Annuities Life Assurance Corporation does not intend, and is under no obligation, to update any particular forward-looking statement included in this document. See “Risk Factors” included in the Annual Report on Form 10-K for the year ended December 31, 2013 for a discussion of certain risks relating to our business and investment in our securities.

 

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Prudential Annuities Life Assurance Corporation

Unaudited Interim Statements of Financial Position

As of September 30, 2014 and December 31, 2013 (in thousands, except share amounts)

 

 

		September 30, 2014				December 31, 2013
ASSETS
Fixed maturities, available-for-sale, at fair value (amortized cost, 2014: $2,644,828; 2013: $3,079,002)		$	2,840,070			$	3,264,216
Trading account assets, at fair value			6,022				6,677
Equity securities, available-for-sale, at fair value (cost, 2014: $14; 2013: $206)			17				208
Commercial mortgage and other loans, net of valuation allowance			413,330				398,991
Policy loans			12,911				12,454
Short-term investments			174,415				118,188
Other long-term investments			110,855				60,585
Total investments			3,557,620				3,861,319
Cash and cash equivalents			700				1,417
Deferred policy acquisition costs			1,218,654				1,345,504
Accrued investment income			29,481				32,169
Reinsurance recoverables			2,232,080				748,690
Value of business acquired			41,104				43,500
Deferred sales inducements			733,803				809,247
Receivables from parent and affiliates			56,255				35,594
Other assets			7,947				16,994
Separate account assets			44,469,241				46,626,828
TOTAL ASSETS		$	52,346,885			$	53,521,262
LIABILITIES AND EQUITY
LIABILITIES
Policyholders’ account balances		$	2,703,446			$	3,191,215
Future policy benefits and other policyholder liabilities			2,720,508				1,127,342
Payables to parent and affiliates			60,990				111,403
Cash collateral for loaned securities			22,273				47,896
Income taxes			359,257				358,818
Short-term debt			200,000				205,000
Other liabilities			95,492				113,125
Separate account liabilities			44,469,241				46,626,828
Total Liabilities			50,631,207				51,781,627
Commitments and Contingent Liabilities (See Note 6)
EQUITY
Common stock, $100 par value; 25,000 shares, authorized, issued and outstanding			2,500				2,500
Additional paid-in capital			901,422				901,422
Retained earnings			728,812				764,846
Accumulated other comprehensive income (loss)			82,944				70,867
Total Equity			1,715,678				1,739,635
TOTAL LIABILITIES AND EQUITY		$	52,346,885			$	53,521,262

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 and Nine Months Ended September 30, 2014 and 2013 (in thousands)

 

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
REVENUES
Premiums		$	7,844			$	6,053			$	26,777			$	21,161
Policy charges and fee income			204,424				204,078				609,787				604,439
Net investment income			39,393				51,321				125,352				168,794
Asset administration fees and other income			57,268				57,556				172,414				180,224
Realized investment gains (losses), net:
Other-than-temporary impairments on fixed maturity securities			-				-				-				-
Other-than-temporary impairments on fixed maturity securities transferred to other comprehensive income			-				-				-				-
Other realized investment gains (losses), net			(923)				(68,980)				(5,289)				(150,491)
Total realized investment gains (losses), net			(923)				(68,980)				(5,289)				(150,491)
Total revenues			308,006				250,028				929,041				824,127
BENEFITS AND EXPENSES
Policyholders’ benefits			42,818				(23,602)				99,734				22,701
Interest credited to policyholders’ account balances			26,546				(127,889)				128,873				(113,113)
Amortization of deferred policy acquisition costs			31,157				(278,452)				132,295				(350,066)
General, administrative and other expenses			96,683				97,420				295,568				297,864
Total benefits and expenses			197,204				(332,523)				656,470				(142,614)
INCOME FROM OPERATIONS BEFORE INCOME TAXES			110,802				582,551				272,571				966,741
Income tax expense			14,765				182,255				41,605				275,387
NET INCOME			96,037				400,296				230,966				691,354
Other comprehensive income (loss), before tax:
Foreign currency translation adjustments			(29)				15				(33)				-
Net unrealized investment gains (losses):
Unrealized investment gains (losses) for the period			(13,105)				356				23,390				(92,502)
Reclassification adjustment for (gains) losses included in net income			(3,899)				(3,909)				(4,776)				(11,718)
Net unrealized investment gains (losses)			(17,004)				(3,553)				18,614				(104,220)
Other comprehensive income (loss), before tax:			(17,033)				(3,538)				18,581				(104,220)
Less: Income tax expense (benefit) related to other comprehensive income (loss)
Foreign currency translation adjustments			(10)				5				(12)				-
Net unrealized income (losses)			(5,951)				(1,244)				6,516				(36,477)
Total			(5,961)				(1,239)				6,504				(36,477)
Other comprehensive income (loss), net of taxes			(11,072)				(2,299)				12,077				(67,743)
COMPREHENSIVE INCOME		$	84,965			$	397,997			$	243,043			$	623,611

See Notes to Unaudited Interim Financial Statements

 

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Prudential Annuities Life Assurance Corporation

Unaudited Interim Statements of Equity

Nine Months Ended September 30, 2014 and 2013 (in thousands)

 

 

				Common   stock						Additional   paid-in capital						Retained   earnings						Accumulated other   comprehensive   income (loss)						Total equity
Balance, December 31, 2013				$	2,500					$	901,422					$	764,846					$	70,867					$	1,739,635
Distribution to parent					-						-						(267,000)						-						(267,000)
Comprehensive income:
Net income					-						-						230,966						-						230,966
Other comprehensive income (loss), net of taxes					-						-						-						12,077						12,077
Total comprehensive income																													243,043
Balance, September 30, 2014				$	2,500					$	901,422					$	728,812					$	82,944					$	1,715,678
				Common   stock						Additional   paid-in capital						Retained   earnings						Accumulated other   comprehensive   income (loss)						Total equity
Balance, December 31, 2012				$	2,500					$	893,336					$	200,754					$	147,287					$	1,243,877
Contributed capital					-						8,086						-						-						8,086
Distribution to parent					-						-						(184,000)						-						(184,000)
Comprehensive income:
Net income					-						-						691,354						-						691,354
Other comprehensive income (loss), net of taxes					-						-						-						(67,743)						(67,743)
Total comprehensive income																													623,611
Balance, September 30, 2013				$	2,500					$	901,422					$	708,108					$	79,544					$	1,691,574

See Notes to Unaudited Interim Financial Statements

 

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Prudential Annuities Life Assurance Corporation

Unaudited Interim Statements of Cash Flows

Nine Months Ended September 30, 2014 and 2013 (in thousands)

 

 

		2014				2013
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income		$	230,966			$	691,354
Adjustments to reconcile net income to net cash provided by operating activities:
Policy charges and fee income			3,274				8,583
Realized investment (gains) losses, net			5,289				150,491
Depreciation and amortization			2,437				7,848
Interest credited to policyholders’ account balances			128,873				(113,113)
Change in:
Future policy benefit reserves			239,825				162,955
Accrued investment income			2,688				3,924
Net receivable/payable to affiliates			(30,430)				(70,315)
Deferred sales inducements			(10,674)				(25,591)
Deferred policy acquisition costs			130,073				(353,372)
Income taxes			(6,077)				328,609
Reinsurance recoverables			(205,994)				(206,512)
Other, net			(80,549)				(57,402)
Cash flows from operating activities		$	409,701			$	527,459
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the sale/maturity/prepayment of:
Fixed maturities, available-for-sale		$	853,821			$	1,024,555
Commercial mortgage and other loans			16,385				86,850
Trading account assets			4,089				5,599
Policy loans			572				353
Other long-term investments			242				1,810
Short-term investments			1,903,756				2,359,997
Payments for the purchase/origination of:
Fixed maturities, available-for-sale			(415,511)				(630,214)
Commercial mortgage and other loans			(30,047)				(63,652)
Trading account assets			(3,261)				(3,223)
Policy loans			(538)				(501)
Other long-term investments			(14,738)				(7,893)
Short-term investments			(1,959,984)				(2,408,829)
Notes receivable from parent and affiliates, net			(15,135)				(586)
Other, net			133				38
Cash flows from investing activities		$	339,784			$	364,304
CASH FLOWS USED IN FINANCING ACTIVITIES:
Cash collateral for loaned securities			(25,623)				171
Net decrease in short-term borrowing			(5,000)				-
Drafts outstanding			1,425				6,686
Distribution to parent			(267,000)				(184,000)
Contributed capital			-				12,439
Policyholders’ account balances
Deposits			900,623				860,450
Withdrawals			(1,354,627)				(1,587,126)
Cash flows used in financing activities		$	(750,202)			$	(891,380)
NET (DECREASE)/INCREASE IN CASH AND CASH EQUIVALENTS			(717)				383
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR			1,417				266
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	700			$	649

See Notes to Unaudited Interim Financial Statements

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements

 

 

1.    BUSINESS AND BASIS OF PRESENTATION

Prudential Annuities Life Assurance Corporation (the “Company” or “PALAC”), with its principal offices in Shelton, Connecticut, is an indirect wholly-owned subsidiary of Prudential Financial, Inc. (“Prudential Financial”), a New Jersey corporation. The Company is a wholly-owned subsidiary of Prudential Annuities, Inc. (“PAI”), which in turn is an indirect wholly-owned subsidiary of Prudential Financial.

The Company developed long-term savings and retirement products, which were distributed through its affiliated broker/dealer company, Prudential Annuities Distributors, Incorporated (“PAD”). The Company issued variable deferred and immediate annuities for individuals and groups in the United States of America, District of Columbia and Puerto Rico. In addition, the Company has a relatively small inforce block of variable life insurance policies, but it no longer actively sells such policies.

Beginning in March 2010, the Company ceased offering its variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product line by each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company). These initiatives were implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. During 2012, the Company suspended additional customer deposits for variable annuities with certain optional living benefit riders. However, subject to applicable contract provisions and administrative rules, the Company continues to accept additional customer deposits on certain inforce contracts.

The Company is engaged in a business that is highly competitive because of the large number of stock and mutual life insurance companies and other entities engaged in marketing long-term savings and retirement products, including insurance products, and individual and group annuities.

On August 30, 2013, the Company received approval from the Arizona and Connecticut Departments of Insurance to redomesticate the Company from Connecticut to Arizona effective August 31, 2013.

As a result of the redomestication, the Company is now an Arizona insurance company and its principal insurance regulatory authority is the Arizona Department of Insurance. Additionally, the Company is now domiciled in the same jurisdiction as the primary reinsurer of the Company’s living benefits, Pruco Reinsurance, Ltd. (“Pruco Re”), which is also regulated by the Arizona Department of Insurance. This change enables the Company to claim statutory reserve credit for business ceded to Pruco Re without the need for Pruco Re to collateralize its obligations under the reinsurance agreement.

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”) on a basis consistent with reporting interim financial information in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (“SEC”).

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

The most significant estimates include those used in determining deferred policy acquisition costs and related amortization; value of business acquired and its amortization; amortization of deferred sales inducements; valuation of investments including derivatives and the recognition of other-than-temporary impairments (“OTTI”); future policy benefits including guarantees; provision for income taxes and valuation of deferred tax assets; and reserves for contingent liabilities, including reserves for losses in connection with unresolved legal matters.

2.    SIGNIFICANT ACCOUNTING POLICIES AND PRONOUNCEMENTS

This section supplements, and should be read in conjunction with, Note 2 to the Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Adoption of New Accounting Pronouncements

In December 2013, the Financial Accounting Standards Board (“FASB”) issued updated guidance establishing a single definition of a public entity for use in financial accounting and reporting guidance. This new guidance is effective for all current and future reporting periods and did not have a significant effect on the Company’s financial position, results of operations, or financial statement disclosures.

In July 2013, the FASB issued new guidance regarding derivatives. The guidance permits the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting, in addition to the United States Treasury rate and London Inter-Bank Offered Rate (“LIBOR”). The guidance also removes the restriction on using different benchmark rates for similar hedges. The guidance is effective for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013, and was applied prospectively. Adoption of the guidance did not have a significant effect on the Company’s financial position, results of operations or financial statement disclosures.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

In July 2013, the FASB issued updated guidance regarding the presentation of unrecognized tax benefits when net operating loss carryforwards, similar tax losses, or tax credit carryforwards exist. This new guidance became effective for interim or annual reporting periods that began after December 15, 2013, and was applied prospectively. Adoption of the guidance did not have a significant effect on the Company’s financial position, results of operations or financial statement disclosures.

In February 2013, the FASB issued updated guidance regarding the presentation of comprehensive income. Under the guidance, an entity is required to separately present information about significant items reclassified out of accumulated other comprehensive income (“AOCI”) by component as well as changes in AOCI balances by component in either the financial statements or the notes to the financial statements. The guidance does not change the items that are reported in other comprehensive income, does not change when an item of other comprehensive income must be reclassified to net income, and does not amend any existing requirements for reporting net income or other comprehensive income. The guidance became effective for interim or annual reporting periods that began after December 15, 2012 and was applied prospectively. The disclosures required by this guidance are included in Note 3.

In December 2011 and January 2013, the FASB issued updated guidance regarding the disclosure of recognized derivative instruments (including bifurcated embedded derivatives), repurchase agreements and securities borrowing/lending transactions that are offset in the statement of financial position or are subject to an enforceable master netting arrangement or similar agreement (irrespective of whether they are offset in the statement of financial position). This new guidance requires an entity to disclose information on both a gross and net basis about instruments and transactions within the scope of this guidance. This new guidance became effective for interim or annual reporting periods that began on or after January 1, 2013, and was applied retrospectively for all comparative periods presented. The disclosures required by this guidance are included in Note 5.

Future Adoption of New Accounting Pronouncements

In January 2014, the FASB issued updated guidance for troubled debt restructurings clarifying when an in substance repossession or foreclosure occurs, and when a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. The new guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2014. This guidance can be elected for prospective adoption or by using a modified retrospective transition method. This guidance is not expected to have a significant effect on the Company’s financial position, results of operations or financial statement disclosures.

In May 2014, the FASB issued updated guidance on accounting for revenue recognition. The guidance is based on the core principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. The guidance also requires additional disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from cost incurred to obtain or fulfill a contract. Revenue recognition for insurance contracts is explicitly scoped out of the guidance. The new guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2016, and must be applied using one of two retrospective application methods. Early adoption is not permitted. The Company is currently assessing the impact of the guidance on the Company’s financial position, results of operations and financial statement disclosures.

In August 2014, the FASB issued updated guidance for measuring the financial assets and the financial liabilities of a consolidated collateralized financing entity. Under the guidance, an entity within scope is permitted to measure both the financial assets and financial liabilities of a consolidated collateralized financing entity based on either the fair value of the financial assets or the financial liabilities, whichever is more observable. If elected, the guidance will eliminate the measurement difference that exists when both are measured at fair value. The new guidance is effective for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2015. Early adoption will be permitted. This guidance can be elected for modified retrospective or full retrospective adoption. The Company is currently assessing the impact of the guidance on the Company’s financial position, results of operations and financial statement disclosures.

In August 2014, the FASB issued guidance requiring that mortgage loans be derecognized and that a separate other receivable be recognized upon foreclosure if certain conditions are met. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The new guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2014, with early adoption permitted. This guidance can be adopted using either a prospective transition method or a modified retrospective transition method. This guidance is not expected to have a significant impact on the Company’s financial position, results of operations or financial statement disclosures.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

3.    INVESTMENTS

Fixed Maturities and Equity Securities

The following tables provide information relating to fixed maturities and equity securities (excluding investments classified as trading) as of the dates indicated:

 

				September 30, 2014
				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				$	6,331					$	-					$	22					$	6,309					$	-
Obligations of U.S. states and their political subdivisions					69,058						1,651						403						70,306						-
Foreign government bonds					25,130						6,941						-						32,071						-
Public utilities					193,968						16,641						1,455						209,154						-
All other corporate securities					1,767,282						155,548						3,659						1,919,171						-
Asset-backed securities (1)					145,579						5,736						185						151,130						(40)
Commercial mortgage-backed securities					305,077						8,641						325						313,393						-
Residential mortgage-backed securities (2)					132,403						6,133						-						138,536						(37)
Total fixed maturities, available-for-sale				$	2,644,828					$	201,291					$	6,049					$	2,840,070					$	(77)
Equity securities, available-for-sale
Common Stocks:
Public utilities				$	-					$	-					$	-					$	-
Mutual funds					14						3						-						17
Total equity securities, available-for-sale				$	14					$	3					$	-					$	17

 

(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 AOCI, which were not included in earnings. Amount excludes $0.1 million of net unrealized gains on impaired available-for-sale securities relating to changes in the value of such securities subsequent to the impairment measurement date.

