INDEX TO FINANCIAL STATEMENTS OF PICA

Transcription

1 INDEX TO FINANCIAL STATEMENTS OF PICA Report of Independent Auditors as of December 31, 2005 and 2004 and for the years ended December 31, 2005 and F-3 Audited Statutory Financial Statements as of December 31, 2005 and 2004 and for the years ended December 31, 2005 and 2004: Statutory Statements of Admitted Assets, Liabilities and Capital and Surplus...F-5 Statutory Statements of Operations and Changes in Capital and Surplus...F-6 Statutory Statements of Cash Flows...F-7 Notes to Statutory Financial Statements...F-8 NYA F-1

2 The PRUDENTIAL INSURANCE COMPANY OF AMERICA STATUTORY FINANCIAL STATEMENTS AND ADDITIONAL INFORMATION December 31, 2005 And 2004 and Report of Independent Auditors F-2

3 PricewaterhouseCoopers LLP PricewaterhouseCoopers Center 300 Madison Avenue New York NY Report of Independent Auditors To the Board of Directors of The Prudential Insurance Company of America We have audited the accompanying statutory statements of admitted assets, liabilities and capital and surplus of The Prudential Insurance Company of America, an indirect wholly owned subsidiary of Prudential Financial, Inc., (the Company ) as of December 31, 2005 and 2004, and the related statutory statements of operations and changes in capital and surplus, and cash flow for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 2 to the financial statements, the Company prepared these financial statements using accounting practices prescribed or permitted by the New Jersey Department of Banking and Insurance (the Department ), which practices differ from accounting principles generally accepted in the United States of America. The effects on the financial statements of the variances between such practices and accounting principles generally accepted in the United States of America are material; they are described in Note 2. In our opinion, because of the effects of the matter discussed in the preceding paragraph, the financial statements referred to above do not present fairly, in conformity with accounting principles generally accepted in the United States of America, the financial position of the Company as of December 31, 2005 and 2004, or the results of its operations or its cash flows for the years then ended. F-3

4 In our opinion, the financial statements referred to above present fairly, in all material respects, the admitted assets, liabilities and capital and surplus of the Company as of December 31, 2005 and 2004, and the results of its operations and its cash flow for the years then ended, on the basis of accounting described in Note 2. Our audit was conducted for the purpose of forming an opinion on the basic statutory basis financial statements taken as a whole. The accompanying Annual Statement Schedule 1 Selected Financial Data, Supplemental Investment Risk Interrogatories and Summary Investment Schedule (collectively the Schedules ) of the Company as of December 31, 2005 and for the year then ended are presented for purposes of additional analysis and are not a required part of the basic statutory basis financial statements. The effects on the Schedules of the variances between the statutory basis of accounting and accounting principles generally accepted in the United States of America are material; they are described in Note 2. As a consequence, the Schedules do not present fairly, in conformity with accounting principles generally accepted in the United States of America, such information of the Company as of December 31, 2005 and for the year then ended. The Schedules have been subjected to the auditing procedures applied in the audit of the basic statutory basis financial statements and, in our opinion, are fairly stated in all material respects in relation to the basic statutory basis financial statements taken as a whole. /s/ PRICEWATERHOUSECOOPERS LLP February 28, 2006 F-4

5 THE PRUDENTIAL INSURANCE COMPANY OF AMERICA STATUTORY STATEMENTS OF ADMITTED ASSETS, LIABILITIES AND CAPITAL AND SURPLUS December 31, ASSETS Bonds... $ 100,480 $ 93,884 Preferred stocks... 1,382 1,520 Common stocks... 7,458 7,097 Mortgage loans on real estate... 14,811 14,561 Real estate Contract loans... 6,348 6,340 Cash and short-term investments... 6,538 6,518 Other invested assets... 2,547 2,610 Total cash and invested assets , ,862 Premiums due and deferred... 1,255 1,057 Accrued investment income... 1,383 1,361 Net deferred tax asset... 1,149 1,286 Other assets Separate account assets... 77,465 69,942 TOTAL ASSETS... $ 221,916 $ 207,012 LIABILITIES AND SURPLUS Liabilities Policy liabilities and insurance reserves: Future policy benefits and claims... $ 90,461 $ 88,367 Advanced premiums Policy dividends... 2,325 2,268 Policyholders account balances... 15,145 12,532 Notes payable and other borrowings... 5,568 1,195 Asset valuation reserve... 2,208 2,153 Federal income tax payable ,140 Interest maintenance reserve... 1,226 1,228 Transfers to separate accounts due or accrued (103) (151) Cash collateral held for loaned securities... 16,482 14,401 Other liabilities... 3,747 5,760 Separate account liabilities... 77,165 69,670 Total liabilities , ,592 Capital and Surplus Common capital stock and gross paid in and contributed surplus... 2,943 3,707 Surplus notes Special surplus fund Unassigned surplus... 2,702 3,327 Total capital and surplus... 7,065 8,420 TOTAL LIABILITIES, CAPITAL AND SURPLUS... $ 221,916 $ 207,012 See Notes to Statutory Financial Statements F-5

