Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") addresses the consolidated financial condition ofPruco Life Insurance Company , or the "Company," as ofJune 30, 2022 , compared withDecember 31, 2021 , and its consolidated results of operations for the three and six months endedJune 30, 2022 and 2021. You should read the following analysis of our consolidated financial condition and results of operations in conjunction with the MD&A, the "Risk Factors" section, and the audited Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , as well as the statements under "Forward-Looking Statements" , and the Unaudited Interim Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q. Overview The Company sells variable annuities, universal life insurance, variable life insurance and term life insurance primarily through affiliated and unaffiliated distributors inthe United States . As ofDecember 31, 2020 , the Company discontinued the sales of traditional variable annuities with guaranteed living benefit riders. EffectiveApril 1, 2022 , Prudential Financial completed the sale ofPrudential Annuities Life Assurance Corporation ("PALAC") toFortitude Group Holdings, LLC ("Fortitude"). As such, PALAC is no longer an affiliate of Prudential Financial or the Company. Fortitude subsequently renamed the companyFortitude Life Insurance & Annuity Company ("FLIAC"). EffectiveJuly 1, 2021 , the Company recaptured the risks related to its variable annuity base contracts, along with the living benefit guarantees, that had previously been reinsured toPrudential Annuities Life Assurance Corporation ("PALAC") fromApril 1, 2016 throughJune 30, 2021 , subsequently renamed FLIAC. The recapture does not impactPruco Life Insurance Company of New Jersey ("PLNJ"), which will continue to reinsure its new and in force business toThe Prudential Insurance Company of America ("Prudential Insurance "). The product risks related to the previously reinsured business that were being managed in PALAC, were transferred to the Company. In addition, the living benefit hedging program related to the previously reinsured living benefit riders are being managed within the Company. This transaction is referred to as the "2021 Variable Annuities Recapture". For more information on this transition, see Note 1 to the Consolidated Financial Statements. EffectiveDecember 1, 2021 , the Company entered into a reinsurance agreement with FLIAC (previously named PALAC) under which the Company assumed all of its variable and fixed indexed annuities and fixed annuities with a guaranteed lifetime withdrawal income feature from FLIAC. Annually during the second quarter of each year, we perform a comprehensive review of actuarial assumptions. As part of this review, we may update these assumptions and make refinements to our models based upon emerging experience, future expectations and other data, including any observable market data. For additional information, see "Accounting Policies & Pronouncements-Application of Critical Accounting Estimates" below as well as the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 .
COVID-19[feminine]
Since the first quarter of 2020, the COVID-19 pandemic has caused extreme stress and disruption in the global economy and financial markets and elevated mortality and morbidity for the global population. The COVID-19 pandemic impacted our results of operations in the current period and is expected to impact our results of operations in future periods. The Company has taken several measures to manage the impacts of this crisis. The actual and expected impacts of these events and other items are included in the following update:
•Outlook. COVID-19 can contribute to high levels of mortality, resulting in
increase in life insurance claims.
•Results of operations. See “Results of operations” for a discussion of the results
for the second quarter and the first six months of 2022.
•Risk Factors. The COVID-19 pandemic has adversely impacted our results of operations, financial position, investment portfolio, new business opportunities and operations, and these impacts are expected to continue. For additional information on the risks to our business posed by the COVID-19 pandemic, see "Risk Factors" included in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 . 57
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•Business Continuity. Throughout the COVID-19 pandemic, we have been executing Prudential Financial Inc.'s ("Prudential Financial") and our business continuity protocols to ensure employees are safe and able to serve our customers. This included effectively transitioning the vast majority of employees to remote work arrangements. InMarch 2022 , Prudential Financial's offices were reopened to employees and we expect that most of the workforce will adopt a hybrid arrangement for the foreseeable future. We believe we can sustain long-term hybrid or fully remote work arrangements while ensuring that critical business operations are sustained. In addition, we are managing COVID-19 related impacts on third-party provided services, and do not anticipate significant interruption in critical operations.
