(See Annex A for definitions of certain terms used in this Management s Discussion and Analysis)

Transcription

1 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF THE PRUDENTIAL INSURANCE COMPANY OF AMERICA AS OF AND FOR THE THREE MONTHS ENDED MARCH 31, 2006 (See Annex A for definitions of certain terms used in this Management s Discussion and Analysis) Summary of Principal Differences between SAP and GAAP The financial information for ( PICA ) in this Management s Discussion and Analysis has been prepared in accordance with SAP. SAP differs in certain respects, which in some cases may be material, from GAAP. The significant differences between SAP and GAAP are noted below: The SAP financial statements of PICA are not consolidated with those of its subsidiaries. Under SAP, policy acquisition costs, such as commissions, and other costs incurred in connection with acquiring new business, are expensed when incurred; under GAAP, such costs are deferred and amortized either over the expected lives of the contracts, based on the level and timing of either gross margins, gross profits or gross premiums, depending on the type of contract. Under SAP, the Commissioner's Reserve Valuation Method is used for the majority of individual insurance reserves; under GAAP, individual insurance policyholder liabilities for traditional forms of insurance are generally established using the net level premium method. For interest-sensitive policies, a liability for policyholder account balances is established under GAAP based on the contract value that has accrued to the benefit of the policyholder. Policy assumptions used in the estimation of policyholder liabilities are generally prescribed under SAP; under GAAP, policy assumptions are based upon best estimates as of the date the policy is issued, with provisions for the risk of adverse deviation. Under SAP, the Commissioner's Annuity Reserve Valuation Method is used for the majority of individual deferred annuity reserves; under GAAP, individual deferred annuity policyholder liabilities are generally equal to the contract value that has accrued to the benefit of the policyholder, together with liabilities for certain guarantees under variable annuity contracts. Under SAP, reinsurance reserve credits taken by ceding entities as a result of reinsurance contracts are netted against the ceding entity s policy and claim reserves and unpaid claims; under GAAP, reinsurance recoverables are reported as assets. Under SAP, an interest maintenance reserve ("IMR") is established to capture realized investment gains and losses, net of tax, on the sale of bonds resulting from changes in the general level of interest rates, and is amortized into income over the remaining years to expected maturity of the assets sold; under GAAP, no such reserve is required. Under SAP, an asset valuation reserve ("AVR") based upon a formula prescribed by the NAIC is established as a liability to offset potential non-interest related investment losses, and changes in the AVR are charged or credited directly to surplus; under GAAP, no such reserve is required. Under SAP, investments in bonds and preferred stocks are generally carried at amortized cost; under GAAP, investments in bonds and preferred stocks, other than those classified as held to

2 maturity, are carried at fair value. Under SAP, certain assets designated as non-admitted are excluded from assets by a direct charge to surplus; under GAAP, such assets are carried on the balance sheet with appropriate valuation allowances. Under SAP, surplus notes are recorded as a component of surplus; under GAAP, surplus notes are recorded as a liability. Overview PICA is one of the largest insurance companies in the United States. The principal products and services of PICA include individual life insurance and annuities, group insurance and pension and retirement products and related services and administration. The results in the analysis below include the results of the Closed Block business, which comprises the assets and related liabilities of the Closed Block defined below. The principal executive offices of PICA are located in Newark, New Jersey. At March 31, 2006, PICA's admitted assets were $232 billion (including $84 billion held in separate accounts), compared to $222 billion (including $77 billion held in separate accounts) at December 31, Excluding separate accounts, assets were primarily comprised of a mix of bonds, mortgage loans, contract loans, cash and short-term investments, and equity investments designed to match the cash flow requirements of insurance liabilities. On April 1, 2004, PICA purchased the retirement business of CIGNA Corporation for $2.12 billion, including $2.10 billion of cash consideration and $21 million of transaction costs. The acquisition of this business included the purchase by PICA of all the shares of CIGNA Life Insurance Company ( CIGNA Life ), which became a wholly owned subsidiary of PICA. Prior to the acquisition, CIGNA Life entered into reinsurance arrangements with wholly owned subsidiaries of CIGNA Corporation (collectively, CIGNA ) to effect the transfer of the retirement business included in the transaction to CIGNA Life. Subsequent to its acquisition, PICA changed the name of CIGNA Life to Prudential Retirement Insurance and Annuity Company ( PRIAC ). Goodwill from the purchase was $1.14 billion. Goodwill amortization relating to the purchase was $188 million for the year ended December 31, 2005 and $44 million for the three months ended March 31, The non-admitted portion of goodwill at March 31, 2006 was $179 million, compared to $195 million at December 31, Demutualization On the date of the demutualization, PICA converted from a mutual life insurance company to a stock life insurance company and became a direct, wholly owned subsidiary of PH, a wholly owned subsidiary of PFI. The demutualization was carried out under PICA s Plan of Reorganization, dated as of December 15, 2000, as amended. On the date of the demutualization, PFI completed an initial public offering of its Common Stock, as well as the sale of shares of Class B Stock, a separate class of common stock, through a private placement. In addition, on the date of the demutualization, PH, which owns the capital stock of PICA, issued $1.75 billion in senior secured notes (the "IHC debt"). A portion of the IHC debt was insured by a bond insurer. The Plan of Reorganization required PICA to establish and operate a regulatory mechanism known as the Closed Block. The policies that are included in the Closed Block (the "Closed Block Policies") are specified participating individual life insurance policies and individual annuity contracts that were in force on the date of the demutualization and on which PICA was paying or expected to pay experience-based policy dividends. The Closed Block is designed generally to provide for the reasonable expectations of holders of participating individual life insurance policies and annuities included in the Closed Block for future policy dividends after 2