 

				December 31, 2013
				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				$	6,382					$	36					$	34					$	6,384					$	-
Obligations of U.S. states and their political subdivisions					67,225						2,911						1,570						68,566						-
Foreign government bonds					25,437						5,717						-						31,154						-
Public utilities					229,807						17,048						3,190						243,665						-
All other corporate securities					2,029,720						158,360						9,103						2,178,977						-
Asset-backed securities (1)					182,888						6,513						1,509						187,892						(1,351)
Commercial mortgage-backed securities					384,764						11,387						5,518						390,633						-
Residential mortgage-backed securities (2)					152,779						5,138						972						156,945						(40)
Total fixed maturities, available-for-sale				$	3,079,002					$	207,110					$	21,896					$	3,264,216					$	(1,391)
Equity securities, available-for-sale
Common Stocks:
Public utilities				$	192					$	-					$	-					$	192
Mutual funds					14						2						-						16
Total equity securities, available-for-sale				$	206					$	2					$	-					$	208

 

(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 AOCI, which were not included in earnings. Amount excludes $1.7 million of net unrealized gains on impaired available-for-sale securities relating to changes in the value of such securities subsequent to the impairment measurement date.

 

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Table of Contents

Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

The amortized cost and fair value of fixed maturities by contractual maturities at September 30, 2014, are as follows:

 

		Available-for-Sale
		Amortized Cost				Fair Value
		(in thousands)
Due in one year or less		$	198,400			$	202,809
Due after one year through five years			918,175				978,862
Due after five years through ten years			525,352				573,982
Due after ten years			419,842				481,358
Asset-backed securities			145,579				151,130
Commercial mortgage-backed securities			305,077				313,393
Residential mortgage-backed securities			132,403				138,536
Total		$	2,644,828			$	2,840,070

Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Asset-backed, commercial mortgage-backed, and residential mortgage-backed securities are shown separately in the table above, as they are not due at a single maturity date.

The following table depicts the sources of fixed maturity proceeds and related investment gains (losses), as well as losses on impairments of both fixed maturities and equity securities:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(in thousands)
Fixed maturities, available-for-sale
Proceeds from sales		$	55,825			$	59,715			$	228,248			$	181,143
Proceeds from maturities/repayments			125,561				249,890				619,263				842,968
Gross investment gains from sales, prepayments, and maturities			4,001				6,506				8,125				14,411
Gross investment losses from sales and maturities			(102	)			(2,597	)			(3,349	)			(2,694	)
Equity securities, available-for-sale
Proceeds from sales		$	-			$	4			$	-			$	5
Gross investment gains from sales			-				2				1				2

As discussed in Note 2 to the Company’s Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2013, a portion of certain OTTI losses on fixed maturity securities is recognized in “Other comprehensive income (loss) (“OCI”)”. For these securities, the net amount recognized in earnings (“credit loss impairments”) represents the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment. Any remaining difference between the fair value and amortized cost is recognized in OCI. The following tables set forth the amount of pre-tax credit loss impairments on fixed maturity securities held by the Company as of the dates indicated, for which a portion of the OTTI loss was recognized in OCI, and the corresponding changes in such amounts.

 

		Three Months Ended September 30, 2014				Nine Months Ended September 30, 2014
		(in thousands)
Balance, beginning of period		$	103			$	1,800
Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period			(2)				(1,679)
Increases due to the passage of time on previously recorded credit losses			-				-
Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected			(1)				(21)
Balance, end of period		$	100			$	100

 

		Three Months Ended September 30, 2013				Nine Months Ended September 30, 2013
		(in thousands)
Balance, beginning of period		$	1,749			$	3,381
Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period			(6)				(1,625)
Increases due to the passage of time on previously recorded credit losses			32				87
Accretion of credit loss impairments previously recognized due to an increase in cash flows expected to be collected			-				(68)
Balance, end of period		$	1,775			$	1,775

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

Trading Account Assets

The following table sets forth the composition of “Trading account assets” as of the dates indicated:

 

		September 30, 2014								December 31, 2013
		Cost				Fair Value				Cost				Fair Value
		(in thousands)
Total trading account assets—Equity securities		$	5,185			$	6,022			$	5,164			$	6,677

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 $(0.2) million and $0.3 million during the three months ended September 30, 2014 and 2013, respectively, and $(0.7) million and $0.7 million during the nine months ended September 30, 2014 and 2013, respectively.

Commercial Mortgage and Other Loans

The Company’s commercial mortgage and other loans are comprised as follows, as of the dates indicated:

 

		September 30, 2014												December 31, 2013
		Amount (in thousands)						% of Total						Amount (in thousands)						% of Total
Commercial and agricultural mortgage loans by property type:
Apartments/Multi-Family		$	136,875						33.3	%				$	125,045						31.5	%
Industrial			85,048						20.7						88,009						22.1
Retail			71,158						17.3						72,325						18.2
Office			44,301						10.8						40,976						10.3
Other			14,177						3.4						13,796						3.5
Hospitality			5,099						1.3						5,133						1.3
Total commercial mortgage loans			356,658						86.8						345,284						86.9
Agricultural property loans			54,462						13.2						52,223						13.1
Total commercial and agricultural mortgage loans by property type			411,120						100.0	%					397,507						100.0	%
Valuation allowance			(530)												(1,256)
Total net commercial and agricultural mortgage loans by property type			410,590												396,251
Other Loans
Uncollateralized loans			2,740												2,740
Total other loans			2,740												2,740
Total commercial mortgage and other loans		$	413,330											$	398,991

The commercial mortgage and agricultural property loans are geographically dispersed throughout the United States with the largest concentrations in California (17%), Texas (12%) and Ohio (8%) at September 30, 2014.

Activity in the allowance for credit losses for all commercial mortgage and other loans, for the periods indicated, is as follows:

 

		September 30, 2014						December 31, 2013
		(in thousands)
Allowance for credit losses, beginning of year		$	1,256					$	2,177
Addition to / (release of) allowance for losses			(726)						(921)
Total ending balance (1)		$	530					$	1,256

 

(1)	Agricultural loans represent less than $0.1 million of the ending allowance at both September 30, 2014 and December 31, 2013.

The following tables set forth the allowance for credit losses and the recorded investment in commercial mortgage and other loans as of the dates indicated:

 

		September 30, 2014						December 31, 2013
		(in thousands)
Allowance for Credit Losses:
Ending balance: individually evaluated for impairment (1)		$	-					$	-
Ending balance: collectively evaluated for impairment (2)			530						1,256
Total ending balance		$	530					$	1,256

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		September 30, 2014						December 31, 2013
		(in thousands)
Recorded Investment (3):
Ending balance gross of reserves: individually evaluated for impairment (1)		$	-					$	-
Ending balance gross of reserves: collectively evaluated for impairment (2)			413,860						400,247
Total ending balance, gross of reserves		$	413,860					$	400,247

 

(1)	There were no loans individually evaluated for impairments at both September 30, 2014 and December 31, 2013.

(2)

Agricultural loans collectively evaluated for impairment had a recorded investment of $54 million and $52 million for the periods ending September 30, 2014 and December 31, 2013, respectively, and a related allowance of less than $0.1 million for both periods. Uncollateralized loans collectively evaluated for impairment had a recorded investment of $3 million at both September 30, 2014 and December 31, 2013 and no related allowance for both periods.

(3)	Recorded investment reflects the balance sheet carrying value gross of related allowance.

Impaired loans include those loans for which it is probable that all amounts due will not be collected according to the contractual terms of the loan agreement. There were no impaired commercial mortgage and other loans identified in management’s specific review of probable loan losses and no related allowance for losses at both September 30, 2014 and December 31, 2013. There were no recorded investments in impaired loans with an allowance recorded, before the allowance for losses, at both September 30, 2014 and December 31, 2013.

Impaired commercial mortgage and other loans with no allowance for losses are loans in which the fair value of the collateral or the net present value of the loans’ expected future cash flows equals or exceeds the recorded investment. The Company had no such loans at both September 30, 2014 and December 31, 2013. See Note 2 to the Company’s Financial Statements included in its Annual Report on Form 10-K for the year ended December 31, 2013, for information regarding the Company’s accounting policies for non-performing loans.

The following table sets forth certain key credit quality indicators as of September 30, 2014, based upon the recorded investment gross of allowance for credit losses.

Total commercial and agricultural mortgage loans

 

		Debt Service Coverage Ratio - September 30, 2014
		Greater than 1.2X				1.0X to <1.2X				Less than 1.0X				Total
		(in thousands)
Loan-to-Value Ratio
0%-59.99%		$	255,219			$	3,658			$	2,916			$	261,793
60%-69.99%			118,722				-				-				118,722
70%-79.99%			29,136				1,469				-				30,605
Greater than 80%			-				-				-				-
Total commercial and agricultural mortgage loans		$	403,077			$	5,127			$	2,916			$	411,120

The following table sets forth certain key credit quality indicators as of December 31, 2013, based upon the recorded investment gross of allowance for credit losses.

Total commercial and agricultural mortgage loans

 

		Debt Service Coverage Ratio - December 31, 2013
		Greater than 1.2X				1.0X to <1.2X				Less than 1.0X				Total
		(in thousands)
Loan-to-Value Ratio
0%-59.99%		$	251,278			$	7,650			$	1,865			$	260,793
60%-69.99%			102,755				-				-				102,755
70%-79.99%			31,712				2,247				-				33,959
Greater than 80%			-				-				-				-
Total commercial and agricultural mortgage loans		$	385,745			$	9,897			$	1,865			$	397,507

As of both September 30, 2014 and December 31, 2013, all commercial mortgage and other loans were in current status. The Company defines current in its aging of past due commercial mortgage and other loans as less than 30 days past due.

There were no commercial mortgage and other loans in nonaccrual status as of both September 30, 2014 and December 31, 2013. Nonaccrual loans are those on which the accrual of interest has been suspended after the loans become 90 days delinquent as to principal or interest payments, or earlier when the Company has doubts about collectability and loans for which a loan-specific reserve has been established. See Note 2 to the Company’s Financial Statements included in its Annual Report on Form 10-K for the year ended December 31, 2013, for further discussion regarding nonaccrual status loans.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

For the three and nine months ended both September 30, 2014 and 2013, there were no new commercial mortgage and other loans acquired, other than those through direct origination.

The Company’s commercial mortgage and other loans may occasionally be involved in a troubled debt restructuring. As of both September 30, 2014 and December 31, 2013, the Company had no significant commitments to fund to borrowers that have been involved in a troubled debt restructuring. During the three and nine months ended both September 30, 2014 and 2013, there were no new troubled debt restructurings related to commercial mortgage and other loans, and no payment defaults on commercial mortgage and other loans that were modified as a troubled debt restructuring within the 12 months preceding each respective period. For additional information relating to the accounting for troubled debt restructurings, see Note 2 to the Company’s Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2013.

Net Investment Income

Net investment income for the three and nine months ended September 30, 2014 and 2013, was from the following sources:

 

		Three Months Ended September 30,										Nine Months Ended September 30,
		2014				2013						2014				2013
		(in thousands)
Fixed maturities, available-for-sale		$	33,864			$	45,868					$	108,045			$	148,402
Trading account assets			1				76						31				137
Commercial mortgage and other loans			5,199				6,075						16,601				22,478
Policy loans			155				176						505				515
Short-term investments			64				77						194				255
Other long-term investments			1,538				754						4,329				2,183
Gross investment income			40,821				53,026						129,705				173,970
Less: investment expenses			(1,428)				(1,705)						(4,353)				(5,176)
Net investment income		$	39,393			$	51,321					$	125,352			$	168,794

Realized Investment Gains (Losses), Net 

Realized investment gains (losses), net, for the three and nine months ended September 30, 2014 and 2013, were from the following sources:

 

		Three Months Ended September 30,										Nine Months Ended September 30,
		2014				2013						2014				2013
		(in thousands)
Fixed maturities		$	3,899			$	3,908					$	4,776			$	11,716
Equity securities			-				1						1				2
Commercial mortgage and other loans			725				52						725				420
Derivatives			(5,547)				(72,935)						(10,791)				(162,600)
Other			-				(6)						-				(29)
Realized investment gains (losses), net		$	(923)			$	(68,980)					$	(5,289)			$	(150,491)

Accumulated Other Comprehensive Income (Loss)

The balance of and changes in each component of “Accumulated other comprehensive income (loss)” for the nine months ended September 30, 2014 and 2013 are as follows:

 

		Accumulated Other Comprehensive Income (Loss)
		Foreign Currency Translation Adjustment				Net Unrealized Investment Gains (Losses) (1)				Total Accumulated Other Comprehensive Income (Loss)
		(in thousands)
Balance, December 31, 2013		$	10			$	70,857			$	70,867
Change in other comprehensive income before reclassifications			(33)				23,390				23,357
Amounts reclassified from AOCI			-				(4,776)				(4,776)
Income tax benefit (expense)			12				(6,516)				(6,504)
Balance, September 30, 2014		$	(11)			$	82,955			$	82,944

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		Accumulated Other Comprehensive Income (Loss)
		Foreign Currency Translation Adjustment				Net Unrealized Investment Gains (Losses) (1)				Total Accumulated Other Comprehensive Income (Loss)
		(in thousands)
Balance, December 31, 2012		$	7			$	147,280			$	147,287
Change in other comprehensive income before reclassifications			-				(92,502)				(92,502)
Amounts reclassified from AOCI			-				(11,718)				(11,718)
Income tax benefit (expense)			-				36,477				36,477
Balance, September 30, 2013		$	7			$	79,537			$	79,544

 

(1)	Includes cash flow hedges of $(1.0) million and $(4.0) million as of September 30, 2014 and December 31, 2013, respectively, and $(4.0) million and $(3.0) million as of September 30, 2013 and December 31, 2012, respectively.

Reclassifications out of Accumulated Other Comprehensive Income (Loss)

 

		Three Months Ended September 30, 2014						Nine Months Ended September 30, 2014
		(in thousands)
Amounts reclassified from AOCI (1)(2):
Net unrealized investment gains (losses):
Cash flow hedges—Currency/Interest rate (3)		$	77					$	43
Net unrealized investment gains (losses) on available-for-sale securities			3,822						4,733
Total net unrealized investment gains (losses) (4)			3,899						4,776
Total reclassifications for the period		$	3,899					$	4,776

 

(1)	All amounts are shown before tax.

(2)	Positive amounts indicate gains/benefits reclassified out of AOCI. Negative amounts indicate losses/costs reclassified out of AOCI.

(3)	See Note 5 for additional information on cash flow hedges.

(4)	See table below for additional information on unrealized investment gains (losses), including the impact on deferred policy acquisition and other costs and future policy benefits.

