MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF PRUDENTIAL INSURANCE

Transcription

1 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF PRUDENTIAL INSURANCE Summary of Principal Differences between SAP and GAAP Statutory financial information for Prudential Insurance has been prepared in accordance with SAP. SAP differs in certain respects, which in some cases may be material, from GAAP. The significant differences between SAP and GAAP are noted below: The SAP financial statements of 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 future expected gross profits or when premiums are earned. Under SAP, the Commissioner's Reserve Valuation Method is used for the majority of individual insurance reserves, whereas for individual insurance, policyholder liabilities are generally established using the net level premium method under GAAP. Policy assumptions used in the estimation of policyholder liabilities are generally prescribed under SAP, but are based upon actual company experience under GAAP. Under SAP, the Commissioner's Annuity Reserve Valuation Method is used for the majority of individual deferred annuity reserves, whereas for individual deferred annuities, policyholder liabilities are generally equal to the full value under GAAP. 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; no such reserve is required under GAAP. 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; no such reserve is required under GAAP. 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 rather than being recorded as a liability under GAAP.

2 Overview On the date of the demutualization, Prudential Insurance 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 principal products and services of Prudential Insurance include individual life insurance and annuities, group insurance and retirement. The results in the analysis below include the results of the Closed Block. On the date of the demutualization, policyholder membership interests in Prudential Insurance were extinguished and eligible policyholders collectively received shares of Common Stock of Prudential Financial, cash and increases to their policy values or benefits in the form of policy credits. Concurrently with the demutualization, Prudential Insurance completed a corporate reorganization (the "destacking") whereby various subsidiaries of Prudential Insurance (and certain related assets and liabilities) were dividended so that they became wholly owned subsidiaries of Prudential Financial rather than Prudential Insurance. The subsidiaries distributed by Prudential Insurance to Prudential Financial included its property and casualty insurance companies, its principal securities brokerage companies, its international insurance companies, its principal asset management operations, its international securities and investments operations, its domestic banking operations and its residential real estate brokerage franchise and relocation services operations. The destacking was reflected as an extraordinary dividend paid to Prudential Holdings, which Prudential Holdings distributed to Prudential Financial. The effect of destacking was to decrease Prudential Insurance's surplus by $4,305 million. At June 30, 2003, Prudential Insurance's assets were $195 billion ($63 billion held in separate accounts), compared to $187 billion ($59 billion held in separate accounts) at December 31, 2002, and $184 billion ($63 billion held in separate accounts) at December 31, Excluding separate accounts, assets were primarily comprised of a mix of bonds, mortgage loans, policy loans, cash and short-term investments, and equity investments designed to match the cash flow requirements of insurance liabilities. Significant industry accounting and reporting changes affected results in Specifically, statutory accounting practices and procedures were codified by the NAIC effective January 1, 2001, which resulted in changes to the NAIC's Accounting Practices and Procedures Manual. Results of Operations Net Income 2003 to 2002 Six Month Comparison. Net income increased $278 million from a net loss of $113 million for the six months ended June 30, 2002, to net income of $165 million for the six months ended June 30, Net income includes a decrease in operating income of $87 million from $497 million for the six months ended June 30, 2002 to $410 million for the six months ended June 30, This decline was mainly attributable to decreases in corporate and other, driven by an increase in other expenses and an increase in asset adequacy reserves related to the Closed Block Business. More than offsetting the decline in operating income was a decrease of $353 million in net realized capital losses, from $440 million for the six months ended June 30, 2002 to $87 million for the six months ended June 30, This decline in losses was driven by gains in bonds and derivatives in the current year, compared to losses for the same period in the prior year. Also contributing to the overall increase in net income was a decrease in federal income taxes of $12 million, from $170 million for the six months ended June 30, 2002, to $158 million for the six months ended June 30, 2003, reflecting a decrease in current taxable income. 2