Impact of a low interest rate environment
As a global financial services company, market interest rates are a key driver of our results of operations and financial condition. Changes in interest rates can affect our results of operations and/or our financial condition in several ways, including favorable or adverse impacts to: • investment-related activity, including: investment income returns, net interest margins, net investment spread results new money rates, mortgage loan prepayments and bond redemptions; • hedging costs and other risk mitigation activities; • insurance reserve levels, amortization of deferred policy acquisition costs ("DAC") and market experience true-ups: • customer account values, including their impact on fee income; • product offerings, design features, crediting rates and sales mix; and • policyholder behavior, including surrender or withdrawal activity.
For more information on interest rate risks, see “Risk Factors – Market Risk”
included in our annual report on Form 10-K for the fiscal year ended
Income and expenses
The Company earns revenues principally from insurance premiums, mortality and expense fees, asset administration fees from insurance and investment products, and from net investment income on the investment of general account and other funds. The Company receives premiums primarily from the sale of individual life insurance and annuity products. The Company earns mortality and expense fees, and asset administration fees, primarily from the sale and servicing of universal life insurance and separate account products including variable life insurance and variable annuities. The Company's operating expenses principally consist of insurance benefits provided and reserves established for anticipated future insurance benefits, general business expenses, reinsurance premiums, commissions and other costs of selling and servicing the various products sold and interest credited on general account liabilities. 58
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Accounting Policies & Pronouncements
Application of critical accounting estimates
The preparation of financial statements in conformity withU.S. GAAP requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews estimates and assumptions used in the preparation of financial statements. If management determines that modifications in assumptions and estimates are appropriate given current facts and circumstances, the Company's results of operations and financial position as reported in the Unaudited Interim Consolidated Financial Statements could change significantly.
Management believes that the accounting policies relating to the following areas are
depend most on the application of estimates and assumptions and require
Management’s most difficult, subjective or complex judgments:
•DAC and other costs, including deferred sales inducements ("DSI"); •Policyholder liabilities; •Valuation of investments, including derivatives, measurement of allowance for credit losses, and recognition of other-than-temporary impairments; •Reinsurance recoverables; •Taxes on income; and •Reserves for contingencies, including reserves for losses in connection with unresolved legal matters.
Market Return – Equity and Interest Rate Assumptions
DAC and other costs associated with the variable and universal life policies and the variable and fixed annuity contracts are generally amortized over the expected lives of these policies in proportion to total gross profits. Total gross profits include both actual gross profits and estimates of gross profits for future periods. The quarterly adjustments for market performance reflect the impact of changes to our estimate of total gross profits to reflect actual fund performance and market conditions. A significant portion of gross profits for our variable annuity contracts and, to a lesser degree, our variable life contracts are dependent upon the total rate of return on assets held in separate account investment options. This rate of return influences the fees we earn on variable annuity and variable life contracts, costs we incur associated with the guaranteed minimum death and guaranteed minimum income benefit features related to our variable annuity contracts and expected claims to be paid on variable life contracts, as well as other sources of profit. Returns that are higher than our expectations for a given period produce higher than expected account balances, which increase the future fees we expect to earn on variable annuity and variable life contracts and decrease the future costs we expect to incur associated with the guaranteed minimum death and guaranteed minimum income benefit features related to our variable annuity contracts and expected claims to be paid on variable life contracts. The opposite occurs when returns are lower than our expectations. The changes in future expected gross profits are used to recognize a cumulative adjustment to all prior periods' amortization. Furthermore, the calculation of the estimated liability for future policy benefits related to certain insurance products includes an estimate of associated revenues and expenses that are dependent on both historical market performance as well as estimates of market performance in the future. Similar to DAC and other costs described above, these liabilities are subject to quarterly adjustments for experience including market performance, in addition to annual adjustments resulting from our annual reviews of assumptions. The weighted average rate of return assumptions used in developing estimated market returns consider many factors specific to each product type, including asset durations, asset allocations and other factors. With regard to equity market assumptions, the near-term future rate of return assumption used in evaluating DAC, other costs and liabilities for future policy benefits for certain of our products, primarily our domestic variable annuity and variable life insurance products, is generally updated each quarter and is derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider historical equity returns and adjust projected equity returns over an initial future period of five years (the "near-term") so that equity returns converge to the long-term expected rate of return. If the near-term projected future rate of return is greater than our near-term maximum future rate of return of 15.0%, we use our maximum future rate of return. If the near-term projected future rate of return is lower than our near-term minimum future rate of return of 0%, we use our minimum future rate of return. As ofJune 30, 2022 , our variable annuities and variable life insurance businesses assume an 8.0% long-term equity expected rate of return and a 6.4% near-term mean reversion equity expected rate of return. 59
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With regard to interest rate assumptions used in evaluating DAC, DSI and liabilities for future policy benefits for certain of our products, we generally update the long-term and near-term future rates used to project fixed income returns annually and quarterly, respectively. As a result of our 2022 annual reviews and update of assumptions and other refinements, we kept our long-term expectation of the 10-yearU.S. Treasury rate unchanged and continue to grade to a rate of 3.25% over ten years. As part of our quarterly market experience updates, we update our near-term projections of interest rates to reflect changes in current rates. For further discussion of impacts that could result from changes in certain key assumptions, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Accounting Policies and Pronouncements-Application of Critical Accounting Estimates" in our Annual Report on Form 10-K for the year endedDecember 31, 2021 .
