Prudential 2011 Annual Report Download - page 127

interest rate environment, we do not believe that the U.S. GAAP value of the embedded derivative liability is an appropriate measure for
determining the hedge target. Our new hedge target is grounded in a U.S. GAAP/capital markets valuation framework but incorporates two
modifications to the U.S. GAAP valuation assumptions. We add a credit spread to the U.S. GAAP risk-free rate of return assumption used
to estimate future growth of bond investments in the customer separate account funds to account for the fact that the underlying customer
separate account funds, which support these living benefits, are invested in assets that contain risk. We also adjust our volatility
assumptions to remove certain risk margins embedded in the valuation technique used to fair value the embedded derivative liability under
U.S. GAAP, as we believe the increase in the liability driven by these margins is temporary and does not reflect the economic value of the
liability. We evaluate hedge levels versus our hedge target based on the overall capital considerations of the Company and prevailing
market conditions. The U.S. GAAP/capital markets valuation framework underlying our hedge target assumes that current interest rate
levels remain unchanged for the full projection period with no reversion to longer term averages. Due to the recent low interest rate
environment, we decided to temporarily hedge to an amount that differs from our hedge target definition to be consistent with our long-
term economic view. Because the hedging decision was based on the overall capital considerations of the Company, the corresponding
impact on results is reported within Corporate and Other operations. For the years ended December 31, 2011 and 2010, “Realized
investment gains (losses), net, and related adjustments” within Corporate and Other operations includes a pre-tax loss of $1,662 million and
a pre-tax gain of $306 million, respectively, resulting from our decision to temporarily hedge to a different target and the decline in interest
rates during the year. Through our Capital Protection Framework, we have access to on-balance sheet capital and contingent sources of
capital that is available to meet capital needs arising from activities such as the after-tax realized investment losses incurred in 2011 from
our living benefits hedging program, including our decision to temporarily hedge to an amount that differs from our hedge target definition.
For a full discussion of the results of our living benefits hedging program, see “—Results of Operations for Financial Services Businesses
by Segment—U.S. Retirement Solutions and Investment Management Division—Individual Annuities.”
We reinsure variable annuity living benefit guarantees from certain of our life insurance companies to a captive reinsurance company,
Pruco Reinsurance, Ltd. (“Pruco Re”). The variable annuity living benefit hedging program described above is primarily executed within
Pruco Re. Effective as of July 1, 2011, Pruco Re re-domiciled from Bermuda to Arizona. As a result, beginning in the third quarter of 2011,
our Arizona domiciled life insurance company, Pruco Life Insurance Company, is able to claim reinsurance reserve credit for business
ceded to Pruco Re without any need for Pruco Re to collateralize its obligations under the reinsurance arrangement. However, for business
ceded to Pruco Re by Prudential Annuities Life Assurance Corporation (“PALAC”) and Pruco Life Insurance Company of New Jersey
(“PLNJ”), we must continue to collateralize Pruco Re’s obligations under the reinsurance arrangement in order for PALAC and PLNJ to
claim reinsurance reserve credit for their business ceded. We satisfy this requirement by depositing assets into statutory reserve credit trusts
for Pruco Re. Funding needs for the statutory reserve credit trusts are separate and distinct from the capital needs of the captive reinsurance
company. However, assets pledged to the statutory reserve credit trusts may include assets supporting the capital of the captive reinsurance
company provided that they meet eligibility requirements prescribed by the relevant insurance regulators.
Reinsurance credit reserve requirements can move materially in either direction due to changes in equity markets and interest rates,
actuarial assumptions and other factors. Higher reinsurance credit reserve requirements would necessitate depositing additional assets in the
statutory reserve credit trusts, while lower reinsurance credit reserve requirements would allow assets to be removed from the statutory
reserve credit trusts. Lower interest rates in 2011 led to an increase in our need to fund the captive reinsurance trusts by an amount of $569
million for the year ended December 31, 2011, primarily relating to business sold by PALAC and PLNJ. We satisfied the overall increase
in funding requirements in 2011 with available cash and by re-hypothecating assets into the trust that were otherwise pledged by our
affiliates under hedging positions related to our living benefit features.
In October 2011, we established a new reinsurance arrangement with our captive reinsurance company domiciled in New Jersey,
whereby the New Jersey captive reinsures 90% of the short-term risks under the policies in Prudential Insurance’s Closed Block. These
short-term risks represent the impact of variations in experience of the Closed Block that are expected to be recovered over time as a result
of corresponding adjustments to policyholder dividends. The new reinsurance arrangement is intended to alleviate the short-term surplus
volatility within Prudential Insurance resulting from the Closed Block, including volatility caused by the impact of any unrealized
mark-to-market losses or realized credit losses within the investment portfolio of the Closed Block.
In connection with the new Closed Block reinsurance arrangement, we entered into a $2 billion letter of credit facility with certain
financial institutions, pursuant to which the New Jersey captive can obtain a letter of credit during a 3-year availability period to support its
funding obligations under the reinsurance arrangement. Prudential Financial guarantees all obligations of the New Jersey captive under the
facility, including its obligation to reimburse any draws made under the letter of credit. Because experience of the Closed Block is
ultimately passed along to policyholders over time through the annual policyholder dividend, we believe that any draw under the letter of
credit is unlikely. Our ability to obtain a letter of credit under the facility is subject to the continued satisfaction of customary conditions,
including the maintenance at all times by Prudential Insurance of total adjusted capital of at least $5.5 billion based on statutory accounting
principles prescribed under New Jersey law and Prudential Financial’s maintenance of consolidated net worth of at least $19.0 billion,
based on U.S. GAAP stockholders’ equity, excluding “Accumulated other comprehensive income (loss).”
International Insurance and Investments Subsidiaries
On February 1, 2011, we completed our acquisition of the Star and Edison Businesses. Gibraltar Life and Prudential of Japan each
contributed $400 million to payment of the acquisition purchase price, with the remaining funding provided by Prudential Financial and
other subsidiaries. Although these contributions reduced local solvency margin ratios in Gibraltar and Prudential of Japan, the solvency
margins for these companies remain in excess of our targets. The contributions did not materially impact Gibraltar Life’s or Prudential of
Japan’s liquidity as their investment portfolios were positioned to provide the funding.
Star and Edison solvency margin ratios at acquisition were in excess of our solvency margin targets and will continue to be managed
to capitalization levels consistent with our “AA” ratings targets. We believe the liquidity profiles of Star and Edison are sufficient to meet
their obligations, including under reasonably foreseeable stress scenarios. Since completing the acquisition, we have further enhanced the
Prudential Financial, Inc. 2011 Annual Report 125