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 Company’s Unaudited Interim Statements of Financial Position as a component of AOCI. Changes in these amounts include reclassification adjustments to exclude from “Other comprehensive income (loss)” those items that are included as part of “Net income” for a period that had been part of “Other comprehensive income (loss)” in earlier periods. The amounts for the periods indicated below, split between amounts related to fixed maturity securities on which an OTTI loss has been recognized, and all other net unrealized investment gains and losses, are as follows:

Net Unrealized Investment Gains and Losses on Fixed Maturity Securities on which an OTTI loss has been recognized

 

				Net Unrealized Gains (Losses) on Investments (1)						Deferred Policy Acquisition Costs and Other Costs						Future Policy Benefits						Deferred Income Tax (Liability) Benefit						Accumulated Other Comprehensive Income (Loss) Related to  Net Unrealized Investment Gains (Losses)
				(in thousands)
Balance, December 31, 2013				$	323					$	(116)					$	(14)					$	(51)					$	142
Net investment gains (losses) on investments arising during the period					5						-						-						(2)						3
Reclassification adjustment for (gains) losses included in net income					(297)						-						-						104						(193)
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs and other costs					-						106						-						(37)						69
Impact of net unrealized investment (gains) losses on future policy benefits					-						-						13						(4)						9
Balance, September 30, 2014				$	31					$	(10)					$	(1)					$	10					$	30

 

(1)	Includes cash flow hedges. See Note 5 for information on cash flow hedges.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

All Other Net Unrealized Investment Gains and Losses in AOCI

 

				Net Unrealized Gains (Losses) on Investments (1)						Deferred Policy Acquisition Costs and Other Costs						Future Policy Benefits						Deferred Income Tax (Liability) Benefit						Accumulated Other Comprehensive Income (Loss) Related To  Net Unrealized Investment Gains (Losses)
				(in thousands)
Balance, December 31, 2013				$	184,727					$	(66,452)					$	(8,187)					$	(39,363)					$	70,725
Net investment gains (losses) on investments arising during the period					18,888						-						-						(6,618)						12,270
Reclassification adjustment for (gains) losses included in net income					(4,479)						-						-						1,566						(2,913)
Impact of net unrealized investment (gains) losses on deferred policy acquisition costs and other costs					-						4,690						-						(1,643)						3,047
Impact of net unrealized investment (gains) losses on future policy benefits					-						-						(311)						107						(204)
Balance, September 30, 2014				$	199,136					$	(61,762)					$	(8,498)					$	(45,951)					$	82,925

 

(1)	Includes cash flow hedges. See Note 5 for information on cash flow hedges.

Net Unrealized Gains (Losses) on Investments by Asset Class

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

 

				September 30, 2014						December 31, 2013
				(in thousands)
Fixed maturity securities on which an OTTI loss has been recognized				$	31					$	323
Fixed maturity securities, available-for-sale—all other					195,211						184,891
Equity securities, available-for-sale					3						2
Affiliated notes					2,541						3,113
Derivatives designated as cash flow hedges (1)					1,004						(3,653)
Other investments					377						374
Net unrealized gains (losses) on investments				$	199,167					$	185,050

 

(1)	See Note 5 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:

 

		September 30, 2014
		Less than twelve months								Twelve months or more								Total
		Fair Value				Gross   Unrealized   Losses				Fair Value				Gross   Unrealized   Losses				Fair Value				Gross   Unrealized   Losses
		(in thousands)
Fixed maturities, available-for-sale
U.S. Treasury securities and obligations of U.S. government authorities and agencies		$	4,676			$	6			$	1,519			$	16			$	6,195			$	22
Obligations of U.S. States and their political subdivisions			-				-				6,937				403				6,937				403
Public utilities			36,553				1,234				3,390				221				39,943				1,455
All other corporate securities			272,038				3,049				16,393				610				288,431				3,659
Asset-backed securities			9,493				4				30,927				181				40,420				185
Commercial mortgage-backed securities			10,068				26				7,178				299				17,246				325
Residential mortgage-backed securities			-				-				-				-				-				-
Total		$	332,828			$	4,319			$	66,344			$	1,730			$	399,172			$	6,049
Equity securities, available-for-sale		$	-			$	-			$	-			$	-			$	-			$	-

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		December 31, 2013
		Less than twelve months								Twelve months or more								Total
		Fair Value				Gross   Unrealized   Losses				Fair Value				Gross   Unrealized   Losses				Fair Value				Gross   Unrealized   Losses
		(in thousands)
Fixed maturities, available-for-sale
U.S. Treasury securities and obligations of U.S. government authorities and agencies		$	3,347			$	34			$	-			$	-			$	3,347			$	34
Obligations of U.S. States and their political subdivisions			5,420				588				6,402				982				11,822				1,570
Public utilities			61,251				3,190				-				-				61,251				3,190
All other corporate securities			290,055				8,733				2,704				370				292,759				9,103
Asset-backed securities			97,575				1,509				-				-				97,575				1,509
Commercial mortgage-backed securities			86,132				5,249				2,941				269				89,073				5,518
Residential mortgage-backed securities			100,150				972				-				-				100,150				972
Total		$	643,930			$	20,275			$	12,047			$	1,621			$	655,977			$	21,896
Equity securities, available-for-sale		$	-			$	-			$	-			$	-			$	-			$	-

The gross unrealized losses on fixed maturity securities at September 30, 2014 and December 31, 2013, are composed of $3.0 million and $20.4 million, respectively, related to high or highest quality securities based on the National Association of Insurance Commissioners (“NAIC”) or equivalent rating and $3.0 million and $1.5 million, respectively, related to other than high or highest quality securities based on NAIC or equivalent rating. At September 30, 2014, the $1.7 million of gross unrealized losses of twelve months or more were concentrated in U.S. obligations, commercial mortgage-backed securities, and the consumer non-cyclical and utility sectors of the Company’s corporate securities. At December 31, 2013, the $1.6 million of gross unrealized losses of twelve months or more were concentrated in U.S. obligations and the consumer non-cyclical sector of the Company’s corporate securities.

In accordance with its policy described in Note 2 to the Company’s Financial Statements included in its 2013 Annual Report on Form 10-K, the Company concluded that an adjustment to earnings for other-than-temporary impairments for these securities was not warranted at September 30, 2014 or December 31, 2013. 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 September 30, 2014, the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities before the anticipated recovery of its remaining amortized cost basis.

4.    FAIR VALUE OF ASSETS AND LIABILITIES

Fair Value Measurement – Fair value represents 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 fair value guidance establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. 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. The Company’s Level 1 assets and liabilities primarily include short term investments and equity securities that trade on an active exchange market.

Level 2 - Fair value is based on significant inputs, other than quoted prices included in Level 1, that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets and liabilities, quoted market prices in markets that are not active for identical or similar assets or liabilities, and other market observable inputs. The Company’s Level 2 assets and liabilities include: fixed maturities (corporate public and private bonds, most government securities, certain asset-backed and mortgage-backed securities, etc.), certain equity securities (mutual funds, which do not actively trade and are priced based on a net asset value), certain short term investments and certain over-the-counter derivatives.

Level 3 - Fair value is based on at least one or more significant unobservable inputs for the asset or liability. The assets and liabilities in this category may require significant judgment or estimation in determining the fair value. 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.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

Assets and Liabilities by Hierarchy Level – The tables below present the balances of assets and liabilities reported at fair value on a recurring basis, as of the dates indicated.

 

		As of September 30, 2014
		Level 1				Level 2				Level 3				Netting (1)				Total
		(in thousands)
Fixed maturities, available-for-sale:
U.S Treasury securities and obligations of U.S. government authorities and agencies		$	-			$	6,309			$	-			$	-			$	6,309
Obligations of U.S. states and their political subdivisions			-				70,306				-				-				70,306
Foreign government bonds			-				32,071				-				-				32,071
Corporate securities			-				2,024,379				103,946				-				2,128,325
Asset-backed securities			-				88,230				62,900				-				151,130
Commercial mortgage-backed securities			-				306,323				7,070				-				313,393
Residential mortgage-backed securities			-				138,536				-				-				138,536
Sub-total			-				2,666,154				173,916				-				2,840,070
Trading account assets:
Equity securities			6,022				-				-				-				6,022
Sub-total			6,022				-				-				-				6,022
Equity securities, available-for-sale			-				17				-				-				17
Short-term investments			174,415				-				-				-				174,415
Cash equivalents			-				-				400				-				400
Other long-term investments			-				98,495				628				(53,827)				45,296
Reinsurance recoverables			-				-				2,231,480				-				2,231,480
Receivables from parent and affiliates			-				21,459				22,526				-				43,985
Sub-total excluding separate account assets			180,437				2,786,125				2,428,950				(53,827)				5,341,685
Separate account assets (2)			945,742				43,523,499				-				-				44,469,241
Total assets		$	1,126,179			$	46,309,624			$	2,428,950			$	(53,827)			$	49,810,926
Future policy benefits (3)		$	-			$	-			$	2,316,741			$	-			$	2,316,741
Payables to parent and affiliates			-				45,712				-				(45,712)				0
Total liabilities		$	-			$	45,712			$	2,316,741			$	(45,712)			$	2,316,741
		As of December 31, 2013
		Level 1				Level 2				Level 3				Netting (1)				Total
		(in thousands)
Fixed maturities, available-for-sale:
U.S Treasury securities and obligations of U.S. government authorities and agencies		$	-			$	6,384			$	-			$	-			$	6,384
Obligations of U.S. states and their political subdivisions			-				68,566				-				-				68,566
Foreign government securities			-				31,154				-				-				31,154
Corporate securities			-				2,325,846				96,796				-				2,422,642
Asset-backed securities			-				124,103				63,789				-				187,892
Commercial mortgage-backed securities			-				390,633				-				-				390,633
Residential mortgage-backed securities			-				156,945				-				-				156,945
Sub-total			-				3,103,631				160,585				-				3,264,216
Trading account assets:
Equity securities			6,364				-				313				-				6,677
Sub-total			6,364				-				313				-				6,677
Equity securities, available-for-sale			-				16				192				-				208
Short-term investments			118,188				-				-				-				118,188
Other long-term investments			-				73,535				486				(73,535)				486
Reinsurance recoverables			-				-				748,005				-				748,005
Receivables from parent and affiliates			-				19,071				6,347				-				25,418
Sub-total excluding separate account assets			124,552				3,196,253				915,928				(73,535)				4,163,198
Separate account assets (2)			1,190,903				45,435,925				-				-				46,626,828
Total assets		$	1,315,455			$	48,632,178			$	915,928			$	(73,535)			$	50,790,026
Future policy benefits (3)		$	-			$	-			$	778,226			$	-			$	778,226
Payables to parent and affiliates			-				94,580				-				(72,822)				21,758
Total liabilities		$	-			$	94,580			$	778,226			$	(72,822)			$	799,984

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

(1)	“Netting” amounts represent cash collateral of $8.1 million and $0.7 million as of September 30, 2014 and December 31, 2013, respectively, and the impact of offsetting asset and liability positions held with the same counterparty, subject to master netting arrangements.

(2)

Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Unaudited Interim Statements of Financial Position.

(3)

As of September 30, 2014, the net embedded derivative liability position of $2,317 million includes $94 million of embedded derivatives in an asset position and $2,411 million of embedded derivatives in a liability position. As of December 31, 2013, the net embedded derivative liability position of $778 million includes $245 million of embedded derivatives in an asset position and $1,023 million of embedded derivatives in a liability position.

The methods and assumptions the Company uses to estimate the fair value of assets and liabilities measured at fair value on a recurring basis are summarized below.

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 for each security are generally sourced from multiple pricing vendors, and a vendor hierarchy is maintained by asset type based on historical pricing experience and vendor expertise. The Company ultimately uses the price from the pricing service highest in the vendor hierarchy based on the respective asset type. The pricing hierarchy is updated for new financial products and recent pricing experience. 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 deemed 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 or classify the security as Level 3. If the pricing service updates the price to be more consistent with the presented market observations, the security remains within Level 2.

Internally-developed valuations or indicative broker quotes are also used to determine fair value in circumstances where vendor pricing is not available, or where the Company ultimately concludes that pricing information received from the independent pricing service is not reflective of market activity. If the Company concludes the values from both pricing services and brokers are not reflective of market activity, it may override the information with an internally developed valuation. As of September 30, 2014 and December 31, 2013 overrides on a net basis were not material. Pricing service overrides, internally developed valuations and indicative broker quotes are generally included in Level 3 in the fair value hierarchy.

The fair value of private fixed maturities, which are comprised of investments in private placement securities, originated by internal private asset managers, are primarily determined using a discounted cash flow model. If the fair value is determined using pricing inputs that are observable in the market, the securities have been reflected within Level 2; otherwise a Level 3 classification is used.

Trading Account Assets – Trading account assets consist primarily of equity securities whose fair values are determined consistent with similar instruments described below under “Equity Securities.”

Equity Securities – Equity securities consist principally of investments in common stock of publicly traded companies, perpetual preferred stock, privately traded securities, as well as mutual fund shares. The fair values of most publicly traded equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value hierarchy. Estimated fair values for most privately traded equity securities are determined using discounted cash flow, earnings multiple and other valuation models that require a substantial level of judgment around inputs and therefore are classified within Level 3. The fair values of mutual fund shares that transact regularly (but do not trade in active markets because they are not publicly available) are based on transaction prices of identical fund shares and are classified within Level 2 in the fair value hierarchy. The fair values of perpetual preferred stock are based on inputs obtained from independent pricing services that are primarily based on indicative broker quotes. As a result, the fair values of perpetual preferred stock are classified as Level 3.

Derivative Instruments – Derivatives are recorded at fair value either as assets, within “Other long-term investments,” or as liabilities, within “Payables to parent and affiliates,” except for embedded derivatives which are recorded with the associated host contract. 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 (“NPR”), liquidity and other factors. Liquidity valuation adjustments are made to reflect the cost of exiting significant risk positions, and consider the bid-ask spread, maturity, complexity, and other specific attributes of the underlying derivative position.

The majority of the Company’s derivative positions are traded in the over-the-counter (“OTC”) derivative market and are classified within Level 2 in the fair value hierarchy. OTC derivatives classified within Level 2 are valued using models that utilize actively quoted or observable market input values from external market data providers, third-party pricing vendors and/or recent trading activity. The Company’s policy is to use mid-market pricing in determining its best estimate of fair value. The fair values of most OTC derivatives, including interest rate and cross currency swaps and single name credit default swaps are determined using discounted cash flow models. The fair values of European style option contracts are determined using Black-Scholes option pricing models. These models’ key inputs include the contractual terms of the respective contract, along with significant observable inputs, including interest rates, currency rates, credit spreads, equity prices, index dividend yields, NPR, volatility, and other factors.

The Company’s cleared interest rate swaps and credit derivatives linked to an index are valued using models that utilize actively quoted or observable market inputs, including Overnight Indexed Swap discount rates, obtained from external market data providers, third-party pricing vendors, and/or recent trading activity. These derivatives are classified as Level 2 in the fair value hierarchy.

To reflect the market’s perception of its own and the counterparty’s NPR, the Company incorporates additional spreads over LIBOR into the discount rate used in determining the fair value of OTC derivative assets and liabilities that are not otherwise collateralized.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

Derivatives classified as Level 3 include structured products. These derivatives are valued based upon models, such as Monte Carlo simulation models and other techniques, that utilize significant unobservable inputs. Level 3 methodologies are validated through periodic comparison of the Company’s fair values to external broker-dealer values. As of September 30, 2014 and December 31, 2013, there were no internally valued derivatives with the fair value classified within Level 3, and all other derivatives were classified within Level 2. See Note 5 for more details on the fair value of derivative instruments by primary underlying.

Short-Term Investments – Short-term investments include money market instruments and other highly liquid debt instruments. Certain money market instruments are valued using unadjusted quoted prices in active markets that are accessible for identical assets and are primarily classified as Level 1.

Separate Account Assets – Separate account assets include fixed maturity securities, treasuries, and equity securities for which values are determined consistent with similar instruments described above under “Fixed Maturity Securities” and “Equity Securities.”

Receivables from Parent and Affiliates – Receivables from Parent and Affiliates carried at fair value include affiliated bonds within the Company’s 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 the Company’s living benefit guarantees on certain of its variable annuity contracts. These guarantees are accounted for as 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 living benefit guarantees.