6 THE PRUDENTIAL INSURANCE COMPANY OF AMERICA STATUTORY STATEMENTS OF OPERATIONS AND CHANGES IN CAPITAL AND SURPLUS REVENUE Year Ended December 31, Premiums and annuity considerations... $16,527 $ 15,469 Net investment income... 7,309 7,155 Other income... (1,522) (265) Total Revenue... 22,314 22,359 BENEFITS AND EXPENSES Death benefits... 3,271 3,804 Annuity benefits... 4,369 4,423 Disability benefits Other benefits Surrenders, benefits and fund withdrawals... 6,617 8,620 Net increase in reserves... 2, Commissions Net transfer to (from) separate accounts (1,814) Other expenses... 1,888 1,944 Total Benefits and Expenses... 20,251 18,903 Operating income before dividends and income taxes... 2,063 3,456 Dividends to policyholders ,615 Operating income before income taxes... 1,512 1,841 Income tax (benefit) provision... (333) 345 Income from Operation... 1,845 1,496 Net Realized Capital Gains NET INCOME... $ 2,170 $ 1,878 CAPITAL AND SURPLUS Capital and Surplus, beginning of year... $ 8,420 $ 7,471 Change in common capital stock and gross paid in and contributed surplus... (764) (600) Change in surplus notes Change in special surplus (221) Net Income... 2,170 1,878 Change in net unrealized capital (losses) gains... (572) 199 Change in non-admitted assets... (450) (443) Change in asset valuation reserve... (54) (14) Change in net deferred taxes... (193) (92) Change due to valuation method Dividends to stockholders... (1,486) - Change in accounting principles... (31) - Other changes, net... (10) 196 Change in Unassigned Surplus... (625) 1,770 CAPITAL AND SURPLUS, END OF PERIOD... $ 7,065 $ 8,420 See Notes to Statutory Financial Statements F-6

7 THE PRUDENTIAL INSURANCE COMPANY OF AMERICA STATUTORY STATEMENTS OF CASH FLOW CASH FLOW FROM OPERATING ACTIVITIES Years Ended December 31, Premiums and annuity considerations... $ 16,368 $ 14,648 Net investment income... 7,296 6,910 Other income... 1,175 (361) Separate account transfers... (866) 2,155 Benefits and claims paid... (18,304) (17,867) Policyholders dividends paid... (493) (1,832) Federal income taxes... (606) 97 Other operating expenses... (1,808) (1,926) Net cash provided by operating activities... 2,762 1,824 CASH FLOW FROM INVESTING ACTIVITIES Proceeds from investments sold, matured, or repaid Bonds... 65,879 67,693 Stocks... 2,111 2,596 Mortgage loans on real estate... 2,372 2,562 Real estate Miscellaneous proceeds ,260 Payments for investments acquired Bonds... (72,457) (74,235) Stocks... (2,533) (5,327) Mortgage loans on real estate... (2,621) (3,399) Real estate... (5) (17) Miscellaneous applications... (912) (1,123) Net cash used in investing activities... (7,391) (7,803) CASH FLOW FROM FINANCING ACTIVITIES Proceeds from borrowed money... 4, Dividends paid to stockholder... (1,486) - Net proceeds from surplus paid in... (764) (600) Other financing activities... 2,684 2,657 Net cash provided by (used in) financing... 4,649 2,575 Net change in cash and short-term investments (3,404) Cash and short-term investments, beginning of year... 6,518 9,922 CASH AND SHORT-TERM INVESTMENTS, END OF PERIOD... $ 6,538 $ 6,518 See Notes to Statutory Financial Statements F-7

8 THE PRUDENTIAL INSURANCE COMPANY OF AMERICA NOTES TO STATUTORY FINANCIAL STATEMENTS 1. BUSINESS The Prudential Insurance Company of America (the Company or Prudential Insurance ) is a wholly owned subsidiary of Prudential Holdings, LLC ( Prudential Holdings ), which is a wholly owned subsidiary of Prudential Financial, Inc. ( Prudential Financial ). The principal products and services of the Company include individual life insurance, annuities, group insurance and retirement services. 2. SIGNIFICANT ACCOUNTING POLICIES AND PRINCIPLES The Company, domiciled in the State of New Jersey, prepares its statutory financial statements in accordance with accounting practices prescribed or permitted by the New Jersey Department of Banking and Insurance (the Department ). Prescribed statutory accounting practices ( SAP ) include publications of the National Association of Insurance Commissioners ( NAIC ), state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. NAIC SAP reporting differs from accounting principles generally accepted in the United States ( GAAP ). NAIC SAP is designed to address the concerns of regulators. GAAP is designed to meet the varying needs of the different users of financial statements. NAIC SAP is considered to be more conservative than GAAP in certain respects and attempts to determine at the financial statement date an insurer s ability to pay claims in the future. GAAP, on the other hand, stresses measurement of emerging earnings of a business from period to period, by matching revenue to expense. A. Basis of presentation The State of New Jersey requires that insurance companies domiciled in the State of New Jersey prepare their statutory basis financial statements in accordance with the NAIC Accounting Practices and Procedures Manual ( NAIC SAP or the "Manual"), subject to any deviations prescribed or permitted by the Department ( NJ SAP ). The Company s statutory accounting policies differ from the Manual due to deviations prescribed and permitted by the Department. NAIC SAP and NJ SAP differ from GAAP in certain respects, which in some cases may be material. The primary differences between SAP and GAAP are noted below: The SAP financial statements of Prudential Insurance 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. 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. For interestsensitive 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. 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. F-8