Future Adoption of New Accounting Pronouncements
ASU 2018-12, Financial Services - Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, was issued by theFinancial Accounting Standards Board ("FASB") onAugust 15, 2018 , and was amended by ASU 2019-09, Financial Services - Insurance (Topic 944): Effective Date, issued inOctober 2019 , and ASU 2020-11,Financial Services-Insurance (Topic 944): Effective Date and Early Application, issued inNovember 2020 . The Company will adopt ASU 2018-12 effectiveJanuary 1, 2023 using the modified retrospective transition method where permitted, and apply the guidance as ofJanuary 1, 2021 (and record transition adjustments as ofJanuary 1, 2021 ) in the 2023 financial statements. ASU 2018-12 will impact, at least to some extent, the accounting and disclosure requirements for all long-duration insurance and investment contracts issued by the Company. The Company expects the standard to have a significant financial impact on the Consolidated Financial Statements and will significantly increase disclosures. In addition to the significant impacts to the balance sheet upon adoption, the Company also expects an impact to the pattern of earnings emergence following the transition date. See Note 2 to the Unaudited Interim Consolidated Financial Statements. for a more detailed discussion of ASU 2018-12, as well as other accounting pronouncements issued but not yet adopted and newly adopted accounting pronouncements. Changes in Financial Position
Total assets decreased
• Segregated account assets decreased
equity performance and net outflows;
•Invested assets decreased$1.0 billion driven by$1.8 billion in unrealized losses on investments primarily due to rising interest rates and partially offset by a$0.8 billion decrease in policy loans from ceding a portion of the variable life business toLotus Reinsurance Company Ltd. ("Lotus Re");
Partially offset by:
• Cash and cash equivalents increased
financing needs.
Total liabilities decreased
2021
• Separate account liabilities decreased
decrease in the assets of the separate account, as indicated above;
•Future policy benefits decreased$3.8 billion driven by a decrease in reserves related to our variable annuity living benefit guarantees due to widening non-performance risk ("NPR") spreads and rising interest rates, partially offset by unfavorable equity market performance;
Partially offset by:
• Policyholder account balances have increased
indexed product sales; and
•Other liabilities increased$0.9 billion driven by the deferred reinsurance gain from ceding a portion of the variable life business to Lotus Re, partially offset by a decrease to cost of reinsurance liabilities. Total equity decreased$1.2 billion from$6.0 billion atDecember 31, 2021 to$4.8 billion atJune 30, 2022 driven by$1.8 billion of unrealized losses on investments driven by rising interest rates reflected in Accumulated other comprehensive income (loss). 60
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Results of Operations
Operating profit (loss) before income taxes
Three-month comparison
Income (loss) from operations before income taxes increased$532 million from a loss of$26 million for the three months endedJune 30, 2021 to income of$506 million for the three months endedJune 30, 2022 . This includes a favorable comparative net gain of$342 million from our annual reviews and update of assumptions and other refinements driven by anNPR assumption update. Excluding the comparative impact of our annual reviews and update of assumptions and other refinements, income (loss) from operations increased$189 million primarily driven by:
• Impact on profits of the recovery of the variable annuity and the new reinsurance with
FLIAC in 2021;
Six Months Comparison Income (loss) from operations before income taxes increased$444 million from income of$32 million for the six months endedJune 30, 2021 to a gain of$476 million for the six months endedJune 30, 2022 . This includes a favorable comparative net gain of$342 million from our annual reviews and update of assumptions and other refinements as noted above. Excluding the comparative impact of our annual reviews and update of assumptions and other refinements, income (loss) from operations increased$102 million primarily driven by:
• Impact on profits of the recovery of the variable annuity and the new reinsurance with
FLIAC in 2021;
Partially offset by:
• Fees paid to
term reinsurance (“YRT”) for most of the company’s variable life insurance policies
policies and selling part of the variable life business to Lotus Re.
