Prudential 2012 Annual Report Download - page 187

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. FAIR VALUE OF ASSETS AND LIABILITIES (continued)
The fair value of private fixed maturities, which are comprised of investments in private placement securities, originated by internal
private asset managers, are primarily determined using a discounted cash flow model. If the fair value is determined using pricing inputs
that are observable in the market, the securities have been reflected within Level 2; otherwise a Level 3 classification is used.
Private fixed maturities also include debt investments in funds that pay a stated coupon and 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 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 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 discounted cash flow, earnings multiple and other
valuation models that require a substantial level of judgment around inputs and therefore are classified within Level 3. The fair values of
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 perpetual preferred
stock are based on inputs obtained from independent pricing services that are primarily based on indicative broker quotes. As a result, 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
estimates. As a result, these loans are included in Level 3 in the fair value hierarchy.
The fair value of other loans held and accounted for using the fair value option is determined utilizing pricing indicators from the
whole loan market, where investors are committed to purchase these loans at a pre-determined price, which is considered the principal exit
market for these loans. The Company has evaluated the valuation inputs used for these assets, including the existence of pre-determined
exit prices, the terms of the loans, prevailing interest rates and credit risk, and deemed that the primary pricing inputs are Level 2 inputs in
the fair value hierarchy.
Other Long-Term Investments—Other long-term investments include limited partnerships which are consolidated because the
Company is either deemed to exercise control or considered the primary beneficiary of a variable interest entity. These entities are
considered investment companies and follow specialized industry accounting whereby their assets are carried at fair value. The investments
held by these entities include various feeder fund investments in underlying master funds (whose underlying holdings generally include
public fixed maturities, equity securities and mutual funds), as well as wholly-owned real estate held within other investment funds. The
fair value is determined by reference to the underlying direct investments, with publicly traded equity securities based on quoted prices in
active markets reflected in Level 1, and public fixed maturities and mutual funds priced via quotes from pricing services or observable data
reflected in Level 2. The fair value of investments in funds that are subject to significant liquidity restrictions are reflected in Level 3.
The fair value of real estate held in consolidated investment funds is determined through an independent appraisal process. The
appraisals generally utilize a discounted cash flow model, supplemented with replacement cost estimates and comparable recent sales data
when available. These appraisals and the related assumptions are updated at least annually. Since many of the assumptions utilized are
unobservable and are considered to be significant inputs to the valuation, the real estate investments within other long-term investments
have been reflected within Level 3 in the fair value hierarchy.
The fair value of fund investments, where the fair value option has been elected, is primarily determined by the fund managers. Since
the valuations may be based on unobservable market inputs and cannot be validated by the Company, these investments have been included
within Level 3 in the fair value hierarchy.
Derivative Instruments—Derivatives are recorded at fair value either as assets, within “Other trading account assets,” or “Other
long-term investments,” or as liabilities, within “Other liabilities,” except for embedded derivatives which are recorded with the associated
host contract. The fair values of derivative contracts can be affected by changes in interest rates, foreign exchange rates, commodity prices,
credit spreads, market volatility, expected returns, non-performance risk, liquidity and other factors. Liquidity valuation adjustments are
made to reflect the cost of exiting significant risk positions, and consider the bid-ask spread, maturity, complexity, and other specific
attributes of the underlying derivative position.
The Company’s exchange-traded futures and options include Treasury futures, Eurodollar futures, commodity futures, Eurodollar
options and commodity options. Exchange-traded futures and options are valued using quoted prices in active markets and are classified
within Level 1 in the fair value hierarchy.
Prudential Financial, Inc. 2012 Annual Report 185