Prudential 2011 Annual Report Download - page 234

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. FAIR VALUE OF ASSETS AND LIABILITIES (continued)
Fixed Maturity Securities—The fair values of the Company’s public fixed maturity securities are generally based on prices obtained
from independent pricing services. Prices from pricing services are sourced from multiple vendors, and a vendor hierarchy is maintained by
asset type based on historical pricing experience and vendor expertise. The Company generally receives prices from multiple pricing
services for each security, but ultimately uses the price from the pricing service highest in the vendor hierarchy based on the respective
asset type. To validate reasonableness, prices are reviewed by internal asset managers through comparison with directly observed recent
market trades and internal estimates of current fair value, developed using market observable inputs and economic indicators. Consistent
with the fair value hierarchy described above, securities with validated quotes from pricing services are generally reflected within Level 2,
as they are primarily based on observable pricing for similar assets and/or other market observable inputs. If the pricing information
received from third party pricing services is not reflective of market activity or other inputs observable in the market, the Company may
challenge the price through a formal process with the pricing service. If the pricing service updates the price to be more consistent in
comparison to the presented market observations, the security remains within Level 2.
If the Company ultimately concludes that pricing information received from the independent pricing service is not reflective of market
activity, non-binding broker quotes are used, if available. If the Company concludes the values from both pricing services and brokers are
not reflective of market activity, it may over-ride the information from the pricing service or broker with an internally-developed valuation.
As of December 31, 2011 and 2010 over-rides on a net basis were not material. Internally-developed valuations or non-binding broker
quotes are also used to determine fair value in circumstances where vendor pricing is not available. These estimates may use significant
unobservable inputs, which reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset.
Circumstances where observable market data are not available may include events such as market illiquidity and credit events related to the
security. Pricing service over-rides, internally-developed valuations and non-binding broker quotes are generally included in Level 3 in the
fair value hierarchy.
The fair value of private fixed maturities, which are primarily comprised of investments in private placement securities, originated by
internal private asset managers, are primarily determined using a discounted cash flow model. In certain cases these models primarily use
observable inputs with a discount rate based upon the average of spread surveys collected from private market intermediaries who are
active in both primary and secondary transactions, taking into account, among other factors, the credit quality and industry sector of the
issuer and the reduced liquidity associated with private placements. Generally, these securities have been reflected within Level 2. For
certain private fixed maturities, the discounted cash flow model may also incorporate significant unobservable inputs, which reflect the
Company’s own assumptions about the inputs market participants would use in pricing the asset. To the extent management determines that
such unobservable inputs are not significant to the price of a security, a Level 2 classification is made. Otherwise, a Level 3 classification is
used.
Private fixed maturities also include debt investments in funds that, in addition to a stated coupon, pay a return based upon the results
of the underlying portfolios. The fair values of these securities are determined by reference to the funds’ net asset value (“NAV”). Since the
NAV at which the funds trade can be observed by redemption and subscription transactions between third parties, the fair values of these
investments have been reflected within Level 2 in the fair value hierarchy.
Trading Account Assets—Trading account assets (including trading account assets supporting insurance liabilities) consist primarily
of public corporate bonds, treasuries, equity securities and derivatives whose fair values are determined consistent with similar instruments
described above under “Fixed Maturity Securities” and below under “Equity Securities” and “Derivative Instruments.”
Equity Securities—Equity securities consist principally of investments in common and preferred stock of publicly traded companies,
perpetual preferred stock, privately traded securities, as well as common stock mutual fund shares. The fair values of most publicly traded
equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value
hierarchy. Estimated fair values for most privately traded equity securities are determined using valuation and discounted cash flow models
that require a substantial level of judgment. In determining the fair value of certain privately traded equity securities the discounted cash
flow model may also use unobservable inputs, which reflect the Company’s assumptions about the inputs market participants would use in
pricing the asset. Most privately traded equity securities are classified within Level 3. The fair values of common stock mutual fund shares
that transact regularly (but do not trade in active markets because they are not publicly available) are based on transaction prices of
identical fund shares and are classified within Level 2 in the fair value hierarchy. The fair values of preferred equity securities are based on
prices obtained from independent pricing services. These prices are then validated for reasonableness against recently traded market prices.
Accordingly, these securities are generally classified within Level 2 in the fair value hierarchy. Fair values of perpetual preferred stock
based on observable market inputs are classified within Level 2. However, when prices from independent pricing services are based on
non-binding broker quotes as the directly observable market inputs become unavailable, the fair values of perpetual preferred stock are
classified as Level 3.
Commercial Mortgage and Other Loans—The fair value of commercial mortgage loans held for investment (i.e., interim portfolio)
and accounted for using the Fair Value Option are determined based on the present value of the expected future cash flows discounted at
the appropriate U.S. Treasury rate, adjusted for the current market spread for similar quality loans. The quality ratings for these loans, a
primary determinant of the appropriate credit spread and a significant component of the pricing input, are based on internally-developed
methodology. As a result, these loans are included in Level 3 in the fair value hierarchy.
232 Prudential Financial, Inc. 2011 Annual Report