Prudential 2015 Annual Report Download - page 32

growth. Interest expense increased $16 million, driven by issuance of longer duration debt, partially offset by repayments of debt. Partially
offsetting these increases was a $45 million decrease in interest credited to policyholders’ account balances driven by lower average
account values in the general account. Amortization of DAC decreased $22 million primarily due to lower amortization rates, and
policyholders’ benefits decreased $22 million primarily due to changes in reserves.
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, along with actuarial assumptions such as contractholder mortality, the timing and amount of annuitization and withdrawals, and
contract lapses. For our actuarial assumptions, we have retained the majority of 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 certain
risks created by capital markets fluctuations through a combination of product design features, such as an automatic rebalancing feature,
also referred to as an asset transfer feature, and inclusion of certain living benefits in our hedging program. In addition, we consider
external reinsurance a form of risk mitigation. Effective April 1, 2015, we entered into an agreement with Union Hamilton Reinsurance,
Ltd. (“Union Hamilton”), an external counterparty, to reinsure approximately 50% of the Highest Daily Lifetime Income (“HDI”) v.3.0
business. HDI v.3.0 is the newest version of our “highest daily” living benefits guarantee that is available with our Prudential Premier®
Retirement Variable Annuity. This reinsurance agreement covers most new HDI v.3.0 variable annuity business issued between April 1,
2015 and December 31, 2016 on a quota share basis, until Union Hamilton’s quota share reaches $5 billion of new rider premiums through
December 31, 2016.
Our automatic rebalancing feature occurs at the contract level, and transfers assets between certain variable investment sub-accounts
selected by the annuity contractholder and, depending on the benefit feature, a fixed-rate account in the general account or a bond fund sub-
account within the separate accounts. The automatic rebalancing feature associated with currently-sold highest daily benefit products uses a
designated bond fund sub-account within the separate accounts. The transfers are based on a 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 feature is to reduce our exposure to equity market risk and
market volatility. Other product design features we utilize include, among others, asset allocation restrictions, minimum issuance age
requirements and certain limitations on the amount of contractholder deposits, as well as a required allocation to our general account for
certain of our products. We have also introduced new products that diversify our risk profile and incorporate provisions in product design
allowing frequent revisions of key pricing elements. In addition, certain fees are primarily based on the benefit guarantee amount, the
contractholder account value and/or premiums, which helps preserve certain revenue streams when market fluctuations cause account
values to decline.
We use our hedging program to help manage certain risks associated with certain of our guarantees. The hedging program’s objective
is to help mitigate fluctuations in net income and capital from living benefit liabilities due to capital market movements, within established
tolerances. Through our hedging program, we enter into derivative positions that seek to offset the net change in our hedge target, discussed
further below. In addition to mitigating fluctuations of the living benefit liabilities due to capital market movements, 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.
For additional information regarding this program, see “—Variable Annuities Hedging Program Results” below.
For certain living benefits features, claims will primarily represent the funding of contractholder lifetime withdrawals after the
cumulative withdrawals have first exhausted the contractholder account value. Due to the age of the in force block, limited claim payments
have occurred to date, and they are not expected to increase significantly within the next five years, based upon current assumptions. The
timing and amount of future claims will depend on actual returns on contractholder account value and actual contractholder behavior
relative to our assumptions. The majority of our current living benefits features provide for guaranteed lifetime contractholder withdrawal
payments inclusive of a “highest daily” contract value guarantee. Our PDI variable annuity complements our variable annuity products
with the highest daily benefit and provides for guaranteed lifetime contractholder withdrawal payments, but restricts contractholder asset
allocation to a single bond fund sub-account within the separate account.
The majority of our variable annuity contracts with living benefits features, and all new contracts sold with our highest daily living
benefits feature, include risk mitigants in the form of an automatic rebalancing feature and/or inclusion in our hedging program. As
discussed above, we also utilize external reinsurance as a form of additional risk mitigation. The guaranteed benefits of certain legacy
products that were sold prior to our implementation of the automatic rebalancing feature are also included in our hedging program. Certain
legacy GMAB products include the automatic rebalancing feature, but are not included in the hedging program. The PDI product and
contracts with the GMIB feature have neither risk mitigant. Rather than utilizing a capital markets hedging strategy, certain risks associated
with PDI are managed through the limitation of contractholder asset allocations to a single bond fund sub-account.
For our GMDBs, we provide a benefit payable in the event of death. Our base GMDB is generally equal to a return of cumulative
deposits adjusted for any partial withdrawals. Certain products include an optional enhanced GMDB based on the greater of a minimum
return on the contract value or an enhanced value. We have retained the risk that the total amount of death benefit payable may be greater
than the contractholder account value. However, a substantial portion of the account values associated with GMDBs are subject to an
automatic rebalancing feature because the contractholder also selected a living benefit feature which includes an automatic rebalancing
feature. All of the variable annuity account values with living benefit features also contain GMDBs. The living and death benefit features
for these contracts cover the same insured life and, consequently, we have insured both the longevity and mortality risk on these contracts.
30 Prudential Financial, Inc. 2015 Annual Report