Prudential 2012 Annual Report Download - page 32

The majority of our variable annuity contracts with optional living benefit features, and all new contracts sold with these features,
include an automatic rebalancing element and are also included in our living benefits hedging program. The guaranteed benefit features of
certain legacy products that were sold prior to our implementation of the automatic rebalancing element product feature are included in our
living benefits hedge program. Certain legacy guaranteed minimum accumulation benefit (GMAB) products include the automatic
rebalancing element, but are not included in the hedging program. Our contracts with the GMIB feature have neither risk mitigant, as we
have retained the associated risk.
For our GMDBs, we provide a benefit payable in the event of death that, together with the existing contractholder’s account balance,
is equal to a return of cumulative deposits less any partial withdrawals, or the greater of a minimum return on the contract value or an
enhanced value. We have retained the risk that the total amount of death benefit payable may be greater than the contractholder account
value. However, a substantial portion of the account values associated with GMDBs are subject to an automatic rebalancing element
because the contractholder also selected a living benefit feature which includes an automatic rebalancing element. All of the variable
annuity account values with living benefit features also contain GMDBs. The living and death benefit features for these contracts cover the
same insured life, and we have insured both the mortality and longevity risk on these lives.
The following table sets forth the risk profile of our optional living benefits and GMDB features as of the periods indicated.
December 31, 2012 December 31, 2011 December 31, 2010
Account Value
%of
Total Account Value
%of
Total Account Value
%of
Total
(in millions)
Optional living benefit/GMDB features(1):
Both risk mitigants ........................................ $ 89,167 68% $ 66,853 61% $ 52,615 51%
Hedging program only ..................................... 11,744 9% 11,615 11% 13,203 13%
Automatic rebalancing only ................................. 2,787 2% 3,488 3% 4,722 5%
Neither risk mitigant ...................................... 3,556 3% 3,685 3% 4,532 4%
Total optional living benefit/GMDB features ............... $107,254 $ 85,641 $ 75,072
GMDB features only(2):
Neither risk mitigant ...................................... 24,354 18% 24,102 22% 27,276 27%
Total variable annuity account value ...................... $131,608 $109,743 $102,348
(1) All contracts with optional living benefit guarantees also contain GMDB features, covering the same insured life.
(2) Reflects contracts that only include a GMDB feature and do not have an automatic rebalancing element.
The increase in account values that include both risk mitigants as of December 31, 2012 compared to prior periods primarily reflects
sales of our latest product offerings which, include an automatic rebalancing element and are also included in our living benefits hedging
program.
Variable Annuity Living Benefits Hedging Program Results
Under U.S. GAAP, the liability for certain optional living benefit features is accounted for as an embedded derivative and recorded at
fair value, based on assumptions a market participant would use in pricing these features. The fair value is calculated as the present value of
future expected benefit payments to customers less the present value of assessed rider fees attributable to the applicable living benefit
features using option pricing techniques. See Note 20 to the Consolidated Financial Statements for additional information regarding the
methodology and assumptions used in calculating the fair value under U.S. GAAP.
As noted within “—Variable Annuity Risks and Risk Mitigants” above, we maintain a hedge program to manage the risk associated
with these guarantees. Prior to the third quarter of 2010, our hedging strategy sought to generally match certain estimated capital markets
sensitivities of the embedded derivative liability as defined by U.S. GAAP, excluding the impact of the market’s perception of our own
non-performance risk (“NPR”). Since then, our program has utilized an internally-defined hedge target that is grounded in a U.S. GAAP/
capital markets valuation framework, with three notable modifications.
1. The impact of NPR is excluded to maximize protection against the entire projected claim irrespective of the possibility of our own
default.
2. A credit spread is added to the risk-free rate of return assumption used under U.S. GAAP to estimate future growth of bond
investments in the customer separate account funds in order to better replicate the projected returns within those funds.
3. The equity volatility assumption is adjusted to remove certain risk margins required under U.S. GAAP valuation which are used in the
projection of customer account values, as we believe the impact of these margins is highly sensitive to short-term market conditions
and does not reflect the long-term nature of these guarantees.
Due to these modifications, we expect differences each period between the change in the value of the embedded derivative as defined
by U.S. GAAP and the change in the value of the hedge positions used to replicate the hedge target, thus potentially increasing volatility in
U.S. GAAP earnings. The following table provides a reconciliation between the fair value of the embedded derivative as defined by U.S.
GAAP and the value of our hedge target as of the periods indicated.
As of December 31,
2012 2011
(in billions)
Embedded derivative liability as defined by U.S. GAAP .............................................................. $3.3 $2.8
Less: NPR Adjustment ........................................................................................ (4.8) (5.5)
Embedded derivative liability as defined by U.S. GAAP, excluding NPR ............................................ 8.1 8.3
Less: Portion of embedded derivative liability, excluding NPR, excluded from hedge target liability ........................... 2.3 1.2
Hedge target liability ...................................................................................... $5.8 $7.1
30 Prudential Financial, Inc. 2012 Annual Report