Prudential 2011 Annual Report Download - page 20

DAC associated with the non-participating whole life and term life policies of our Individual Life segment and the non-participating
whole life, term life, endowment and health policies of our International Insurance segment is amortized in proportion to gross premiums.
We evaluate the recoverability of our DAC related to these policies as part of our premium deficiency testing. If a premium deficiency
exists, we reduce DAC by the amount of the deficiency or to zero through a charge to current period earnings. If the deficiency is more
than the DAC balance, we reduce the DAC balance to zero and increase the reserve for future policy benefits by the excess, by means of a
charge to current period earnings. Generally, we do not expect significant deterioration in future experience, and therefore do not expect
significant writedowns to the related DAC.
DAC and DSI associated with the variable and universal life policies of our Individual Life and International Insurance segments and
the variable and fixed annuity contracts of our Individual Annuities and International Insurance segments are amortized over the expected
life of these policies in proportion to total gross profits. DAC and DSI are also subject to recoverability testing which we perform at the end
of each reporting period to ensure that each balance does not exceed the present value of estimated gross profits. In calculating gross
profits, we consider mortality, persistency, and other elements as well as rates of return on investments associated with these contracts and
the costs related to our guaranteed minimum death and guaranteed minimum income benefits. Total gross profits include both actual
experience and estimates of gross profits for future periods. We regularly evaluate and adjust the related DAC and DSI balances with a
corresponding charge or credit to current period earnings for the effects of our actual gross profits and changes in our assumptions
regarding estimated future gross profits. Adjustments to the DAC and DSI balances include the impact to our estimate of total gross profits
of the annual review of assumptions, our quarterly adjustments for current period experience, and our quarterly adjustments for market
performance. Each of these adjustments is further discussed below in “—Annual assumptions review and quarterly adjustments.”
In addition to the gross profit components mentioned above, we also include the impact of the embedded derivatives associated with
certain of the optional living benefit features of our variable annuity contracts and related hedging activities in actual gross profits used as
the basis for calculating current period amortization. Prior to the third quarter of 2010, we also included the impact of these embedded
derivatives and related hedging activities, excluding the impact of the market-perceived risk of our own non-performance, in our estimate
of total gross profits used to determine the DAC and DSI amortization rates. In the third quarter of 2010, we revised our hedging strategy,
which resulted in a change in how certain gross profit components are used to determine the DAC and DSI amortization rates. Prior to the
third quarter of 2010 our hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by U.S.
GAAP, excluding the impact of the market-perceived risk of our own non-performance, with capital market derivatives. Under our current
hedging strategy, our hedge target continues to be 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 assumption
to remove certain risk margins embedded in the valuation technique used to determine the fair value of 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. For a discussion of the change in our hedging strategy and the results of our hedging program, see “—Results of Operations
for Financial Services Businesses by Segment—U.S. Retirement Solutions and Investment Management Division—Individual Annuities—
Net impact of embedded derivatives related to our living benefit features and related hedge positions.”
As mentioned above, this change in our hedging strategy also led to a change in the components included in our estimate of total gross
profits used to determine the DAC and DSI amortization rates. Beginning in the third quarter of 2010, management’s best estimate of the
total gross profits associated with these optional living benefit features and related hedge positions is based on the updated hedge target
definition as described above. However, total gross profits for these purposes includes the difference between the change in the value of the
hedge target liability and the change in the asset value only to the extent this net amount is determined by management to be other-than-
temporary, as well as the impact of assumption updates on the valuation of the hedge target liability. The determination of whether the
difference between the change in the value of the hedge target liability and the change in the asset value is other-than-temporary is based on
an evaluation of the effectiveness of the hedge program. Management generally expects differences between the value of the hedge target
liability and asset value to be temporary and to reverse over time. Such differences would not be included in total gross profits for purposes
of determining the amortization rates. However, based on the effectiveness of the hedge program, management may determine that the
difference between the value of the hedge target liability and the asset value is other-than-temporary and would include that amount in our
best estimate of total gross profits for setting the DAC and DSI amortization rates.
Management may also decide to temporarily hedge to an amount that differs from the hedge target definition, given overall capital
considerations of the Company and prevailing market conditions. The impact from temporarily hedging to an amount that differs from the
hedge target definition, as well as the results of the capital hedge program we began in the second quarter of 2009 and modified in 2010,
are not considered in calculating total gross profits used to determine amortization rates nor included in actual gross profits used in
calculating current period amortization as these items are related to capital considerations and are not directly related to product profits.
Annual assumptions review and quarterly adjustments
Annually, during the third quarter, we perform a comprehensive review of the assumptions used in estimating gross profits for future
periods. Although we review these assumptions on an ongoing basis throughout the year, we generally only update these assumptions and
adjust the DAC and DSI balances during the third quarter, unless a material change that we feel is indicative of a long term trend is
observed in an interim period. Over the last several years, the Company’s most significant assumption updates resulting in a change to
expected future gross profits and the amortization of DAC and DSI have been related to lapse experience and other contractholder behavior
assumptions, mortality, and revisions to expected future rates of returns on investments. We expect these assumptions to be the ones most
likely to cause potential significant changes in the future. The impact on our results of operations of changes in these assumptions can be
offsetting and we are unable to predict their movement or offsetting impact over time.
The quarterly adjustments for current period experience referred to above reflect the impact of differences between actual gross profits
for a given period and the previously estimated expected gross profits for that period. To the extent each period’s actual experience differs
from the previous estimate for that period, the assumed level of total gross profits may change. In these cases, we recognize a cumulative
adjustment to all previous periods’ amortization, also referred to as an experience true-up adjustment.
18 Prudential Financial, Inc. 2011 Annual Report