3 demutualization by allocating assets that will be used for payment of benefits, including policyholder dividends, on these policies. The Plan of Reorganization provided that PICA may, with the prior consent of the Commissioner, enter into agreements to transfer to a third party all or any part of the risks under the Closed Block Policies. As of March 31, 2006, PICA had entered into reinsurance agreements covering 90% of the Closed Block Policies, including 17% with an affiliate. Results of Operations Net Income 2006 to 2005 Three Month Comparison. Net income decreased $79 million, from $401 million for the three months ended March 31, 2005 to $322 million for the three months ended March 31, Net income included a decrease in operating income before income taxes of $83 million, from $424 million for the three months ended March 31, 2005 to $341 million for the three months ended March 31, The decrease in operating income before income taxes was primarily driven by the following: A $48 million decline in the retirement business mainly due to lower net investment income and an increase in commissions as a result of increased structured settlement annuity sales; A $40 million decline in corporate and other primarily due to a decline in net investment income and an increase in general insurance expenses. The increase in general insurance expenses was driven by a decline in the prepaid pension benefit between periods; A $19 million decline in the group insurance business mainly due to less favorable mortality experience in the group life business. In addition, commissions, insurance expenses, and premium taxes increased between periods driven by an increase in premiums and the ongoing growth in the group insurance business. Partially offset by: A $35 million increase in the individual life and annuity business driven by increases in reserves in the prior year related to reinsurance agreements with affiliates, regarding assumed secondary guarantee reserves. These specific increases in reserves lowered operating income in the prior year, while not impacting the current year. Also contributing to the decline in net income was a $7 million decrease in net realized capital gains from $63 million for the three months ended March 31, 2005 to $56 million for the three months ended March 31, The change in net realized capital gains is discussed below under Capital Gains. Partially offsetting the declines in operating income before income taxes and net realized capital gains was a $11 million decrease in the income tax provision from $86 million for the three months ended March 31, 2005 to $75 million for the three months ended March 31, The change in the income tax provision is discussed below under Income Taxes. Change in Capital and Surplus 2006 to 2005 Three Month Comparison. Statutory capital (surplus plus the asset valuation reserve) increased $538 million, from $9,273 million at December 31, 2005 to $9,811 million at March 31, The change in capital was primarily driven by the following: Net income of $322 million, as discussed above under Net Income; and Change in net unrealized capital gains (losses) of $206 million, mainly attributable to an increase in common stock gains, driven by favorable equity market conditions in the first quarter of

4 Revenues 2006 to 2005 Three Month Comparison. Revenues increased $3,316 million, from $5,308 million for the three months ended March 31, 2005 to $8,624 million for the three months ended March 31, Premiums increased $3,771 million from $3,730 million for the three months ended March 31, 2005 to $7,501 million for the three months ended March 31, The change in premiums was primarily driven by: A $2,037 million increase in group insurance premiums, driven by increased sales of TOLI in the separate accounts and ongoing growth in the business for group life and disability and long-term care products; A $1,479 million increase in retirement premiums, driven by an increase in separate account premiums, primarily due to increased investments by institutional investors; A $277 million increase in premiums assumed, primarily under reinsurance agreements with affiliates, Gibraltar and PLIC. Net investment income, including amortization of IMR, decreased $56 million, from $1,847 million for the three months ended March 31, 2005 to $1,791 million for the three months ended March 31, The decrease between periods was mainly driven by an increase in investment expenses that was primarily the result of higher interest expenses on short-term borrowings from an affiliate and rebate expenses on reverse repurchase agreements. These increases were driven by higher overall levels of borrowings, as well as an increasing interest rate environment. Partially offsetting the increase in investment expenses was an increase in bond income, which was mainly due to a larger portfolio and higher interest rates. Other income decreased $399 million, from ($269) million for the three months ended March 31, 2005 to ($668) million for the three months ended March 31, The decrease in other income was driven by a $387 million change in reinsurance adjustments and commissions on reinsurance ceded mainly as a result of the reinsurance of a portion of the Closed Block business. The reinsurance of parts of the Closed Block business began in the fourth quarter of At March 31, 2005, 75% of the Closed Block business was reinsured. At March 31, 2006, 90% of the Closed Block business was reinsured. These reinsurance adjustments are mostly offset by premiums, benefits, withdrawals and policyholder dividends ceded as part of the reinsurance of the Closed Block business. Therefore, the impact of the reinsurance of the Closed Block business had a minimal effect on overall operating income. Benefits 2006 to 2005 Three Month Comparison. Total benefits, surrenders and fund withdrawals increased $2,151 million, from $3,852 million for the three months ended March 31, 2005 to $6,003 million for the three months ended March 31, The increase in total benefits, surrenders and fund withdrawals was primarily due to an increase in the retirement business as a result of several large withdrawals from separate accounts by institutional investors during the first quarter of Net Increase in Reserves 2006 to 2005 Three Month Comparison. Reserves decreased $46 million for the three months ended March 31, 2006, compared to an increase of $185 million for the three months ended March 31, The decrease of $231 million in the change in reserves between periods was primarily a result of decreases in the change in reserves in the retirement business of $384 million and the individual life and annuity business of $175 million. Partially offsetting these decreases in reserves was an increase of $293 million in reserves assumed, primarily under reinsurance agreements with affiliates, Gibraltar and PLIC. The decrease in the change in retirement 4

