Prudential 2003 Annual Report Download - page 30

of either estimated profits or premiums, depending on the type of contract. For products with amortization based on
estimated profits, the amortization rate is periodically updated to reflect current period experience or changes in
assumptions that affect future profitability, such as lapse rates, investment returns, mortality experience, expense
margins and surrender charges. However, for products with amortization based on future premiums, the amortization
rate is locked-in when the product is sold.
Expected profitability is a significant element in evaluating deferred policy acquisition costs related to annuity
products. Deferred policy acquisition costs related to annuity products are evaluated quarterly by comparing our actual
profitability to our expectations. Expected profitability considers, among other assumptions, our estimate of future
asset returns that determine the future fees we will earn, the costs we expect to incur associated with minimum death
benefit and other contractual guarantees, as well as other profitability factors. If actual asset returns do not differ
significantly from our expectations, they do not result in a change in the rate of amortization of deferred acquisition
costs. Where actual asset returns differ significantly from expectations, future asset return assumptions are evaluated
using a reversion to mean approach. Under the reversion to mean approach, we consider historical returns over a period
of time and project returns for a future four year period so that the investments underlying the annuities grow at a
targeted return for the entire period. A calculated rate of return over the four future years, which we refer to as the
look-forward period, is determined so that this calculated rate, together with the actual rate of return for the historical
period, produces the targeted return for the entire period. If the calculated rate of return is consistent with our range of
expectations in light of market conditions, we use it to project the asset growth for the next four years. If the calculated
rate of return is not supported by our current expectations, we adjust the rate of return for purposes of these
computations. For contract years after the look-forward period, we project asset growth using our long-term rate,
currently an 8% annual blended rate of return, which reflects an assumed rate of return of 8.85% for equity type assets.
Beginning in the second quarter of 2002 and continuing throughout 2002, we utilized a rate of return lower than the
calculated return, which contributed to our additional amortization of deferred acquisition costs during the second and
third quarters of 2002. The equity rate of return used in the immediate four year look-forward period varies by product,
but was under 10% for all of our variable annuity products for our evaluation of deferred policy acquisition costs as of
December 31, 2003. For the average remaining life of our variable annuity contracts in force as of December 31, 2003,
our evaluation of deferred policy acquisition costs is based on a 7.7% annual blended rate of return that reflects an
assumed rate of return of 8.9% for equity type assets. Deterioration in market conditions may result in increases in the
amortization of deferred policy acquisition costs, while further improvement in market conditions may result in a
decrease in the amortization of deferred policy acquisition costs. These changes in DAC balances are included as a
component of “General and administrative expenses” in our statements of operations.
See “—Insurance Division—Individual Life and Annuities” for discussion of the impact of DAC amortization on
our results of our annuities businesses, including a reduction in amortization recorded in 2003 reflecting an increase in
our estimate of future gross profits on variable annuities and increases in amortization recorded in 2002 and 2001
reflecting our decreases in estimates of future gross profits during those years.
Goodwill
We test goodwill for impairment on an annual basis as of December 31 of each year and more frequently if events
occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its
carrying amount. Impairment testing requires us to compare the fair value of each reporting unit to its carrying amount,
including goodwill, and record an impairment charge if the carrying amount of a reporting unit exceeds its estimated
fair value. The determination of a reporting unit’s fair value is based on management’s best estimate, which generally
considers the unit’s expected future earnings and market-based earning multiples of peer companies. As of
December 31, 2003, we have $435 million of goodwill reflected on our statement of financial position.
Reserves For Contingencies
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon
the occurrence of future events. Under GAAP, reserves for contingencies are required to be established when the future
event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in
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