The following table presents the net impact on the unaudited interim statements
of operations, which is mainly driven by changes
Embedded derivative liabilities and hedging positions under Asset Liabilities
management strategy (“ALM”), and related amortization of DAC and other
costs.
Three Months Ended Six Months EndedJune 30, 2022 June 30, 2022
(in millions)(1)
Change in value of USGAAP liabilities, before
(13) $ 1,364 Change in the NPR adjustment 1,125 1,602
Change in fair value of plan assets, excluding capital
hedges(3)
(752) (2,145) Change in fair value of capital hedges(4) 439 620 Other (399) (709)
Realized, net and related investment gains (losses)
adjustments
400 732 Market experience updates(5) (43) (120)
Costs related to realized gains (losses) on investments,
report
(36) (237)
Net impact of changes in the
derivative and hedging positions, after impact
CAD and other costs(6)
$ 321 $ 375 (1)Positive amount represents income; negative amount represents a loss. (2)Represents the change in the liability (excludingNPR ) for our variable annuities which is measured utilizing a valuation methodology that is required underU.S. GAAP. This liability includes such items as risk margins which are required byU.S. GAAP but not included in our best estimate of the liability. (3)Represents the changes in fair value of the derivatives utilized to hedge potential claims associated with our variable annuity living benefit guarantees. (4)Represents the changes in fair value of equity derivatives of the capital hedge program intended to protect a portion of the overall capital position of our business against exposure to the equity markets. (5)Represents the immediate impacts in current period results from changes in current market conditions on estimates of profitability. (6)Excludes amounts from the changes in unrealized gains and losses from fixed income instruments recorded in OCI (versus net income) of($120) million and($233) million for the three and six months endedJune 30, 2022 , respectively. 61
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For the three months endedJune 30, 2022 , the gain of$321 million was primarily driven by a favorable impact from theNPR adjustment, partially offset by an unfavorable impact related to the change in the fair value of hedge assets. For the six months endedJune 30, 2022 , the gain of$375 million was primarily driven by a favorable impact from theNPR adjustment and from a favorable impact related to the portions of ourU.S. GAAP liability beforeNPR , that are excluded from hedge target, driven by rising interest rates, partially offset by an unfavorable impact related to the change in the fair value of hedge assets.
Income, benefits and expenses
Three-month comparison
Revenues increased$1,120 million from$230 million for the three months endedJune 30, 2021 to$1,350 million for the three months endedJune 30, 2022 . This includes a favorable comparative increase of$523 million from our annual reviews and update of assumptions and other refinements as noted above. Excluding the comparative impact of our annual reviews and update of assumptions and other refinements, revenues increased$597 million primarily driven by:
• Higher realized investment gains (losses), net, mainly due to a
the impact of
related to changes in the fair value of plan assets;
• Higher policy fees and fee income are driven by the variable annuity
reprise.
Benefits and expenses increased$588 million from$256 million for the three months endedJune 30, 2021 to$844 million for the three months endedJune 30, 2022 . This includes an unfavorable comparative increase of$181 million from our annual reviews and update of assumptions and other refinements as noted above. Excluding the comparative impact of our annual reviews and update of assumptions and other refinements, benefits and expenses increased$407 million primarily driven by:
• Higher benefits and expenses due to the clawback of the variable annuity and the new
reinsurance with FLIAC in 2021.
Six-month comparison
Revenues increased$1,705 million from$626 million for the six months endedJune 30, 2021 to$2,331 million for the six months endedJune 30, 2022 . This includes a favorable comparative increase of$523 million from our annual reviews and update of assumptions and other refinements as noted above. Excluding the comparative impact of our annual reviews and update of assumptions and other refinements, revenues increased$1,183 million primarily driven by: •Higher realized investment gains (losses), primarily driven by a favorable impact from theNPR adjustment and from a favorable impact related to the portions of ourU.S. GAAP liability beforeNPR , that are excluded from hedge target, driven by rising interest rates, partially offset by an unfavorable impact related to the change in the fair value of hedge assets; and
• Higher policy fees and fee income are driven by the variable annuity
recovery, partially compensated by the commission paid to
recovery of YRT reinsurance for the majority of the company’s variable life insurance
insurance policies and by selling part of the variable life business to
Lotus Re.