5 reserves was driven by an increase in general account surrenders and fund withdrawals. The decline in the individual life and annuity business was mainly due to an increase in reserves in the prior year related to reinsurance agreements with affiliates, regarding assumed secondary guarantee reserves. In addition, an increase in general account withdrawals and a decrease in general account premiums in the individual annuity products also contributed to the decrease in the change in reserves between periods. Commissions 2006 to 2005 Three Month Comparison. Commissions increased $18 million, from $110 million for the three months ended March 31, 2005 to $128 million for the three months ended March 31, The increase was primarily driven by an increase in the group insurance business as a result of increased sales and an increase in commissions and expense allowances assumed, which is primarily the result of the reinsurance agreements with Gibraltar and PLIC. The reinsurance agreements are discussed further under Contingencies. Other Expenses 2006 to 2005 Three Month Comparison. Other expenses increased $94 million, from $454 million for the three months ended March 31, 2005 to $548 million for the three months ended March 31, The increase was primarily driven by increases in the group insurance business, as expenses and premiums taxes rose consistent with the increase in sales. In addition, interest and adjustments on funds held under deposit-type fund contracts in the retirement business increased $44 million, mainly due to the increase in funding agreements issued by PICA over the last several periods. Net Transfer to Separate Accounts 2006 to 2005 Three Month Comparison. Net transfer to separate accounts was $1,497 million for the three months ended March 31, 2006, compared to $14 million for the three months ended March 31, The change between periods was driven by the group insurance and retirement businesses, mainly due to the increase in separate account premiums, as discussed above under Revenues. Dividends to Policyholders 2006 to 2005 Three Month Comparison. Dividends to policyholders decreased $116 million, from $269 million for the three months ended March 31, 2005 to $153 million for the three months ended March 31, The decrease was driven by the ceding of dividends related to the reinsurance of the Closed Block business, as described above under Revenues. Excluding the impact of the reinsurance of the Closed Block business, dividends to policyholders increased $33 million, which was primarily driven by increases in the individual life and annuity and group insurance businesses, as in-force policies matured. Income Taxes 2006 to 2005 Three Month Comparison. The income tax provision decreased $11 million, from $86 million for the three months ended March 31, 2005 to $75 million for the three months ended March 31, The decrease in the income tax provision was mainly driven by the reduction in operating income between periods. Capital Gains 2006 to 2005 Three Month Comparison. Net realized capital gains, after taxes and contribution to IMR, decreased $7 million, from $63 million for the three months ended March 31, 2005 to $56 million for the three months ended March 31, The following table sets forth the components of net realized capital gains: 5

6 Three Months Ended Three Months Ended March 31, March 31, Change Bonds... $ (57) $ 114 $ (171) Equity securities (12) Derivative instruments. (22) 11 (33) Other Gross realized capital gains (losses).. 21 $ 229 $ (208) Less capital gains tax (benefit) (116) Less IMR transfers, net of tax.. (40) 45 (85) Net realized capital gains (losses) $ 56 $ 63 $ (7) Gross realized capital gains decreased $208 million from $229 million for the three months ended March 31, 2005 to $21 million for the three months ended March 31, The decrease in gross realized capital gains was driven by a decline in gains on bonds and derivative instruments. The decline in bond gains was primarily due to a decline in trading gains between periods coupled with foreign exchange losses in the current period. In addition, a credit related gain during the first quarter of 2005 also contributed to the decline in bond gains between periods. Capital gains tax declined $116 million driven by lower gross realized gains. In addition to the reduction in taxes was a decrease of $85 million in IMR transfers, mainly driven by the lower gains on bonds. Net unrealized capital gains (losses) increased $206 million for the three months ended March 31, 2006 compared to a decrease of $129 million for the three months ended March 31, As discussed above under Change in Capital and Surplus, the increase during the first quarter of 2006 was mainly attributable to an increase in common stock gains, as equity markets were favorable during that period. The decrease in unrealized gains during the first quarter of 2005 was driven by losses in common stocks, as equity markets declined in that period. Other Components of Capital and Surplus 2006 to 2005 Three Month Comparison Change in net deferred taxes was $11 million for the three months ended March 31, 2006, compared to $79 million for the three months ended March 31, The decline between periods was driven by the declines in operating income and gross capital gains. Change in non-admitted assets was ($1) million for the three months ended March 31, 2006, compared to ($22) million for the three months ended March 31, The change during the first quarter of 2006 was driven by an increase in the prepaid pension asset partially offset by a reduction of non-admitted deferred income taxes and a reduction in non-admitted goodwill related mostly to the purchase of CIGNA Life (renamed PRIAC) in This decrease is mainly due to the ongoing amortization of the company s goodwill. The 6

