Prudential 2012 Annual Report Download - page 207

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
21. DERIVATIVE INSTRUMENTS (continued)
maturity securities with bifurcated embedded derivatives (total return swaps). Changes in the value of the fixed maturity securities are
reported in Equity under the heading “Accumulated Other Comprehensive Income (Loss)” and changes in the market value of the
embedded total return swaps are included in current period earnings in “Realized investment gains (losses), net.” The Company’s
maximum exposure to loss from these investments was $314 million and $664 million at December 31, 2012 and 2011, respectively.
In addition to writing credit protection, the Company has purchased credit protection using credit derivatives in order to hedge specific
credit exposures in the Company’s investment portfolio. As of December 31, 2012 and 2011, the Company had $1.680 billion and $1.978
billion of outstanding notional amounts, respectively, reported at fair value as a liability of $35 million and an asset of $2 million,
respectively.
Types of Derivative Instruments and Derivative Strategies used in a dealer or broker capacity
Futures, forwards and options contracts, and swap agreements, were also used in a derivative dealer or broker capacity in the
Company’s commodities operations, prior to the sale of this business to Jefferies on July 1, 2011, to facilitate transactions of clients, hedge
proprietary trading activities and as a means of risk management. These derivatives allowed the Company to structure transactions to
manage its exposure to commodities and securities prices, foreign exchange rates and interest rates. Risk exposures were managed through
diversification, by controlling position sizes and by entering into offsetting positions.
The fair value of the Company’s derivative contracts used in a derivative dealer or broker capacity were reported on a net-by-
counterparty basis in the Company’s Consolidated Statements of Financial Position when management believes a legal right of setoff exists
under an enforceable netting agreement.
Realized and unrealized gains and losses from marking-to-market the derivatives used in proprietary positions were recognized on a
trade date basis and reported in “Income from discontinued operations, net of taxes. The pre-tax amounts reported in “Income (loss) from
discontinued operations, net of taxes” for these derivatives were gains of $0 million, $63 million and $97 million for the years ended
December 31, 2012, 2011 and 2010, respectively.
Counterparty Credit Risk
The Company is exposed to credit-related losses in the event of non-performance by counterparties to financial derivative transactions.
The Company manages credit risk by entering into derivative transactions with highly rated major international financial institutions and
other creditworthy counterparties, and by obtaining collateral where appropriate. Additionally, limits are set on single party credit
exposures which are subject to periodic management review.
The credit exposure of the Company’s over-the-counter (“OTC”) derivative transactions is represented by the contracts with a positive
fair value (market value) at the reporting date. To reduce credit exposures, the Company seeks to (i) enter into OTC derivative transactions
pursuant to master agreements that provide for a netting of payments and receipts with a single counterparty (ii) enter into agreements that
allow the use of credit support annexes, which are bilateral rating-sensitive agreements that require collateral postings at established
threshold levels. Likewise, the Company effects exchange-traded futures and options transactions through regulated exchanges and these
transactions are settled on a daily basis, thereby reducing credit risk exposure in the event of non-performance by counterparties to such
financial instruments.
Under fair value measurements, the Company incorporates the market’s perception of its own and the counterparty’s non-performance
risk in determining the fair value of the portion of its OTC derivative assets and liabilities that are uncollateralized. Credit spreads are
applied to the derivative fair values on a net basis by counterparty. To reflect the Company’s own credit spread a proxy based on relevant
debt spreads is applied to OTC derivative net liability positions. Similarly, the Company’s counterparty’s credit spread is applied to OTC
derivative net asset positions.
Certain of the Company’s derivative agreements with some of its counterparties contain credit-rating related triggers. If the
Company’s credit rating were to fall below a certain level, the counterparties to the derivative instruments could request termination at the
then fair value of the derivative or demand immediate full collateralization on derivative instruments in net liability positions. If a
downgrade occurred and the derivative positions were terminated, the Company anticipates it would be able to replace the derivative
positions with other counterparties in the normal course of business. The aggregate fair value of all derivative instruments with credit-risk-
related contingent features that are in a net liability position were $84 million as of December 31, 2012. In the normal course of business
the Company has posted collateral related to these instruments of $63 million as of December 31, 2012. If the credit-risk-related contingent
features underlying these agreements had been triggered on December 31, 2012, the Company estimates that it would be required to post a
maximum of $21 million of additional collateral to its counterparties.
22. SEGMENT INFORMATION
Segments
The Company has organized its principal operations into the Financial Services Businesses and the Closed Block Business. Within the
Financial Services Businesses, the Company operates through three divisions, which together encompass six reportable segments.
Businesses that are not sufficiently material to warrant separate disclosure and divested businesses are included in Corporate and Other
operations within the Financial Services Businesses. Collectively, the businesses that comprise the three operating divisions and Corporate
and Other are referred to as the Financial Services Businesses.
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