3 Change in Capital and Surplus 2003 to 2002 Six Month Comparison. Statutory capital (surplus plus the asset valuation reserve) increased $184 million to $8,014 million at June 30, 2003, from $7,830 million at December 31, The change in capital during 2003 was driven by the following: Increase in unrealized gains of $196 million mainly attributable to increases in common stock as a result of favorable market conditions; Net income in 2003 of $165 million as discussed above in Management s Discussion and Analysis of Financial Condition and Results of Operations of Prudential Insurance Results of Operations Net Income; Decrease in non-admitted assets of $116 million driven by a decline in non-admitted deferred tax assets as a result of an increase in current year taxes available for carryback; and Decrease in change in surplus notes of $300 million as a result of notes maturing in April of Revenues 2003 to 2002 Six Month Comparison. Revenues increased $159 million to $11,459 million for the six months ended June 30, 2003, from $11,300 million for the six months ended June 30, This increase was driven by an increase in retirement separate account premiums of $450 million, mainly in short term money market accounts as institutional investors were rebalancing their portfolios by making temporary deposits in short term accounts as a result of uncertain equity markets. This increase was partially offset by a decrease in individual life premiums. Over the last few years, there has been a shift of sales to Prudential Insurance s life insurance subsidiaries, Pruco Life Insurance Company and Pruco Life of New Jersey, resulting in a continued decline in renewal premiums for individual life in Prudential Insurance. Additionally, a reduction in dividends to policyholders led to a decline in additional insurance being purchased. Net investment income, including amortization of the IMR, decreased $32 million, from $3,457 million for the six months ended June 30, 2002, to $3,425 million for the six months ended June 30, The decline was driven by reinvestment in a declining interest rate environment. Benefits 2003 to 2002 Six Month Comparison. Total benefits, surrenders and other fund withdrawals increased $1,483 million to $8,704 million for the six months ended June 30, 2003, from $7,221 million for the six months ended June 30, The increase was primarily due to a $704 million increase in annuity benefits driven by the reclassification of policy credits in In the fourth quarter of 2001, annuity benefits increased as a result of expensing policy credits related to demutualization. Policy credits were reversed in benefits in the first quarter of 2002 and applied to reserve balances in both the general account and separate accounts. Also contributing to the increase in total benefits, surrenders and other fund withdrawals was a $614 million increase in retirement separate account surrenders. This increase was primarily due to withdrawals by institutional investors from separate account money market accounts. As discussed above in Management s Discussion and Analysis of Financial Condition and Results of Operations of Prudential Insurance Results of Operations Revenues, institutional investors were 3

4 rebalancing their portfolios by making temporary deposits in short term accounts as a result of uncertain equity markets. Net Increase in Reserves 2003 to 2002 Six Month Comparison. Reserves increased $554 million for the six months ended June 30, 2003, compared to an increase of $1,468 million for the six months ended June 30, Reserves increased less between years mainly as a result of policy credits related to demutualization that were reversed in 2002 from benefits and applied to general account reserves. Partially offsetting this decrease was an increase in asset adequacy reserves in corporate and other. The asset/liability analysis is used to determine the adequacy of reserves to meet anticipated cash flows required by the contractual obligations and related expenses of Prudential Insurance. Reserves are tested under a number of scenarios to determine whether they will be adequate to provide for the future obligations. Other factors contributing to the overall decline in the change in reserves were a decline in general account premiums and an increase in general account surrenders, benefits and fund withdrawals. Other Expenses 2003 to 2002 Six Month Comparison. Other expenses increased by $175 million to $1,074 million for the six months ended June 30, 2003, from $899 million for the six months ended June 30, Contributing to the increase in other expenses was a reporting change in group insurance for unearned premium reserves. In 2002, other expenses included a decrease of $66 million for this reserve. In 2003, unearned premium reserves were reported through net increase in reserves. Excluding this reclassification, other expenses increased $109 million primarily due to an increase of $140 million in corporate and other as a result of a reduction in the net periodic pension benefit between years. Income Taxes 2003 to 2002 Six Month Comparison. Income tax provision decreased $12 million to $158 million for the six months ended June 30, 2003, from $170 million for the six months ended June 30, The decrease was driven by a reduction in current taxable income. 4

5 Capital Gains 2003 to 2002 Six Month Comparison. Net realized capital losses, after taxes and contribution to the IMR, decreased $353 million to $87 million for the six months ended June 30, 2003, from $440 million for the six months ended June 30, The following table sets forth the components of net realized capital losses: Six Months Six Months Ended Ended June 30, 2003 June 30, 2002 Change Bonds.. $ 54 $ (408) $ 462 Common Stock.. (49) (6) (43) Derivative instruments 2 (195) 197 Other 27 (15) 42 Gross realized capital gains/(losses). $ 34 $ (624) $ 658 Less Capital gains tax (benefit).. (26) (50) 24 Less IMR Transfers, net of tax 147 (134) 281 Net realized capital (losses) $ (87) $ (440) $ 353 Gross realized capital gains increased $658 million from losses of $624 million for the six months ended June 30, 2002 to gains of $34 million for the six months ended June 30, The increase was primarily attributable to an increase in gains on bonds of $462 million and gains on derivatives of $197 million. The increase in gains on bonds was primarily attributable to a reduction in impairments and credit-related losses, which decreased $321 million from $533 million for the six months ended June 30, 2002 to $212 million for the six months ended June 30, The remaining increase in gains on bonds of $141 million was primarily attributable to bond sales in a declining interest rate environment. Gains on derivatives for the six months ended June 30, 2003 were $2 million compared to losses for the six months ended June 30, 2002 of $195 million. The gains for the six months ended June 30, 2003 were primarily attributable to gains on treasury futures used to manage the duration of the bond portfolio and equity futures used in anticipation of common stock purchases, largely offset by losses on foreign currency forward contracts and swaps used to hedge non-us dollar investments. Losses on derivatives for the six months ended June 30, 2002 were primarily attributable to losses on foreign currency forward contracts and swaps used to hedge non-us dollar investments. Additional losses were incurred on treasury futures used to manage the duration of the bond portfolio and equity futures used in anticipation of common stock purchases. Partially offsetting the increase in gross realized gains was an increase of $281 million in IMR transfers. This increase was driven by the increase in bond trading gains for the six months ended June 30, 2003, compared to trading losses for the six months ended June 30, Net unrealized capital gains (losses) increased $196 million for the six months ended June 30, 2003, compared to a decrease of $75 million for six months ended June 30, The increase between years was primarily driven by increases in common stock as a result of favorable market conditions in the current year as compared to the prior year. 5

