Report of Independent Auditors

Transcription

1 PricewaterhouseCoopers LLP PricewaterhouseCoopers Center 300 Madison Avenue New York NY Telephone (646) Facsimile (813) 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, 2009 and 2008, and the related statutory statements of operations and changes in capital and surplus, and cash flows 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 the statutory basis of accounting 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, 2009 and 2008, or the results of its operations or its cash flows for the years then ended. 1

2 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, 2009 and 2008, and the results of its operations and its cash flows for the years then ended, on the basis of accounting described in Note 2. As described in Note 3 to the financial statements, the Company changed its method of calculating admissible deferred tax assets as of December 31, 2009 and its method of identifying and accounting for impairment of investments on January 1, 2009 and again on September 30, Also, the Company changed its method of accounting for income-tax related cash flow generated by a leverage lease transaction on January 1, 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 Schedule and Summary Investment Schedule (collectively the "Schedules") of the Company as of December 31, 2009 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, 2009 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 financial statements taken as a whole. April 15,

3 STATUTORY STATEMENTS OF ADMITTED ASSETS, LIABILITIES AND CAPITAL AND SURPLUS December 31, December 31, ASSETS Bonds... $ 94,130 $ 98,027 Preferred stocks Common stocks... 8,014 6,673 Mortgage loans on real estate... 18,668 20,173 Real estate Contract loans... 6,895 6,777 Cash and short-term investments... 8,683 7,883 Other invested assets... 4,946 4,481 Total cash and invested assets , ,026 Premiums due and deferred... 1,644 1,656 Accrued investment income... 1,340 1,334 Net deferred tax asset... 2,814 1,081 Other assets Separate account assets... 76,981 87,871 TOTAL ASSETS... $ 225,788 $ 237,498 LIABILITIES AND SURPLUS Liabilities Policy liabilities and insurance reserves: Future policy benefits and claims... $ 99,607 $ 98,240 Advanced premiums Policy dividends... 1,982 2,210 Policyholders account balances... 20,788 21,339 Notes payable and other borrowings... 2,115 5,566 Asset valuation reserve... 1,788 1,247 Federal income tax payable Interest maintenance reserve ,075 Transfers to separate accounts due or accrued (207) (154) Securities sold under agreement to repurchase ,699 7,262 Cash collateral held for loaned securities ,850 2,588 Other liabilities... 3,562 3,247 Separate account liabilities... 76,891 87,763 Total liabilities... $ 215,746 $ 231,066 Capital and Surplus Common capital stock and gross paid in and contributed surplus... $ 2,958 $ 2,555 Surplus notes Special surplus fund Unassigned surplus... 5,295 2,780 Total capital and surplus... 10,042 6,432 TOTAL LIABILITIES, CAPITAL AND SURPLUS... $ 225,788 $ 237,498 See Notes to Statutory Financial Statements 3

4 STATUTORY STATEMENTS OF OPERATIONS AND CHANGES IN CAPITAL AND SURPLUS Years Ended December 31, REVENUE Premiums and annuity considerations... $ 15,602 $ 15,864 Net investment income... 8,420 7,423 Other income (losses)... (1,614) (281) Total Revenue... $ 22,408 $ 23,006 BENEFITS AND EXPENSES Death benefits... $ 3,842 $ 3,644 Annuity benefits... 4,982 4,929 Disability benefits Other benefits Surrenders, benefits and fund withdrawals... 7,525 9,520 Net increase in reserves... 2,662 4,162 Commissions Net transfer (from) to separate accounts... (1,666) (2,261) Other expenses Total Benefits and Expenses... $ 19,472 $ 21,401 Operating income before dividends and income taxes... $ 2,936 $ 1,605 Dividends to policyholders ,130 Operating income before income taxes... 2, Income (benefit) tax provision... (33) (23) Income from Operations.... 2, Net Realized Capital (Losses)... (1,324) (1,306) NET INCOME (LOSS)... $ 1,101 $ (808) CAPITAL AND SURPLUS Capital and Surplus, beginning of year... $ 6,432 $ 6,981 Change in common capital stock and gross paid in and contributed surplus ,992 Change in surplus notes Change in special surplus funds (300) Net income (loss)... 1,101 (808) Change in net unrealized capital gains (losses) (1,298) Change in non-admitted assets (994) Change in asset valuation reserve... (541) 1,162 Change in net deferred income tax Change due to valuation method Dividends to stockholders... - (950) Cumulative effect of changes in accounting principles... (84) (63) Other changes, net Change in unassigned surplus... 2,514 (2,241) CAPITAL AND SURPLUS, END OF PERIOD... $ 10,042 $ 6,432 See Notes to Statutory Financial Statement 4