Benefits and expenses increased$1,260 million from$594 million for the six months endedJune 30, 2021 to$1,854 million for the six months endedJune 30, 2022 . This includes an unfavorable comparative increase of$181 million from our annual reviews and update of assumptions and other refinements as noted above. Excluding the comparative impact of our annual reviews and update of assumptions and other refinements, benefits and expenses increased$1,079 million primarily driven by:
• Higher benefits and expenses due to the clawback of the variable annuity and the new
reinsurance with FLIAC in 2021.
Risks and Risk Mitigation Factors
Variable Annuity Risks and Risk Mitigation Factors:
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 these risk exposures, achievement of our expected returns is subject to the risk that actual experience will differ from the assumptions used in the original pricing of these products. Prudential Financial manages our exposure to certain risks driven by fluctuations in capital markets primarily through a combination of Product Design Features and an Asset Liability Management Strategy ("ALM"), as discussed below. The Company also manages these risk exposures through external reinsurance for certain of our variable annuity products. 62
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EffectiveJuly 1, 2021 , the Company recaptured the risks related to its variable annuity base contracts, along with the living benefit guarantees, that had previously been reinsured to PALAC fromApril 1, 2016 throughJune 30, 2021 , subsequently renamed FLIAC. The recapture does not impact PLNJ, which will continue to reinsure its new and in force business toPrudential Insurance . The product risks related to the previously reinsured business that were being managed in PALAC, were transferred to the Company. In addition, the living benefit hedging program related to the previously reinsured living benefit riders will be managed within the Company. For more information on this transaction, see Note 1 to the Consolidated Financial Statements. Fixed Annuity Risks and Risk Mitigants. EffectiveDecember 1, 2021 , the Company entered into a reinsurance agreement with FLIAC (previously named PALAC) under which the Company assumed all of its fixed indexed annuities and fixed annuities with a guaranteed lifetime withdrawal income feature from FLIAC. The primary risk exposure of these fixed annuity products relates to investment risks we bear for providing customers a minimum guaranteed interest rate or an index-linked interest rate required to be credited to the customer's account value, which include interest rate fluctuations and/or sustained periods of low interest rates, and credit risk related to the underlying investments. We manage these risk exposures primarily through our investment strategies and product design features, which include credit rate resetting subject to the minimum guaranteed interest rate, as well as surrender charges applied during the early years of the contract that help to provide protection for premature withdrawals. In addition, a portion of our fixed annuity products has a market value adjustment provision that affords protection of lapse in the case of rising interest rates. We also manage these risk exposures through external reinsurance for certain of our fixed annuity products. Indexed Variable Annuity Risks and Risk Mitigants. EffectiveDecember 1, 2021 , the Company entered into a reinsurance agreement with FLIAC (previously named PALAC) under which the Company assumed all of its indexed variable annuities from FLIAC. The primary risk exposure of these indexed variable annuity products relates to the investment risks we bear in order to credit to the customer's account balance the required crediting rate based on the performance of the elected indices at the end of each term. We manage this risk primarily through our investment strategies including derivatives and product design features, which include credit rate resetting subject to contractual minimums as well as surrender charges applied during the early years of the contract that help to provide protection for premature withdrawals. In addition, our indexed variable annuity strategies have an interim value provision that provides protection from lapse in the case of rising interest rates.
Product design features:
A portion of the variable annuity contracts that we offer include an asset transfer feature. This feature is implemented 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 account. The objective of the asset transfer feature is to reduce our exposure to equity market risk and market volatility. The asset transfer feature associated with currently-sold highest daily living benefit products uses a designated bond fund sub-account within the separate account. 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. Other product design features we utilize include, among others, asset allocation restrictions, minimum issuance age requirements and certain limitations on the amount of contractholder purchase payments, as well as a required minimum allocation to our general account for certain of our products. We continue to introduce products that diversify our risk profile and have incorporated provisions in product design allowing frequent revisions of key pricing elements for certain of our products. In addition, there is diversity in our fee arrangements, as 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.