6 Other Components of Capital and Surplus 2003 to 2002 Six Month Comparison. Change in non-admitted assets increased $116 million for the six months ended June 30, 2003, compared to a decrease of $179 million for the six months ended June 30, The increase in the current year was driven by a decline in non-admitted deferred tax assets of $140 million, which was primarily due to an increase in current year taxes available for carryback. During the six months ended June 30, 2002, non-admitted deferred tax assets increased $95 million. Surplus notes decreased $300 million for the six months ended June 30, 2003, compared to no change for the six months ended June 30, Notes in the amount of $300 million matured in April of Investment Results Summary of Investments The following table sets forth the composition of Prudential Insurance's invested assets as of the dates indicated in accordance with SAP. June 30, 2003 December 31, 2002 Carrying % of Carrying % of Amount Total Amount Total Long-term bonds Public bonds $57, % $54, % Private bonds 28, , Preferred stock Common stock 4, , Mortgage Loans 13, , Real estate Policy loans 6, , Cash and short-term investments 8, , Other invested assets 4, , Receivables for securities 2, Aggregate write-ins Total invested assets $128, % $123, % The overall income yield on Prudential Insurance's invested assets after investment expenses, but excluding realized investment gains (losses), was 5.40% for the first six months of 2003, compared to 5.83% for the first six months of The change in yield between periods was primarily due to reinvestment activities in a declining interest rate environment and lower commercial loan prepayment income in

7 The following table sets forth the income yield and investment income, excluding realized investment gains (losses), for each major asset category of Prudential Insurance for the periods indicated. Six Months Ended June 30, 2003 June 30, 2002 Yield (1) Amount (2) Yield (1) Amount (2) Long-term bonds 6.32 % $2, % $2,694 Stocks Mortgage loans (4.06) 8.27 (94) 541 Policy loans Cash and short-term investments Other investments Total before investment expenses $3, $3,801 Total after investment expenses 5.40 % $3, % $3,442 (1) Yields are based on average carrying values. (2) Investment income amounts do not include amortization of IMR. Portfolio composition is a critical element of the investment management process. The composition of Prudential Insurance's portfolio reflects, within the discipline provided by its risk management approach, its need for competitive results and the diverse selection of investment alternatives available through its affiliated asset manager. The size of Prudential Insurance's portfolio enables it to invest in asset classes that may be unavailable to the typical investor. Long-term Bonds Prudential Insurance held 67% of general account assets in long-term bonds at June 30, 2003, unchanged from 67% at December 31, These securities include both publicly traded and privately placed debt securities. Prudential Insurance manages its public portfolio to a risk profile directed by the Asset Liability and Risk Management Group. Prudential Insurance seeks to employ relative value analysis both in credit selection and in purchasing and selling securities. The total return that it earns on the portfolio is reflected both as investment income and also as realized gain and loss on investments. Prudential Insurance uses its private placement and asset-backed portfolios to enhance the diversification and yield of its overall bond portfolio. The Investment Manager's investment staff directly originates approximately half of all of its private placements. The Investment Manager's origination capability offers the opportunity to lead transactions and gives it the opportunity for better terms, including covenants and call protection, and to take advantage of innovative deal structures. 7