9 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 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. The following is a summary of accounting practices permitted and prescribed by the Department and reflected in the Company s statutory financial statements: The Company sold synthetic guaranteed investment contracts ( GICs ) containing minimum investment related guarantees on qualified pension plan assets. The assets are owned by the trustees of such plan, who invest the assets under the terms of investment guidelines agreed to with the Company. The investment related guarantees may include a minimum rate of return on the underlying assets and/or a guarantee of liquidity to meet plan cash flow requirements. The Company, with the approval of the Department, reports in Exhibit 7 of its Annual Statement the net reserve for these contracts. The net reserve is calculated as the excess, if any, of the present value of liability cash flows over the market value of the assets. NAIC guidance allows for an interest rate of up to 5% to be used for the calculation of the present value of liability cash flows. The practice permitted by the Department requires a 4.5% interest rate to be used. For both 2005 and 2004 the liability was zero. In conjunction with the Company s reinsurance of the Closed Block (See Note 2.H for further information regarding the Closed Block formation) in 2003, the Company received approval on January 29, 2004 from the Department to report the initial Modified Coinsurance ( MODCO ) reserves ceded to the reinsurer as Other income in the revenue section of the Summary of Operations. Although not specifically outlined in statutory guidance, industry practice is to report this amount in Premium and annuity considerations in the Statutory Statements of Operations and Changes in Capital and Surplus. The Company records leasehold improvements as admitted assets. NJ SAP allows insurance companies domiciled in New Jersey to admit leasehold improvements as admitted assets. Prescribed statutory accounting practices, per the Manual, require non-admittance of leasehold improvements. F-9

10 A reconciliation of the Company s net income and capital and surplus at December 31, between NAIC SAP and NJ SAP is shown below: Net Income, NJ SAP... $ 2,170 $ 1,878 State Permitted Practices (Income) State Prescribed Practices (Income) Net Income, per the Manual... $ 2,170 $ 1,878 Statutory Surplus, NJ SAP... $ 7,065 $ 8,420 State Permitted Practices (Surplus) State Prescribed Practices (Surplus): Admit leasehold improvements Statutory Surplus, per the Manual... $ 7,005 $ 8,353 The effects of the difference on surplus and net income between accounting practices prescribed or permitted by the Department and GAAP are as follows: GAAP net income is increased by $150 million and $18 million, to $2,320 million and $1,896 million in 2005 and 2004, respectively. GAAP equity is increased by $10,694 million and $10,247 million, to $17,699 million and $18,600 million in 2005 and 2004, respectively. B. Use of estimates The preparation of financial statements in conformity with NJ SAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ from those estimates. C. Investments Bonds, which consist of long-term bonds, are stated primarily at amortized cost in accordance with the valuation prescribed by the Department and the NAIC. For other than temporary impairments, the cost basis of the bond is written down to fair market value as a new cost basis and the amount of the write down is accounted for as a realized loss. Preferred stocks include unaffiliated preferred stocks and investments in subsidiaries. Preferred stocks rated by the NAIC are classified into six categories ranging from highest quality preferred stocks to those in or near default. Preferred stocks rated in the top three categories are generally valued at amortized cost while preferred stock rated in the lower three categories are valued at lower of amortized cost or market. Common Stocks include unaffiliated common stocks and investments in subsidiaries. Unaffiliated common stocks are carried at fair value. Investments in subsidiaries are accounted for using an equity method as defined in SSAP No. 88, Investments in Subsidiary, Controlled and Affiliated Entities, a Replacement of SSAP No. 46 ( SSAP No. 88 ). Investments in insurance subsidiaries are recorded based on the underlying audited statutory equity of the respective entity's financial statements, adjusted for unamortized goodwill as provided for in SSAP No. 68, Business Combinations and Goodwill. Investments in non-insurance subsidiaries that do not engage in certain transactions or activities, per paragraph 8b ii of SSAP No. 88, are recorded based on the audited U.S. GAAP equity of the investee. The subsidiaries' change in net assets, excluding capital contributions and distributions, is included in Change in net unrealized capital F-10