Future Policy Benefits – The liability for future policy benefits primarily includes general account liabilities for the optional living benefit features of the Company’s variable annuity contracts, including guaranteed minimum accumulation benefits (“GMAB”), guaranteed minimum withdrawal benefits (“GMWB”) and guaranteed minimum income and withdrawal benefits (“GMIWB”), accounted for as embedded derivatives. The fair values of the GMAB, GMWB, and GMIWB liabilities are calculated as the present value of future expected benefit payments to contractholders less the present value of assessed rider fees attributable to the optional living benefit feature. This methodology could result in either a liability or contra-liability balance, given changing capital market conditions and various actuarial assumptions. Since there is no observable active market for the transfer of these obligations, the valuations are calculated using internally developed models with option pricing techniques. The models are based on a risk neutral valuation framework and incorporate premiums for risks inherent in valuation techniques, inputs, and the general uncertainty around the timing and amount of future cash flows. The determination of these risk premiums requires the use of management judgment.

The significant inputs to the valuation models for these embedded derivatives include capital market assumptions, such as interest rate levels and volatility assumptions, the Company’s market-perceived NPR, as well as actuarially determined assumptions, including contractholder behavior, such as lapse rates, benefit utilization rates, withdrawal rates, and mortality rates. Since many of these assumptions 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.

Capital market inputs and actual policyholders’ account values are updated each quarter based on capital market conditions as of the end of the quarter, including interest rates, equity markets, and volatility. In the risk neutral valuation, the initial swap curve drives the total return used to grow the policyholders’ account value. The Company’s discount rate assumption is based on the LIBOR swap curve, adjusted for an additional spread relative to LIBOR to reflect NPR.

Actuarial assumptions, including contractholder behavior and mortality, are reviewed at least annually, and updated based upon emerging experience, future expectations, and other data, including any observable market data. These assumptions are generally updated in the third quarter of each year unless a material change that the Company feels is indicative of a long term trend is observed in an interim period.

Transfers between Levels 1 and 2 – Transfers between levels are generally reported at the values as of the beginning of the period in which the transfers occur. Periodically there are transfers between Level 1 and Level 2 for assets held in the Company’s Separate Account. The classification of Separate Account funds may vary dependent on the availability of information to the public. Should a fund’s net asset value become publicly observable, the fund would be transferred from Level 2 to Level 1. During the nine months ended September 30, 2014, $7 million was transferred from Level 1 to Level 2. During both the three months ended September 30, 2014 and the three and nine months ended June 30, 2013, there were no transfers between Level 1 and Level 2.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

Level 3 Assets and Liabilities by Price Source – The tables below present the balances of Level 3 assets and liabilities measured at fair value with their corresponding pricing sources.

 

		As of September 30, 2014
		Internal (1)				External (2)				Total
		(in thousands)
Corporate securities		$	102,067			$	1,879			$	103,946
Asset-backed securities			-				62,900				62,900
Commercial mortgage-backed securities			-				7,070				7,070
Cash equivalents			400				-				400
Other long-term investments			-				628				628
Reinsurance recoverables			2,231,480				-				2,231,480
Receivables from parent and affiliates			-				22,526				22,526
Total assets		$	2,333,947			$	95,003			$	2,428,950
Future policy benefits			2,316,741				-				2,316,741
Total liabilities		$	2,316,741			$	-			$	2,316,741
		As of December 31, 2013
		Internal (1)				External (2)				Total
		(in thousands)
Corporate securities		$	94,730			$	2,066			$	96,796
Asset-backed securities			-				63,789				63,789
Equity securities			192				313				505
Other long-term investments			-				486				486
Reinsurance recoverables			748,005				-				748,005
Receivables from parent and affiliates			-				6,347				6,347
Total assets		$	842,927			$	73,001			$	915,928
Future policy benefits			778,226				-				778,226
Total liabilities		$	778,226			$	-			$	778,226

 

(1)	Represents valuations reflecting both internally-derived and market inputs. See below for additional information related to internally-developed valuation for significant items in the above table.

(2)	Represents unadjusted prices from independent pricing services and independent indicative broker quotes where pricing inputs are not readily available.

Quantitative Information Regarding Internally Priced Level 3 Assets and Liabilities – The tables below present quantitative information on significant internally-priced Level 3 assets and liabilities (see narrative below for quantitative information for separate account assets).

 

		As of September 30, 2014
		Fair     Value				Primary Valuation     Techniques		Unobservable     Inputs		Minimum				Maximum				Weighted     Average				Impact of Increase in     Input on Fair     Value (1)
		(in thousands)
Assets:
Corporate securities		$	102,067			Discounted cash flow		Discount rate			3.59	%			11.35	%			3.99	%			Decrease
Reinsurance recoverables		$	2,231,480			Fair values are determined in the same manner as future policy benefits
Liabilities:
Future policy benefits (2)		$	2,316,741			Discounted cash flow		Lapse rate (3)			0	%			14	%							Decrease
								NPR spread (4)			0.04	%			1.14	%							Decrease
								Utilization rate (5)			63	%			95	%							Increase
								Withdrawal rate (6)			74	%			100	%							Increase
								Mortality rate (7)			0	%			14	%							Decrease
								Equity Volatility curve			16	%			28	%							Increase

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		As of December 31, 2013
		Fair     Value				Primary Valuation     Techniques		Unobservable     Inputs		Minimum				Maximum				Weighted     Average				Impact of Increase in     Input on Fair     Value (1)
		(in thousands)
Assets:
Corporate securities		$	94,730			Discounted cash flow		Discount rate			3.73	%			12.06	%			3.90	%			Decrease
Reinsurance recoverables		$	748,005			Fair values are determined in the same manner as future policy benefits
Liabilities:
Future policy benefits (2)		$	778,226			Discounted cash flow		Lapse rate (3)			0	%			11	%							Decrease
								NPR spread (4)			0.08	%			1.09	%							Decrease
								Utilization rate (5)			70	%			94	%							Increase
								Withdrawal rate (6)			86	%			100	%							Increase
								Mortality rate (7)			0	%			13	%							Decrease
								Equity Volatility curve			15	%			28	%							Increase

 

(1)	Conversely, the impact of a decrease in input would have the opposite impact for the fair value as that presented in the table.

(2)

Future policy benefits primarily represent general account liabilities for the optional living benefit features of the Company’s variable annuity contracts which are accounted for as embedded derivatives. Since the valuation methodology for these liabilities uses a range of inputs that vary at the contract level over the cash flow projection period, presenting a range, rather than weighted average, is a more meaningful representation of the unobservable inputs used in the valuation.

(3)

Lapse rates are adjusted at the contract level based on a the in-the-moneyness of the living benefit, and reflect other factors, such as the applicability of any surrender charges. Lapse rates are reduced when contracts are more in-the-money. Lapse rates are also generally assumed to be lower for the period where surrender charges apply.

(4)

To reflect NPR, the Company incorporates an additional spread over LIBOR into the discount rate used in the valuation of individual living benefit contracts in a liability position and generally not to those in a contra-liability position. The NPR spread reflects the financial strength ratings of the Company, as these are insurance liabilities and senior to debt. The additional spread over LIBOR is determined by utilizing the credit spreads associated with issuing funding agreements adjusted for any illiquidity risk premium.

(5)

The utilization rate assumption estimates the percentage of contracts that will utilize the benefit during the contract duration, and begin lifetime withdrawals at various time intervals from contract inception. The remaining contractholders are assumed to either begin lifetime withdrawals immediately or never utilize the benefit. Utilization assumptions may vary by product type, tax status, and age. The impact of changes in these assumptions is highly dependent on the product type, the age of the contractholder at the time of the sale, and the timing of the first lifetime income withdrawal.

(6)

The withdrawal rate assumption estimates the magnitude of annual contractholder withdrawals relative to the maximum allowable amount under the contract. These assumptions may vary based on the product type, contractholder, age, tax status, and withdrawal timing. The fair value of the liability will generally increase the closer the withdrawal rate is to 100%.

(7)

Range reflects the mortality rate for the vast majority of business with living benefits, with policyholders ranging from 35 to 90 years old. While the majority of living benefits have a minimum age requirement, certain benefits do not have an age restriction. This results in contractholders for certain benefits with mortality rates approaching 0%. Based on historical experience, the Company applies a set of age and duration specific mortality rate adjustments compared to standard industry tables. A mortality improvement assumption is also incorporated into the overall mortality table.

Interrelationships Between Unobservable Inputs – In addition to the sensitivities of fair value measurements to changes in each unobservable input in isolation, as reflected in the table above, interrelationships between these inputs may also exist, such that a change in one unobservable input may give rise to a change in another, or multiple, inputs. Examples of such interrelationships for significant internally-priced Level 3 assets and liabilities are as follows:

Corporate Securities – The rate used to discount future cash flows reflects current risk-free rates plus credit and liquidity spread requirements that market participants would use to value an asset. The discount rate may be influenced by many factors, including market cycles, expectations of default, collateral, term, and asset complexity. Each of these factors can influence discount rates, either in isolation, or in response to other factors.

Future Policy Benefits – The Company expects efficient benefit utilization and withdrawal rates to generally be correlated with lapse rates. However, behavior is generally highly dependent on the facts and circumstances surrounding the individual contractholder, such as their liquidity needs or tax situation, which could drive lapse behavior independent of other contractholder behavior assumptions. To the extent more efficient contractholder behavior results in greater in-the-moneyness at the contract level, lapse rates may decline for those contracts. Similarly, to the extent that increases in equity volatility are correlated with overall declines in the capital markets, lapse rates may decline as contracts become more in-the-money.

Valuation Process for Fair Value Measurements Categorized within Level 3 – The Company has established an internal control infrastructure over the valuation of financial instruments that requires ongoing oversight by its various Business Groups. These management control functions are segregated from the trading and investing functions. For invested assets, the Company has established oversight teams, often in the form of Pricing Committees within each asset management group. The teams, which typically include representation from investment, accounting, operations, legal and other disciplines are responsible for overseeing and monitoring the pricing of the Company’s investments and performing periodic due diligence reviews of independent pricing services. An actuarial valuation team oversees the valuation of optional living benefit features of the Company’s variable annuity contracts.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

The Company has also established policies and guidelines that require the establishment of valuation methodologies and consistent application of such methodologies. These policies and guidelines govern the use of inputs and price source hierarchies and provide controls around the valuation processes. These controls include appropriate review and analysis of investment prices against market activity or indicators of reasonableness, approval of price source changes, price overrides, methodology changes and classification of fair value hierarchy levels. For optional living benefit features of the Company’s variable annuity products, the actuarial valuation unit periodically performs baseline testing of contract input data and actuarial assumptions are reviewed at least annually, and updated based upon emerging experience, future expectations and other data, including any observable market data. The valuation policies and guidelines are reviewed and updated as appropriate.

Within the trading and investing functions, the Company has established policies and procedures that relate to the approval of all new transaction types, transaction pricing sources and fair value hierarchy coding within the financial reporting system. For variable annuity product changes or new launches of optional living benefit features, the actuarial valuation unit validates input logic and new product features and agrees new input data directly to source documents.

Changes in Level 3 assets and liabilities – The following tables provide summaries of the changes in fair values of Level 3 assets and liabilities as of the dates indicated, as well as the portion of gains or losses included in income attributable to unrealized gains or losses related to those assets and liabilities still held at the end of their respective periods.

 

		Three Months Ended September 30, 2014
		Fixed Maturities Available-For-Sale
		Corporate Securities						Asset- Backed Securities						Commercial Mortgage- Backed Securities						Cash Equivalents						Other Long- term Investments
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	102,008					$	74,301					$	-					$	400					$	536
Total gains (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			149						-						-						-						-
Asset management fees and other income			-						-						-						-						(17)
Included in other comprehensive income (loss)			(996)						94						-						-						-
Net investment income			1,265						28						-						-						-
Purchases			2,122						-						7,070						-						109
Sales			(202)						-						-						-						-
Issuances			-						-						-						-						-
Settlements			(400)						(10,260)						-						-						-
Transfers into Level 3 (1)			-						-						-						-						-
Transfers out of Level 3 (1)			-						(1,263)						-						-						-
Fair Value, end of period assets/(liabilities)		$	103,946					$	62,900					$	7,070					$	400					$	628
Unrealized gains (losses) for the period relating to those
Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	-					$	-					$	-					$	-					$	-
Asset management fees and other income		$	-					$	-					$	-					$	-					$	(17)
		Three Months Ended September 30, 2014
		Reinsurance Recoverables						Receivables from parent and affiliates						Future Policy Benefits
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	1,594,311					$	27,762					$	(1,662,957)
Total gains (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			578,588						(1)						(592,334)
Asset management fees and other income			-						-						-
Included in other comprehensive income (loss)			-						(292)						-
Net investment income			-						-						-
Purchases			58,581						-						-
Sales			-						-						-
Issuances			-						-						(61,450)
Settlements			-						-						-
Transfers into Level 3 (1)			-						-						-
Transfers out of Level 3 (1)			-						(4,943)						-
Fair Value, end of period assets/(liabilities)		$	2,231,480					$	22,526					$	(2,316,741)

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		Three Months Ended September 30, 2014
		Reinsurance Recoverables						Receivables from parent and affiliates						Future Policy Benefits
		(in thousands)
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	592,438					$	-					$	(606,724)
Asset management fees and other income		$	-					$	-					$	-
			Nine Months Ended September 30, 2014
		Fixed Maturities Available-For-Sale
		Corporate Securities						Asset- Backed Securities						Commercial Mortgage- Backed Securities						Trading Account Assets - Equity Securities						Equity Securities Available-for - Sale
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	96,796					$	63,789					$	-					$	313					$	192
Total gains (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			149						-						-						-						-
Asset management fees and other income			-						-						-						15						-
Included in other comprehensive income (loss)			(513)						394						(83)						-						-
Net investment income			3,738						110						-						-						-
Purchases			5,362						14,933						52,518						-						-
Sales			(202)						-						-						-						(192)
Issuances			-						-						-						-						-
Settlements			(1,384)						(39,600)						-						(328)						-
Transfers into Level 3 (1)			-						28,152						-						-						-
Transfers out of Level 3 (1)			-						(4,878)						(45,365)						-						-
Fair Value, end of period assets/(liabilities)		$	103,946					$	62,900					$	7,070					$	-					$	-
Unrealized gains (losses) for the period relating to those
Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	-					$	-					$	-					$	-					$	-
Asset management fees and other income		$	-					$	-					$	-					$	15					$	-
		Nine Months Ended September 30, 2014
		Cash Equivalents						Other Long-term Investments						Reinsurance Recoverables						Receivables from parent and affiliates						Future Policy Benefits
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	-					$	486					$	748,005					$	6,347					$	(778,226)
Total gains (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			-						-						1,307,462						-						(1,353,916)
Asset management fees and other income			-						(19)						-						-						-
Included in other comprehensive income (loss)			-						-						-						(213)						-
Net investment income			-						-						-						-						-
Purchases			400						166						176,013						19,350						-
Sales			-						-						-						-						-
Issuances			-						-						-						-						(184,599)
Settlements			-						(5)						-						-						-
Transfers into Level 3 (1)			-						-						-						1,985						-
Transfers out of Level 3 (1)			-						-						-						(4,943)						-
Fair Value, end of period assets/(liabilities)		$	400					$	628					$	2,231,480					$	22,526					$	(2,316,741)
Unrealized gains (losses) for the period relating to those
Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	-					$	-					$	1,327,516					$	-					$	(1,374,751)
Asset management fees and other income		$	-					$	(19)					$	-					$	-					$	-