8 Prudential Insurance's and the Investment Manager's credit and portfolio management processes help ensure prudent controls over valuation and management of the private portfolio. Prudential Insurance has separate pricing and authorization processes to establish "checks and balances" for new investments. Prudential Insurance applies consistent standards of credit analysis and due diligence for all transactions, whether they originate through the Investment Manager's own in-house origination staff or through agents. The Investment Manager's regional offices closely monitor the portfolios in their regions. Prudential Insurance sets all valuation standards centrally, and it assesses the fair value of all investments quarterly. The following table sets forth the composition of Prudential Insurance's bond portfolio by industry category as of the dates indicated. June 30, 2003 December 31, 2002 % of Estimated % of Estimated Amortized Total Fair Amortized Total Fair Cost Cost Value Cost Cost Value US governments $7, % $8,631 $7, % $8,110 All other governments 1, , ,022 States, territories & possessions (direct & guaranteed) Political subdivisions of states, territories and possessions (direct & guaranteed) Special revenue & special assessment obligations & 6, ,137 7, ,108 Non-guaranteed obligations of Public agencies utilities 6, ,123 6, ,570 Industrial & miscellaneous (unaffiliated) 61, ,072 59, ,192 Credit tenant loans (unaffiliated) Parent, subsidiaries and affiliates 1, , Total long-term bonds $85, % $94,035 $83, % $88,668 The amortized cost of Prudential Insurance's below-investment grade long-term bonds as of June 30, 2003 totaled $10.7 billion, or 12.5%, of total long-term bonds on that date, compared to $10.4 billion, or 12.5% as of December 31, As of June 30, 2003, Prudential Insurance had cash and short-term investments of approximately $8.5 billion and investment grade bonds with a fair value of $82.5 billion. The Securities Valuation Office ( SVO ) of the NAIC evaluates the investments of insurers for regulatory reporting purposes and assigns fixed maturity securities to one of six categories called NAIC Designations. NAIC designations of 1 or 2 include fixed maturities considered investment grade, which include securities rated Baa3 or higher by Moody s or BBB- or higher by S&P. NAIC Designations of 3 through 6 are referred to as below investment grade, which include securities rated Ba1 or lower by Moody s and BB+ or lower by S&P. As a result of time lags between the funding of investments, finalization of legal documents, and completion of the SVO filing process, the fixed maturity portfolio generally includes securities that have not yet been rated by the SVO as of each balance sheet date. Pending receipt of SVO ratings, the categorization of these securities by NAIC designation is based on the expected ratings indicated by internal analysis. The following tables set forth Prudential Insurance's public and private bond portfolios by NAIC rating as of the dates indicated. 8

9 Public Bonds by Credit Quality June 30, 2003 December 31, 2002 Rating % of Estimated % of Estimated NAIC Agency Amortized Total Fair Amortized Total Fair Rating Equivalent Cost Cost Value Cost Cost Value 1 Aaa, Aa, A $38, % $42,218 $37, % $40,022 2 Baa 13, ,331 12, ,749 3 Ba 2, ,131 2, ,780 4 B 1, ,687 1, ,211 5 C and lower In or near default Total $57, % $62,690 $54, % $57,970 Private Bonds by Credit Quality June 30, 2003 December 31, 2002 Rating % of Estimated % of Estimated NAIC Agency Amortized Total Fair Amortized Total Fair Rating Equivalent Cost Cost Value Cost Cost Value 1 Aaa, Aa, A $9, % $9,982 $9, % $9,707 2 Baa 13, ,971 13, ,644 3 Ba 3, ,054 3, ,916 4 B 1, ,157 1, ,148 5 C and lower , ,112 6 In or near default Total $28, % $31,345 $29, % $30,698 Prudential Insurance maintains separate monitoring processes for public and private bonds and creates watch lists to highlight securities which require special scrutiny and management. The Investment Manager's public bond asset managers formally review all public bond holdings on a monthly basis and more frequently when necessary to identify potential credit deterioration whether due to ratings downgrades, unexpected price variances, and/or industry specific concerns. The Investment Manager classifies public bond securities of issuers that have defaulted as loans not in good standing and all other public watch list assets as closely monitored. The Investment Manager's private bond asset managers conduct specific servicing tests on each investment on an ongoing basis to determine whether the investment is in compliance or should be placed on the watch list or assigned an early warning classification. The Investment Manager assigns early warning classifications to those issuers that have failed a servicing test or experienced a minor covenant default, and the Investment Manager continues to monitor them for improvement or deterioration. In certain situations, the general account benefits from negotiated rate increases or fees resulting from a covenant breach. The Investment Manager assigns closely monitored status to those investments that have been recently restructured or for which restructuring is a possibility due to substantial credit deterioration or material covenant defaults. The Investment Manager classifies as not in good standing securities of issuers that are in more severe conditions, for example bankruptcy or payment default. When a decline in value of a security is deemed to be other than temporary, Prudential Insurance records an impairment loss in its Statement of Operations and Changes in Surplus within "Net Realized Capital (Losses) Gains." Factors Prudential Insurance considers in evaluating whether a decline in value is other than temporary 9