11 gains. Dividends are recognized in net investment income when declared. The subsidiaries are engaged principally in the business of life insurance and annuities. Mortgage loans on real estate are stated primarily at unpaid principal balances, net of unamortized premiums and discounts and impairments. Impaired loans are identified by management as loans in which a probability exists that all amounts due according to the contractual terms of the loan agreement will not be collected. Interest received on impaired loans, including loans that were previously modified in a troubled debt restructuring, is generally either applied against the principal or reported as revenue, according to management s judgment as to the collectibility of principal. Management discontinues accruing interest on impaired loans after the loans are 90 days delinquent as to principal or interest, or earlier when management has substantial doubts about collectibility. When this interest is deemed uncollectible, it is reversed against interest income on loans for the current period. Generally, a loan is restored to accrual status only after all delinquent interest and principal are brought current and, in the case of loans where interest has been interrupted for a substantial period, a regular payment performance has been established. Interest income on non-performing loans is generally recognized on a cash basis. Real estate includes properties occupied by the Company, properties held for production of income and properties held for sale. Properties occupied by the Company and properties held for the production of income are carried at cost less accumulated straight-line depreciation, encumbrances and permanent impairments in value. Properties held for sale are valued at lower of depreciated cost or fair value less encumbrances and disposition costs. Contract loans are stated at unpaid principal balances. Cash includes cash on deposit and cash equivalents. Cash equivalents are short-term, highly liquid investments, with original maturities of three months or less, that are both readily convertible to known amounts of cash and so near their maturity that they represent insignificant risk of changes in value because of changes in interest rates. Short-term investments include money market funds and highly liquid debt instruments purchased with a remaining maturity of twelve months or less, excluding those investments classified as cash equivalents. They are stated at amortized cost, which approximates fair value. Other invested assets include primarily the Company's investment in joint ventures, limited liability companies and other forms of partnerships. These investments are accounted for using an equity method as defined in SSAP No. 88. These entities are valued based on the underlying audited U.S. GAAP equity of the investee. The cost method is used for all other assets. Derivatives used by the Company include swaps, futures, forwards and option contracts and may be exchange-traded or contracted in the over-the-counter market. Derivatives are recognized in the Statutory Statements of Admitted Assets, Liabilities and Capital and Surplus at their estimated fair value or at amortized cost in "Other invested assets" or "Other liabilities. Derivatives that qualify for hedge accounting are recognized in a manner consistent with the hedged item at their estimated fair value or at amortized cost. All other derivatives are recognized at their estimated fair value. Securities lending is a program whereby the Company loans securities to third parties, primarily major brokerage firms. Company and NAIC policies require a minimum of 102% and 105% of the fair value of the domestic and foreign loaned securities, respectively, to be separately maintained as collateral for the loans. Cash collateral received of $4,560 million is not restricted and is invested in Bonds, Short-term investments and Cash ; the offsetting collateral liability of $4,560 million is included in Cash collateral held for loaned securities. Non-cash collateral of $250 million is not reflected in the Statements of Assets, Liabilities and Capital and Surplus. Repurchase agreements and reverse repurchase agreements are agreements between a seller and a buyer, whereby the seller of securities sells and simultaneously agrees to repurchase the same or substantially the same securities from the buyer at an agreed upon price and, usually, at a stated date. Dollar repurchase agreements and reverse dollar repurchase agreements involve debt instruments that are pay-through securities collateralized with GNMA, FNMA and FHLMC and similar securities. The Company typically uses "to be announced" ("TBAs") securities in the dollar repurchase and F-11

12 reverse dollar repurchase agreements which are accounted for as derivatives. Dollar repurchase and reverse dollar repurchase agreements are reported in "Other invested assets" with the change in value reported as "Change in net unrealized capital gains". "Net realized capital gains" are recorded upon termination of the agreements. Loan-backed and structured securities holdings are carried at amortized cost. Cost is recalculated utilizing a retrospective method with the exception of interest only bonds. Each acquisition lot is reviewed to recalculate the effective yield. The recalculated effective yield is used to derive a book value as if the new yield is applied at the time of acquisition. Outstanding principal factors from the time of acquisition to adjustment date were used to calculate the prepayment history for all applicable securities. Conditional prepayment rates, computed with life to date factor histories and weighted average maturities, are used to affect the calculation of projected payments for pass through, interest only and principal only security types. Interest only bond adjustments are developed on a prospective basis with adjustments made for permanent impairments, if needed. Net realized capital gains/(losses) are computed using the specific identification method. Costs of investments are adjusted for impairments considered other than temporary. Interest rate related gains and losses are transferred to the IMR and amortized into net investment income over the expected remaining life of the investments sold. D. Separate account assets and liabilities Separate account assets and liabilities are reported at estimated fair value and represent segregated funds, which are invested for certain policyholders, pension funds and other customers. The assets consist primarily of common stocks, long-term bonds, real estate, mortgages and short-term investments. The assets of each account are legally segregated and are not subject to claims that arise out of any other business of the Company. The liabilities include reserves established to meet withdrawal and future benefit payment contractual provisions. Investment risks associated with fair value changes are generally borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Mortality, policy administration and surrender charges on the accounts are included in Other income. F-12