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		Three Months Ended September 30, 2013
		Fixed Maturities Available-For-Sale
		Corporate Securities						Asset Backed Securities						Commercial Mortgage- Backed						Trading Account Assets - Equity  Securities						Other Long Term Investments
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	96,192					$	86,086					$	-					$	279					$	407
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			-						-						-						-						(19)
Asset management fees and other income			-						-						-						6						14
Included in other comprehensive income (loss)			1,243						(226)						1						-						-
Net investment income			1,188						88						-						-						-
Purchases			-						-						-												75
Sales			-						-						8,079						-						-
Issuances			-						-						-						-						-
Settlements			(266)						(2,310)						-						-						-
Transfers into Level 3 (1)			-						-						-						-						-
Transfers out of Level 3 (1)			(4,522)						-						-						-						-
Other (3)			-						(2,996)						-						-						-
Fair Value, end of period assets/(liabilities)		$	93,835					$	80,642					$	8,080					$	285					$	477
Unrealized gains (losses) for the period relating to those
Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	-					$	-					$	-					$	-					$	721
Asset management fees and other income		$	-					$	-					$	-					$	7					$	14
		Three Months Ended September 30, 2013
		Reinsurance Recoverables						Receivables from parent and affiliates						Future Policy Benefits
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	654,058					$	5,250					$	(669,989)
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			539,919						-						(572,570)
Asset management fees and other income			-						-						-
Included in other comprehensive income (loss)			-						39						-
Net investment income			-						-						-
Purchases			58,928						2,996						-
Sales			-						(2,996)						-
Issuances			-						-						(61,788)
Settlements			-						-						-
Transfers into Level 3 (1)			-						-						-
Transfers out of Level 3 (1)			-						-						-
Other (3)			-						2,996						-
Fair Value, end of period assets/(liabilities)		$	1,252,905					$	8,285					$	(1,304,347)
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	545,040					$	-					$	(577,920)

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		Nine Months Ended September 30, 2013
		Fixed Maturities Available-For-Sale
		Corporate Securities						Asset Backed Securities						Commercial Mortgage- Backed Securities						Trading Account Assets - Equity Securities						Other Long Term Investments
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	95,555					$	69,298					$	-					$	207					$	1,054
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			49						-						-						-						(740)
Asset management fees and other income			-						-						-						78						51
Included in other comprehensive income (loss)			(2,817)						(215)						18						-						-
Net investment income			3,518						404						-						-						-
Purchases			1,243						25,980						17,169						-						112
Sales			-						-						-						-						-
Issuances			-						-						-						-						-
Settlements			(4,167)						(11,829)						-						-						-
Transfers into Level 3 (1)			4,976						-						-						-						-
Transfers out of Level 3 (1)			(4,522)						-						(9,107)						-						-
Other (3)			-						(2,996)						-						-						-
Fair Value, end of period assets/(liabilities)		$	93,835					$	80,642					$	8,080					$	285					$	477
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	-					$	-					$	-					$	-					$	-
Asset management fees and other income		$	-					$	-					$	-					$	79					$	51
		Nine Months Ended September 30, 2013
		Reinsurance Recoverables						Other Assets						Future Policy Benefits
		(in thousands)
Fair Value, beginning of period assets/(liabilities)		$	1,732,094					$	1,995					$	(1,793,136)
Total gains or (losses) (realized/unrealized):
Included in earnings:
Realized investment gains (losses), net			(655,869)						-						674,014
Asset management fees and other income			-						-						-
Included in other comprehensive income (loss)			-						40						-
Net investment income			-						-						-
Purchases			176,680						6,250						-
Sales			-						(2,996)						-
Issuances			-						-						(185,225)
Settlements			-						-						-
Transfers into Level 3 (1)			-						-						-
Transfers out of Level 3 (1)			-						-						-
Other (3)			-						2,996						-
Fair Value, end of period assets/(liabilities)		$	1,252,905					$	8,285					$	(1,304,347)
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held at the end of the period (2):
Included in earnings:
Realized investment gains (losses), net		$	(618,782)					$	-					$	636,071
Asset management fees and other income		$	-					$	-					$	-

 

(1)	Transfers into or out of Level 3 are 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)	Other primarily represents reclasses of certain assets between reporting categories.

Transfers – Transfers into Level 3 are generally the result of unobservable inputs utilized within valuation methodologies and the use of indicative broker quotes for assets that were previously valued using observable inputs. Transfers out of Level 3 are generally due to the use of observable inputs in valuation methodologies as well as the availability of pricing service information for certain assets that the Company is able to validate.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

Fair Value of Financial Instruments

The table below presents the carrying amount and fair value by fair value hierarchy level of certain financial instruments that are not reported at fair value. The financial instruments presented below are reported at carrying value on the Company’s Unaudited Interim Consolidated Statements of Financial Position. However, in some cases, as described below, the carrying amount equals or approximates fair value.

 

		September 30, 2014
		Fair Value																Carrying Amount (1)
		Level 1				Level 2				Level 3				Total				Total
		(in thousands)
Assets:
Commercial mortgage and other loans		$	-			$	2,678			$	437,098			$	439,776			$	413,330
Policy loans			-				-				12,911				12,911				12,911
Other long term investments			-				-				2,433				2,433				2,041
Cash and cash equivalents			300				-				-				300				300
Accrued investment income			-				29,481				-				29,481				29,481
Receivables from parent and affiliates			-				12,270				-				12,270				12,270
Other assets			-				2,546				-				2,546				2,546
Total assets		$	300			$	46,975			$	452,442			$	499,717			$	472,879
Liabilities:
Policyholders’ account balances - investment contracts		$	-			$	-			$	89,008			$	89,008			$	90,560
Cash collateral for loaned securities			-				22,273				-				22,273				22,273
Short-term debt			-				201,891				-				201,891				200,000
Payables to parent and affiliates			-				35,823				-				35,823				35,823
Other liabilities			-				81,937				-				81,937				81,937
Separate account liabilities - investment contracts			-				534				-				534				534
Total liabilities		$	-			$	342,458			$	89,008			$	431,466			$	431,127

 

		December 31, 2013
		Fair Value																Carrying Amount (1)
		Level 1				Level 2				Level 3				Total				Total
		(in thousands)
Assets:
Commercial mortgage and other loans		$	-			$	-			$	422,584			$	422,584			$	398,991
Policy loans			-				-				12,454				12,454				12,454
Other long term investments			-				-				1,623				1,623				1,440
Cash and cash equivalents			1,417				-				-				1,417				1,417
Accrued investment income			-				32,169				-				32,169				32,169
Receivables from parent and affiliates			-				10,177				-				10,177				10,177
Other assets			-				11,190				-				11,190				11,190
Total assets		$	1,417			$	53,536			$	436,661			$	491,614			$	467,838
Liabilities:
Policyholders’ account balances - investment contracts		$	-			$	-			$	84,153			$	84,153			$	85,672
Cash collateral for loaned securities			-				47,896				-				47,896				47,896
Short-term debt			-				218,488				-				218,488				205,000
Payables to parent and affiliates			-				85,204				-				85,204				85,204
Other liabilities			-				101,656				-				101,656				101,656
Separate account liabilities - investment contracts			-				796				-				796				796
Total liabilities		$	-			$	454,040			$	84,153			$	538,193			$	526,224

 

(1)

Carrying values presented herein differ from those in the Company’s Unaudited Interim Statements of Financial Position because certain items within the respective financial statement captions are not considered financial instruments or out of scope under authoritative guidance relating to disclosures of the fair value of financial instruments. Financial statement captions excluded from the above table are not considered financial instruments.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

The fair values presented above 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 most commercial mortgage loans is based upon the present value of the expected future cash flows discounted at the appropriate U.S. Treasury rate plus an appropriate credit spread for similar quality loans. The quality ratings for these loans, a primary determinant of the credit spreads and a significant component of the pricing process, are based on an internally-developed methodology.

Policy Loans

Policy loans carrying value approximates fair value.

Other Long-term Investments

Other long-term investments include investments in joint ventures and limited partnerships. The estimated fair values of these cost method investments are generally based on the Company’s share of the net asset value (“NAV”) as provided in the financial statements of the investees. In certain circumstances, management may adjust the NAV by a premium or discount when it has sufficient evidence to support applying such adjustments. No such adjustments were made as of September 30, 2014 and December 31, 2013.

Cash and Cash Equivalents, Accrued Investment Income, Receivables from Parent and Affiliates, and Other Assets

The Company believes that due to the short-term nature of certain assets, the carrying value approximates fair value. These assets include: cash, accrued investment income, and other assets that meet the definition of financial instruments, including receivables such as unsettled trades and accounts receivable.

Policyholders’ Account Balances - Investment Contracts

Only the portion of policyholders’ account balances related to products that are investment contracts (those without significant mortality or morbidity risk) are reflected in the table above. For fixed deferred annuities and 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 reflect the Company’s own NPR. For those balances that can be withdrawn by the customer at any time without prior notice or penalty, the fair value is the amount estimated to be payable to the customer as of the reporting date, which is generally the carrying value.

Cash Collateral for Loaned Securities

Cash collateral for loaned securities represents the collateral received or paid in connection with loaning or borrowing securities. For these transactions, the carrying value of the related asset/liability approximates fair value as they equal the amount of cash collateral received or paid.

Debt

The fair value of short-term and long-term debt is generally determined by either prices obtained from independent pricing services, which are validated by the Company, or discounted cash flow models. These fair values consider the Company’s own NPR. Discounted cash flow models predominately use market observable inputs such as the borrowing rates currently available to the Company for debt and financial instruments with similar terms and remaining maturities.

Other Liabilities and Payables to Parent and Affiliates

Other liabilities and Payables to Parent and Affiliates are primarily payables, such as unsettled trades, drafts, escrow deposits and accrued expense payables. Due to the short term until settlement of most of these liabilities, the Company believes that carrying value approximates fair value.

Separate Account Liabilities - Investment Contracts

Only the portion of separate account liabilities related to products that are investments contracts are reflected in the table above. Separate account liabilities are recorded at the amount credited to the contractholder, which reflects the change in fair value of the corresponding separate account assets including contractholder deposits less withdrawals and fees. Therefore, carrying value approximates fair value.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

5.    DERIVATIVE INSTRUMENTS

Types of Derivative Instruments and Derivative Strategies

Interest Rate Contracts

Interest rate swaps are used by the Company to reduce risks from changes in interest rates, 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 owns or anticipates acquiring or selling. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the contract and no principal payments are made by either party. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty at each due date.

Equity Contracts

Equity index options are contracts which will settle in cash based on differentials in the underlying indices at the time of exercise and the strike price. The Company uses combinations of purchases and sales of equity index options to hedge the effects of adverse changes in equity indices within a predetermined range.

Total return swaps are contracts whereby the Company agrees with other parties to exchange, at specified intervals, the difference between the return on an asset (or market index) and LIBOR based on a notional amount. The Company generally uses total return swaps to hedge the effect of adverse changes in equity indices.

Foreign Exchange Contracts

Currency derivatives, including 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.

Credit Contracts

Credit derivatives are used by the Company to enhance the return on the Company’s investment portfolio by creating credit exposure similar to an investment in public fixed maturity cash instruments. With credit derivatives the Company sells credit protection on an identified name, and in return receives a quarterly premium. With 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. If there is an event of default by the referenced name, 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 or pay the referenced amount less the auction recovery rate. See credit derivatives section for discussion of guarantees related to credit derivatives written. 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.

Embedded Derivatives

The Company sells variable annuity products, which may include guaranteed benefit features that are accounted for as embedded derivatives. The Company has reinsurance agreements to transfer the risk related to certain of these benefit features to affiliates, Pruco Re and The Prudential Insurance Company of America (“Prudential Insurance”). The embedded derivatives related to the living benefit features and the related reinsurance agreements are carried at fair value. 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, as described in Note 4.

The fair value of the living benefit feature embedded derivatives included in “Future policy benefits” was a liability of $2,317 million and $778 million as of September 30, 2014 and December 31, 2013, respectively. The fair value of the embedded derivatives related to the reinsurance of certain of these benefits to Pruco Re and Prudential Insurance included in “Reinsurance recoverables” was an asset of $2,232 million and $748 million as of September 30, 2014 and December 31, 2013, respectively.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

The table below provides a summary of the gross notional amount and fair value of derivatives contracts by the primary underlying, excluding embedded derivatives which are recorded with the associated host. Many derivative instruments contain multiple underlyings.

 

				September 30, 2014														December 31, 2013
								Gross Fair Value														Gross Fair Value
Primary Underlying				Notional				Assets				Liabilities						Notional				Assets				Liabilities
				(in thousands)
Derivatives Designated as Hedge Accounting Instruments:
Currency/Interest Rate
Currency/Interest Rate				$	82,247			$	2,793			$	(1,749)					$	72,747			$	940			$	(4,635)
Total Qualifying Hedges				$	82,247			$	2,793			$	(1,749)					$	72,747			$	940			$	(4,635)
Derivatives Not Qualifying as Hedge Accounting Instruments:
Interest Rate
Interest Rate Swaps				$	1,902,750			$	77,005			$	(40,756)					$	1,533,750			$	59,872			$	(80,601)
Interest Rate Options					100,000				8,855				-						100,000				6,534				-
Currency/Interest Rate
Foreign Currency Swaps					57,013				1,775				(10)						55,919				19				(1,349)
Credit
Credit Default Swaps					1,200				-				(55)						6,050				-				(115)
Equity
Total Return Swaps					213,764				2,486				-						219,896				-				(4,712)
Equity Options					15,798,390				5,581				(3,142)						13,170,805				6,170				(3,168)
Total Non-Qualifying Hedges				$	18,073,117			$	95,702			$	(43,963)					$	15,086,420			$	72,595			$	(89,945)
Total Derivatives (1)				$	18,155,364			$	98,495			$	(45,712)					$	15,158,667			$	73,535			$	(94,580)

 

(1)

Excludes embedded derivatives which contain multiple underlyings. The fair value of these embedded derivatives was a liability of $2,317 million and $778 million as of September 30, 2014 and December 31, 2013, respectively, included in “Future policy benefits.” The fair value of the embedded derivatives related to the reinsurance of certain of these benefits to Pruco Re and Prudential Insurance included in “Reinsurance recoverables” was an asset of $2,232 million and $748 million as of September 30, 2014 and December 31, 2013, respectively.

Offsetting Assets and Liabilities

The following table presents recognized derivative instruments (including bifurcated embedded derivatives) that are offset in the balance sheet, and/or are subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in the balance sheet.

 

		September 30, 2014
		Gross Amounts of Recognized Financial Instruments				Gross Amounts Offset in the Statement of Financial Position				Net Amounts Presented in the Statement of Financial Position				Financial Instruments/ Collateral				Net Amount
		(in thousands)
Offsetting of Financial Assets:
Derivatives		$	98,495			$	(53,827)			$	44,668			$	(36,441)			$	8,227
Offsetting of Financial Liabilities:
Derivatives		$	45,712			$	(45,712)			$	-			$	-			$	-
		December 31, 2013
		Gross Amounts of Recognized Financial Instruments				Gross Amounts Offset in the Statement of Financial Position				Net Amounts Presented in the Statement of Financial Position				Financial Instruments/ Collateral				Net Amount
		(in thousands)
Offsetting of Financial Assets:
Derivatives		$	73,535			$	(73,535)			$	-			$	-			$	-
Offsetting of Financial Liabilities:
Derivatives		$	94,580			$	(72,822)			$	21,758			$	(24,491)			$	(2,733)

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

For information regarding the rights of offset associated with the derivative assets and liabilities in the table above see “Credit Risk” below.

Cash Flow Hedges

The primary derivative instruments used by the Company in its cash flow hedge accounting relationships are currency swaps. These instruments are only designated for hedge accounting in instances where the appropriate criteria are met. The Company does not use futures, options, credit, equity or embedded derivatives in any of its cash flow hedge accounting relationships.

