Prudential 2012 Annual Report Download - page 24

The remaining 4% of the reserves for future policy benefits as of December 31, 2012 primarily represent reserves for the guaranteed
minimum death benefit (“GMDB”) and optional living benefit features of the variable annuity products in our Individual Annuities
segment, and group life and disability benefits in our Group Insurance segment. The optional living benefits are primarily accounted for as
embedded derivatives, with fair values calculated as the present value of future expected benefit payments to customers less the present
value of assessed rider fees attributable to the embedded derivative feature. For additional information regarding the valuation of these
optional living benefit features, see Note 20 to the Consolidated Financial Statements and “—Valuation of Assets and Liabilities—Fair
Value of Assets and Liabilities—Variable Annuity Optional Living Benefit Features.”
In establishing reserves for GMDBs and guaranteed minimum income benefits (“GMIB”s) related to variable annuity contracts, we
must make estimates and assumptions about the timing of annuitization, contract lapses and contractholder mortality, as well as interest
rates and equity market returns. Assumptions relating to contractholder behavior, such as the timing of annuitization and contract lapses,
are based on our experience by contract group, and vary by product type and year of issuance. We adjust base lapse rate assumptions at the
contract level based on a comparison of the actuarially-calculated value and the current policyholder account value, as well as other factors,
such as the applicability of any surrender charges. This dynamic lapse rate adjustment reduces the base lapse rate when the guaranteed
amount is greater than the account value, as in-the-money contracts are less likely to lapse. Lapse rates are also generally assumed to be
lower for the period where surrender charges apply. Mortality assumptions are generally based on standard industry tables, which we adjust
based on our historical experience, and also incorporate a mortality improvement assumption. These mortality assumptions vary by
contract group. Over the last several years, the Company’s most significant assumption updates that have resulted in changes to our
reserves for GMDBs and GMIBs have been related to lapse experience and other contractholder behavior assumptions and revisions to
expected future rates of returns on investments. The Company expects these assumptions to be the ones most likely to cause significant
changes in the future. Changes in these assumptions can be offsetting and can also impact our DAC and other balances as discussed above.
For additional information on the calculation of these reserves, see Note 11 to the Consolidated Financial Statements.
The future rate of return assumptions used in establishing reserves for GMDBs and GMIBs related to variable annuity contracts are
derived using a reversion to the mean approach, a common industry practice. For additional information regarding our future expected rate
of return assumptions and our reversion to the mean approach see, “—Deferred Policy Acquisition and Other Costs.” The following table
provides a demonstration of the sensitivity of the reserves for GMDBs and GMIBs related to variable annuity contracts relative to our
future rate of return assumptions by quantifying the adjustments to these reserves that would be required assuming both a 100 basis point
increase and decrease in our future rate of return. The sensitivity includes an increase and decrease of 100 basis points to both the near-term
future rate of return assumptions used over the next four years, and the long-term expected rate of return used thereafter. While the
information below is for illustrative purposes only and does not reflect our expectations regarding future rate of return assumptions, it is a
near-term, reasonably likely change that illustrates the potential impact of such a change. This information considers only the direct effect
of changes in our future rate of return on operating results due to the change in the reserve balance and not changes in any other
assumptions such as persistency, mortality, or expenses included in our evaluation of the reserves, or any changes on DAC or other
balances, discussed above in “—Deferred Policy Acquisition and Other Costs.”
December 31, 2012
Increase/(Reduction) in
GMDB/GMIB Reserves
(in millions)
Decrease in future rate of return by 100 basis points ............................................................. $154
Increase in future rate of return by 100 basis points .............................................................. $(126)
For a discussion of adjustments to the reserves for GMDBs and GMIBs related to our Individual Annuities segment for the years
ended December 31, 2012, 2011 and 2010, see “—Results of Operations for Financial Services Businesses by Segment—U.S. Retirement
Solutions and Investment Management Division—Individual Annuities.”
Unpaid claims and claim adjustment expenses
Our liability for unpaid claims and claim adjustment expenses of $2.9 billion as of December 31, 2012 is reported as a component of
“Future policy benefits” and relates primarily to the group long-term disability products of our Group Insurance segment. This liability
represents our estimate of future disability claim payments and expenses as well as estimates of claims that we believe have been incurred,
but have not yet been reported as of the balance sheet date. We do not establish loss liabilities until a loss has occurred. As prescribed by
U.S. GAAP, our liability is determined as the present value of expected future claim payments and expenses. Expected future claim
payments are estimated using assumed mortality and claim termination factors and an assumed interest rate. The mortality and claim
termination factors are based on standard industry tables and the Company’s historical experience. Our interest rate assumptions are based
on factors such as market conditions and expected investment returns. Of these assumptions, our claim termination assumptions have
historically had the most significant effect on our level of liability. We compare our claim termination assumptions to actual terminations
annually. These studies review actual claim termination experience over a number of years with more weight placed on the actual
experience in the more recent years. If actual experience results in a different assumption, we adjust our liability for unpaid claims and
claims adjustment expenses accordingly with a charge or credit to current period earnings. In recent years, we have experienced an increase
in the volume of new long-term disability claims, as well as unfavorable claim termination experience, driven by the economic downturn.
During 2012, our claim termination experience has shown improvement, but has been outpaced by a continued increase in new claims. We
are investing in our claims management process which, over time, should drive improvements in this area.
Unearned revenue reserves for universal life and investment contracts
Our unearned revenue reserve, or URR, reported as a component of “Policyholders’ account balances,” is $1.2 billion as of
December 31, 2012. This reserve primarily relates to variable and universal life products within our Individual Life segment and represents
policy charges for services to be provided in future periods. The charges are deferred as unearned revenue and amortized over the expected
life of the contract in proportion to the product’s estimated gross profits, similar to DAC as discussed above.
22 Prudential Financial, Inc. 2012 Annual Report