Prudential 2012 Annual Report Download - page 104

• Estimated total gross profits and the amortization of deferred policy acquisition and other costs
• Net exposure to the guarantees provided under certain products
We actively manage investment equity price risk against benchmarks in respective markets. We benchmark our return on equity
holdings against a blend of market indices, mainly the S&P 500 and Russell 2000 for U.S. equities. For foreign equities we benchmark
against the Tokyo Price Index, or TOPIX, and the MSCI EAFE, a market index of European, Australian, and Far Eastern equities. We
target price sensitivities that approximate those of the benchmark indices.
We estimate our investment equity price risk from a hypothetical 10% decline in equity benchmark market levels and measure this
risk in terms of the decline in fair market value of equity securities we hold. The following table sets forth the net estimated potential loss
in fair value from such a decline as of December 31, 2012 and 2011. While these scenarios are for illustrative purposes only and do not
reflect our expectations regarding future performance of equity markets or of our equity portfolio, they represent near term reasonably
possible hypothetical changes that illustrate the potential impact of such events. These scenarios consider only the direct impact on fair
value of declines in equity benchmark market levels and not changes in asset-based fees recognized as revenue, changes in our estimates of
total gross profits used as a basis for amortizing deferred policy acquisition and other costs, or changes in any other assumptions such as
market volatility or mortality, utilization or persistency rates in our variable annuity contracts that could also impact the fair value of our
living benefit features. In addition, these scenarios do not reflect the impact of basis risk, such as potential differences in the performance
of the investment funds underlying the variable annuity products relative to the market indices we use as a basis for developing our hedging
strategy. The impact of basis risk could result in larger differences between the change in fair value of the equity-based derivatives and the
related living benefit features, in comparison to the scenarios above. In calculating these amounts, we exclude separate account equity
securities related to products for which the investment risk is borne primarily by the separate account contractholder.
As of December 31, 2012 As of December 31, 2011(4)
Notional Fair Value
Hypothetical
Change in
Fair Value Notional Fair Value
Hypothetical
Change in
Fair Value
(in millions)
Equity securities(1) ........................................ $10,754 $(1,075) $10,067 $(1,007)
Equity-based derivatives(2) ................................. $55,054 248 1,504 $23,862 357 1,022
Variable annuity and other living benefit feature embedded
derivatives(2)(3) ........................................ (3,348) (1,052) (2,886) (622)
Net estimated potential loss ............................. $ (623) $ (607)
(1) Includes equity securities classified as “trading account assets supporting insurance liabilities” and other equity securities classified as trading securities
under U.S. GAAP, but are held for “other than trading” activities in our segments that offer insurance, retirement and annuities products.
(2) The notional and fair value of equity-based derivatives and the fair value of variable annuity and other living benefit feature embedded derivatives are
also reflected in amounts under “Market Risk Related to Interest Rates” above, and are not additive.
(3) Reflects only the gross change on the embedded derivatives, and excludes any offsetting impact of derivative instruments purchased to hedge such
changes.
(4) Prior periods have been restated to conform to current period presentation.
The sensitivity level as of December 31, 2012 was essentially flat compared with December 31, 2011, as the change in the estimated
equity price risk associated with the living benefit features accounted for as an embedded derivative was offset by a corresponding change
in equity-based derivatives used to hedge these features. For a discussion of derivatives, see “Derivatives” below. For an additional
discussion of our variable annuity optional living benefit guarantees accounted for as embedded derivatives and related derivatives used to
hedge the changes in fair value of these embedded derivatives, see “Market Risk Related to Certain Variable Annuity Products” below. For
additional information regarding our capital hedging program, see “Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Liquidity and Capital Resources.”
Market Risk Related to Foreign Currency Exchange Rates
As a U.S.-based company with significant business operations outside the U.S., we are exposed to foreign currency exchange rate risk
related to these operations, as well as related to our general account investment portfolio and other proprietary-investment portfolios.
For our international insurance operations, changes in foreign currency exchange rates create risk that we may experience volatility in
the U.S. dollar-equivalent earnings and value of our equity investments in these operations. We actively manage this risk through various
hedging strategies, including the use of foreign currency hedges and through holding U.S. dollar-denominated securities in the investment
portfolios of certain of these operations. Additionally, certain of our international insurance operations issue product liabilities that are
denominated in currencies other than their own functional currencies, and hold underlying investments denominated in the corresponding
currencies. This results in reporting of economically-matched foreign currency exchange gains or losses on the assets and liabilities.
However, we experience volatility in U.S. GAAP earnings due to the fact that the changes in the value of the liabilities are recorded in
earnings within “Asset management fees and other income,” while changes in the value of the majority of the investments are recorded in
equity in “Accumulated other comprehensive income (loss),” and, thereafter, are ultimately recorded in earnings in “Realized investment
gains (losses), net” in the period of maturity, sale or other-than-temporary impairment.
For our domestic general account investment portfolios supporting our U.S. insurance operations and other proprietary-investment
portfolios, our foreign currency exchange rate risk arises primarily from investments that are denominated in foreign currencies. We
manage this risk by hedging substantially all domestic foreign currency-denominated fixed-income investments into U.S. dollars. We
generally do not hedge all of the foreign currency risk of our investments in equity securities of unaffiliated foreign entities.
102 Prudential Financial, Inc. 2012 Annual Report