Prudential 2011 Annual Report Download - page 23

liabilities is then compared to the reporting unit’s total fair value as calculated in Step 1. The excess of fair value over the net asset value
equals the implied fair value of goodwill. The implied fair value of goodwill is then compared to the carrying value of goodwill to
determine the reporting unit’s goodwill impairment loss, if any.
A qualitative assessment was performed by International Insurance’s Gibraltar business. After consideration of the relevant macro
economic factors, as well as conditions specific to the insurance industry and the reporting unit, it was determined that the fair value of the
reporting unit was not more likely than not below its carrying value and accordingly, there was no impairment of goodwill.
The International Insurance’s Life Planner business and the Asset Management segment elected to bypass the qualitative assessment
and complete their impairment analysis using an earnings multiple approach. The earnings multiple approach indicates the value of a
business based on comparison to publicly-traded comparable companies in similar lines of business. Each comparable company is analyzed
based on various factors, including, but not limited to, financial risk, size, geographic diversification, profitability, adequate financial data,
and an actively traded stock price. A multiple of price to earnings is developed for the comparable companies using independent analysts’
consensus estimates for each company’s 2012 forecasted earnings. The multiples are then aggregated and a mean and median multiple is
calculated for the group. The lower of the mean or median multiple is then applied to the 2012 forecasted earnings of the reporting unit to
develop a value. A control premium is then added to determine a total estimated fair value for the reporting unit.
The Retirement Full Service business also elected to bypass the qualitative assessment and complete their impairment analysis using a
discounted cash flow approach. The discounted cash flow approach calculates the value of a business by applying a discount rate reflecting
the market expected weighted average rate of return to the projected future cash flows of the reporting unit. These projected future cash
flows were based on our internal forecasts, an expected growth rate and a terminal value. The weighted average rate of return, or WARR,
represents the required rate of return on total capitalization. It is comprised of a required rate of return on equity of a company and the
current tax-affected cost of debt, which are then weighted by the relative percentages of equity and debt assumed in the capital structure. To
estimate the return on equity, we applied the Capital Asset Pricing Model, or CAPM. The CAPM is a generally accepted method for
estimating an equity investor’s return requirement, and hence a company’s cost of equity capital. CAPM is determined by beginning with
the long-term risk-free rate of return then applying adjustments that consider the equity risk premium required for large company common
stock investments as well as company specific adjustments to address volatility, small company premiums and other risks particular to a
specific company. The WARR calculation is applied to a group of companies considered peers of the reporting unit to develop a weighted
average rate of return for the peer group which is then used to estimate the market expected weighted average rate of return for the
reporting unit. This process resulted in a discount rate of 12% which was then applied to the expected future cash flows of the Retirement
Full Service business to estimate its fair value.
After completion of Step 1 of the quantitative tests, it was determined that fair values exceeded the carrying amounts for each of the
three reporting units and it was concluded there was no impairment as of December 31, 2011. The Asset Management, International
Insurance’s Life Planner and Retirement Full Service businesses had estimated fair values that exceeded their carrying amounts by 425%,
27% and 5%, respectively.
Estimating the fair value of reporting units is a subjective process that involves the use of estimates and judgments. The Retirement
Full Service business’ quantitative test is sensitive to a number of key assumptions. For example, a decline in its forecasted cash flows of
4%, an increase in the discount rate above 12.5%, or an increase in the equity attributed to support this business (representing the carrying
value) of 5% could result in failing Step 1 of the quantitative test and therefore require a Step 2 assessment. Regarding all four reporting
units tested, further market declines or other events impacting the fair value of these businesses, including discount rates, interest rates and
growth rate assumptions or increases in the level of equity required to support these businesses, could result in goodwill impairments,
resulting in a charge to income.
As of December 31, 2011, the Company experienced a market capitalization that was below its consolidated book value. An analysis
was performed in order to confirm the reasonableness of the reporting unit fair values calculated in the goodwill impairment tests discussed
above. The Company considered the fact that certain reporting units that do not contain goodwill have lower estimated fair values due to
the nature of the risks in their businesses and also considered the negative impact of our Corporate & Other operations on the overall fair
value of the Company. The Company also considered the amount of control premium necessary to estimate a fair value equal to book
value. When comparing this control premium to actual control premiums experienced in recent insurance company acquisitions, as well as
the impact of the lower market environment which can increase industry control premiums, the Company concluded that the calculated
control premium reflected an amount which we believe is within a range of reasonableness. Based on these factors, the Company
concluded that the reporting unit fair values calculated in the goodwill impairment test were reasonable.
Valuation of Investments, Including Derivatives, and the Recognition of Other-than-Temporary Impairments
Our investment portfolio consists of public and private fixed maturity securities, commercial mortgage and other loans, equity
securities, other invested assets, and derivative financial instruments. Derivatives are financial instruments whose values are derived from
interest rates, foreign exchange rates, financial indices or the values of securities or commodities. Derivative financial instruments we
generally use include swaps, futures, forwards and options and may be exchange-traded or contracted in the over-the-counter market. We
are also party to financial instruments that contain derivative instruments that are “embedded” in the financial instruments. Management
believes the following accounting policies related to investments, including derivatives, are most dependent on the application of estimates
and assumptions. Each of these policies is discussed further within other relevant disclosures related to the investments and derivatives, as
referenced below.
• Valuation of investments, including derivatives
• Recognition of other-than-temporary impairments
• Determination of the valuation allowance for losses on commercial mortgage and other loans
Prudential Financial, Inc. 2011 Annual Report 21