13 The following table provides the Company s separate accounts premiums, considerations or deposits and reserves as of December 31: Nonindexed Guarantee Less than/equal to 4% Nonindexed Guarantee More than 4% 2005 Nonguaranteed Separate Accounts Premiums, considerations or deposits for year ended December 31, 2005 $ 76 $ - $ 8,828 $ 8,904 Reserves at December 31, 2005: For accounts with assets at: Market value Amortized cost Total reserves $ 20, $ 20,966 $ $ 381 $ 47,373 - $ 47,373 Total $ 68, ,720 By withdrawal characteristics With market value adjustment At book value without market value adjustment At market value Subtotal Not subject to discretionary withdrawal Total reserves $ ,633 3,577 17,389 $ 20,966 $ $ 381 $ ,619 46, $ 47,373 $ ,633 50,578 18,143 $ 68,721 Nonindexed Guarantee Less than/equal to 4% Nonindexed Guarantee More than 4% 2004 Nonguaranteed Separate Accounts Premiums, considerations or deposits for year ended December 31, 2004 $ 1,246 $ - $ 6,527 $ 7,773 Reserves at December 31, 2004: For accounts with assets at: Market value Amortized cost Total reserves $ 21, $ 21,845 $ $ 378 $ 40,339 - $ 40,339 Total $ 62, ,562 By withdrawal characteristics With market value adjustment At book value without market value adjustment At market value Subtotal Not subject to discretionary withdrawal Total reserves $ ,017 3,966 17,879 $ 21,845 $ $ 378 $ ,620 39, $ 40,339 $ ,015 43,964 18,598 $ 62,562 Net transfers to (from) the separate accounts as of December 31 were as follows: Nonindexed Guarantee Less than/equal to 4% Nonindexed Guarantee More than 4% 2005 Nonguaranteed Separate Accounts Transfers to separate accounts... $ 76 $ - $ 8,673 $ 8,750 Transfers from separate accounts... 1, ,182 7,836 Net transfers to (from) separate accounts... $ (1,574) $ (4) $ 2,491 $ 914 Total F-13

14 Nonindexed Guarantee Less than/equal to 4 % Nonindexed Guarantee More than 4% 2004 Nonguaranteed Separate Accounts Transfers to separate accounts... $ 1,246 $ - $ 5,810 $ 7,056 Transfers from separate accounts... (551) 21 9,400 8,870 Net transfers to (from) separate accounts... $ 1,797 $ (21) $ (3,590) $ (1,814) Total E. Policyholders dividends The amount of dividends to be paid to policyholders is determined annually by the Company s Board of Directors. The aggregate amount of policyholders dividends is based on statutory results and past experience of the Company, including investment income, net realized investment gains or losses over a number of years, mortality experience and other factors. Dividends declared by the Board of Directors, which have not been paid, are included in Policy dividends in the Statutory Statements of Admitted Assets, Liabilities, and Capital and Surplus. F. Insurance revenue and expense recognition Life premiums are recognized as revenue over the premium-paying period of the related policies. Annuity considerations are recognized as revenue when received. Health premiums are earned ratably over the terms of the related insurance and reinsurance contracts or policies. Expenses incurred in connection with acquiring new insurance business, including acquisition costs such as sales commissions, are charged to operations as incurred. G. Income taxes The Company and its domestic subsidiaries file a consolidated federal income tax return with Prudential Financial. The Internal Revenue Code (the Code ) taxes the Company on operating income after dividends to policyholders plus realized gains/losses. Deferred income taxes are recognized in accordance with SSAP No. 10, based upon enacted rates, when assets and liabilities have different values for financial statement and tax reporting purposes. Income from sources outside the United States is taxed under applicable foreign statutes. Pursuant to a tax allocation arrangement, total federal income tax expense is determined on a separate company basis. Members with losses record current tax benefits to the extent such losses are recognized in the consolidated federal and state and local provision. H. Closed Block On December 18, 2001 (the date of demutualization ) the Company converted from a mutual life insurance company to a stock life insurance company and became a direct, wholly owned subsidiary of Prudential Holdings, which became a direct wholly owned subsidiary of Prudential Financial. The demutualization was completed in accordance with the Company s Plan of Reorganization, which was approved by the Commissioner of Banking and Insurance of the State of New Jersey in October On the date of demutualization, the Company established a closed block for certain individual life insurance policies and annuities issued by the Company in the United States and a separate closed block for participating individual life insurance policies issued by the Company s Canadian branch (collectively the closed block ). The policies included in the closed block are specified individual life insurance policies and individual annuity contracts that were in force on the effective date of the Plan of Reorganization and on which the Company is currently paying or expects to pay experience-based policy dividends. Assets have been allocated to the closed block in an amount that has been determined to produce cash flows F-14

