Prudential 2012 Annual Report Download - page 31

2011 to 2010 Annual Comparison. Adjusted operating income decreased $288 million. Excluding the impacts of changes in the
estimated profitability of the business on the reserves for the GMDB and GMIB features of our variable annuity products and on the
amortization of DAC and other costs, discussed below, adjusted operating income increased $270 million. This increase was driven by
higher asset-based fees due to growth in average variable annuity account values, net of an increased level of distribution costs. The
increase was partially offset by higher general and administrative expenses, net of capitalization, reflecting increased costs to support
business growth and higher financing expenses, and the impact of a $25 million benefit in 2010 from refinements based on a review and
settlement of reinsurance contracts related to acquired business.
The impacts of changes in the estimated profitability of the business resulted in a $222 million net charge in 2011, and a $336 million
net benefit in 2010. The $222 million net charge in 2011 was primarily driven by the impact of negative market performance on customer
accounts relative to our assumptions. The $336 million net benefit in 2010 reflected the impacts of annual assumption updates, driven by
reductions to lapse rate assumptions and more favorable assumptions relating to fee income, as well as the impacts of favorable market
performance on customer accounts relative to our assumptions, and favorable claims, lapse and fee experience.
Revenues, Benefits and Expenses
2012 to 2011 Annual Comparison. Revenues, as shown in the table above under “—Operating Results,” increased $345 million,
primarily driven by a $384 million increase in policy charges and fee income, and asset management fees and other income, due to growth
in average variable annuity account values.
Benefits and expenses, as shown in the table above under “—Operating Results,” decreased $32 million. Absent the $303 million net
decrease related to the impacts of certain changes in our estimated profitability of the business, discussed above, benefits and expenses
increased $271 million. General and administrative expenses, net of capitalization, increased $211 million, driven by higher asset-based
trail commissions, reflecting account value growth, as well as higher costs to support business initiatives. The amortization of DAC
increased $92 million driven by higher gross profits primarily related to the increase in fee income discussed above, and higher
amortization rates driven primarily by the inclusion of unfavorable results from our living benefits hedging program in our best estimate of
total gross profits used to determine amortization rates.
2011 to 2010 Annual Comparison. Revenues increased $443 million. Policy charges and fees and asset management fees and other
income increased $576 million driven by growth in average variable annuity account values. Partially offsetting the increase in revenues
was a decrease in net investment income of $88 million, reflecting lower average annuity account values in the general account primarily
resulting from net transfers from the general account to the separate accounts, driven by an automatic rebalancing element in some of our
optional living benefit features.
Benefits and expenses increased $731 million. Absent the $558 million net increase related to the impacts of certain changes in our
estimated profitability of the business, discussed above, benefits and expenses increased $173 million. General and administrative
expenses, net of capitalization, increased $195 million, driven by higher distribution and asset management costs, reflecting business and
account value growth. The amortization of DAC increased $78 million driven by higher gross profits primarily related to the increase in fee
income discussed above. Interest expense also increased $46 million driven by higher borrowings to fund costs related to new business
sales. Interest credited to policyholders’ account balances decreased $107 million primarily due to lower average annuity account values in
the general account partially offset by higher amortization of deferred sales inducements reflecting the impact of higher gross profits.
Variable Annuity Risks and Risk Mitigants
The primary risk exposures of our variable annuity contracts relate to actual deviations from, or changes to, the assumptions used in
the original pricing of these products, including capital markets assumptions, such as equity market returns, interest rates and market
volatility, and actuarial assumptions, such as contractholder longevity/mortality, the timing of annuitization and withdrawals, and contract
lapses. For our actuarial assumptions, we have retained the risk that actual experience will differ from the assumptions used in the original
pricing of these products. For our capital markets assumptions, we hedge or limit our exposure to the risk created by capital markets
fluctuations through a combination of product design elements, such as an automatic rebalancing element, also referred to as an asset
transfer feature, and inclusion of certain optional living benefits in our living benefits hedging program.
Our automatic rebalancing element occurs at the contractholder level, and transfers assets between certain variable investments
selected by the annuity contractholder and, depending on the benefit feature, the fixed-rate account in the general account or a bond
portfolio within the separate accounts. The automatic rebalancing element associated with currently-sold products uses a designated bond
portfolio within the separate accounts. The transfers are based on the static mathematical formula used with the particular benefit which
considers a number of factors, including, but not limited to, the impact of investment performance on the contractholder’s total account
value. The objective of the automatic rebalancing element is to mitigate our exposure to equity market risk and market volatility. Other
product design elements we utilize include, among others, asset allocation restrictions and minimum issuance age requirements. In
addition, certain fees are based on a benefit guarantee amount rather than the account value, which helps preserve certain revenue streams
when market fluctuations cause account values to decline.
We use our living benefits hedging program to manage the risk associated with certain of our optional living benefit guarantees. This
program represents a balance among three objectives: 1) provide severe scenario protection, 2) minimize net income volatility associated
with an internally-defined hedge target, and 3) maintain capital efficiency. Through our hedge program, we purchase derivatives that seek
to replicate the net change in our hedge target, discussed further below. In addition to mitigating capital markets risk and income statement
volatility, the hedging program is also focused on a long-term goal of accumulating assets that could be used to pay claims under these
benefits irrespective of market path, recognizing that, under the terms of the contracts, we do not expect to begin substantial payment of
such claims until many years in the future. For additional information regarding this program see “—Variable Annuities Living Benefits
Hedging Program Results” below.
For our optional living benefits features, claims will primarily be paid in the form of lifetime contractholder withdrawal payments.
These payments commence only after the cumulative withdrawals have first exhausted the policy account value. Due to the age of the
block, no such claims payments have occurred to date, nor are they expected to occur within the next five years. The timing and amount of
actual future claims depend on actual returns on contractholder account value and actual policyholder behavior relative to our assumptions.
Prudential Financial, Inc. 2012 Annual Report 29