Prudential 2011 Annual Report Download - page 236

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. FAIR VALUE OF ASSETS AND LIABILITIES (continued)
However, the non-performance risk adjustment is applied only to the uncollateralized portion of the OTC derivative assets and liabilities,
after consideration of the impacts of two-way collateral posting. Most OTC derivative contract inputs have bid and ask prices that are
actively quoted or can be readily obtained from external market data providers. The Company’s policy is to use mid-market pricing in
determining its best estimate of fair value.
Derivatives classified as Level 3 include first-to-default credit basket swaps, look-back equity options and other structured products.
These derivatives are valued based upon models with some significant unobservable market inputs or inputs from less actively traded
markets. The fair values of first-to-default credit basket swaps are derived from relevant observable inputs (e.g., individual credit default
spreads, interest rates and recovery rates), and unobservable model-specific input values such as correlation between different credits
within the same basket. Look-back equity options and other structured options and derivatives are valued using simulation models such as
the Monte Carlo and other techniques. The input values for look-back equity options are derived from observable market indices (e.g.,
interest rates, dividend yields and equity indices), and unobservable model-specific input values including certain volatility parameters.
Level 3 methodologies are validated through periodic comparison of the Company’s fair values to broker-dealer values.
Cash Equivalents and Short-Term Investments—Cash equivalents and short-term investments include money market instruments,
commercial paper and other highly liquid debt instruments. Money market instruments are generally valued using unadjusted quoted prices
in active markets that are accessible for identical assets and are primarily classified as Level 1. The remaining instruments in the Cash
Equivalents and Short-term Investments category are typically not traded in active markets; however, their fair values are based on market
observable inputs and, accordingly, these investments have been classified within Level 2 in the fair value hierarchy.
Other Assets and Other Liabilities—Other assets carried at fair value as of December 31, 2010 include U.S. Treasury bills held
within the Company’s former global commodities business whose fair values are based on unadjusted quoted prices in active markets that
are accessible to the Company for identical assets or liabilities. As a result, they are reported in the Level 1 hierarchy. Other Liabilities as
of both December 31, 2011 and 2010, respectively, include derivative instruments for which fair values are determined as described above
under “Derivative Instruments.”
Future Policy Benefits—The liability for future policy benefits includes general account liabilities for guarantees on variable annuity
contracts, including guaranteed minimum accumulation benefits (“GMAB”), guaranteed minimum withdrawal benefits (“GMWB”) and
guaranteed minimum income and withdrawal benefits (“GMIWB”), accounted for as embedded derivatives. The fair values of the GMAB,
GMWB and GMIWB liabilities are calculated as the present value of future expected benefit payments to customers less the present value
of assessed rider fees attributable to the embedded derivative feature. This methodology could result in either a liability or contra-liability
balance, given changing capital market conditions and various policyholder behavior assumptions. Since there is no observable active
market for the transfer of these obligations, the valuations are calculated using internally-developed models with option pricing techniques.
The models are based on a risk neutral valuation framework and incorporate premiums for risks inherent in valuation techniques, inputs,
and the general uncertainty around the timing and amount of future cash flows. The determination of these risk premiums requires the use
of management judgment.
The Company is also required to incorporate the market-perceived risk of its own non-performance (“NPR”) in the valuation of the
embedded derivatives associated with its optional living benefit features. Since insurance liabilities are senior to debt, the Company
believes that reflecting the financial strength ratings of the Company’s insurance subsidiaries in the valuation of the liability or contra-
liability appropriately takes into takes into consideration its NPR. To reflect NPR, the Company incorporates an additional credit spread
over LIBOR rates into the discount rate used in the valuations of the embedded derivatives associated with its optional living benefit
features. The additional credit spread over LIBOR rates is determined taking into consideration publicly available information relating to
the financial strength of the Company’s insurance subsidiaries, as indicated by the credit spreads associated with funding agreements issued
by these subsidiaries. The Company adjusts these credit spreads to remove any illiquidity risk premium, which is subject to a floor based on
a percentage of the credit spread. The additional credit spread over LIBOR rates incorporated into the discount rate as of December 31,
2011 generally ranged from 150 to 250 basis points for the portion of the interest rate curve most relevant to these liabilities. This
additional spread is applied at an individual contract level and only to those individual living benefit contracts in a liability position and not
to those in a contra-liability position.
Other significant inputs to the valuation models for the embedded derivatives associated with the optional living benefit features of the
Company’s variable annuity products include capital market assumptions, such as interest rate and implied volatility assumptions, as well
as various policyholder behavior assumptions that are actuarially determined, including lapse rates, benefit utilization rates, mortality rates
and withdrawal rates. These assumptions are reviewed at least annually, and updated based upon historical experience and give
consideration to any observable market data, including market transactions such as acquisitions and reinsurance transactions. Since many
of the assumptions utilized in the valuation of the embedded derivatives associated with the Company’s optional living benefit features are
unobservable and are considered to be significant inputs to the liability valuation, the liability included in future policy benefits has been
reflected within Level 3 in the fair value hierarchy.
As of December 31, 2011, the value of the embedded derivatives associated with the optional living benefit features of the Individual
Annuities segment, before NPR, was a net liability of $8,341 million. This net liability was comprised of $8,555 million of individual
living benefit contracts in a liability position, net of $214 million of individual living benefit contracts in a contra-liability position. As of
234 Prudential Financial, Inc. 2011 Annual Report