Asset-liability management strategy (including fixed income instruments and
derivatives):
We employ an ALM strategy that utilizes a combination of both traditional fixed income instruments and derivatives to meet expected liabilities associated with our variable annuity living benefit guarantees. The economic liability we manage with this ALM strategy consists of expected living benefit claims under less severe market conditions, which are managed using fixed income instruments, derivatives, or a combination thereof, and potential living benefit claims resulting from more severe market conditions, which are hedged using derivative instruments. For the portion of our ALM strategy executed with derivatives, we enter into a range of exchange-traded and over-the-counter equity, interest rate and credit derivatives, including, but not limited to: equity and treasury futures; total return, credit default and interest rate swaps; and options, including equity options, swaptions, and floors and caps. The intent of this strategy is to more efficiently manage the capital and liquidity associated with these products while continuing to mitigate fluctuations in net income due to movements in capital markets. 63
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The valuation of the economic liability we seek to defray excludes certain items that are included within theU.S. GAAP liability, such asNPR in order to maximize protection irrespective of the possibility of our own default, as well as risk margins (required byU.S. GAAP but different from our best estimate) and valuation methodology differences. The following table provides a reconciliation between the liability reported underU.S. GAAP and the economic liability we manage through our ALM strategy, net of reinsurance recoverables, as of the period indicated: As of June 30, 2022 (in millions) U.S. GAAP Liability, including NPR $5,152 NPR Adjustment 3,649 Subtotal 8,801
Adjustments including risk margins and differences in valuation methodology
(2,710) Economic liability managed by ALM strategy $ 6,091
Of the
derivative assets exceed our economic liabilities.
Under our ALM strategy, we expect differences in theU.S. GAAP net income impact between the changes in value of the fixed income instruments (either designated as available-for-sale or designated as trading) and derivatives as compared to the changes in the embedded derivative liability these assets support. These differences can be primarily attributed to three distinct areas: •Different valuation methodologies in measuring the liability we intend to cover with fixed income instruments and derivatives versus the liability reported underU.S. GAAP. The valuation methodology utilized in estimating the economic liability we intend to defray with fixed income instruments (either designated as available-for-sale or designated as trading) and derivatives is different from that required to be utilized to measure the liability underU.S. GAAP. Additionally, the valuation of the economic liability excludes certain items that are included within theU.S. GAAP liability, such asNPR in order to maximize protection irrespective of the possibility of our own default and risk margins (required byU.S. GAAP but different from our best estimate). •Different accounting treatment between liabilities and assets supporting those liabilities. UnderU.S. GAAP, changes in value of the embedded derivative liability, derivative instruments and fixed income instruments designated as trading immediately reflected in net income, while changes in the fair value of fixed income instruments that are designated as available-for-sale are recorded as unrealized gains (losses) in other comprehensive income. •General hedge results. For the derivative portion of the ALM strategy, the net hedging impact (the extent to which the changes in value of the hedging instruments offset the change in value of the portion of the economic liability we are hedging) may be impacted by a number of factors, including: cash flow timing differences between our hedging instruments and the corresponding portion of the economic liability we are hedging, basis differences attributable to actual underlying contractholder funds to be hedged versus hedgeable indices, rebalancing costs related to dynamic rebalancing of hedging instruments as markets move, certain elements of the economic liability that may not be hedged (including certain actuarial assumptions), and implied and realized market volatility on the hedge positions relative to the portion of the economic liability we seek to hedge.
Capital hedging program:
We employ a capital hedge program within the Company to protect a portion of the overall capital position of the variable annuities business against its exposure to the equity markets. The capital hedge program is conducted using equity derivatives which include equity call and put options, total return swaps and futures contracts. 64
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Income Taxes
For more information regarding income taxes, see note 7 of the unaudited interim statement.
Consolidated financial statements.