7 change during the first quarter of 2005 was driven by an increase in non-admitted deferred income taxes and an increase in the prepaid pension asset and was also partially offset by a decline in non-admitted goodwill. Investment Results Management of Investments AL&RM designs asset mix strategies for PICA to match the characteristics of its products and other obligations and seeks to closely approximate the interest rate sensitivity of the assets with the estimated interest rate sensitivity of the product liabilities. AL&RM achieves income objectives through asset/liability management and strategic and tactical asset allocations within a disciplined risk management framework. AL&RM's asset allocation also reflects PICA's desire for broad diversification across asset classes, sectors and issuers. The Investment Committee of PICA's Board of Directors oversees its proprietary investments. It also reviews performance and risk positions quarterly. AL&RM oversees the investment process for PICA's general account and a Senior Vice President of AL&RM approves the investment policy for the general account assets of PICA and its insurance subsidiaries. Under his direction, AL&RM works with the business units to develop investment objectives, performance factors and measures and asset allocation ranges. AL&RM also works closely with each of PICA's business units to ensure that the specific characteristics of its products are incorporated into its processes. AL&RM has the authority to initiate tactical shifts within exposure ranges approved annually by the Investment Committee. The Investment Manager manages substantially all of PICA's investments, under the direction of AL&RM. Asset/Liability Management AL&RM uses a disciplined, risk-controlled approach to asset/liability management. The methodology focuses on aligning PICA's assets to the effective sensitivity of the cash flow and return requirements of PICA's liabilities. AL&RM consults with the product experts in the businesses on an ongoing basis to arrive at asset/liability matching policies and decisions. AL&RM s dynamic process allows them to adjust their strategy as products change, as PICA develops new products and as changes in the market environment occur. AL&RM develops asset strategies for specific classes of product liabilities and attributed or accumulated surplus, each with distinct risk characteristics. Most of PICA's products can be categorized according to the following three classes: interest-crediting products for which the rates credited to customers are periodically adjusted to reflect market and competitive forces and actual investment experience, such as fixed annuities; participating individual and experience rated group products in which customers participate in actual investment and business results through annual dividends, interest or return of premium; and guaranteed products for which there are price or rate guarantees for the life of the contract, such as GICs. AL&RM determines a target asset mix for each product class that PICA implements in its investment policies. AL&RM's asset/liability management process has permitted PICA to manage interest-sensitive products successfully through several market cycles. Summary of Investments PICA's general account investment portfolio consists of public and private bonds, mortgage loans, stocks, contract loans, real estate and other invested assets. The composition of PICA's portfolio reflects, within the 7

8 discipline provided by its risk management approach, its need for competitive results and the selection of diverse investment alternatives available primarily through its Investment Manager. The size of PICA's portfolio enables it to invest in asset classes that may be unavailable to the typical investor. The following table sets forth the composition of PICA's invested assets as of the dates indicated in accordance with SAP. March 31, 2006 December 31, 2005 Carrying % of Carrying % of Amount Total Amount Total Public bonds $75, % $73, % Private bonds 25, , Preferred stock 2, , Common stock 7, , Mortgage loans 14, , Real estate Contract loans 6, , Cash and short-term investments 7, , Other invested assets 1, , Receivables for securities Aggregate write-ins Total invested assets $142, % $139, % The overall income yield on PICA's invested assets after investment expenses, but excluding realized investment gains (losses), was 5.03% for the three months ended March 31, 2006, versus 5.39% for the three months ended March 31, The following table sets forth the income yield and investment income, excluding realized investment gains (losses), for each of PICA s major asset categories for the periods indicated. Quarter Ended March 31, 2006 March 31, 2005 Yield Amount Yield Amount Bonds 6.20 % $1, % $1,478 Stocks Mortgage loans Contract loans Cash and short-term investments Other investments Total before investment expenses 6.01 % $2, % $2,016 Total after investment expenses 5.03 % $1, % $1,814 Bonds PICA held approximately 71% of its invested general account assets in bonds at March 31, 2006, compared to approximately 72% at December 31, These securities included both publicly traded and privately placed debt securities representing an array of industry categories. PICA manages its public portfolio to a risk profile directed by AL&RM. PICA seeks to employ relative value analysis both in credit selection and in purchasing and selling securities. The total return that it earns on the portfolio is reflected both as investment income and also as realized gains or losses on investments. 8