5 STATUTORY STATEMENTS OF CASH FLOWS CASH FLOWS FROM OPERATING ACTIVITIES Years Ended December 31, Premiums and annuity considerations... $ 15,584 $ 15,754 Net investment income... 8,140 7,573 Other income... 1,549 1,426 Separate account transfers... 1,613 2,397 Benefits and claims paid... (19,557) (19,666 ) Policyholders dividends paid... (773) (1,471) Federal income taxes... (182) (469) Other operating expenses... (1,713) (1,789) Net cash provided by operating activities... $ 4,661 $ 3,755 CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from investments sold, matured, or repaid Bonds... $ 27,487 $ 58,953 Stocks... 1,919 2,813 Mortgage loans on real estate... 2,825 1,865 Real estate Miscellaneous proceeds... 1,580 3,466 Payments for investments acquired Bonds... (24,079) (54,378) Stocks... (2,258) (3,553) Mortgage loans on real estate... (1,469) (3,816) Real estate... (18) (21) Miscellaneous applications... (2,818) (1,997) Net cash provided by investing activities... $ 3,169 $ 3,332 CASH FLOWS FROM FINANCING ACTIVITIES (Payments of) proceeds from borrowed money... $ (3,461) $ 243 Proceeds from (payments of) surplus paid in ,992 Dividends to stockholders paid... - (950) Surplus notes Other financing activities... (4,471) (6,080) Net cash (used in) financing activities... (7,030) (4,795) Net change in cash and short-term investments ,292 Cash and short-term investments, beginning of year... 7,883 5,591 CASH AND SHORT-TERM INVESTMENTS, END OF PERIOD... $ 8,683 $ 7,883 See Notes to Statutory Financial Statements 5

6 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 Company was founded in 1875 under the laws of the State of New Jersey. Prudential Insurance provides a wide range of insurance, investment management, and other financial products and services to both individual and institutional customers throughout the United States. The principal products and services of the Company include individual life insurance and annuities, group insurance and pension and retirement products and related services and administration. The Company conducts its businesses through its operations and the operations of certain of its subsidiaries and affiliates in all 50 states. The principal executive offices of Prudential Insurance are located in Newark, New Jersey. On December 18, 2001 (the date of demutualization ), Prudential Insurance converted from a mutual life insurance company to a stock life insurance company. The demutualization was completed in accordance with Prudential Insurance s Plan of Reorganization, which was approved by the Commissioner of Banking and Insurance of the State of New Jersey in October CURRENT MARKET CONDITIONS The global financial markets have shown marked improvement after experiencing extreme stress since the second half of 2007 through the early portion of The Company s results of operations and financial condition may be adversely affected, possibly materially, if these conditions recur or current market or economic conditions deteriorate. These economic conditions included, but were not limited to: A period of extreme volatility and limited market liquidity, particularly in the global fixed-income markets, which led to decreased liquidity, increased price volatility, credit downgrade events, depressed valuations and increased probability of default; Markets in the United States and elsewhere experienced extreme and unprecedented volatility and disruption which adversely impacted Prudential Financial s and the Company s liquidity, access to capital and cost of capital; Market conditions impacted the Company s businesses and profitability and a recurrence or further deterioration of these conditions would affect the Company s businesses and profitability. These impacts include: o Profitability of many of the Company s insurance products are dependent in part on the value of the separate accounts supporting these products; o Guaranteed minimum benefits contained in many of the Company s variable annuity products may be higher than the current account value or pricing assumptions would support requiring material increases to reserves for such products and may cause customers to retain contracts in force in order to benefit from the guarantees, thereby increasing the cost to the Company; o Prudential Financial, Prudential Insurance and Prudential Funding LLC, the commercial paper subsidiary of Prudential Insurance, experienced downgrades in their insurance claims-paying rating and credit ratings issued by rating agencies, including a downgrade of Prudential Insurance s insurance claims-paying ratings to A2 from Aa3, by Moody s on March 18, 2009 and a downgrade of Prudential Funding s short-term debt rating for commercial paper to P-2 from P-1, by Moody s on August 20, Prudential Financial, Prudential Insurance or Prudential Funding could experience additional ratings downgrades if conditions recur or deteriorate. Credit and claims-paying ratings are important factors in Prudential Financial s, Prudential Insurance s and Prudential Funding s ability to issue debt and the cost of such financing, potential collateral posting requirements, ability to market products and may impact the level of surrender activity on products Prudential Insurance has issued. 6