Liquidity and Capital Resources Overview Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long-term financial resources available to support the operations of our business, fund business growth, and provide a cushion to withstand adverse circumstances. Our ability to generate and maintain sufficient liquidity and capital depends on the profitability of our business, general economic conditions, our ability to borrow from affiliates and our access to the capital markets through affiliates as described herein. Effective and prudent liquidity and capital management is a priority across the organization. Management monitors the liquidity of the Company on a daily basis and projects borrowing and capital needs over a multi-year time horizon. We use a Risk Appetite Framework ("RAF") to ensure that all risks taken by the Company align with our capacity and willingness to take those risks. The RAF provides a dynamic assessment of capital and liquidity stress impacts, including scenarios similar to, and more severe than, those occurring due to COVID-19, and is intended to ensure that sufficient resources are available to absorb those impacts. We believe that our capital and liquidity resources are sufficient to satisfy the capital and liquidity requirements of the Company. Our businesses are subject to comprehensive regulation and supervision by domestic and international regulators. These regulations currently include requirements (many of which are the subject of ongoing rule-making) relating to capital, leverage, liquidity, stress-testing, overall risk management, credit exposure reporting and credit concentration. For information on these regulatory initiatives and their potential impact on us, see "Business-Regulation" and "Risk Factors" included in our Annual Report on Form 10-K for the year endedDecember 31, 2021 . Capital We manage the Company to regulatory capital levels consistent with our "AA" ratings targets. We utilize the risk-based capital ("RBC") ratio as a primary measure of capital adequacy. RBC is calculated based on statutory financial statements and risk formulas consistent with the practices of theNational Association of Insurance Commissioners ("NAIC"). RBC considers, among other things, risks related to the type and quality of the invested assets, insurance-related risks associated with an insurer's products and liabilities, interest rate risks and general business risks. RBC ratio calculations are intended to assist insurance regulators in measuring an insurer's solvency and ability to pay future claims. The reporting of RBC measures is not intended for the purpose of ranking any insurance company or for use in connection with any marketing, advertising or promotional activities, but is available to the public. The Company's capital levels substantially exceed the minimum level required by applicable insurance regulations. Our regulatory capital levels may be affected in the future by changes to the applicable regulations, proposals for which are currently under consideration by both domestic and international insurance regulators. The regulatory capital level of the Company can be materially impacted by interest rate and equity market fluctuations, changes in the values of derivatives, the level of impairments recorded, and credit quality migration of the investment portfolio, among other items. In addition, the reinsurance of business or the recapture of business subject to reinsurance arrangements due to defaults by, or credit quality migration affecting, the reinsurers or for other reasons could negatively impact regulatory capital levels. The Company's regulatory capital level is also affected by statutory accounting rules, which are subject to change by each applicable insurance regulator.
Captive reinsurance companies:
See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Capital-Affiliated Captive Reinsurance Companies" included in our Annual Report on Form 10-K for the year endedDecember 31, 2021 , for a discussion of our use of captive reinsurance companies. 65
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Liquidity
Our liquidity is managed to ensure stable, reliable and cost-effective sources of cash flows to meet all of our obligations. Liquidity is provided by a variety of sources, as described more fully below, including portfolios of liquid assets. Our investment portfolios are integral to the overall liquidity of the Company. We use a projection process for cash flows from operations to ensure sufficient liquidity to meet projected cash outflows, including claims. The impact ofPrudential Funding, LLC's ("Prudential Funding"), a wholly-owned subsidiary ofPrudential Insurance , financing capacity on liquidity (as described below) is considered in the internal liquidity measures of the Company. Liquidity is measured against internally-developed benchmarks that take into account the characteristics of both the asset portfolio and the liabilities that they support. We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in calculating internal liquidity measures to evaluate our liquidity under various stress scenarios, including company-specific and market-wide events. We continue to believe that cash generated by ongoing operations and the liquidity profile of our assets provide sufficient liquidity under reasonably foreseeable stress scenarios. The principal sources of the Company's liquidity are premiums and certain annuity considerations, investment and fee income, investment maturities, sales of investments and internal borrowings. The principal uses of that liquidity include benefits, claims, and payments to policyholders and contractholders in connection with surrenders, withdrawals and net policy loan activity. Other uses of liquidity include commissions, general and administrative expenses, purchases of investments, the payment of dividends and returns of capital to the parent company, hedging and reinsurance activity and payments in connection with financing activities. In managing liquidity, we consider the risk of policyholder and contractholder withdrawals of funds earlier than our assumptions when selecting assets to support these contractual obligations. We use surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of withdrawals of funds by customers.