15 which, together with revenues from policies included in the closed block, are reasonably expected to be sufficient to support obligations and liabilities relating to these policies, including provision for payment of benefits, certain expenses, and taxes and to provide for continuation of the policyholder dividend scales in effect in 2000, if experience underlying such scale continues and for appropriate adjustments in such scales if the experience changes. The closed block assets, the cash flows generated by the closed block assets and the anticipated revenues from the policies in the closed block will benefit only the policyholders in the closed block. To the extent that, over time, cash flows from the assets allocated to the closed block and claims and other experience related to the closed block are, in the aggregate, more or less favorable than what was assumed when the closed block was established, total dividends paid to closed block policyholders in the future may be greater than or less than the total dividends that would have been paid to these policyholders if the policyholder dividend scales in effect in 2000 had been continued. Any cash flows in excess of amounts assumed will be available for distribution over time to closed block policyholders and will not be available to stockholders. If the closed block has insufficient funds to make guaranteed policy benefit payments, such payments will be made from assets outside of the closed block. The closed block will continue in effect as long as any policy in the closed block remains in-force. I. Reclassification Certain amounts in the prior year have been reclassified to conform to the current year presentation. 3. ADOPTION OF NEW STATUTORY ACCOUNTING PRINCIPLES On January 1, 2005 the Company adopted SSAP No. 88, which resulted in the following changes: Prior to SSAP No. 88, investments in the preferred stock of subsidiaries were accounted for using an equity method as defined in SSAP No. 46, Investments in Subsidiary, Controlled and Affiliated Entities ( SSAP No. 46 ). Investments in non-insurance subsidiary, controlled and affiliated entities ( SCAs ) that had no significant ongoing operations other than to hold assets that were primarily for the direct or indirect benefit or use of the reporting entity or its affiliates were recorded based upon the underlying equity of the respective entity s financial statements adjusted to a statutory basis of accounting. The change in net assets was included in Change in net unrealized capital gains (losses). Effective with SSAP No. 88, investments in the preferred stock of subsidiaries are accounted for using an amortized cost method as defined in SSAP No. 32, Investments in Preferred Stock. Prior to SSAP No. 88, investments in the common stock of investment subsidiaries, controlled and affiliated entities ( SCAs ) and in joint venture, limited liability companies and other forms of partnerships that were classified as SCAs were also accounted for using an equity method as defined in SSAP No. 46. Investments in non-insurance SCAs that had no significant ongoing operations other than to hold assets that were primarily for the direct or indirect benefit or use of the reporting entity or its affiliates were recorded based upon the underlying equity of the respective entity s financial statements adjusted to a statutory basis of accounting. Investments in non-insurance SCAs that had significant operations beyond the holding of assets that were primarily for the direct or indirect benefit or use of the reporting entity or its affiliates were recorded based upon the audited U.S. GAAP equity of the investee. Effective with SSAP No. 88, all of the Company s noninsurance SCAs that are classified as Common stocks or Other invested assets are recorded based on the audited U.S. GAAP equity of the investee. The change in US GAAP equity is included in Change in net unrealized capital gains. The Company has assessed the non-insurance entities subject to SSAP No. 88 and, based upon the amount of capital that these entities represent and the Company s strong capital position, the Company has decided not to obtain GAAP audits for 32 entities as of December 31, The Company will therefore value these entities for purposes of its financial statements at zero as of that date and record the change in Change in net unrealized capital (losses) gains in the Statement of Operations and Changes in Surplus. Notwithstanding this valuation, the Company expects its capital and surplus position to remain at a level consistent with its AA rating objective. At the end of future fiscal years, the Company may decide to obtain U.S. GAAP audits for entities subject to SSAP No. 88 and thereby restore their equity value for purposes of inclusion in capital and surplus. F-15

16 As of January 1, 2005, the Company reported a change of accounting principle due to the adoption of SSAP No. 88, as an adjustment of approximately $30 million that decreased unassigned funds via Change in accounting principles in the Statement of Operations and Changes in Surplus. Accounting changes adopted to conform to the provisions of the Manual are reported as changes in accounting principles. The cumulative effect of changes in accounting principles is reported as an adjustment to unassigned funds (surplus) in the period of the change in accounting principle. The cumulative effect is the difference between the amount of capital and surplus at the beginning of the year and the amount of capital and surplus that would have been reported at that date if the new accounting principles had been applied retroactively for all prior periods. 4. BUSINESS COMBINATIONS AND GOODWILL On April 1, 2004, the Company 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 the Company of all the shares of CIGNA Life Insurance Company ("CIGNA Life"), which became a wholly owned subsidiary of the Company. 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, the Company 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 and $194 million for the years ended December 31, 2005 and 2004, respectively. The non-admitted portion of goodwill for the years ended December 31, 2005 and 2004 was $195 million and $443 million, respectively. 5. INVESTED ASSETS A. Bonds and stocks The Company invests in both investment grade and non-investment grade public and private bonds. The Securities Valuation Office of the NAIC rates the bonds held by insurers for regulatory purposes and classifies investments into six categories ranging from highest quality bonds to those in or near default. The lowest three NAIC categories represent primarily high-yield securities and are defined by the NAIC as including any security with a public agency rating equivalent to B+ or B1 or less. Securities in these lowest three categories approximated 3.8% and 3.4% of the Company s bonds at December 31, 2005 and 2004, respectively. F-16

