Prudential 2011 Annual Report Download - page 38

The net impact of both the change in the value of the embedded derivative liabilities associated with our living benefit features and the
change in fair value of the related derivative hedge positions are included in “Realized investment gains (losses), net, and related
adjustments” and the related impact to the amortization of DAC and other costs is included in “Related charges,” both of which are
excluded from adjusted operating income. The following table shows the net impact of changes in the embedded derivative liability and
related hedge positions, as well as the related amortization of DAC and other costs, for the years ended December 31, 2011, 2010 and 2009
for the Individual Annuities segment.
Year Ended December 31,
2011 2010 2009
(1)
(in millions)
Change in fair value of hedge positions .................................................................... $3,873 $(224) $(2,715)
Change in value of hedge target liability, excluding unhedged portions and assumption updates(2) ..................... (5,170) 364 3,049
Net hedging impact, excluding unhedged portions and assumption updates .................................... (1,297) 140 334
Change in portions of embedded derivative liability, before NPR, excluded from hedge target definition(3) .............. (457) 387 0
Impact of assumption updates on hedge target liability ........................................................ (17) (902) (110)
Change in the NPR adjustment(4) ......................................................................... 4,786 412 312
Net benefit from changes in embedded derivative liability and hedge positions reported in the Individual Annuities
segment ....................................................................................... 3,015 37 536
Related charge to amortization of DAC and other costs(5) ..................................................... (1,736) (4) (410)
Net benefit from changes in embedded derivative liability and hedge positions, after the impact of NPR, DAC and other
costs, reported in the Individual Annuities segment ..................................................... $1,279 $ 33 $ 126
Change in value of unhedged portion of hedge target liability—reported in Corporate & Other operations(6) ......... $(1,662) $ 306 $ 0
(1) Positive amount represents income; negative amount represents a loss.
(2) Beginning with the third quarter of 2010, represents the change in value based on our hedge target definition as described above, excluding the impacts
of temporarily hedging to an amount that differs from our hedge target definition and assumption updates. 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 NPR.
(3) Represents the impact attributable to the difference between the value of the hedge target liability, based on our hedge target definition, and the value of
the embedded derivative liability as defined by U.S. GAAP, before adjusting for NPR.
(4) To reflect NPR, we incorporate an additional spread over LIBOR into the discount rate used in the valuation of those individual living benefit contracts
in a liability position and not to those in a contra-liability position. As of December 31, 2011, the value of the embedded derivatives, before the
adjustment for NPR, was a net liability of $8.3 billion. This net liability was comprised of $8.5 billion of individual living benefit contracts in a liability
position, net of $0.2 billion of individual living benefit contracts in a contra-liability position.
(5) Related charge to amortization of DAC and other costs is excluded from adjusted operating income and included in operating results in “Related
charges.”
(6) Represents the impact of temporarily hedging to an amount that differs from our hedge target definition. This amount is not reported in the Individual
Annuities segment. See “—Corporate and Other” for details.
As shown in the table above, the net impacts from changes in the embedded derivative liability and hedge positions, after the impact
of DAC and other costs, reported in the Individual Annuities segment were net benefits of $1,279 million, $33 million and $126 million for
2011, 2010 and 2009, respectively.
The net benefit of $1,279 million in 2011 included a net charge of $1,297 million resulting from the net impact of hedging, excluding
the unhedged portions and assumption updates, driven by significant capital markets volatility in the second half of 2011. Also included in
the net benefit of $1,279 million was a net charge of $457 million attributable to the difference between the valuation of the embedded
derivative liability as defined by U.S. GAAP and the valuation of the hedge target liability, which we choose not to hedge. These charges
were offset by a $4,786 million adjustment to the embedded derivative liability to reflect NPR, primarily from a higher base of embedded
derivative liabilities, driven by significant declines in risk-free interest rates and the impact of account value performance, as well as an
overall widening of the credit spreads used in valuing NPR, which reflect the financial strength ratings of our insurance subsidiaries.
Partially offsetting these items was a net charge of $1,736 million from the inclusion of these items in current period gross profits used in
calculating the amortization of DAC. In the third and fourth quarters of 2011, we also determined that the cumulative difference between
the change in the value of the hedge target liability, excluding the unhedged portions and assumption updates, and the change in the fair
value of the hedge assets was other-than-temporary. As a result, we included the cumulative differences in our best estimate of total gross
profits, which resulted in an increase in our DAC amortization rates. For a further discussion of the assumptions used in estimating total
gross profits used as the basis for amortizing DAC and other costs, see “—Accounting Policies and Pronouncements—Application of
Critical Accounting Estimates.”
The net benefit of $33 million in 2010 included a net benefit of $140 million resulting from the net impact of hedging, excluding the
unhedged portions and assumption updates, driven by differences in the actual performance of the underlying separate accounts funds
relative to the performance of the market indices we utilized as a basis for developing our hedging strategy. Also included in the net benefit
of $33 million was a net benefit of $387 million attributable to the difference between the valuation of the embedded derivative liability as
defined by U.S. GAAP and the valuation of the hedge target liability, which we choose not to hedge, and a net charge of $902 million
related to reductions in the expected lapse rate assumption based on actual experience. These items were partially offset by a $412 million
adjustment to the embedded derivative liability to reflect NPR, primarily resulting from an increase in the value of embedded derivatives in
a liability position, reflecting an increase in the present value of future expected benefit payments driven by lower interest rates and a
reduction in the expected lapse rate assumption. Partially offsetting these items was a net charge of $4 million from the inclusion of these
items in current period gross profits used in calculating the amortization of DAC.
36 Prudential Financial, Inc. 2011 Annual Report