10 are: (1) whether this decline is substantial; (2) its ability and intent to retain its investment for a period of time sufficient to allow for an anticipated recovery in value; (3) the duration and extent to which the market value has been less than cost; and (4) the financial condition and near-term prospects of the issuer. Unrealized Losses from Bonds The following table sets forth the amortized cost and gross unrealized losses of bonds where the estimated fair value had declined and remained below amortized cost by 20% or more for the following timeframes: June 30, 2003 December 31, 2002 Gross Gross Amortized Unrealized Amortized Unrealized Cost Losses Cost Losses Less than six months $49 $16 $458 $139 Six months but less than nine months Nine months but less than twelve months Twelve months or more Total $57 $19 $462 $140 Gross unrealized losses where amortized cost had been 20% or more below estimated fair value were $19 million as of June 30, 2003 compared to $140 million as of December 31, The gross unrealized losses for the first six months of 2003 were primarily concentrated in the services sector and asset backed securities, while the gross unrealized losses in 2002 were concentrated in the utilities, manufacturing and finance sectors. Mortgage Loans As of June 30, 2003, Prudential Insurance held 11% of its portfolio in mortgage loans, essentially unchanged from December 31, The portfolio as of June 30, 2003 consisted of 1,062 commercial mortgage loans with a carrying value of $11.7 billion and 2,471 residential and agricultural loans with a carrying value of $1.9 billion. The Investment Manager originates commercial mortgages through two sources, both managed out of three regional offices in Atlanta, Chicago and San Francisco. The direct channel, staffed by the Investment Manager's investment personnel, originates loans with principal amounts of $20 million and higher. The Pru Express channel uses a network of independent companies to originate loans in the $2 million to $25 million range. All loans are underwritten consistently to Prudential Insurance standards using its proprietary rating system that was developed using its experience in real estate and mortgage lending. Prudential Insurance's loan portfolio strategy emphasizes diversification by property type and geographic location. The following tables set forth the breakdown of the mortgage loan portfolio by geographic region and property type as of the dates indicated. 10

11 June 30, 2003 December 31, 2002 Carrying % of Carrying % of U.S. Regions: Value Total Value Total Pacific $4, % $4, % South Atlantic 2, , Middle Atlantic 2, , East North Central 1, , Mountain West South Central West North Central New England East South Central Other Total mortgage loans $13, % $13, % Of the mortgage loan portfolio as of June 30, 2003, the states with the most significant concentrations of mortgage loans were California and New York, with $3.5 billion and $1.3 billion, respectively. June 30, 2003 December 31, 2002 Carrying % of Carrying % of Value Total Value Total Property Type: Commercial properties $11, % $11, % Residential properties Agricultural properties 1, , Total mortgage loans $13, % $13, % The Investment Manager evaluates its mortgage loans on a quarterly basis for watch list status based on compliance with various financial ratios and other covenants set forth in the loan agreements, borrower credit quality, property condition and other factors. The Investment Manager may place loans on early warning status in cases where it detects that the physical condition of the property, the financial situation of the borrower or tenant, or other factors could lead to a loss of principal or interest. The Investment Manager classifies as closely monitored those loans that have experienced material covenant defaults or substantial credit or collateral deterioration. Loans not in good standing are those for which there is a high probability of loss of principal, such as when the borrower is in bankruptcy or the loan is in foreclosure. An experienced staff of workout professionals actively manages the loans in the closely monitored and not in good standing categories. The following table shows the respective amounts of Prudential Insurance's mortgage loan portfolio that are in good standing, are in good standing with restructured terms, have interest overdue more than three months but are not in foreclosure and are in the process of foreclosure as of the dates indicated. 11

12 June 30, December 31, Carrying Carrying Value Value Good standing $13,496 $13,563 Good standing with restructured terms Interest overdue more than three months, not in foreclosure 3 14 Foreclosure in process Total mortgage loans $13,643 $13,702 The low level of delinquencies and loans in the process of foreclosure is primarily attributable to the strong commercial real estate market in the United States during the above periods. Common Stocks Prudential Insurance held 4% of its invested assets in common stock as of June 30, 2003, essentially unchanged from 4% as of December 31, Approximately 99% of Prudential Insurance's unaffiliated common stocks are publicly traded on national securities exchanges. Unrealized Losses from Common Stocks The following table sets forth the cost and gross unrealized losses of Prudential Insurance's common stocks where the estimated fair value had declined and remained below cost by 20% or more for the following timeframes: June 30, 2003 December 31, 2002 Gross Gross Unrealized Unrealized Cost Losses Cost Losses Less than six months $31 $8 $97 $31 Six months but less than nine months Nine months but less than twelve months Twelve months or more Total $31 $8 $108 $37 Gross unrealized losses where cost had been 20% or more below estimated fair value were $8 million as of June 30, 2003 compared to $37 million as of December 31, The gross unrealized losses for the first six months of 2003 were primarily concentrated in the manufacturing, services, and retail and wholesale sectors, while the gross unrealized losses in 2002 were concentrated in the manufacturing, finance and energy sectors. Joint Ventures and Limited Partnerships Prudential Insurance's investments in joint ventures and limited partnerships were $4.4 billion and $4.8 billion as of June 30, 2003 and December 31, 2002 respectively. The following table sets forth the composition of Prudential Insurance's joint ventures and limited partnerships by type as of the dates indicated. 12