9 PICA uses its private placement and asset-backed portfolios to enhance the diversification and yield of its overall bond portfolio. Over the last several years, the Investment Manager's investment staff has directly originated more than half of PICA's annual private placement originations. The Investment Manager's origination capability provides it with the opportunity to lead transactions and obtain better terms, such as covenants and call protection, and to take advantage of innovative transaction structures. The following table sets forth the composition of PICA's bond portfolio by industry category as of the dates indicated. March 31, 2006 December 31, 2005 % of Estimated % of Estimated Amortized Total Fair Amortized Total Fair Cost Cost Value Cost Cost Value US governments $6, % $6,598 $6, % $7,156 All other governments 1, ,586 1, ,430 States, territories & possessions (direct & guaranteed) Political subdivisions of states, territories and possessions (direct & guaranteed) Special revenue & special assessment obligations & 9, ,315 8, ,467 non guaranteed obligations of agencies Public utilities 6, ,243 7, ,915 Industrial & miscellaneous (unaffiliated) 75, ,874 75, ,205 Credit tenant loans (unaffiliated) Parent, subsidiaries and affiliates 1, ,426 1, ,491 Total long-term bonds $100, % $105,681 $100, % $104,330 The SVO of the NAIC evaluates the investments of insurers for regulatory reporting purposes and assigns bonds to one of six categories called "NAIC Designations." NAIC designations of "1" or "2" include bonds considered investment grade, which include securities rated Baa3 or higher by Moody's or BBB- or higher by S&P. NAIC Designations of "3" through "6" are referred to as below investment grade, which include securities rated Ba1 or lower by Moody's and BB+ or lower by S&P. As a result of time lags between the funding of investments, the finalization of legal documents, and the completion of the SVO filing process, the bond portfolio generally includes securities that have not yet been rated by the SVO as of each balance sheet date. Pending receipt of SVO ratings, the categorization of these securities by NAIC designation is based on the expected ratings indicated by internal analysis. 9

10 The following tables set forth PICA's public and private bond portfolios by NAIC rating as of the dates indicated. Public Bonds by Credit Quality March 31, 2006 December 31, 2005 Rating % of Estimated % of Estimated NAIC Agency Amortized Total Fair Amortized Total Fair Rating Equivalent Cost Cost Value Cost Cost Value 1 Aaa, Aa, A $51, % $55,705 $50, % $52,660 2 Baa 16, ,440 17, ,713 Subtotal Investment Grade $68, % $72,145 $67, % $70,373 3 Ba 4, ,447 4, ,176 4 B 2, ,591 2, ,088 5 C and lower In or near default Subtotal Below Investment Grade $7, % $7,239 $6, % $6,458 Total $75, % $79,384 $73, % $76,831 Private Bonds by Credit Quality March 31, 2006 December 31, 2005 Rating % of Estimated % of Estimated NAIC Agency Amortized Total Fair Amortized Total Fair Rating Equivalent Cost Cost Value Cost Cost Value 1 Aaa, Aa, A $7, % $7,553 $7, % $7,777 2 Baa 14, ,936 15, ,829 Subtotal Investment Grade $22, % $22,489 $22, % $23,606 3 Ba 2, ,184 2, ,193 4 B ,004 1, ,063 5 C and lower In or near default Subtotal Below Investment Grade $3, % $3,808 $3, % $3,893 Total $25, % $26,297 $26, % $27,499 The amortized cost of PICA's below-investment grade bonds as of March 31, 2006 totaled $10.7 billion, or 10.6% of total bonds, compared to $10.0 billion, or 10.0% of total bonds, as of December 31, PICA maintains separate monitoring processes for public and private bonds and creates watch lists to 10

11 highlight bonds that require special scrutiny and management. The public bond asset managers formally review all public bond holdings on a quarterly basis, and more frequently when necessary, to identify potential credit deterioration, whether due to ratings downgrades, unexpected price variances, and/or industry specific concerns. The Investment Manager classifies public bonds of issuers that have defaulted as securities not in good standing and all other public watch list assets as closely monitored. For private placements, the Investment Manager's credit and portfolio management processes help ensure prudent controls over valuation and management. The Investment Manager has separate pricing and authorization processes to establish "checks and balances" for new investments. The Investment Manager applies consistent standards of credit analysis and due diligence for all transactions, whether they originate through its own in-house origination staff or through agents. The Investment Manager's regional offices closely monitor the portfolios in their regions. The Investment Manager sets all valuation standards centrally and assesses the fair value of all investments quarterly. The private bond asset managers conduct specific servicing tests on each investment on an ongoing basis to determine whether the investment is in compliance or should be placed on the watch list or assigned an early warning classification. The Investment Manager assigns early warning classifications to those issuers that have failed a servicing test or experienced a minor covenant default, and the Investment Manager continues to monitor them for improvement or deterioration. In certain situations, the general account benefits from negotiated rate increases or fees resulting from a covenant breach. The Investment Manager assigns closely monitored status to those investments that have been recently restructured or for which restructuring is a possibility due to substantial credit deterioration or material covenant defaults. The Investment Manager classifies as not in good standing securities of issuers that are in relatively severe condition, for example bankruptcy or payment default. All bonds with unrealized losses are subject to review to identify other-than-temporary impairments in value. In evaluating whether a decline in value is other-than-temporary, PICA considers several factors including, but not limited to, the following: the extent (generally if greater than 20%) and the duration (generally if greater than six months) of the decline; the reasons for the decline in value (credit event or interest rate related); PICA's ability and intent to hold the investment for a period of time to allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When it is determined that there is an other-than-temporary impairment, PICA records a write down in its Statement of Operations and Changes in Surplus within "Net Realized Capital Gains (Losses)" to the estimated fair value of the bond, which reduces its amortized cost. The new cost basis of an impaired bond is not adjusted for subsequent increases in estimated fair value. Estimated fair values for bonds, other than private placement bonds, are based on quoted market prices or prices obtained from independent pricing services. Estimated fair values for private placement bonds are determined primarily by using a discounted cash flow model which considers the current market spreads between the U.S. Treasury yield curve and corporate bond yield curve, adjusted for type of issue, its current credit quality and its remaining average life. The estimated fair value of certain non-performing private placement bonds is based on management's estimates. Unrealized Losses from Bonds The following table sets forth the amortized cost and gross unrealized losses of bonds where the estimated fair value had declined and remained below amortized cost by 20% or more for the following timeframes: 11