17 The following tables provide additional information relating to bonds and unaffiliated preferred stocks as of December 31: 2005 Gross Gross Estimated Carrying Unrealized Unrealized Fair Amount Gains Losses Value Bonds U.S. government... $ 6,434 $ 725 $ 3 $ 7,156 All other governments... 1, ,430 States, territories and possessions Political subdivisions of states, territories and possessions Special revenue and special assessment obligations and all non guaranteed obligations of agencies... 8, ,467 Public utilities... 7, ,915 Industrial and miscellaneous (unaffiliated)... 75,096 2, ,204 Credit tenant loans (unaffiliated) Parent, subsidiaries and affiliates... 1, ,491 Total bonds... $ 100,480 $ 4,587 $ 737 $ 104,330 Unaffiliated Preferred Stocks Redeemable Non-redeemable Total unaffiliated preferred stocks... $ 89 $ 24 $ - $ Gross Gross Estimated Carrying Unrealized Unrealized Fair Amount Gains Losses Value Bonds US governments... $ 6,428 $ 644 $ 2 $ 7,070 All other governments... 1, ,460 States, territories and possessions Political subdivisions of states, territories and possessions Special revenue and special assessment obligations and all non guaranteed obligations of agencies... 8, ,420 Public utilities... 6, ,986 Industrial & miscellaneous (unaffiliated)... 69,524 4, ,574 Credit tenant loans (unaffiliated) Parent, subsidiaries and affiliates... 1, ,486 Total bonds... $ 93,884 $ 6,224 $ 405 $ 99,703 Unaffiliated Preferred Stocks Redeemable Non-redeemable Total unaffiliated preferred stocks... $ 89 $ 24 $ - $ 113 F-17

18 The carrying value and estimated fair value of bonds at December 31, 2005, categorized by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers may prepay obligations with or without call or prepayment penalties. Carrying Amount Estimated Fair Value Due in one year or less... $ 5,608 $ 5,625 Due after one year through five years... 18,893 19,285 Due after five years through ten years... 23,151 24,054 Due after ten years... 24,329 26,856 71,981 75,820 Mortgage-backed securities... 28,499 28,510 Total... $ 100,480 $ 104,330 Proceeds from the sale and maturity of bonds during 2005 and 2004 were $65,879 million and $67,693 million, respectively. Gross gains of $554 million and $611 million and gross losses of $279 million and $275 million were realized on such sales during 2005 and 2004, respectively. Write-downs for impairments, which were deemed to be other than temporary, for bonds were $42 million and $105 million, and for unaffiliated common stocks were $5 million and $9 million for the years 2005 and 2004, respectively. There were no write-downs for preferred stock in 2005 and Additional information relating to the amortized cost and fair value of bonds, unaffiliated preferred stock, and common stock lots held for which the estimated fair value had temporarily declined and remained below cost as of December 31, 2005 are shown below. The following table reflects the difference of cost and fair value for such lots and differs from gross unrealized losses reported in the previous table, which reflects the unrealized losses of aggregate lots of the identical bonds, unaffiliated preferred stock, and common stock, due to the varying costs associated with each lot purchased: Declines For Less Than Twelve Months Declines For Greater Than Twelve Months Cost Fair Value Difference Cost Fair Value Difference Bonds $ 28,217 $ 27,701 $ 516 $ 4,187 $ 3,867 $ 320 Unaffiliated Preferred and Common Stocks Total. $ 28,970 $ 28,361 $ 609 $ 4,291 $ 3,952 $ 339 B. Mortgage loans The maximum and minimum lending rates for new mortgage loans as of December 31, 2005 were: Farm loans, 7.25% and 4.05%; City loans, 6.91% and 4.34%. There were no purchase money mortgages loaned during the year. During 2005, the Company reduced interest rates of outstanding mortgage loans as follows: Greater than 2% on one loan totaling $7 million, between 1% and 2% on one loan totaling $1 million and less than 1% on three loans totaling $14 million. During 2004, the Company reduced interest rates of outstanding mortgage loans as follows: 1.27% on one loan totaling $1 million and less than 1% on five loans totaling $254 million. The maximum percentage of any one loan to the value of security at the time of the loan, exclusive of insured or guaranteed or purchase money mortgages was: 80% except loans made pursuant to title 17B, Chapter 20, Section 1h, Revised Statutes of New Jersey. The mortgage loans are geographically dispersed or distributed throughout the United States and Canada with the largest concentrations in California (30.21%) and New York (9.10%). F-18