13 June 30, 2003 December 31, 2002 Carrying % of Carrying % of Value Total Value Total Joint venture interests in real estate $ % $ % % Joint venture interests in common stock Joint venture interests in fixed income 3, , Joint venture interests - other Total joint ventures and limited partnerships $4, % $4, % % Liquidity and Capital Resources Liquidity Prudential Insurance's principal cash flow sources from insurance, annuities and guaranteed products are premiums and annuity considerations, investment and fee income, and investment maturities and sales. Prudential Insurance supplements these cash inflows with financing activities. Cash outflow requirements principally relate to benefits, claims, dividends paid to policyholders, and payments to contract holders as well as amounts paid to policyholders and contract holders in connection with surrenders, withdrawals and net policy loan activity. Benefits include the payment of benefits under life insurance, annuity and guaranteed products. Uses of cash also include commissions, general and administrative expenses, purchases of investments, and debt service and repayments in connection with financing activities as well as dividend payments to its parent. Some of Prudential Insurance's products, such as guaranteed products offered to institutional customers, provide for payment of accumulated funds to the contract holder at a specified maturity date unless the contract holder elects to roll over the funds into another contract with Prudential Insurance. Prudential Insurance regularly monitors its liquidity requirements associated with policyholder and contract holder obligations so that Prudential Insurance can manage cash inflows to match anticipated cash outflow requirements. The liquidity of Prudential Insurance's operations is also related to the overall quality of Prudential Insurance's investments and its asset-liability management. Net cash from operations was $393 million and $5 million for the six months ended June 30, 2003 and 2002, respectively. The fluctuation between periods was due to increased net investment income and lower policyholder dividends paid. Net cash from (used in) investing activities was ($583) million and $588 million for the six months ended June 30, 2003 and 2002, respectively. The fluctuation between periods was due to an increase in cash collateral received for securities lending activity during the first six months of 2002, compared to a decrease in cash collateral during the first six months of Net cash from (used in) financing activities was $146 million and ($398) million for the six months ended June 30, 2003 and 2002, respectively. The fluctuation between periods was primarily due to an increase in proceeds from borrowed money. Prudential Insurance's management believes that its sources of liquidity are more than adequate to meet its current cash requirements, particularly considering the liquidity of its investment portfolio. 13

14 The withdrawals included in operating activity above reflect contractually scheduled maturities of general account GICs totaling $633 million in the first six months of Since these contractual withdrawals, as well as the level of surrenders experienced, were consistent with Prudential Insurance's assumptions in asset liability management, the associated cash outflows did not have an adverse impact on its overall liquidity. Prudential Insurance uses surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of withdrawals of funds by customers from annuity contracts. The following table sets forth withdrawal characteristics of Prudential Insurance's annuity reserves and deposit liabilities (based on statutory liability values) as of the dates indicated. June 30, 2003 December 31, 2002 Amount % of Total Amount % of Total Not subject to discretionary withdrawal provisions... $17,802 55% $17,541 56% Subject to discretionary withdrawal, with adjustment: With market value adjustment... 5,531 17% 5,282 17% At market value % 0 0% At contract value, less surrender charge of 5% or more... 1,449 5% 1,419 4% Subtotal... $24,782 77% $24,242 77% Subject to discretionary withdrawal at contract value with no surrender charge or surrender charge of less than 5%... 7,348 23% 7,119 23% Total annuity reserves and deposit liabilities... $32, % $31, % Prudential Insurance believes that cash flows from operating and investing activities of its insurance, annuity and guaranteed products operations are adequate to satisfy liquidity requirements of these operations based on its current liability structure and considering a variety of reasonably foreseeable stress scenarios. The continued adequacy of this liquidity will depend upon factors including future securities market conditions, changes in interest rate levels and policyholder perceptions of Prudential Insurance's financial strength, which could lead to reduced cash inflows or increased cash outflows. As of June 30, 2003 and December 31, 2002, Prudential Insurance had cash and short-term investments of approximately $8.5 billion and $8.6 billion, and investment grade bonds with a fair value of $82.5 billion and $78.1 billion respectively. Non-Insurance Contractual Obligations The following table presents Prudential Insurance's contractual cash flow commitments on short-term and long-term debt and surplus notes as of June 30, This table does not reflect Prudential Insurance's obligations under its insurance, annuity and guaranteed products contracts. 14