The following tables provide 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 September 30, 2014
				Realized Investment Gains/(Losses)						Net Investment Income						Other Income						Accumulated Other Comprehensive Income (Loss) (1)
				(in thousands)
Derivatives Designated as Hedging Instruments:
Cash flow hedges
Currency/Interest Rate				$	-					$	(3)					$	80					$	5,080
Total cash flow hedges					-						(3)						80						5,080
Derivatives Not Qualifying as Hedging Instruments:
Interest Rate					14,059						-						-						-
Currency					-						-						-						-
Currency/Interest Rate					3,546						-						47						-
Credit					-						-						-						-
Equity					414						-						-						-
Embedded Derivatives					(23,566)						-						-						-
Total non-qualifying hedges					(5,547)						-						47						-
Total				$	(5,547)					$	(3)					$	127					$	5,080
				Nine Months Ended September 30, 2014
				Realized Investment Gains/(Losses)						Net Investment Income						Other Income						Accumulated Other Comprehensive Income (Loss) (1)
				(in thousands)
Derivatives Designated as Hedging Instruments:
Cash flow hedges
Currency/Interest Rate				$	-					$	(20)					$	63					$	4,657
Total cash flow hedges					-						(20)						63						4,657
Derivatives Not Qualifying as Hedging Instruments:
Interest Rate					77,657						-						-						-
Currency					-						-						-						-
Currency/Interest Rate					3,332						-						55						-
Credit					(11)						-						-						-
Equity					(15,568)						-						-						-
Embedded Derivatives					(76,201)						-						-						-
Total non-qualifying hedges					(10,791)						-						55						-
Total				$	(10,791)					$	(20)					$	118					$	4,657

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

		Three Months Ended September 30, 2013
		Realized Investment Gains/(Losses)						Net Investment Income						Other Income						Accumulated Other Comprehensive Income (Loss) (1)
		(in thousands)
Derivatives Designated as Hedging Instruments:
Cash flow hedges
Currency/Interest Rate		$	-					$	(17)					$	(30)					$	(2,781)
Total cash flow hedges			-						(17)						(30)						(2,781)
Derivatives Not Qualifying as Hedging Instruments:
Interest Rate			(11,810)						-						-						-
Currency			-						-						-						-
Currency/Interest Rate			(2,137)						-						(23)						-
Credit			(28)						-						-						-
Equity			(14,507)						-						-						-
Embedded Derivatives			(44,453)						-						-						-
Total non-qualifying hedges			(72,935)						-						(23)						-
Total		$	(72,935)					$	(17)					$	(53)					$	(2,781)
		Nine Months Ended September 30, 2013
		Realized Investment Gains/(Losses)						Net Investment Income						Other Income						Accumulated Other Comprehensive Income (Loss) (1)
		(in thousands)
Derivatives Designated as Hedging Instruments:
Cash flow hedges
Currency/Interest Rate		$	-					$	(68)					$	2					$	(438)
Total cash flow hedges			-						(68)						2						(438)
Derivatives Not Qualifying as Hedging Instruments:
Interest Rate			(94,040)						-						-						-
Currency			-						-						-						-
Currency/Interest Rate			(353)						-						17						-
Credit			(86)						-						-						-
Equity			(55,934)						-						-						-
Embedded Derivatives			(12,187)						-						-						-
Total non-qualifying hedges			(162,600)						-						17						-
Total		$	(162,600)					$	(68)					$	19					$	(438)

 

(1)

Amounts deferred in “Accumulated other comprehensive income (loss).”

For the three and nine months ended September 30, 2014 and 2013, the ineffective portion of derivatives accounted for using hedge accounting was not material to the Company’s results of operations. Also, there were no material amounts reclassified into earnings relating to instances in which the Company discontinued cash flow hedge accounting because the forecasted transaction did not occur by the anticipated date or within the additional time period permitted by the authoritative guidance for the accounting for derivatives and hedging.

Presented below is a rollforward of current period cash flow hedges in “Accumulated other comprehensive income (loss)” before taxes:

 

		(in thousands)
Balance, December 31, 2013		$	(3,653)
Net deferred gains (losses) on cash flow hedges from January 1 to September 30, 2014			4,700
Amount reclassified into current period earnings			(43)
Balance, September 30, 2014		$	1,004

As of September 30, 2014 and 2013, the Company did 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 19 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 Unaudited Interim Statements of Equity.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

Credit Derivatives

The Company no longer has exposure from credit derivatives where it has written credit protection as of September 30, 2014 and December 31, 2013.

The Company has purchased credit protection using credit derivatives in order to hedge specific credit exposures in the Company’s investment portfolio. As of September 30, 2014 and December 31, 2013, the Company had $1 million and $6 million of outstanding notional amounts, respectively, reported at fair value as a liability of less than $1 million for both periods.

Credit Risk

The Company is exposed to credit-related losses in the event of non-performance by its counterparty to financial derivative transactions.

The Company has credit risk exposure to an affiliate, Prudential Global Funding, LLC (“PGF”), related to its OTC derivative transactions. PGF 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. Additionally, limits are set on single party credit exposures which are subject to periodic management review.

Under fair value measurements, the Company incorporates the market’s perception 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.

6.    COMMITMENTS, CONTINGENT LIABILITIES AND LITIGATION AND REGULATORY MATTERS

Commitments

The Company had made commitments to fund $5 million of commercial loans as of September 30, 2014. The Company also made commitments to purchase or fund investments, mostly private fixed maturities, of $27 million as of September 30, 2014.

Contingent Liabilities

On an ongoing basis, the Company’s internal supervisory and control functions review the quality of sales, marketing and other customer interface procedures and practices and may recommend modifications or enhancements. From time to time, this review process results in the discovery of product administration, servicing or other errors, including errors relating to the timing or amount of payments or contract values due to customers. In certain cases, if appropriate, the Company may offer customers remediation and may incur charges, including the cost of such remediation, administrative costs and regulatory fines.

The Company is subject to the laws and regulations of states and other jurisdictions concerning the identification, reporting and escheatment of unclaimed or abandoned funds, and is subject to audit and examination for compliance with these requirements. For additional discussion of these matters, see “Litigation and Regulatory Matters” below.

It is possible that the results of operations or the cash flow of the Company in a particular quarterly or annual period could be materially affected as a result of payments in connection with the matters discussed above or other matters depending, in part, upon the results of operations or cash flow for such period. Management believes, however, that ultimate payments in connection with these matters, after consideration of applicable reserves and rights to indemnification, should not have a material adverse effect on the Company’s financial position.

Litigation and Regulatory Matters

The Company is subject to legal and regulatory actions in the ordinary course of its business. Pending legal and regulatory actions include proceedings specific to the Company and proceedings generally applicable to business practices in the industry in which it operates. The Company is subject to class action lawsuits and other litigation involving a variety of issues and allegations involving sales practices, claims payments and procedures, premium charges, policy servicing and breach of fiduciary duty to customers. The Company is also subject to litigation arising out of its general business activities, such as its investments, contracts, leases and labor and employment relationships, including claims of discrimination and harassment, and could be exposed to claims or litigation concerning certain business or process patents. In addition, the Company, along with other participants in the businesses in which it engages, may be subject from time to time to investigations, examinations and inquiries, in some cases industry-wide, concerning issues or matters upon which such regulators have determined to focus. In some of the Company’s pending legal and regulatory actions, parties are seeking large and/or indeterminate amounts, including punitive or exemplary damages. The outcome of litigation or a regulatory matter, and the amount or range of potential loss at any particular time, is often inherently uncertain. The following is a summary of certain pending proceedings.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

The Company establishes accruals for litigation and regulatory matters when it is probable that a loss has been incurred and the amount of that loss can be reasonably estimated. For litigation and regulatory matters where a loss may be reasonably possible, but not probable, or is probable but not reasonably estimable, no accrual is established, but the matter, if material, is disclosed, including matters discussed below. The Company estimates that as of September 30, 2014, the aggregate range of reasonably possible losses in excess of accruals established for those litigation and regulatory matters for which such an estimate currently can be made is $0 to approximately $3 million. This estimate is not an indication of expected loss, if any, or the Company’s maximum possible loss exposure on such matters. The Company reviews relevant information with respect to its litigation and regulatory matters on a quarterly and annual basis and updates its accruals, disclosures and estimates of reasonably possible loss based on such reviews.

In January 2013, a qui tam action on behalf of the State of Florida, Total Asset Recovery Services v. Met Life Inc., et al., Manulife Financial Corporation, et. al., Prudential Financial, Inc., The Prudential Insurance Company of America, and Prudential Insurance Agency, LLC, filed in the Circuit Court of Leon County, Florida, was served on Prudential Insurance. The complaint alleges that Prudential Insurance failed to escheat life insurance proceeds to the State of Florida in violation of the Florida False Claims Act and seeks injunctive relief, compensatory damages, civil penalties, treble damages, prejudgment interest, attorneys’ fees and costs. In March 2013, the Company filed a motion to dismiss the complaint. In August 2013, the court dismissed the complaint with prejudice. In September 2013, plaintiff filed an appeal with Florida’s Circuit Court of the Second Judicial Circuit in Leon County. In September 2014, the Florida District Court of Appeal First District affirmed the trial court’s decision.

In January 2012, a Global Resolution Agreement entered into by the Company and a third party auditor became effective upon its acceptance by the unclaimed property departments of 20 states and jurisdictions. Under the terms of the Global Resolution Agreement, the third party auditor acting on behalf of the signatory states will compare expanded matching criteria to the Social Security Master Death File (“SSMDF”) to identify deceased insureds and contract holders where a valid claim has not been made. In February 2012, a Regulatory Settlement Agreement entered into by the Company to resolve a multi-state market conduct examination regarding its adherence to state claim settlement practices became effective upon its acceptance by the insurance departments of 20 states and jurisdictions. The Regulatory Settlement Agreement applies prospectively and requires the Company to adopt and implement additional procedures comparing its records to the SSMDF to identify unclaimed death benefits and prescribes procedures for identifying and locating beneficiaries once deaths are identified. Substantially all other jurisdictions that are not signatories to the Global Resolution Agreement or the Regulatory Settlement Agreement have entered into similar agreements with the Company.

The Company is one of several companies subpoenaed by the New York Attorney General regarding its unclaimed property procedures. Additionally, the New York State Department of Financial Services (“NYDFS”) has requested that 172 life insurers (including the Company) provide data to the NYDFS regarding use of the SSMDF. The New York Office of Unclaimed Funds is conducting an audit of the Company’s compliance with New York’s unclaimed property laws. In February 2012, the Massachusetts Office of the Attorney General requested information regarding the Company’s unclaimed property procedures. In December 2013, this matter was closed without prejudice.

The Company’s litigation and regulatory matters are subject to many uncertainties, and given their complexity and scope, their outcome cannot be predicted. It is possible that the Company’s results of operations or cash flow in a particular quarterly or annual period could be materially affected by an ultimate unfavorable resolution of pending litigation and regulatory matters depending, in part, upon the results of operations or cash flow for such period. In light of the unpredictability of the Company’s litigation and regulatory matters, it is also possible that in certain cases an ultimate unfavorable resolution of one or more pending litigation or regulatory matters could have a material adverse effect on the Company’s financial position. Management believes, however, that, based on information currently known to it, the ultimate outcome of all pending litigation and regulatory matters, after consideration of applicable reserves and rights to indemnification, is not likely to have a material adverse effect on the Company’s financial position.

7.    RELATED PARTY TRANSACTIONS

The Company has extensive transactions and relationships with Prudential Insurance and other affiliates. Although we seek to ensure that these transactions and relationships are fair and reasonable, it is possible that the terms of these transactions are not the same as those that would result from transactions among unrelated parties.

Expense Charges and Allocations

Many of the Company’s expenses are allocations or charges from Prudential Insurance or other affiliates.

The Company’s general and administrative expenses are charged to the Company using allocation methodologies based on business production processes. Management believes that the methodology is reasonable and reflects costs incurred by Prudential Insurance to process transactions on behalf of the Company. The Company operates under service and lease agreements whereby services of officers and employees, supplies, use of equipment and office space are provided by Prudential Insurance. The Company reviews its allocation methodology periodically which it may adjust accordingly. General and administrative expenses also include allocations of stock compensation expenses related to a stock option program and a deferred compensation program issued by Prudential Financial. The expense charged to the Company for the stock option program and deferred compensation program was less than $1 million for the three months ended September 30, 2014 and 2013, and less than $1 million and $1 million for the nine months ended September 30, 2014 and 2013, respectively.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(Continued)

 

 

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 less than $1 million for the three months ended September 30, 2014 and 2013, and $1 million and $2 million for the nine months ended September 30, 2014 and 2013, 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 less than $1 million for the three months ended September 30, 2014 and 2013, and less than $1 million for the nine months ended September 30, 2014 and 2013.

Affiliated Asset Administration Fee Income

In accordance with a revenue sharing agreement with AST Investment Services, Inc. and Prudential Investments LLC, the Company receives fee income calculated on contractholder separate account balances invested in the Advanced Series Trust. Income received from AST Investment Services, Inc. and Prudential Investments LLC related to this agreement was $56 million for the three months ended September 30, 2014 and 2013, and $167 million and $170 million for the nine months ended September 30, 2014 and 2013, respectively. These revenues are recorded as “Asset administration fees and other income” in the Unaudited Interim Statements of Operations and Comprehensive Income.

Affiliated Investment Management Expenses

In accordance with an agreement with Prudential Investment Management, Inc. (“PIMI”), the Company pays investment management expenses to PIMI who acts as investment manager to certain Company general account and separate account assets. Investment management expenses paid to PIMI related to this agreement were $1 million and $2 million for the three months ended September 30, 2014 and 2013, respectively, and $4 million and $5 million for the nine months ended September 30, 2014 and 2013, respectively. These expenses are recorded as “Net investment income” in the Unaudited Interim Statements of Operations and Comprehensive Income.

Cost Allocation Agreements with Affiliates

Certain operating costs (including rental of office space, furniture, and equipment) have been charged to the Company at cost by Prudential Annuities Information Services and Technology Corporation (“PAIST”), an affiliated company. PALAC signed a written service agreement with PAIST for these services executed and approved by the Connecticut Insurance Department in 1995. This agreement automatically continues in effect from year to year and may be terminated by either party upon 30 days written notice.

Allocated lease expense was $1 million and less than $1 million for the three months ended September 30, 2014 and 2013, respectively, and $3 million and $2 million for the nine months ended September 30, 2014 and 2013, respectively. Allocated sub-lease rental income, recorded as a reduction to lease expense was less than $1 million for the three months ended September 30, 2014 and 2013, and less than $1 million and $2 million for the nine months ended September 30, 2014 and 2013, respectively.

The Company pays commissions and certain other fees to PAD in consideration for PAD’s marketing and underwriting of the Company’s products. Commissions and fees are paid by PAD to broker-dealers who sold and service the Company’s products. Commissions and fees paid by the Company to PAD were $45 million and $43 million for the three months ended September 30, 2014 and 2013, respectively, and $134 million and $128 million for the nine months ended September 30, 2014 and 2013, respectively.

Debt Agreements

Short-term Debt

The Company is authorized to borrow funds up to $2 billion from Prudential Financial and its affiliates to meet its capital and other funding needs. The Company had debt of $0 million and $5 million outstanding with Prudential Funding, LLC as of September 30, 2014 and December 31, 2013, respectively. Total interest expense on debt with Prudential Funding, LLC was less than $1 million for the three months ended September 30, 2014 and 2013, and less than $1 million for the nine months ended September 30, 2014 and 2013.

The Company had debt of $200 million outstanding with Prudential Financial as of September 30, 2014 and December 31, 2013. This loan has a fixed interest rate of 4.49% and matures on December 29, 2014. In December 2013, a $200 million partial pay down was made on this outstanding debt. Total interest expense on debt with Prudential Financial was $2 million and $4 million for the three months ended September 30, 2014 and 2013, respectively, and $7 million and $13 million for the nine months ended September 30, 2014 and 2013, respectively.

 

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Prudential Annuities Life Assurance Corporation

Notes to Unaudited Interim Financial Statements—(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. Fees ceded under these agreements are included in “Realized investment gains (losses), net” on the Unaudited Interim Statement of Operations and Comprehensive Income. The Company ceded fees of $68 million and $70 million to Pruco Re for the three months ended September 30, 2014 and 2013, respectively and $206 million for the nine months ended September 30, 2014 and 2013. The Company ceded fees of less than $1 million to Prudential Insurance for the three months ended September 30, 2014 and 2013, and less than $1 million for the nine months ended September 30, 2014 and 2013. The Company’s reinsurance payables related to affiliated reinsurance were $25 million as of both September 30, 2014 and December 31, 2013.