Cash
Liquid assets include cash and cash equivalents, short-term investments,U.S. Treasury fixed maturities, and fixed maturities that are not designated as held-to-maturity and public equity securities. As ofJune 30, 2022 andDecember 31, 2021 , the Company had liquid assets of$18,544 million and$17,793 million , respectively. The portion of liquid assets comprised of cash and cash equivalents and short-term investments was$2,061 million and$1,101 million as ofJune 30, 2022 andDecember 31, 2021 , respectively. As ofJune 30, 2022 ,$13,056 million , or 90%, of the fixed maturity investments in the Company's general account portfolios, were rated high or highest quality based on NAIC or equivalent rating.Prudential Funding, LLC Prudential Financial and Prudential Funding borrow funds in the capital markets primarily through the direct issuance of commercial paper. The borrowings serve as an additional source of financing to meet our working capital needs. Prudential Funding operates under a support agreement withPrudential Insurance wherebyPrudential Insurance has agreed to maintain Prudential Funding's positive tangible net worth at all times.
Hedging Activities Associated with Living Benefit Benefits
The hedging portion of our risk management strategy associated with our living benefit guarantees is being managed within the Company. For the portion of the risk management strategy executed through hedging, we enter into a range of exchange-traded, cleared and other OTC equity and interest rate derivatives in order to hedge certain living benefit guarantees accounted for as embedded derivatives against changes in certain capital market risks above a designated threshold. The portion of the risk management strategy comprising the hedging portion requires access to liquidity to meet the Company's payment obligations relating to these derivatives, such as payments for periodic settlements, purchases, maturities and terminations. These liquidity needs can vary materially due to, among other items, changes in interest rates, equity markets, mortality and policyholder behavior. The hedging portion of the risk management strategy may also result in derivative-related collateral postings to (when we are in a net pay position) or from (when we are in a net receive position) counterparties. The net collateral position depends on changes in interest rates and equity markets related to the amount of the exposures hedged. Depending on market conditions, the collateral posting requirements can result in material liquidity needs when we are in a net pay position. 66
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Financing of the term and universal reserve
The Company uses affiliated captive reinsurance subsidiaries to finance the portion of the statutory reserves required to be held under Regulation XXX and Guideline AXXX that is considered to be non-economic. The financing arrangements involve the reinsurance of term and universal life business to our affiliated captive reinsurers and the issuance of surplus notes by those affiliated captives that are treated as capital for statutory purposes. These surplus notes are subordinated to policyholder obligations, and the payment of principal and interest on the surplus notes can only be made with prior insurance regulatory approval. As ofJune 30, 2022 , the affiliated captive reinsurance companies have entered into agreements with external counterparties providing for the issuance of up to an aggregate of$14,600 million of surplus notes by our affiliated captive reinsurers in return for the receipt of credit-linked notes ("Credit-Linked Note Structures"), of which$12,821 million of surplus notes was outstanding, compared to an aggregate issuance capacity of$14,600 million , of which$12,721 million was outstanding as ofDecember 31, 2021 . Under the agreements, the affiliated captive receives in exchange for the surplus notes one or more credit-linked notes issued by a special-purpose affiliate of the Company with an aggregate principal amount equal to the surplus notes outstanding. The affiliated captive holds the credit-linked notes as assets supporting Regulation XXX or Guideline AXXX non-economic reserves, as applicable. For more information on our Credit-Linked Note Structures, see "Management's Discussion and Analysis of Financial Condition and Results of Operation-Liquidity and Capital Resources-Financing Activities" in the Annual Report on Form 10-K for the year endedDecember 31, 2021 . As ofJune 30, 2022 , our affiliated captive reinsurance companies had outstanding an aggregate of$3,025 million of debt issued for the purpose of financing Regulation XXX and Guideline AXXX non-economic reserves, of which approximately$1,125 million relates to Regulation XXX reserves and approximately$1,900 million relates to Guideline AXXX reserves. In addition, as ofJune 30, 2022 , for purposes of financing Guideline AXXX reserves, one of our affiliated captives had approximately$3,982 million of surplus notes outstanding that were issued to affiliates. The Company has introduced updated versions of its individual life products in conjunction with the requirement to adopt principle-based reserving byJanuary 1, 2020 . These updated products are currently priced to support the principle-based statutory reserve level without the need for reserve financing. 67
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