Prudential 2012 Annual Report Download - page 188

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. FAIR VALUE OF ASSETS AND LIABILITIES (continued)
The majority of the Company’s derivative positions are traded in the over-the-counter (“OTC”) derivative market and are classified
within Level 2 in the fair value hierarchy. OTC derivatives classified within Level 2 are valued using models that utilize actively quoted or
observable market input values from external market data providers, third-party pricing vendors and/or recent trading activity. The
Company’s policy is to use mid-market pricing in determining its best estimate of fair value. The fair values of most OTC derivatives,
including interest rate and cross currency swaps, currency forward contracts, commodity swaps, commodity forward contracts, single name
credit default swaps, loan commitments held for sale and to-be-announced (or TBA) forward contracts on highly rated mortgage-backed
securities issued by U.S. government sponsored entities are determined using discounted cash flow models. The fair values of European
style option contracts are determined using Black-Scholes option pricing models. These models’ key inputs include the contractual terms of
the respective contract, along with significant observable inputs, including interest rates, currency rates, credit spreads, equity prices, index
dividend yields, non-performance risk, volatility and other factors.
The vast majority of the Company’s derivative agreements are with highly rated major international financial institutions. To reflect
the market’s perception of its own and the counterparty’s non-performance risk, the Company incorporates additional spreads over London
Interbank Offered Rate (“LIBOR”) into the discount rate used in determining the fair value of OTC derivative assets and liabilities that are
not otherwise collateralized.
Derivatives classified as Level 3 include look-back equity options and other structured products. These derivatives are valued based
upon models (such as Monte Carlo simulation models and other techniques) with some significant unobservable market inputs or inputs
(e.g., interest rates, equity indices, dividend yields, etc.) from less actively traded markets (e.g., model-specific input values, including
volatility parameters, etc.). 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. Certain money market instruments are 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 this category are
generally fair valued based on market observable inputs and these investments have primarily been classified within Level 2.
Separate Account Assets—Separate Account Assets include fixed maturity securities, treasuries, equity securities and real estate
investments for which values are determined consistent with similar instruments described above under “Fixed Maturity Securities,”
“Equity Securities” and “Other Long-Term Investments.”
Notes of Consolidated VIEs—The fair values of these notes are based on broker quotes and classified within Level 3. See Note 5 and
the fair value option section below for additional information.
Other Liabilities—Other liabilities include certain derivative instruments, the fair values of which are determined consistent with
similar derivative instruments described above under “Derivative Instruments.”
Future Policy Benefits—The liability for future policy benefits primarily includes general account liabilities for the optional living
benefit features of the Company’s 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 significant inputs to the valuation models for these embedded derivatives include capital market assumptions, such as interest rate
and implied volatility assumptions, the Company’s market-perceived risk of its own non-performance (“NPR”), as well as actuarially
determined assumptions, including contractholder behavior, such as lapse rates, benefit utilization rates, withdrawal rates, and mortality
rates. Since many of these assumptions 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.
Capital market inputs and actual policyholders’ account values are updated each quarter based on capital market conditions as of the
end of the quarter, including interest rates, equity markets and implied volatility. In the risk neutral valuation, interest rates are used to both
grow the policyholders’ account values and discount all projected future cash flows. The Company’s discount rate assumption is based on
the LIBOR swap curve adjusted for an additional spread over LIBOR to reflect NPR.
Actuarial assumptions, including contractholder behavior and mortality, are reviewed at least annually, and updated based upon
historical experience giving consideration to any observable market data, including available industry studies or market transactions such as
acquisitions and reinsurance transactions. These assumptions are generally updated in the third quarter of each year unless a material
change that the Company feels is indicative of a long term trend is observed in an interim period.
Transfers between Levels 1 and 2—Periodically there are transfers between Level 1 and Level 2 for foreign common stocks held in
the Company’s Separate Account. In certain periods, an adjustment may be made for the fair value of these assets beyond the quoted
market price to reflect events that occurred between the close of foreign trading markets and the close of U.S. trading markets for the
respective day. As a result of this type of adjustment, net transfers of $2.9 billion were moved from Level 1 to Level 2 for the year ended
December 31, 2012 and net transfers of $3.4 billion were moved from Level 2 to Level 1 for the year ended December 31, 2010.
186 Prudential Financial, Inc. 2012 Annual Report