12 Bonds March 31, 2006 December 31, 2005 Gross Gross Amortized Unrealized Amortized Unrealized Cost Losses Cost Losses Less than six months $24 $7 $55 $12 Six months or greater but less than nine months Nine months or greater but less than twelve months Twelve months and greater Total $24 $7 $55 $12 The gross unrealized losses as of March 31, 2006 and December 31,2005 were both primarily concentrated in the manufacturing sector. Preferred Stock PICA held approximately 2% of its invested general account assets in preferred stock as of March 31, 2006, compared to approximately 1% as of December 31, Common Stocks PICA held approximately 5% of its invested general account assets in common stock as of March 31, 2006, virtually unchanged from December 31, Substantially all of PICA's unaffiliated common stocks are publicly traded on national securities exchanges. Unrealized Losses from Common Stocks The following table sets forth the cost and gross unrealized losses of PICA's common stocks where the estimated fair value had declined and remained below cost by 20% or more for the following timeframes. Common Stocks March 31, 2006 December 31, 2005 Gross Gross Unrealized Unrealized Cost Losses Cost Losses Less than six months $24 $6 $72 $17 Six months or greater but less than nine months Nine months or greater but less than twelve months Twelve months and greater Total $24 $6 $72 $17 The gross unrealized losses as of March 31, 2006 were primarily concentrated in the manufacturing and services sectors while gross unrealized losses as of December 31, 2005 were primarily concentrated in the manufacturing, services and finance sectors. 12

13 Impairments of Common Stocks Common stocks with unrealized losses are subject to review to identify other-than-temporary impairments in value. In evaluating whether a decline in value is other-than-temporary, PICA considers several factors including, but not limited to, the following: the extent (generally if greater than 20%) and the duration (generally if greater than six months) of the decline; the reasons for the decline in value (a credit event or market fluctuation); PICA's ability and intent to hold the investment for a period of time to allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When it has been determined that there is an other-than-temporary impairment, PICA records a write down in its Statement of Operations and Changes in Capital and Surplus within "Net Realized Capital Gains (Losses)" to the estimated fair value, which reduces the cost basis. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. Estimated fair values for publicly traded common stock are based on quoted market prices or prices obtained from independent pricing services. Estimated fair values for privately traded common stock are determined using valuation and discounted cash flow models that call for the exercise of a substantial level of judgment by management. Mortgage Loans As of March 31, 2006, PICA held 10% of its invested general account assets in mortgage loans, compared to 11% as of December 31, The portfolio as of March 31, 2006 consisted of 1,043 commercial mortgage loans with an aggregate carrying value of $13.1 billion and 1,582 residential and agricultural mortgage loans with an aggregate carrying value of $1.7 billion. The Investment Manager originates commercial mortgages using dedicated investment staff and a network of independent companies through PICA's various regional offices across the country. All loans are underwritten consistently with PICA's standards using a proprietary quality rating system that has been developed using the Investment Manager's experience in real estate and mortgage lending. The loan portfolio strategy emphasizes diversification by property type and geographic location. The following tables set forth the breakdown of the mortgage loan portfolio by geographic region and property type as of the dates indicated. 13

14 March 31, 2006 December 31, 2005 Carrying % of Carrying % of U.S. Regions: Value Total Value Total Pacific $4, % $5, % South Atlantic 3, , Middle Atlantic 2, , East North Central 1, , Mountain West South Central 1, West North Central New England East South Central Total mortgage loans $14, % $14, % Of the mortgage loan portfolio as of March 31, 2006, the states with the most significant concentrations of mortgage loans were California and New York, with $3.8 billion and $1.5 billion, respectively. March 31, 2006 December 31, 2005 Carrying % of Carrying % of Value Total Value Total Property Type: Commercial properties $13, % $13, % Residential properties Agricultural properties 1, , Total mortgage loans $14, % $14, % The Investment Manager performs ongoing surveillance of the portfolio and places loans on watch list status based on a predefined set of criteria. Loans are placed on early warning status in cases where the Investment Manager detects that the physical condition of the property, the financial situation of the borrower or tenant, or other market factors could lead to a loss of principal or interest. Loans are classified as closely monitored when there is a collateral deficiency or other credit events that may lead to a potential loss of principal or interest. Loans not in good standing are those loans where there is a high probability of loss of principal, such as when the loan is in the process of foreclosure or the borrower is in bankruptcy. Workout and special servicing professionals manage the loans on the watch list. The following table shows the respective amounts of PICA's mortgage loan portfolio that are in good standing, are in good standing with restructured terms, have interest overdue more than three months but are not in foreclosure, and are in the process of foreclosure, as of the dates indicated. 14

