Prudential 2012 Annual Report Download - page 190

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. FAIR VALUE OF ASSETS AND LIABILITIES (continued)
(5) To reflect NPR, the Company incorporates an additional spread over LIBOR into the discount rate used in the valuation of individual living benefit
contracts in a liability position and generally not to those in a contra-liability position. In determining the NPR spread, the Company believes it
appropriate to reflect the financial strength ratings of the Company’s insurance subsidiaries as these are insurance liabilities and senior to debt. The
additional spread over LIBOR is determined by the credit spreads associated with funding agreements issued by these subsidiaries, adjusted for any
illiquidity risk premium.
(6) The utilization rate assumption estimates the percentage of contracts that will utilize the benefit during the contract duration, and begin lifetime
withdrawals at various time intervals from contract inception. The remaining contractholders are assumed to either begin lifetime withdrawals
immediately or never utilizing the benefit. These assumptions vary based on the product type, the age of the contractholder and the age of the contract.
The impact of changes in these assumptions is highly dependent on the contract type and age of the contractholder at the time of the sale and the timing
of the first lifetime income withdrawal.
(7) The withdrawal rate assumption estimates the magnitude of annual contractholder withdrawals relative to the maximum allowable amount under the
contract. The fair value of the liability will generally increase the closer the withdrawal rate is to 100%.
(8) Range reflects the mortality rate for the vast majority of business with living benefits, with policyholders ranging from 35 to 90 years old. While the
majority of living benefits have a minimum age requirement, certain benefits do not have an age restriction. This results in contractholders for certain
benefits with mortality rates approaching 0%. Based on historical experience, the Company applies a set of age and duration specific mortality rate
adjustments compared to standard industry tables. A mortality improvement assumption is also incorporated into the overall mortality table.
Separate Account Assets—In addition to the significant internally-priced Level 3 assets and liabilities presented and described
above, the Company also has internally-priced separate account assets reported within Level 3. Changes in the fair value of separate
account assets are borne by customers and thus are offset by changes in separate account liabilities on the Company’s Consolidated
Statement of Financial Position. As a result, changes in value associated with these investments do not impact the Company’s Consolidated
Statement of Operations. In addition, fees earned by the Company related to the management of most separate account assets classified as
Level 3 do not change due to changes in the fair value of these investments. Quantitative information about significant internally-priced
Level 3 separate account assets is as follows:
Real Estate and Other Invested Assets—Separate account assets include $19,518 million of investments in real estate as of
December 31, 2012 that are classified as Level 3 and reported at fair value. In general, these fair value estimates are based on property
appraisal reports prepared by independent real estate appraisers. Key inputs and assumptions to the appraisal process include rental income
and expense amounts, related growth rates, discount rates and capitalization rates. In cases where real estate investments are made through
indirect investments, fair value is generally determined by the Company’s equity in net assets of the entities. The debt associated with real
estate, other invested assets and the Company’s equity position in entities are externally valued. Because of the subjective nature of inputs
and the judgment involved in the appraisal process, real estate investments and their corresponding debt are typically included in the Level
3 classification. Key unobservable inputs to real estate valuation include capitalization rates, which range from 4.75% to 10.5% (6.49%
weighted average) and discount rates, which range from 6.25% to 15.0% (7.92% weighted average). Key unobservable inputs to real estate
debt valuation include yield to maturity, which ranges from 3.59% to 7.62% (4.74% weighted average) and market spread over base rate,
which ranges from 1.67% to 4.48% (3.22% weighted average).
Commercial Mortgage Loans—Separate account assets include $833 million of commercial mortgage loans as of December 31, 2012
that are classified as Level 3 and reported at fair value. Commercial mortgage loans are primarily valued internally using discounted cash
flow techniques, as described further under “Fair Value of Financial Instruments.” The primary unobservable input used is the spread to
discount cash flows, which range from 1.65% to 4.15% (1.87% weighted average). In isolation, an increase (decrease) in the value of this
input would result in a lower (higher) fair value measurement.
Valuation Process for Fair Value Measurements Categorized within Level 3—The Company has established an internal control
infrastructure over the valuation of financial instruments that requires ongoing oversight by its various Business Groups. These
management control functions are segregated from the trading and investing functions. For invested assets, the Company has established
oversight teams, often in the form of Pricing Committees within each asset management group. The teams, which typically include
representation from investment, accounting, operations, legal and other disciplines are responsible for overseeing and monitoring the
pricing of the Company’s investments and performing periodic due diligence reviews of independent pricing services. An actuarial
valuation unit oversees the valuation of optional living benefit features of the Company’s variable annuity contracts. The valuation unit
works with segregated modeling and database administration teams to validate the appropriateness of input data and logic, data flow and
implementation.
The Company has also established policies and guidelines that require the establishment of valuation methodologies and consistent
application of such methodologies. These policies and guidelines govern the use of inputs and price source hierarchies and provide controls
around the valuation processes. These controls include appropriate review and analysis of investment prices against market activity or
indicators of reasonableness, approval of price source changes, price overrides, methodology changes and classification of fair value
hierarchy levels. For optional living benefit features of the Company’s variable annuity products, the valuation unit periodically performs
baseline testing of contract input data and actuarial assumptions are reviewed at least annually, and updated based upon historical
experience giving consideration to any observable market data, including available industry studies. The valuation policies and guidelines
are reviewed and updated as appropriate.
Within the trading and investing functions, the Company has established policies and procedures that relate to the approval of all new
transaction types, transaction pricing sources and fair value hierarchy coding within the financial reporting system. For variable annuity
product changes or new launches of optional living benefit features, the actuarial valuation unit validates input logic and new product
features and agrees new input data directly to source documents.
188 Prudential Financial, Inc. 2012 Annual Report