15 Payment Due by Period Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years Short-term and senior long-term debt... $ 669 $ 523 $ 115 $ 31 $ Surplus notes Total... $ 1,369 $ 523 $ 115 $ 281 $ 450 In addition to the amounts above, Prudential Insurance is party to operating leases for which its future minimum lease payments under non-cancelable operating leases were $533 million as of December 31, Prudential Insurance's use of operating leases has not changed significantly from December 31, In the normal course of Prudential Insurance's business, it utilizes financial instruments with offbalance sheet credit risk such as commitments, financial guarantees and letters of credit. Commitments include commitments to originate and sell mortgage loans, and the unfunded portion of commitments to fund investments in private placement securities. These mortgage loans and private placement commitments amounted to $1,309 million as of June 30, Financing Prudential Insurance actively utilizes its balance sheet capacity for financing activities on a secured basis through securities lending, repurchase and dollar roll transactions, and on an unsecured basis for temporary cash flow mismatch coverage. Unsecured borrowings are funded primarily through Prudential Funding, a wholly owned financing subsidiary of Prudential Insurance. Prudential Insurance and Prudential Funding also lend funds to de-stacked subsidiaries on a limited basis; however Prudential Insurance expects the amount of these loans to decline over time. Prudential Insurance has entered into a support agreement with Prudential Funding under which Prudential Insurance agrees to maintain Prudential Funding's tangible net worth, including subordinated debt, at a minimum of $1.00. As of June 30, 2003, Prudential Funding had a tangible net worth of $13 million and short-term and long-term notes payable of $3,411 million and $905 million, respectively. Since inception, no payments have been required under this agreement. As of June 30, 2003, Prudential Insurance and Prudential Funding had unsecured committed lines of credit totaling $1.6 billion. The lines consist of $0.1 billion expiring in October 2003, $1.0 billion expiring in May 2004, and $0.5 billion expiring in October Borrowings under the outstanding facilities must mature no later than the respective expiration dates of the facilities. The facility expiring in May 2004 includes 28 financial institutions, many of which are also among the 27 financial institutions participating in the October 2006 facility. Prudential Insurance uses these facilities primarily as back-up liquidity lines for its commercia l paper programs and there were no outstanding borrowings under these facilities at either June 30, 2003 or December 31, The ability to borrow under these facilities is conditioned on the continued satisfaction of customary conditions, including maintenance at all times by Prudential Insurance of total adjusted capital of at least $5.5 billion based on statutory accounting principles prescribed under New Jersey law. Prudential Insurance's total adjusted capital as of June 30, 15

16 2003, December 31, 2002, and December 31, 2001 was $9.3 billion, $9.1 billion and $10.0 billion, respectively. RECENT DEVELOPMENTS Prudential Insurance has completed its statutory results for the quarter ended September 30, The following table sets forth selected statutory statement of operations data for such period. The data is derived from the quarterly unaudited statutory statements of operations for Prudential Insurance filed with the New Jersey Department and incorporated by reference in the offering circular. Three Months Ended Nine Months Ended September 30, September 30, Revenues $ 5,352 $ 16,811 $ 17,839 Benefits and expenses 4,348 14,119 14,980 Dividends to policyholders 652 1,930 2,030 Operating income Income tax expense Income from operations Net realized capital gains (losses) 58 (29) (671) Net Income Quarter Ended September 30, Net Income for the quarter ended September 30, 2003 was $351 million. Net income for the quarter was driven primarily by $352 million of operating income. Operating income for the third quarter was greater than each of the first two quarters, mainly as a result of lower other expenses. Other expenses decreased in the third quarter compared to the first two quarters as a result of an increase in the net periodic prepaid pension benefit. Realized capital gains (losses) improved during the third quarter as compared to the first two quarters as a result of a lower level of impairments and credit related losses on bonds to 2002 Nine Month Comparison. Net income increased $468 million from a net income of $48 million for the nine months ended September 30, 2002, to $516 million for the nine months ended September 30, Net income included a decrease of $642 million in net realized capital losses, from $671 million for the nine months ended September 30, 2002 to $29 million for the nine months ended September 30, This decline in realized capital losses was driven by gains in bonds in the current year, compared to losses in the prior year. Additionally, derivative losses decreased between periods. Partially offsetting the decline in net realized capital losses was an increase in federal income taxes of $107 million, from $110 million for the nine months ended September 30, 2002, to $217 million for the nine months ended September 30, The increase was primarily due to an increase in taxes with respect to prior years. Net income also included a decrease in operating income of $67 million from $829 million for the nine months ended September 30, 2002 to $762 million for the nine months ended September 30, The decline in operating income was mainly attributable to decreases in corporate and other, driven by an increase in other expenses. Other expenses increased mainly as the result of a decrease in the net periodic prepaid pension benefit between periods. 16