7 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. The NAIC Accounting Practices and Procedures Manual ( NAIC SAP or the "Manual") 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 SAP, 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 or 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. The value of its subsidiaries are recorded as Preferred Stock, Common Stock and Other Invested Assets. 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 or interest-related other-than-temporary impairment of 7

8 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 or impaired; 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. Under SAP, an extraordinary distribution approved by the Company s regulator may be recorded as a return of capital; under GAAP, the distribution is recorded as a dividend when the Company has undistributed retained earnings. Under SAP, goodwill is subject to admissability limits and is amortized over a period not to exceed ten years; under GAAP, goodwill is subject to impairment testing and not amortized. Under SAP, income tax expense is based upon taxes currently payable. Changes in deferred taxes are reported in surplus and subject to admissability limits; under GAAP, changes in deferred taxes are recorded in income tax expense. Under SAP, charges recorded for pension and postretirement health benefits only include charges for vested employees; under GAAP charges for pension and postretirement health benefits include charges for both vested and non-vested employees. Under SAP, deposits to universal life contracts and limited payment contracts are credited to revenue; under GAAP, such deposits are reported as policyholder account balances. Under SAP, interest-related other-than-temporary impairments for bonds are determined based primarily upon the Company s intent to sell or inability to assert its intent and ability to hold the security until recovery; under GAAP, interest-related other-than-temporary impairments for debt securities are based primarily upon whether the Company intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis. 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 policyholders' account balances, the net 8

9 reserves for these contracts as opposed to gross assets and liabilities. 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. At December 31, 2009 and 2008, the net reserve recorded to policyholder's account balances on the Statutory Statement of Admitted Assets, Liabilities, Capital and Surplus was $0 and $49 million, respectively. The permitted practice is a presentation change on the Statutory Statements of Admitted Assets, Liabilities, and Capital and Surplus and does not change capital, surplus and income from operations. 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. 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 $ 1,101 $ (808) State Permitted Practices (Income) - - State Prescribed Practices (Income) - - Net Income, per the Manual $ 1,101 $ (808) Statutory Surplus, NJ SAP State Permitted Practices (Surplus) $ 10,042 - $ 6,432 - State Prescribed Practices (Surplus): - - Admit leasehold improvements (33) (44) Statutory Surplus, per the Manual $ 10,009 $ 6,388 The effects of the difference on surplus and net income between accounting practices prescribed or permitted by the Department, as described above, and GAAP are as follows: GAAP net income of $2,312 million is $1,211 million greater than NJ SAP net income in 2009, as compared to the GAAP net loss of $668 million which was $140 million less than the NJ SAP net loss in The net income increase in 2009 and the net loss decrease in 2008 were primarily due to GAAP deferred acquisition costs and differences in reserves held, and in 2009 the gain on the sale of the Wachovia joint venture by Prudential Securities Group, LLC ( PSG LLC ). GAAP equity of $20,627 million is $10,585 million greater than NJ SAP equity in 2009, as compared to the GAAP equity of $11,045 million which was $4,613 million more than the NJ SAP equity in The equity increases were primarily due to GAAP deferred acquisition costs, SAP non-admitted assets, and differences in reserves held, as well as the differing valuation basis for investments. 9

