Prudential 2011 Annual Report Download - page 250

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. FAIR VALUE OF ASSETS AND LIABILITIES (continued)
Policy Loans
The fair value of U.S. insurance policy loans is calculated using a discounted cash flow model based upon current U.S. Treasury rates
and historical loan repayment patterns, while Japanese insurance policy loans use the risk-free proxy based on the Yen LIBOR. For group
corporate-, bank- and trust-owned life insurance contracts and group universal life contracts, the fair value of the policy loans is the amount
due, excluding interest, as of the reporting date.
Investment Contracts—Policyholders’ Account Balances
Only the portion of policyholders’ account balances related to products that are investment contracts (those without significant
mortality or morbidity risk) are reflected in the table above. For fixed deferred annuities, single premium endowments, payout annuities
and other similar contracts without life contingencies, fair values are derived using discounted projected cash flows based on interest rates
that are representative of the Company’s financial strength ratings, and hence reflect the Company’s own non-performance risk. For
guaranteed investment contracts, funding agreements, structured settlements without life contingencies and other similar products, fair
values are derived using discounted projected cash flows based on interest rates being offered for similar contracts with maturities
consistent with those of the contracts being valued. For those balances that can be withdrawn by the customer at any time without prior
notice or penalty, the fair value is the amount estimated to be payable to the customer as of the reporting date, which is generally the
carrying value. For defined contribution and defined benefit contracts and certain other products the fair value is the market value of the
assets supporting the liabilities.
Debt
The fair value of short-term and long-term debt, as well as debt of consolidated VIEs, is generally determined by either prices
obtained from independent pricing services, which are validated by the Company, or discounted cash flow models. With the exception of
the debt of consolidated VIEs, these fair values consider the Company’s own non-performance risk. Discounted cash flow models
predominately use market observable inputs such as the borrowing rates currently available to the Company for debt and financial
instruments with similar terms and remaining maturities. For commercial paper issuances and other debt with a maturity of less than 90
days, the carrying value approximates fair value. Debt of consolidated VIEs is reflected within “Other liabilities.”
A portion of the senior secured notes issued by Prudential Holdings, LLC (the “IHC debt”) is insured by a third-party financial
guarantee insurance policy. The effect of the third-party credit enhancement is not included in the fair value measurement of the IHC debt
and the methodologies used to determine fair value consider the Company’s own non-performance risk.
Bank Customer Liabilities
The carrying amount for certain deposits (interest and non-interest demand, savings and money market accounts) approximates or
equals their fair values. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies
interest rates being offered on certificates at the reporting dates to a schedule of aggregated expected monthly maturities. Bank customer
liabilities are reflected within “Other liabilities.”
21. DERIVATIVE INSTRUMENTS
Types of Derivative Instruments and Derivative Strategies used in a non-dealer or broker capacity
Interest Rate Contracts
Interest rate swaps are used by the Company to manage interest rate exposures arising from mismatches between assets and liabilities
(including duration mismatches) and to hedge against changes in the value of assets it anticipates acquiring and other anticipated
transactions and commitments. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest
rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate
interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the
contract and no principal payments are made by either party. These transactions are entered into pursuant to master agreements that provide
for a single net payment to be made by one counterparty at each due date.
Exchange-traded futures and options are used by the Company to reduce risks from changes in interest rates, to alter mismatches
between the duration of assets in a portfolio and the duration of liabilities supported by those assets, and to hedge against changes in the
value of securities it owns or anticipates acquiring or selling. In exchange-traded futures transactions, the Company agrees to purchase or
sell a specified number of contracts, the values of which are determined by the values of underlying referenced investments, and to post
variation margin on a daily basis in an amount equal to the difference in the daily market values of those contracts. The Company enters
into exchange-traded futures and options with regulated futures commission’s merchants who are members of a trading exchange.
Equity Contracts
Equity index options are contracts which will settle in cash based on differentials in the underlying indices at the time of exercise and
the strike price. The Company uses combinations of purchases and sales of equity index options to hedge the effects of adverse changes in
equity indices within a predetermined range. These hedges do not qualify for hedge accounting.
248 Prudential Financial, Inc. 2011 Annual Report