The Company’s reinsurance recoverables related to affiliated reinsurance were $2,232 million and $748 million as of September 30, 2014 and December 31, 2013, respectively. The assets are reflected in “Reinsurance recoverables” in the Company’s Unaudited Interim Statements of Financial Position. Realized gains (losses) were $569 million and $528 million for the three months ended September 30, 2014 and 2013, respectively, and $1,278 million and $(686) million for the nine months ended September 30, 2014 and 2013, respectively. Changes in realized gains (losses) for the 2014 and 2013 periods were primarily due to changes in market conditions in each respective period.

Derivative Trades

In its ordinary course of business, the Company enters into OTC derivative contracts with an affiliate, PGF.

Purchase/sale of fixed maturities from/to an affiliate

During the first quarter of 2013, the Company sold fixed maturity securities to Prudential Financial. These securities had an amortized cost of $90 million and a fair value of $103 million. The net difference between historic amortized cost and the fair value was accounted for as an increase of $8 million to additional paid-in capital, net of taxes.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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”) as of September 30, 2014, compared with December 31, 2013, and its results of operations for the three and nine months ended September 30, 2014 and 2013. You should read the following analysis of our financial condition and results of operations in conjunction with the MD&A, the “Risk Factors” section, and the audited Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, as well as the statements under “Forward-Looking Statements” and the Unaudited Interim Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.

Overview

The Company was established in 1969 and has been a 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 Company has sold a wide array of annuities, including deferred and immediate variable annuities with (1) fixed interest rate allocation options, subject to a market value adjustment, that are registered with the United States Securities and Exchange Commission (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 inforce block of variable life insurance policies, but it no longer actively sells such policies.

Beginning in March 2010, the Company ceased offering its variable annuity products (and where offered, the companion market value adjustment option) to new investors upon the launch of a new product line by each of Pruco Life Insurance Company and Pruco Life Insurance Company of New Jersey (which are affiliates of the Company). These initiatives were implemented to create operational and administrative efficiencies by offering a single product line of annuity products from a more limited group of legal entities. During 2012, the Company suspended additional customer deposits for variable annuities with certain optional living benefit riders. However, subject to applicable contract provisions and administrative rules, the Company continues to accept additional customer deposits on certain inforce contracts.

On August 30, 2013, the Company received approval from the Arizona and Connecticut Departments of Insurance to redomesticate the Company from Connecticut to Arizona effective August 31, 2013. As a result of the redomestication, the Company is now an Arizona insurance company and its principal insurance regulatory authority is the Arizona Department of Insurance. See Note 1 to the Unaudited Interim Financial Statements for additional information.

Regulatory Developments

Prudential Financial is a “Designated Financial Company” under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). As a “Designated Financial Company,” Prudential Financial is subject to supervision and examination by the Federal Reserve Bank of Boston and to prudential regulatory standards under the Dodd-Frank Act. The Financial Stability Board (the “FSB”), consisting of representatives of national financial authorities of the G20 nations, has also identified Prudential Financial as a global systemically important insurer that is to be subject to enhanced regulation.

Pursuant to the Collins Amendment of the Dodd Frank Act requiring the establishment of capital requirements for Designated Financial Companies, the Federal Reserve Board (“FRB”) announced in September 2014 that it would begin a quantitative impact study to evaluate the potential effects of a revised regulatory capital framework on insurance holding companies. Prudential Financial has elected to respond to FRB requests for information in connection with this study.

At the direction of the FSB, the International Association of Insurance Supervisors (the “IAIS”) is currently developing a model framework (“ComFrame”) for the supervision of internationally active insurance groups (“IAIGs”) that contemplates “group wide supervision” across national boundaries. Prudential Financial qualifies as an IAIG. Prudential Financial has participated in field testing to assist the IAIS in its development of ComFrame. On October 23, 2014, the IAIS released preliminary elements of its risk-based global insurance capital standards, known as the “Basic Capital Requirements” (“BCR”). The IAIS is scheduled to seek G20 endorsement of the proposed BCR framework in November 2014. Global systemically important insurers (“G-SII”), such as Prudential Financial, will be required to report their BCR results beginning in 2015 on a confidential basis, depending on the directions of domestic group wide supervisors. The BCR will continue to be revised and refined by the IAIS once the confidential reporting period begins, and a final capital framework is not anticipated until 2019.

We are a licensed insurance company in New York, but are not domiciled in New York. In February 2014, the New York State Department of Financial Services (“NY DFS”) notified us that it does not agree with our calculation of statutory reserves (including the applicable credit for reinsurance) for New York purposes in respect of certain variable annuity products. The Company is continuing discussions with the NY DFS regarding the proper level of statutory reserves (including the applicable credit for reinsurance) for these products. If we are ultimately required to establish material additional reserves on a New York statutory accounting basis or post material amounts of additional collateral with respect to such variable annuity products, our ability to deploy capital for other purposes could be affected and/or we could be required to obtain additional funding from Prudential Financial or its affiliates.

The National Association of Insurance Commissioners (“NAIC”), the NY DFS and other regulators continue to review life insurers’ use of captive reinsurance companies. A committee of the NAIC continues to consider changes to the NAIC accreditation standards that would regulate captive reinsurance companies that assume business directly written in more than one state as “multi-state reinsurers” and apply accreditation standards to those captives that historically were applicable only to traditional insurers. For information on our use of captive reinsurance companies and the potential effects of these proposals on us, see “—Liquidity and Capital Resources—Capital—Affiliated Captive Reinsurance Companies” below.

 

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For additional information on the potential impacts of regulation on the Company, including the topics described above, see “Business—Regulation” and “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2013.

Revenues and Expenses

The Company earns revenues from policy charges, fee income, asset administration from insurance and investment products and from net investment income on the investment of general account and other funds. The Company’s operating expenses principally consist of insurance benefits provided and reserves established for anticipated future insurance benefits, general business expenses, commissions and other costs of selling and servicing the various products it sold.

Effective February 25, 2013, the Advanced Series Trust (“AST”) adopted a Rule 12b-1 Plan under the Investment Company Act of 1940 with respect to most of the AST portfolios that are offered through the Company’s variable annuity and variable life investment products. Under the Rule 12b-1 Plan, AST pays an affiliate of the Company for distribution and administrative services. Prior to the adoption of the 12b-1 Plan, the Company received an administrative service fee from AST and incurred expenses associated with administration services provided.

Profitability

The Company’s profitability depends principally on its ability to manage risk on insurance and annuity products. Profitability also depends on, among other items, our actuarial and policyholder behavior experience on insurance and annuity products, our ability to retain customer assets, generate and maintain favorable investment results, and to manage expenses. See “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 for a discussion of risks that have materially affected and may affect in the future the Company’s business, results of operations or financial condition, or cause the Company’s actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.

Products

The Company’s inforce variable annuities provide its contractholders with tax-deferred asset accumulation together with a base death benefit and a suite of optional guaranteed living benefits (including versions with guaranteed death benefits) and annuitization options. Certain optional living benefit guarantees include, among other features, the ability to make withdrawals based on the highest daily contract value plus a minimum return, credited for a period of time. This guaranteed contract value is a notional amount that forms the basis for determining periodic withdrawals for the life of the contractholder, and cannot be accessed as a lump-sum surrender value. Most contracts also guarantee the contractholder a return of total deposits made to the contract, less any partial withdrawals, upon death. Our variable annuities generally provide our contractholders with the opportunity to allocate purchase payments to sub-accounts that invest in underlying proprietary and non-proprietary mutual funds, frequently under asset allocation programs, and fixed-rate accounts. The fixed-rate accounts, which are within the general account, are credited with interest at rates we determine, subject to certain minimums. Certain allocations made in the fixed-rate accounts of our variable annuities impose a market value adjustment if the contract is not held to maturity.

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, contractholder longevity/mortality, timing and amount of annuitization and withdrawals, withdrawal efficiency and contract lapses. The 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. Our returns can also vary due to the impact and effectiveness of our hedging programs for any capital markets movements that we may hedge, the impact of affiliated reinsurance, the impact of that portion of our variable annuity contracts with an asset transfer feature, the impact of risks we have retained and the impact of risks that are not able to be hedged.

Our risk management strategy helps to limit our exposure to certain of these risks primarily through a combination of product design elements, our living benefits hedging program and affiliated reinsurance arrangements. The product design elements we utilize for certain products include, among others, asset allocation restrictions, minimum issuance age requirements, certain limitations on the amount of subsequent contractholder deposits and an asset transfer feature. The objective of the asset transfer feature is to help mitigate our exposure to equity market risk and market volatility by transferring assets between certain variable investment sub-accounts selected by the annuity contractholder, and investments that are expected to be more stable (e.g., a bond fund sub-account within the separate account or a fixed-rate account within the general account). The transfers are based on the static mathematical formula used with the particular optional benefit which considers a number of factors, including, but not limited to, the impact of investment performance on the contractholder’s total account value. This occurs at the contractholder level, rather than at the fund level, which we believe enhances our risk mitigation. As of September 30, 2014 approximately $38.8 billion or 83% of total variable annuity account values contain a living benefit feature, compared to approximately $40.7 billion or 83% as of December 31, 2013. As of September 30, 2014 approximately $30.7 billion or 79% of variable annuity account values with living benefit features included an asset transfer feature in the product design, compared to approximately $32.1 billion or 79% as of December 31, 2013.

As mentioned above, in addition to our asset transfer feature, we also manage certain risks associated with our variable annuity products through our living benefits hedging programs and affiliated reinsurance agreements. We reinsure the majority of our variable annuity living benefit guarantees to an affiliated reinsurance company, Pruco Reinsurance, Ltd. (“Pruco Re”). The living benefits hedging program is primarily executed within Pruco Re to manage capital markets risk associated with the reinsured optional living benefit guarantees. The program is also executed within the Company related to certain non-reinsured optional living benefit guarantees. This program represents a balance among three objectives that seek to: 1) provide severe scenario protection, 2) minimize net income volatility associated with an internally-defined hedge target, and 3) maintain capital efficiency.

 

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Through the hedge program, derivatives are entered into that seek to replicate the net change in an internally-defined hedge target. In addition to mitigating capital markets risk and income statement volatility, the hedging program is also focused on a long-term goal of accumulating assets that could be used to pay claims under these benefits irrespective of market path, recognizing that, under the terms of the contracts, we do not expect to begin substantial payment of such claims until at least five years in the future.

Application of Critical Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”), requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews estimates and assumptions used in the preparation of financial statements. If management determines that modifications in assumptions and estimates are appropriate given current facts and circumstances, the Company’s results of operations and financial position as reported in the Unaudited Interim Financial Statements could change significantly.

Management believes the accounting policies relating to the following areas are most dependent on the application of estimates and assumptions and require management’s most difficult, subjective, or complex judgments:

 

—

Deferred policy acquisition costs (“DAC”) and other costs, including deferred sales inducements (“DSI”) and value of business acquired (“VOBA”);

—

Valuation of investments, including derivatives, and the recognition of other-than-temporary impairments;

—

Policyholder liabilities;

—

Taxes on income; and

—

Reserves for contingencies, including reserves for losses in connection with unresolved legal matters.

DAC and Other Costs

We amortize DAC and other costs over the expected lives of the respective contracts, based on our estimates of the level and timing of gross margins, gross profits, or gross premiums, depending on the type of contract. Variability in the level of amortization expense has historically been driven by costs that are amortized in proportion to total gross profits. In calculating gross profits for these contracts, we consider mortality, persistency, and other elements as well as rates of return on investments and the costs related to our guaranteed minimum death benefits (“GMDB”) and guaranteed minimum income benefits (“GMIB”). We estimate the amounts of gross profits that will be included in our U.S. GAAP results and utilize these estimates to calculate amortization rates and expense amounts. U.S. GAAP gross profits and amortization rates include the impacts of the embedded derivatives associated with certain of the optional living benefit features of our variable annuity contracts and related hedging activities, regardless of in which affiliated legal entity this activity occurs.

The near-term future equity rate of return assumptions used in evaluating DAC and DSI for our domestic variable annuity products are derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider historical equity returns and adjust projected equity returns over an initial future period (the “near-term”) so that equity returns converge to the long-term expected rate of return. If the near-term projected future rate of return is greater than our near-term maximum future rate of return, we use our maximum future rate of return. Historically, we have utilized a four year near-term period and a 13% maximum future rate of return in applying this methodology. Beginning in the third quarter of 2014, we adjust future projected equity returns over a five year near-term period and utilize a 15% maximum. As of September 30, 2014, we assume an 8.0% long-term equity expected rate of return and a 4.2% near-term mean reversion equity rate of return.

The weighted average rate of return assumptions consider many factors, including asset durations, asset allocations and other factors. We generally update the near term equity rate of return and our estimate of total gross profits each quarter to reflect the result of the reversion to the mean approach, which assumes a convergence to the long-term equity expected rate of return. These market performance related adjustments to our estimate of total gross profits result in cumulative adjustments to prior amortization, reflecting the application of the new required rate of amortization to all prior periods’ gross profits.

For additional information on our policies for DAC and other costs and for the remaining critical accounting estimates listed above, see our Annual Report on Form 10-K for the year ended December 31, 2013, under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Accounting Policies & Pronouncements—Application of Critical Accounting Estimates.”

Adoption of New Accounting Pronouncements

See Note 2 to our Unaudited Interim Financial Statements for a discussion of newly adopted accounting pronouncements.

Changes in Financial Position

September 30, 2014 versus December 31, 2013

Total assets decreased by $1.2 billion from $53.5 billion at December 31, 2013 to $52.3 billion at September 30, 2014. Separate account assets decreased $2.2 billion primarily driven by net outflows on the runoff block and policy charges, partially offset by market appreciation and the impact of the asset transfer feature which moved contractholder account values from the general account to the separate account due to favorable markets in 2014. Total investments decreased $0.3 billion primarily due to asset sales associated with contractholder surrenders and the impact of the asset transfer feature which moved contractholder account values from the general account to the separate account due to favorable markets in 2014 and

 

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DAC and DSI decreased $0.2 billion primarily resulting from base amortization. Partially offsetting the above decrease was an increase in reinsurance recoverables of $1.5 billion related to the reinsured liability for living benefit embedded derivatives primarily resulting from an increase in the present value of future expected benefit payments driven by decreases in interest rates and the impact of the annual assumption update.

Total liabilities decreased by $1.2 billion, from $51.8 billion at December 31, 2013 to $50.6 billion at September 30, 2014. Separate account liabilities decreased $2.2 billion offsetting the decrease in separate accounts assets above. Policyholders’ account balance decreased $0.5 billion primarily driven by account value runoff due to contractholder surrenders and the impact of the asset transfer feature which moved contractholder account values from the general account to the separate account, as discussed above. Partially offsetting the above decrease was an increase in Future policy benefits and other policyholder liabilities of $1.6 billion primarily driven by the mark-to-market of the liability for living benefit embedded derivatives, as discussed above.

Total equity was relatively unchanged from December 31, 2013 to September 30, 2014, reflecting dividends of $267 million paid to our parent, Prudential Annuities, Inc., partially offset by net income of $231 million for the first nine months of 2014.

Results of Operations

Income (Loss) from Operations before Income Taxes

2014 versus 2013 Three Month Comparison. Income from operations before income taxes decreased $472 million from $583 million in the third quarter of 2013 to $111 million in the third quarter of 2014. Excluding the impact on amortization of DAC and other costs, and on the reserves for the GMDB and GMIB features, due to the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and of changes in the estimated profitability of the business, as discussed in more detail below, income from operations before income taxes increased $65 million. The increase was primarily related to the mark-to-market of our non-reinsured living benefit features and related hedge positions, primarily due to the favorable variance of the annual assumption updates and NPR gains in the third quarter of 2014 compared to NPR losses in the third quarter of 2013 due to changes in interest rates.

The impact on amortization due to the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and the changes in the estimated profitability of the business resulted in a net benefit of $11 million in the third quarter of 2014. The net benefit primarily reflects an annual review and update of assumptions, partially offset by NPR gains in the third quarter of 2014 due to NPR spread widening and lower interest rates and an unfavorable impact of market performance on contractholder accounts relative to our assumptions. The net benefit of $548 million in the third quarter of 2013 primarily reflects an annual review and update of assumptions and other refinements and NPR losses in the third quarter of 2013 due to higher interest rates and a favorable impact of market performance on contractholder accounts relative to our assumptions.