10 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 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. The most significant estimates include those used in determining measurement of goodwill and any related impairment; valuation of investments including derivatives (in the absence of quoted market values) and the recognition of other-than-temporary impairments; aggregate reserves for life, accident, and health contracts including guarantees; pension and other postretirement benefits; provision for income taxes and valuation of deferred tax assets; and reserves for contingent liabilities, including reserves for losses in connection with unresolved legal matters. 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. Bonds rated by the NAIC are classified into six categories ranging from highest quality bonds to those in or near default. Bonds rated in the top five categories are generally valued at amortized cost while bonds rated at the lowest category are valued at lower of amortized cost or fair market value. The Company follows both the prospective and retrospective methods for amortizing bond premium and discount. Both methods require the recalculation of the effective yield at each reporting date if there has been a change in the underlying assumptions. For the prospective method, the recalculated yield will equate the carrying amount of the investment to the present value of the anticipated future cash flows. The recalculated yield is then used to accrue income on the investment balance for subsequent accounting periods. There are no accounting changes in the current period unless the undiscounted anticipated cash flow is less than the carrying amount of the investment. For the retrospective method, the recalculated yield is the rate that equates the present value of actual and anticipated future cash flows with the original cost of the investment. The current balance of the investment is increased or decreased to the amount that would have resulted had the revised yield been applied since inception and investment income is correspondingly decreased or increased. For other than temporary impairments, the cost basis of the bond excluding loan-backed and structured securities 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. See below for additional disclosure regarding the Company s adoption of SSAP 43R, Loan-backed and Structured Securities and accounting for other-than-temporary impairments for loan-backed and structured securities. Loan-backed and structured securities holdings are carried primarily at amortized cost. For loan-backed and structured securities, the effective yield is based on estimated cash flows, including prepayment assumptions based on data from widely accepted third-party data sources or internal estimates. For high credit quality loan-backed and structured securities (those rated AA or above), cash flows are provided quarterly, and the amortized cost and effective yield of the security are adjusted as necessary to reflect historical prepayment experience and changes in estimated future prepayments. The adjustments to amortized cost for those securities rated AA or above are recorded in accordance with the retrospective method. For loan-backed and structured securities rated below AA, the effective yield is adjusted prospectively for any changes in estimated cash flows. See below for additional disclosure on the Company s adoption of SSAP No. 43R. 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 fair market value. For other-than-temporary impairments, the cost basis of the preferred stock is written down to fair 10

11 market value as a new cost basis and the amount of the write down is accounted for as a realized loss. Effective for 2009, hybrid securities were reclassed from preferred stocks to bonds per NAIC accounting guidance. 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. 97, Investments in Subsidiary, Controlled and Affiliated Entities, a Replacement of SSAP No. 88, ( SSAP No. 97 ). 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. The subsidiaries are engaged principally in the business of life insurance and annuities. Investments in non-insurance subsidiaries that do not engage in certain transactions or activities, per paragraph 8b ii of SSAP No. 97, 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 gains (losses). Dividends are recognized in net investment income when declared. For other-than-temporary impairments, the cost basis of the common stock 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. 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. These loans are measured based on the fair value of the collateral less estimated costs to obtain and sell. The difference between the net value of the collateral and the recorded investment in the mortgage loan is recognized as an impairment by creating a valuation allowance with a corresponding charge to unrealized loss or by adjusting an existing valuation allowance for the impaired loan with a corresponding charge or credit to unrealized gain or loss. 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 collectability 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 collectability. 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 and properties held for sale. Properties occupied by the Company are carried at cost less accumulated straight-line depreciation, encumbrances and 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 certain 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. 11

12 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 under the equity method as defined in SSAP No. 97 or SSAP No. 48, Joint Ventures, Partnerships and Limited Liability Companies. These entities are valued based primarily on the underlying audited U.S. GAAP equity of the investee. 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. 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. Repurchase agreements are reported as a liability in "Securities sold under agreement to repurchase" and reverse repurchase agreements are reported as an asset in Cash and short-term investments. Dollar repurchase agreements and reverse dollar repurchase agreements involve debt instruments that are pay-through securities collateralized with the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and similar securities. The Company typically uses "to be announced" ("TBAs") securities in the dollar repurchase and 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 (losses)" are recorded upon termination of the agreements. 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 is not restricted and is invested in Bonds and Cash and Short-term investments ; the offsetting collateral liability is included in Cash collateral held for loaned securities. Non-cash collateral is not reflected in the Statements of Admitted Assets, Liabilities, and Capital and Surplus. Net realized capital gains (losses) are computed using the specific identification method. Net realized investment gains and losses are generated from numerous sources, including the sale of bonds, stocks, other type of investments, as well as adjustments to the cost basis of investments for other than temporary impairments. Realized investment gains and losses are also generated from prepayment premiums received on private bonds, recoveries of principal on previously impaired securities, provisions for losses on mortgage loans on real estate, fair value changes on derivatives that do not qualify for hedge accounting treatment, except those derivatives used in the Company s capacity as a broker or dealer. Amortized cost of investments are adjusted for impairments considered other than temporary. All bonds, preferred stocks and common stocks with unrealized losses are subject to review to identify other-than-temporary impairments in value. Under SAP, several factors must be considered to determine whether a decline in value of a security is other than temporary, including: 1) the reasons for the decline in value (credit event, currency or interest related, including general spread widening); 2) a company s ability and intent to hold its investment for a period of time to allow for recovery of value; 3) a company s intent to sell its investment before recovery of the cost of the investment; 4) the financial condition of and near-term prospects of the issuer; and 12