17 Revenues decreased $1,028 million to $16,811 million for the nine months ended September 30, 2003, from $17,839 million for the nine months ended September 30, This decrease was driven by a decline in retirement separate account premiums, mainly in short-term money market accounts. Institutional investors were rebalancing their portfolios in the prior year by making temporary deposits in short-term accounts as a result of the poor equity market in Also contributing to the decrease in revenues was a decline in individual life and annuity premiums. Over the last few years, there has been a shift of sales to Prudential Insurance s life insurance subsidiaries, Pruco Life Insurance Company and Pruco Life of New Jersey, resulting in a continued decline in premiums for individual life and annuity in Prudential Insurance. On November 17, 2003, Prudential Financial announced that it had entered into a definitive Stock Purchase and Asset Transfer Agreement, dated as of November 17, 2003 (the Stock Purchase Agreement ), with CIGNA Corporation ( CIGNA ) and certain of its affiliates, pursuant to which Prudential Financial will acquire CIGNA s retirement business. Pursuant to the Stock Purchase Agreement, the transaction is structured as an acquisition of all of the issued and outstanding capital stock of CIGNA Life Insurance Company, a life insurance company domiciled in the State of Connecticut ( CIGNA Life ), Global Portfolio Strategies, Inc., a registered investment advisor, and CIGNA Financial Services, Inc., a registered broker dealer. Prudential Financial intends that Prudential Insurance will pay the cash purchase price of $2.1 billion, subject to certain adjustments, and that CIGNA Life will become a wholly owned subsidiary of Prudential Insurance following the closing of the acquisition. It is Prudential Insurance s current intention to liquidate general account assets to fund the purchase price. In addition, CIGNA s thrift subsidiary, CIGNA Bank & Trust Company, FSB, will merge into Prudential Financial s thrift subsidiary, The Prudential Savings Bank, FSB. Prior to the acquisition by Prudential Financial of CIGNA Life, CIGNA and its affiliates will undertake a reorganization of its retirement business, which will include transferring to CIGNA Life certain assets and liabilities related to the business and approximately $840 million of surplus related to the business. In connection with the Stock Purchase Agreement, CIGNA Life and Connecticut General Life Insurance Company, a life insurance company domiciled in the State of Connecticut and an indirectly wholly owned subsidiary of CIGNA ( CGLIC ), will enter into certain coinsurance and modified coinsurance arrangements in respect of the insurance liabilities related to the business. The assets underlying the general account insurance liabilities will be deposited into trust accounts to secure each party s obligations under these arrangements. Following the closing of the transaction, the parties will ask CGLIC s customers to agree to enter into similar arrangements with CIGNA Life so that CIGNA Life can assume direct responsibility for the contracts from CGLIC. The transaction is subject to various closing conditions, including, among others, state insurance regulatory approvals, expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act and other regulatory approvals. At this time, Prudential Financial does not intend to cause the voting stock of American Skandia Life Assurance Corporation to be sold to Prudential Insurance. On December 9, 2003, the Board of Directors of Prudential Insurance elected Karl J. Krapek to the Board, effective January 1, In addition, Allan Gilmour will leave the Board effective December 31, 2003, due to scheduling conflicts with his responsibilities as Vice Chairman of Ford Motor Company. 17

18 Legal Proceedings In September 2003, the United States District Court of New Jersey dismissed Wright, et al. v. Ryan, et al., a purported nationwide class action that challenged the allocation of certain demutualization consideration payments. Plaintiffs have appealed to the Third Circuit Court of Appeals. On November 3, 2003, in In the Matter of the Plan of Reorganization of The Prudential Insurance Company of America, the Supreme Court of New Jersey denied appellants petition for certification and dismissed their appeal of the Appellate Division s affirmance of the Decision and Order of the New Jersey Commissioner of Banking and Insurance approving the Plan of Reorganization. On November 6, 2003, an action was commenced in the United States Bankruptcy Court for the Southern District of New York, Enron Corp. v. J.P. Morgan Securities, Inc., et al., against approximately 100 defendants, including Prudential Insurance and other Prudential Financial entities, who invested in Enron s commercial paper. The complaint alleges that Enron s October 2001 prepayment of its commercial paper is a voidable preference under the bankruptcy laws and constitutes a fraudulent conveyance. The complaint alleges that Prudential Financial entities received prepayments of approximately $100 million. All of the policyholder complaints against the Company in In Re Managed Care Litigation, the consolidated proceeding pending in the United States District Court for the Southern District of Florida, have been resolved. In early September, the Eleventh Circuit Court of Appeals heard oral argument on defendants appeal of the certification of a class of provider physicians. Contingencies Prudential Financial has confirmed that it has received formal requests for information from regulators and governmental entities in connection with issues relating to the purchase and sale of mutual fund shares. Prudential Financial has also received a formal request from the New York Attorney General s Office in connection with its variable annuity business. Prudential Financial is cooperating with all such inquiries and is conducting its own internal review. Because of the complexity and scope of the internal review and the uncertainties of potential regulatory proceedings and civil litigation, Prudential Financial and Prudential Insurance are unable to estimate their potential exposure, if any, at this time. 18