2014 versus 2013 Nine Month Comparison. Income from operations before income taxes decreased $694 million from $967 million in the first nine months of 2013 to $273 million in the first nine months of 2014. Excluding the impact on amortization of DAC and other costs, and on the reserves for the GMDB and GMIB features, due to the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and of changes in the estimated profitability of the business, as discussed in more detail below, income from operations before income taxes increased $148 million. The increase was primarily related to the mark-to-market of our non-reinsured living benefit features and related hedge positions, primarily due to net hedge gains and lower interest rates in 2014 compared to net hedge losses and higher interest rates in 2013.

The impact on amortization due to the mark-to-market of the liability for living benefit embedded derivatives and related hedge positions and the changes in the estimated profitability of the business resulted in a net charge of $24 million in 2014. The net charge primarily reflects NPR gains in 2014 due to lower interest rates, and an unfavorable impact of market performance on contractholder accounts relative to our assumptions, partially offset by a net benefit driven by an annual review and update of assumptions, as discussed above. The net benefit of $818 million in 2013 primarily reflects an annual review and update of assumptions as discussed above, NPR losses in 2013 due to higher interest rates and a favorable impact of market performance on contractholder accounts relative to our assumptions.

Revenues, Benefits and Expenses

2014 versus 2013 Three Month Comparison. Revenues increased $58 million, primarily driven by a favorable variance in realized gains and losses of $68 million due to differences between the mark-to-market of the non-reinsured portion of the living benefit embedded derivative liability and related hedge positions. Offsetting this benefit was a decrease in net investment income of $12 million primarily as a result of lower portfolio yields due to lower reinvestment rates and lower average annuity account values in the general account.

Benefits and expenses increased $530 million. Absent the $537 million impacts of the amortization of DAC and other costs and to the reserves for the GMDB and GMIB features as discussed above, benefits and expenses decreased $7 million, primarily driven by lower interest credited of $6 million and lower interest expense of $2 million.

2014 versus 2013 Nine Month Comparison. Revenues increased $105 million, primarily driven by a favorable variance in realized gains and losses of $145 million due to differences between the mark-to-market of the non-reinsured portion of the living benefit embedded derivative liability and related hedge positions. Offsetting this benefit was a decrease in net investment income of $43 million primarily as a result of lower portfolio yields due to lower reinvestment rates and lower average annuity account values in the general account.

Benefits and expenses increased $799 million. Absent the $842 million impacts of the amortization of DAC and other costs and to the reserves for the GMDB and GMIB features as discussed above, benefits and expenses decreased $43 million, primarily driven by lower interest credited of $23 million and lower interest expense of $7 million.

 

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Income Taxes

Income tax expense decreased $167 million from $182 million for the three months ended September 30, 2013 to $15 million for the three months ended September 30, 2014. Income tax expense decreased $233 million from $275 million for the nine months ended September 30, 2013 to $42 million for the nine months ended September 30, 2014. The decrease in income tax expense was primarily driven by the decrease in pre-tax income.

The Company’s liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the Internal Revenue Service (“IRS”) or other taxing authorities. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards (“tax attributes”), the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the liability for income taxes.

The Company does not anticipate any significant changes within the next 12 months to its total unrecognized tax benefits related to tax years for which the statute of limitations has not expired.

As of September 30, 2014, the Company remains subject to examination in the U.S. for tax years 2009 through 2013.

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 2013 and current year results, and was adjusted to take into account the current year’s equity market performance. The actual current year DRD can vary from the estimate based on factors such as, but not limited to, changes in the amount of dividends received that are eligible for the DRD, changes in the amount of distributions received from mutual fund investments, changes in the account balances of variable life and annuity contracts, and the Company’s taxable income before the DRD.

In August 2007, the IRS released Revenue Ruling 2007-54, which included, among other items, guidance on the methodology to be followed in calculating the DRD related to variable life insurance and annuity contracts. In September 2007, the IRS released Revenue Ruling 2007-61. Revenue Ruling 2007-61 suspended Revenue Ruling 2007-54 and informed taxpayers that the U.S. Treasury Department and the IRS intend to address through new guidance the issues considered in Revenue Ruling 2007-54, including the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. In May 2010, the IRS issued an Industry Director Directive (“IDD”) confirming 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. In February 2014, the IRS released Revenue Ruling 2014-7, which modified and superseded Revenue Ruling 2007-54, by removing the provisions of Revenue Ruling 2007-54 related to the methodology to be followed in calculating the DRD and obsoleting Revenue Ruling 2007-61. These activities had no impact on the Company’s results in 2013 or in the first nine months of 2014. However, there remains the possibility that the IRS and the U.S. Treasury will address, through subsequent guidance, the issues related to the calculation of the DRD. For the last several years, the revenue proposals included in the Obama Administration’s budgets included a proposal that would change the method used to determine the amount of the DRD. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through guidance or legislation, could increase actual tax expense and reduce the Company’s consolidated net income.

In 2009, the Company joined in filing the consolidated federal tax return with its parent, Prudential Financial. For tax years 2009 through 2014, the Company is participating in the IRS’s Compliance Assurance Program (“CAP”). Under CAP, the IRS assigns an examination team to review completed transactions as they occur in order to reach agreement with the Company on how they should be reported in the relevant tax return. If disagreements arise, accelerated resolutions programs are available to try to resolve the disagreements in a timely manner before the tax return is filed.

In July 2014, the IRS issued an IDD relating to the hedging of variable annuity guaranteed minimum benefits (“Hedging IDD”). The Hedging IDD provides an elective safe harbor tax accounting method for these hedging activities that can be applied to open years under IRS examination beginning with the earliest open year. The Company is analyzing the potential impact of electing this tax accounting method.

Liquidity and Capital Resources

This section supplements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” included in our Annual Report on Form 10-K for the year ended December 31, 2013.

Overview

Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long term financial resources available to support the operations of our business, fund business growth, and provide a cushion to withstand adverse circumstances. Our ability to generate and maintain sufficient liquidity and capital depends on the profitability of our business, general economic conditions and our access to the capital markets through affiliates as described herein.

Effective and prudent liquidity and capital management is a priority across the organization. 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 available to us are sufficient to satisfy the current liquidity requirements of Prudential Financial, and the Company, including under reasonably foreseeable stress scenarios. Prudential Financial has a capital management framework in place that governs the allocation of capital and approval of capital uses, and Prudential Financial forecasts capital sources

 

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and uses on a quarterly basis. Prudential Financial also employs a “Capital Protection Framework” to ensure the availability of capital resources to maintain adequate capitalization and competitive risk-based capital ratios under various stress scenarios.

Prudential Financial is a “Designated Financial Company” under the Dodd-Frank Act. As a Designated Financial Company, Prudential Financial is subject to supervision and examination by the Federal Reserve Bank of Boston and to prudential regulatory standards, which include or will include requirements and limitations (some of which are the subject of ongoing rule-making) relating to risk-based capital, leverage, liquidity, stress-testing, overall risk management, resolution plans, early remediation; and may also include additional standards regarding capital, public disclosure, short-term debt limits, and other related subjects. In addition, the FSB, consisting of representatives of national financial authorities of the G20 nations, has identified Prudential Financial as a global systemically important insurer. For information on these recent actions and their potential impact on use, see “—Regulatory Developments” above, as well as “Business—Regulation” and “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2013.

On December 16, 2013, June 26, 2013 and June 27, 2014 the Company paid dividends of $100 million, $184 million and $267 million, respectively, to our parent, Prudential Annuities, Inc.

Capital

The Risk Based Capital, or RBC, ratio is a primary measure of the capital adequacy of the Company. RBC is calculated based on statutory financial statements and risk formulas consistent with the practices of the NAIC. RBC considers, among other things, risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer’s products and liabilities, interest rate risks and general business risks. RBC ratio calculations are intended to assist insurance regulators in measuring an insurer’s solvency and ability to pay future claims. The reporting of RBC measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities, but is available to the public. The RBC ratio is an annual calculation, however, as of September 30, 2014 we estimate that the Company’s RBC ratio exceeds the minimum level required by applicable insurance regulations.

The regulatory capital level of the Company can be materially impacted by interest rate and equity market fluctuations, changes in the values of derivatives, the level of impairments recorded, and credit quality migration of the investment portfolio, among other items. Further, the recapture of business subject to third-party reinsurance arrangements due to defaults by, or credit quality migration affecting, the third-party reinsurers or for other reasons could negatively impact regulatory capital.

Our regulatory capital levels are also affected by statutory accounting rules, which are subject to change by each applicable insurance regulator. As discussed above in “—Regulatory Developments,” the NY DFS has notified us that it does not agree with our calculation of statutory reserves (including the applicable credit for reinsurance) for New York purposes in respect of certain variable annuity products. If we are ultimately required to establish material additional reserves on a New York statutory accounting basis or post material amounts of additional collateral with respect to such variable annuity products, our ability to deploy capital for other purposes could be affected and/or we could be required to obtain additional funding from Prudential Financial or its affiliates.

In addition, the NAIC recently issued new guidance regarding the calculation of Total Adjusted Capital (“TAC”) that will directly affect the calculation of the RBC ratio. The new guidance, which is effective for December 31, 2014, will limit the portion of an insurer’s asset valuation reserve that can be counted as TAC to the amount not utilized in asset adequacy testing. We are currently assessing the impact of this guidance on the Company’s RBC ratio.

We employ a “Capital Protection Framework” to ensure that sufficient capital resources are available to maintain adequate capitalization and a competitive risk based capital ratio, under various stress scenarios. The Capital Protection Framework incorporates the potential impacts from market related stresses, including equity markets, real estate, interest rates, and credit losses. Potential sources of capital include on-balance sheet capital, derivatives, reinsurance and contingent sources of capital. Although we continue to enhance our approach, we believe we currently have access to sufficient resources to maintain adequate capitalization and a competitive RBC ratio under a range of potential stress scenarios.

Affiliated Captive Reinsurance Companies

Prudential Financial and the Company use captive reinsurance companies to more effectively manage its reserves and capital on an economic basis and to enable the aggregation and transfer of risks. The captive reinsurance companies assume business from affiliates only. To support the risks they assume, the captives are capitalized to a level we believe is consistent with the “AA” financial strength rating targets of Prudential Financial’s insurance subsidiaries. All of the captive reinsurance companies are wholly-owned subsidiaries of Prudential Financial and are located domestically, typically in the state of domicile of the direct writing insurance subsidiary that cedes the majority of business to the captive. In addition to state insurance regulation, our captives are subject to internal policies governing their activities. Prudential Financial provides support to these captives, typically through net worth maintenance agreements, and in the normal course of business will contribute capital to the captives to support business growth and other needs. In addition, in connection with financing arrangements, Prudential Financial may guarantee certain of the captives’ obligations.

We also manage certain risks associated with our variable annuity products through arrangements with an affiliated captive reinsurance company. We reinsure variable annuity living benefit guarantees to Pruco Re. This enables Prudential Financial to aggregate these risks within Pruco Re and manage them more efficiently through a hedging program. We believe Pruco Re currently maintains an adequate level of capital and access to liquidity to support this hedging program. However, Pruco Re’s capital and liquidity needs can vary significantly due to, among other things, changes in equity markets, interest rates, mortality and policyholder behavior. Through our Capital Protection Framework, Prudential Financial holds on-balance sheet capital and maintains access to committed sources of capital that are available to meet these needs as they arise.

 

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The NAIC, the NY DFS and other regulators continue to review life insurers’ use of captive reinsurance companies. A committee of the NAIC continues to consider changes to the NAIC accreditation standards that would regulate captive reinsurance companies that assume business directly written in more than one state as “multi-state reinsurers” and apply accreditation standards to those captives that historically were applicable only to traditional insurers. We cannot predict what changes may result from these initiatives, and what the ultimate impact may be to our business. We are evaluating, and will continue to monitor, the development of rules and regulations regarding captive reinsurance companies. If insurance laws are changed in a way that restricts our use of captive reinsurance companies in the future, our ability to write certain products and efficiently manage their associated risks could be adversely affected and we may need to increase prices on certain products, modify certain products or find alternate financing sources, any of which could adversely affect our competitiveness, capital and financial position and results of operations. Given the uncertainty of the ultimate outcome of these initiatives, at this time we are unable to estimate their expected effects on our future capital and financial position and results of operations.

Effective August 31, 2013, the Company re-domesticated from Connecticut to Arizona, and, as a result, PALAC is able to claim reinsurance reserve credit for business ceded to Pruco Re without the need for Pruco Re to post collateral.

Liquidity

There have been no material changes to the liquidity position of the Company since December 31, 2013. We continue to believe that cash generated by ongoing operations and the liquidity profile of our assets provide sufficient liquidity under reasonably foreseeable stress scenarios for the Company.

The principal sources of the Company’s liquidity are certain annuity considerations, investment and fee income, investment maturities, as well as internal borrowings. The principal uses of that liquidity include benefits, claims, and payments to policyholders and contractholders in connection with surrenders, withdrawals and net policy loan activity. Other uses of liquidity include commissions, general and administrative expenses, purchases of investments, and payments in connection with financing activities. As discussed above, in March 2010, the Company ceased offering its existing variable annuity products to new investors upon the launch of a new product line by certain affiliates. Therefore, the Company expects to continue to see the overall level of cash flows decrease going forward as the book of business runs off.

Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of the Company. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact of Prudential Funding, LLC’s financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company.

Liquid assets include cash and cash equivalents, short-term investments and fixed maturities that are not designated as held-to-maturity and public equity securities. As of September 30, 2014 and December 31, 2013, the Company had liquid assets of $3.0 billion and $3.4 billion, respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was $0.2 billion and $0.1 billion as of September 30, 2014 and December 31, 2013, respectively. As of September 30, 2014, $2.6 billion, or 92%, of the fixed maturity investments in company general account portfolios were rated high or highest quality based on NAIC or equivalent rating. The remaining $0.2 billion, or 8%, of these fixed maturity investments were rated other than high or highest quality.

Prudential Financial and Prudential Funding, LLC, or Prudential Funding, a wholly-owned subsidiary of Prudential Insurance, borrow funds in the capital markets primarily through the direct issuance of commercial paper. The borrowings serve as an additional source of financing to meet our working capital needs. Prudential Funding operates under a support agreement with Prudential Insurance whereby Prudential Insurance has agreed to maintain Prudential Funding’s positive tangible net worth at all times.

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 Exchange Act of 1934, or the “Exchange Act”, as amended, as of September 30, 2014. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2014, 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 September 30, 2014 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

See Note 6 to the Unaudited Interim Financial Statements under “—Litigation and Regulatory Matters” for a description of material pending litigation and regulatory matters affecting us, and certain risks to our businesses presented by such matters, which is incorporated herein by reference.

Item 1A. Risk Factors

You should carefully consider the risks described under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013. 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.

 

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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.

 

101.INS		-XBRL Instance Document.
101.SCH		-XBRL Taxonomy Extension Schema Document.
101.CAL		-XBRL Taxonomy Extension Calculation Linkbase Document.
101.LAB		-XBRL Taxonomy Extension Label Linkbase Document.
101.PRE		-XBRL Taxonomy Extension Presentation Linkbase Document.
101.DEF		-XBRL Taxonomy Extension Definition Linkbase Document.

 

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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.

 

Date: November 13, 2014

 

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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.

 

101.INS		-XBRL Instance Document.
101.SCH		-XBRL Taxonomy Extension Schema Document.
101.CAL		-XBRL Taxonomy Extension Calculation Linkbase Document.
101.LAB		-XBRL Taxonomy Extension Label Linkbase Document.
101.PRE		-XBRL Taxonomy Extension Presentation Linkbase Document.
101.DEF		-XBRL Taxonomy Extension Definition Linkbase Document.

 

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