13 5) for stocks, the extent and duration of the decline. For stocks, when it is determined that there is an other-than-temporary impairment, the Company records a write down in the 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 the 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 require a substantial level of judgment. For bonds, excluding loan-backed and structured securities, when it is determined that there is an other-thantemporary impairment, the Company records a write down to the estimated fair value of the bond, which reduces its amortized cost. Credit event related impairments are recorded in the Statement of Operations and Changes in Surplus within "Net Realized Capital Gains" and applied to the AVR, and interest related impairments are directly applied to the IMR, on a post tax basis. 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 generally based on quoted market prices or prices obtained from independent pricing services. Estimated fair values for private placement bonds are typically determined primarily by using a discounted cash flow model, which relies upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions and takes into account, among other factors, the credit quality of the issuer and the reduced liquidity associated with private placements. In determining the fair value of certain securities, including those that are distressed, the discounted cash flow model may also use unobservable inputs, which reflect management s own assumptions about the inputs market participants would use in pricing the asset. See below for additional disclosure on the Company s measurement of fair value. For loan-backed and structured securities, when an other-than-temporary impairment has occurred because the entity does not expect to recover the entire amortized cost basis of the security, even if the entity has no intent to sell and the entity has the intent and ability to hold to recovery, the amount of the other-than-temporary impairment recognized as a realized loss shall equal the difference between the investment's amortized cost basis and the present value of cash flows expected to be collected, discounted at the loan-backed or structured security's effective interest rate. Additionally, the amortized cost of the security, less the other-than-temporary impairment recognized as a realized loss, shall become the new amortized cost basis of the investment. When the entity has the intent to sell or cannot assert ability and intent to hold to recovery, the security is impaired to the fair value basis. See below for additional disclosure on the Company s adoption of SSAP No. 43R, Loan-backed and Structured Securities. 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 (loss). 13

14 The following table provides the Company s separate accounts premiums, considerations or deposits and reserves as of December 31: Premiums, considerations or deposits for year ended December 31, 2009 Nonindexed Guarantee Less than/equal to 4% 2009 Nonindexed Guarantee More than 4% Nonguaranteed Separate Accounts Total $ 413 $ - $ 5,717 $ 6,130 Reserves at December 31, 2009: For accounts with assets at: Market value $ 15,114 $ 436 $ 51,016 $ 66,566 Amortized cost Total reserves $ 15,115 $ 436 $ 51,016 $ 66,567 By withdrawal characteristics With market value adjustment $ 55 $ - $ - $ 55 At book value without market value adjustment At market value ,016 52,157 Subtotal $ 761 $ 436 $ 51,016 $ 52,213 Not subject to discretionary withdrawal 14, ,354 Total reserves $ 15,115 $ 436 $ 51,016 $ 66, Premiums, considerations or deposits for year ended December 31, 2008 Nonindexed Guarantee Less than/equal to 4% Nonindexed Guarantee More than 4% Nonguaranteed Separate Accounts Total $ 442 $ - $ 6,053 $ 6,495 Reserves at December 31, 2008: For accounts with assets at: Market value $ 15,819 $ 412 $ 52,686 $ 68,917 Amortized cost Total reserves $ 15,900 $ 412 $ 52,686 $ 68,998 By withdrawal characteristics With market value adjustment $ 64 $ - $ - $ 64 At book value without market value adjustment At market value ,686 53,263 Subtotal $ 310 $ 412 $ 52,686 $ 53,408 Not subject to discretionary withdrawal 15, ,590 Total reserves $ 15,900 $ 412 $ 52,686 $ 68,998 14