19 There were no mortgages with interest more than 180 days past due. Taxes, assessments, and other amounts advanced by the Company on account of mortgage loans outstanding are included in the mortgage loan total. Impaired mortgage loans and the related allowance for losses at December 31 are as follows: Current year impaired loans with a related allowance for credit losses... $ 6 $ 88 Related allowance for credit losses... $ 1 $ 32 Impaired mortgage loans without an allowance for credit losses... $ 15 $ 25 Average recorded investment in impaired loans... $ 67 $ 145 Interest income recognized during the period the loans were impaired... $ 2 $ 8 Amount of interest income recognized on a cash basis during the period the loans were impaired... $ 2 $ 8 Activity in the allowance for credit losses for all mortgage loans is summarized as follows: Balance, January 1... $ 32 $ 15 Additions charged / (Reductions credited) to operations... (31) 17 Balance, December $ 1 $ 32 C. Debt restructuring Restructured mortgage loans at December 31 were as follows: Total recorded investment in restructured loans... $ 7 $ 1 Total related realized capital losses... $ 1 $ - Total contractual commitments to extend credit to debtors owning receivables whose terms have been modified in troubled debt restructurings... $ - $ - The Company accrues interest income on impaired loans to the extent it is deemed collectible (delinquent less than 90 days) and the loan continues to perform under its original or restructured contractual terms. Interest income on nonperforming loans is generally recognized on a cash basis. D. Loan-backed securities The Company has elected to use the book value as of January 1, 1994 as the cost for applying the retrospective adjustment method to securities purchased prior to that date. Prepayment assumptions for single class and multi-class mortgagebacked/asset-backed securities were obtained from broker dealer survey values or internal estimates. F-19

20 E. Repurchase agreements The Company s policies require a minimum of 100% of the fair value of securities purchased under reverse repurchase agreements to be maintained as collateral. Securities subject to reverse repurchase agreements, dollar repurchase and dollar reverse repurchase agreements as of December 31: 2005 Book Value Fair Value Maturities Weighted Average Interest Rate Reverse repurchase agreements... $ 11,189.3 $ 11, Years 4.14% Dollar repurchase agreements Years 5.22% Dollar reverse repurchase agreements... (1.8) (1.8) 30 Years 5.48% 2004 Book Value Fair Value Maturities Weighted Average Interest Rate Reverse repurchase agreements... $ 7,910.7 $ 8, Years 3.86% Dollar repurchase agreements... (2.1) (2.1) 23 Years 5.45% Dollar reverse repurchase agreements... (0.1) (0.1) 30 Years 5.00% F. Real estate Impairment losses of $0 million and $13 million at December 31, 2005 and 2004, respectively, were recognized on real estate and are included in "Net realized capital gains (losses)". The impairments were the result of unfavorable market conditions and fair value was determined via internal appraisals. G. Restricted assets and special deposits Assets in the amount of $209 million and $309 million at December 31, 2005 and 2004, respectively, were on deposit with government authorities or trustees as required by law. Assets valued at $1,351 million and $841 million at December 31, 2005 and 2004, respectively, were maintained as compensating balances or pledged as collateral for bank loans and other financing agreements. Restricted stocks amounted to $2 million in 2005 and $2 million in Restricted stocks by asset class at December 31 are as follows: Common Stocks... $ 1 $ 1 Preferred Stocks Total... $ 2 $ 2 H. Accrued investment income Due and accrued income was excluded from investment income on the following bases: Mortgage loans - Interest overdue is accrued up to a maximum of ninety days. If accrued interest is more than ninety days overdue, it is reversed and recognized as income when received. Interest on mortgage loans over ninety days due as of December 31, 2005 was $0.2 million. In 2004, interest overdue was accrued up to a maximum of three months. If this interest subsequently became greater than 180 days overdue, it was non-admitted and, therefore, excluded from investment income. The total amount of non-admitted interest on mortgage loans at December 31, 2004 was $0.1 million. F-20

21 Real estate - Rent that is in arrears for more than three months or the collection of rent that is uncertain is non-admitted and excluded from investment income. Non-admitted due and accrued rental income on real estate for both December 31, 2005 and 2004, was $0.003 million. Bonds - Income is not accrued on bonds in or near default and is excluded from net investment income. Income not accrued on bonds at December 31, 2005 and 2004, was $138 million and $118 million, respectively. I. Wash sales In the course of the Company s asset management, securities are sold and reacquired within 30 days of the sale date. The details by NAIC designation 3 or below of securities sold during 2005 and 2004, respectively, and reacquired within 30 days of the sale date are: Number of Transactions Book Value of Securities Sold 2005 Cost of Securities Repurchased Gain/(Loss) Bonds NAIC 4... NAIC $ $ $ Total bonds $ 4.1 $ 4.1 $ 0.1 Number of Transactions Book Value of Securities Sold 2004 Cost of Securities Repurchased Gain/(Loss) Bonds NAIC 4... NAIC $ $ $ Total bonds... 9 $ 0.6 $ 0.7 $ 0.1 There were no wash sales for preferred stocks in 2005 and RESERVES FOR LIFE CONTRACTS AND DEPOSIT-TYPE CONTRACTS A. Life and annuity contracts reserves Claims reserves for life insurance and annuities include estimates of benefits on reported claims and those that are incurred but not reported. Individual life insurance future policy benefit reserves are calculated using various methods, interest rates and mortality tables, which are prescribed by the Department and produce reserves that in the aggregate meet the requirements of state laws and regulations Approximately 42% and 46% at December 31, 2005 and 2004, respectively, of individual life insurance reserves are determined using the net level premium method, or by using the greater of the net level premium method reserve or the policy cash value. About 58% and 54% of individual life insurance reserves are calculated according to the CRVM, or methods, which compare CRVM to policy cash values at December 31, 2005 and 2004, respectively. F-21