15 March 31, December 31, Carrying Carrying Value Value Good standing $14,796 $14,796 Good standing with restructured terms 7 7 Interest overdue more than three months, not in foreclosure 2 8 Foreclosure in process 0 0 Total mortgage loans $14,805 $14,811 The low levels of delinquencies and loans in the process of foreclosure as of March 31, 2006 and December 31, 2005 were primarily attributable to the strong commercial real estate market in the United States in 2005 and to date in Joint Ventures and Limited Partnerships PICA's investments in joint ventures and limited partnerships were $1.8 billion as of March 31, 2006 and $1.6 billion as of December 31, The following table sets forth the composition of PICA's joint ventures and limited partnerships by type, as of the dates indicated. March 31, 2006 December 31, 2005 Carrying % of Carrying % of Value Total Value Total Joint venture interests in real estate $ % $ % Joint venture interests in common stock Joint venture interests in fixed income Joint venture interests - other Total joint ventures and limited partnerships $1, % $1, % Liquidity and Capital Resources Liquidity PICA's principal cash flow sources from insurance, annuities and guaranteed products are premiums and annuity considerations, investment and fee income, and investment maturities and sales. PICA supplements these cash inflows with financing activities. PICA s cash outflow requirements principally relate to benefits, claims, dividends paid to policyholders, and payments to contract holders in connection with surrenders, withdrawals and net policy loan activity. Benefits include the payment of benefits under life insurance, annuity and guaranteed products. PICA s uses of cash also include commissions, general and administrative expenses, purchases of investments, and debt service and repayments in connection with financing activities, as well as dividend payments to its parent, PH. Some of PICA's products, such as guaranteed products offered to institutional customers, provide for 15

16 payment of accumulated funds to the contract holder at a specified maturity date unless the contract holder elects to roll over the funds into another contract with PICA. PICA regularly monitors its liquidity requirements associated with policyholder and contract holder obligations so that it can manage cash inflows to match anticipated cash outflow requirements. In addition, PICA has several subsidiaries which are subject to regulatory limitations on the payment of dividends to PICA. The liquidity of PICA's operations is also related to the overall quality of its investments and its assetliability management. Net cash used in operations was ($205) million and ($29) million for the three months ended March 31, 2006 and March 31, 2005, respectively. The fluctuation between periods was primarily driven by higher other operating expenses, an increase in dividends to policyholders, and an increase in general account withdrawals in the retirement business. Net cash used in investing activities was ($459) million and ($2,637) million for the three months ended March 31, 2006 and March 31, 2005, respectively. The fluctuation between periods was primarily driven by an increase in bond proceeds. Net cash provided by financing activities was $1,463 million and $3,434 million for the three months ended March 31, 2006 and March 31, 2005, respectively. The decrease between periods was primarily due to less of an increase in proceeds from borrowed money of $2,137 million. During the first quarter of 2005, proceeds from borrowed money increased $2,514 million. During the first quarter of 2006, proceeds from borrowed money increased $377 million. PICA's management believes that its sources of liquidity are adequate to meet its current cash requirements and reasonably foreseeable contingencies, particularly considering the liquidity of its investment portfolio. The withdrawals included in operating activity above reflect contractually scheduled maturities of general account GICs totaling $428 million in Because these contractual withdrawals, as well as the level of surrenders experienced, were consistent with PICA's assumptions in asset liability management, the associated cash outflows did not have an adverse impact on PICA s overall liquidity. PICA uses surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of withdrawals of funds by customers from annuity and deposit contracts. The following table sets forth withdrawal characteristics of PICA's general account annuity reserves and deposit liabilities, based on statutory liability values, as of the dates indicated. March 31, 2006 December 31, 2005 Amount % of Total Amount % of Total Not subject to discretionary withdrawal provisions... $24, % $23,388 50% Subject to discretionary withdrawal, with adjustment: With market value adjustment... 4, % 5,848 12% At market value... 1,038 2 % 1,041 2% At contract value, less surrender charge of 5% or more... 1, % 1,693 4% Subtotal... $31, % $31,970 68% Subject to discretionary withdrawal at contract value with no surrender charge or surrender charge of less than 5%... 15, % 15,130 32% 16