15 Net transfers to (from) the separate accounts as of December 31 were as follows: 2009 Nonindexed Guarantee Less than/equal to 4% Nonindexed Gruarantee More than 4% Nonguaranteed Separate Accounts Total Transfers to separate accounts $ 413 $ - $ 7,138 $ 7,551 Transfers from separate accounts 1, ,318 9,217 Net transfers from separate accounts $ (1,482) $ (4) $ (180) $ (1,666) 2008 Nonindexed Guarantee Less than/equal to 4% Nonindexed Gruarantee More than 4% Nonguaranteed Separate Accounts Total Transfers to separate accounts $ 442 $ - $ 6,291 $ 6,733 Transfers from separate accounts 1, ,995 8,994 Net transfers from separate accounts $ (1,551) $ (6) $ (704) $ (2,261) 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. 15

16 G. Income taxes The Company and its domestic subsidiaries file a consolidated federal income tax return with Prudential Financial. The Internal Revenue Code of 1986, as amended (the Code ), taxes the Company on operating income after dividends to policyholders plus realized gains/losses. Effective December 31, 2009, the Company adopted SSAP No. 10R Income Taxes-Revised, a Temporary Replacement of SSAP No. 10 ( SSAP No. 10R ), which allows for increased admittance of deferred income taxes. SSAP No. 10R requires this incremental increased admittance of deferred income taxes to be reflected separately through Change in special surplus funds and Special surplus funds in the Statutory Statement of Operations and Changes in Capital and Surplus and the Statutory Statement of Admitted Assets, Liabilities, and Capital and Surplus, respectively. See below for additional disclosure on the Company s adoption of SSAP No. 10R. Deferred income taxes are recognized in accordance with SSAP No. 10R, based upon enacted rates, when assets and liabilities have different values for financial statement and tax reporting purposes. Tax planning strategies are relied upon in limited circumstances to support the admissibility of deferred tax assets in accordance with SSAP No. 10R. 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 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 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 the stockholder. 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. 16

17 The Company has modified co-insurance ( MODCO ) agreements for the closed block. Adjustments related to the MODCO agreements are based on formulas set forth in these agreements that are mainly affected by investment experience. These adjustments are recorded in Other income/loss in the Statement of Operations and Changes in Capital and Surplus and are offset by similar adjustments in premiums, benefits, expenses and dividends to policyholders. As a result, the MODCO agreements of the closed block have a minimal impact on net gain from operations. I. Reclassification Certain amounts in the prior year have been reclassified to conform to the current year presentation. J. Correction of Accounting Errors During the fourth quarter of 2008, it was determined that two affiliates of the Company, Pruco Life Insurance Company and Universal Prudential Arizona Reinsurance Company, overpaid reinsurance premiums to the Company during the years 2004 through An adjustment of $20 million, net of tax, relating to these reinsurance premium overpayments from these affiliates in prior years was made in the fourth quarter of 2008 through "Other changes, net in the Statutory Statements of Operations and Changes in Capital and Surplus. There was no overall surplus impact to the Company for this overpayment, since identical offsetting adjustments were made in these affiliates. These affiliates are direct subsidiaries of the Company, and therefore their change in equity, including the offsetting adjustments, are reported through the Change in net unrealized capital gains (losses) line. During the third quarter of 2009, the Company determined that it excluded realized gains/(losses) on derivative transactions entered into solely for the purpose of altering the interest rate characteristics of the Company s liabilities from the transfer to the IMR during An adjustment of $58 million, net of amortization, relating to the realized gains/(losses) on derivative transactions in 2008 was transferred to the IMR in the third quarter 2009 through Other changes, net. After the filing of the 2009 Annual Statutory Statement with the NAIC and State Insurance Departments on March 1, 2010, the Company determined that it overstated both Premium and annuity considerations and Surrenders, benefits and fund withdrawals on the Statutory Statement of Operations and Changes in Capital and Surplus by equal amounts of $1,598 million and $444 million in 2009 and 2008, respectively. The correct amounts are reported in these audited financial statements, and therefore differ from the premiums and surrender amounts reported in the March 1, 2010 filing. The correction did not impact the Company s Net Income or Capital and Surplus since the overstatement of Premium and annuity considerations and Surrenders, benefits and fund withdrawals equally offset. 3. ADOPTION OF NEW STATUTORY ACCOUNTING PRINCIPLES Accounting changes adopted to conform to the provisions of the Manual are reported as changes in accounting principles, where applicable. 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 adoption date 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. 17