17 Total annuity reserves and deposit liabilities... $47, % $47, % PICA believes that cash flows from operating and investing activities of its insurance, annuity and guaranteed products operations are adequate to satisfy liquidity requirements of these operations based on its current liability structure and considering a variety of reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors including future securities market conditions, changes in interest rate levels and policyholder perceptions of PICA's financial strength, which could lead to reduced cash inflows or increased cash outflows. As of March 31, 2006 and December 31, 2005, PICA had cash and short-term investments of approximately $7.3 billion and $6.5 billion, respectively, and investment grade bonds with a fair market value of $94.6 billion and $94.0 billion, respectively. Non-Insurance Contractual Obligations The following table presents PICA's contractual cash flow commitments on notes payable and other borrowings and surplus notes, excluding interest payable, as of March 31, This table does not reflect PICA's obligations under its insurance, annuity and guaranteed products contracts. Payment Due by Period Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years Notes payable and other borrowings... $ 7,408 $ 5,723 $ $1,685 $ Surplus notes Total... $ 8,108 $ 5,723 $ 250 $1,685 $ 450 In addition to the amounts shown above, PICA is party to operating leases for which its future minimum lease payments under non-cancelable leases were $364 million and $402 million as of March 31, 2006 and December 31, 2005, respectively. In the ordinary course of business, PICA utilizes financial instruments with off-balance sheet credit risk such as commitments and financial guarantees. Commitments primarily include commitments to fund investments in private placement securities, limited partnerships and other investments, as well as commitments to originate mortgage loans. These commitments totaled $7,217 million and $7,035 million as of March 31, 2006 and December 31, 2005, respectively. PICA also provides financial guarantees in connection with other transactions. These credit-related financial instruments have off-balance sheet credit risk because only their origination fees, if any, and accruals for probable losses, if any, are recognized until the obligation under the instrument is fulfilled or expires. These instruments can extend for several years and expirations are not concentrated in any period. PICA seeks to control credit risk associated with these instruments by limiting credit, maintaining collateral where customary and appropriate, and performing other monitoring procedures. PICA had issued financial guarantees of $1,521 million and $1,459 as of March 31, 2006 and December 31, 2005, respectively. 17

18 Contingencies PICA has entered into reinsurance agreements with PLIC, PLICK, and PLICT, all of which are affiliates of PICA. In each case, PICA has agreed to reinsure certain individual life insurance policies through a yearly renewable term contract. In addition, PICA has agreed to assume, on a co-insurance basis, U.S. dollardenominated annuities from PLIC and in 2005, PICA has agreed to assume, on a co-insurance basis, U.S. dollardenominated annuities from Gibraltar. Dryden Holdings Corporation, a wholly owned subsidiary of PICA, is subject to a Capitalization Condition that requires it to hold assets having an aggregate principal amount of at least $1,100 million as of July 23, PICA is obligated to satisfy any deficit in this Capitalization Condition. As of March 31, 2006, Dryden Holdings Corporation held assets with an aggregate principal amount of $1,030 million. PICA has committed to repurchase securities under master repurchase agreements in the amount of $13,766 million as of March 31, Financing PF, a wholly owned subsidiary of PICA, continues to serve as a source of financing for PICA and its subsidiaries, as well as for other subsidiaries of PFI. PF operates under a support agreement with PICA whereby PICA has agreed to maintain PF's positive tangible net worth at all times. PF borrows funds primarily through the direct issuance of commercial paper. PF s outstanding loans to other subsidiaries of PFI have declined over time as it transitions into a financing company primarily for PICA and its remaining subsidiaries. As of March 31, 2006, PF had a tangible net worth of $6.6 million and short-term and long-term notes outstanding of $7.6 billion and $803 million, respectively. As of March 31, 2006, PICA and PF had unsecured committed lines of credit totaling $2.54 billion. Of this amount, $0.5 billion is under a facility that expires in December 2006, $1.5 billion under a facility that expires in September 2010, and $0.54 billion under a facility that expires in December Borrowings under the outstanding facilities will mature no later than the respective expiration dates of the facilities. PICA uses these facilities primarily as back-up liquidity lines for its commercial paper programs and there were no outstanding borrowings under these facilities at March 31, 2006 or December 31, The ability to borrow under these facilities is conditioned on the continued satisfaction of customary conditions, including maintenance at all times by PICA of total adjusted capital of at least $5.5 billion based on SAP. PICA's total adjusted capital as of December 31, 2005 was $10.6 billion. In 2003, PICA established a Funding Agreement Notes Issuance Program pursuant to which a Delaware statutory trust issues medium-term notes secured by funding agreements issued to the trust by PICA. The funding agreements provide cash flow sufficient for the debt service on the medium-term notes. The mediumterm notes are sold in transactions not requiring registration under the Securities Act of 1933, as amended. Under SAP, debt of subsidiaries is not included in debt of PICA. Similarly, under SAP, debt of variable interest entities such as the trust is not included in debt of PICA. As a result, the medium-term notes are not included in the line item Notes payable and other borrowings on PICA s Statutory Statements of Admitted Assets, Liabilities and Capital and Surplus. As of March 31, 2006 and December 31, 2005, the outstanding aggregate principal amount of medium-term notes under the program totaled approximately $5.0 billion and $4.2 billion, respectively. Liabilities under the funding agreements issued by PICA to the trust in connection with each tranche of medium-term notes are included, along with liabilities relating to other funding agreements, in the line item Policyholders account balances on PICA s Statutory Statements of Admitted Assets, Liabilities and Capital and Surplus. 18