Prudential 2012 Annual Report Download - page 55

securities included approximately $4.5 billion as of December 31, 2012 and $3.2 billion as of December 31, 2011 of public fixed
maturities, with values primarily based on indicative broker quotes, and approximately $1.5 billion as of December 31, 2012 and $1.6
billion as of December 31, 2011 of private fixed maturities, with values primarily based on internally-developed models. Significant
unobservable inputs used included: issue specific credit adjustments, material non-public financial information, management judgment,
estimation of future earnings and cash flows, default rate assumptions, liquidity assumptions and indicative quotes from market makers.
These inputs are usually considered unobservable, as not all market participants will have access to this data.
The impact our determination of fair value for fixed maturity and equity securities has on our results of operations is dependent on our
classification of the security as either trading, available-for-sale, or held-to-maturity. For our investments classified as trading, the impact
of changes in fair value is recorded within “Asset management fees and other income.” For our investments classified as available-for-sale,
the impact of changes in fair value is recorded as an unrealized gain or loss in AOCI, a separate component of equity. Our investments
classified as held-to-maturity are carried at amortized cost.
Other Long-Term Investments
Other long-term investments classified in Level 3 primarily include real estate held in consolidated investment funds and fund
investments where the fair value option has been elected. 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. The appraisals also include
replacement cost estimates and recent sales data as alternate methods of fair value. 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 are reflected within Level 3. Consolidated real estate investment
funds classified as Level 3 totaled approximately $0.5 billion and $0.4 billion as of December 31, 2012 and 2011, respectively. 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 are included within Level 3.
Investments in these funds included in Level 3 totaled approximately $0.5 billion and $0.4 billion as of December 31, 2012 and 2011,
respectively.
Derivative Instruments
Derivatives classified as Level 3, excluding embedded derivatives which are discussed in “—Variable Annuity Optional Living
Benefit Features” below, include look-back equity options and other structured products. These 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,” and are
valued based upon models with some significant unobservable market inputs or inputs from less actively traded markets. We validate these
values through periodic comparison of our fair values to broker-dealer values. The fair values of OTC derivative assets and liabilities
classified as Level 3 totaled approximately $19 million and $0 million, respectively, as of December 31, 2012 and $84 million and $3
million, respectively, as of December 31, 2011, without giving consideration to the impact of netting.
All realized and unrealized changes in fair value of these derivatives, with the exception of the effective portion of qualifying cash
flow hedges and hedges of net investments in foreign operations, are recorded in current earnings. Generally, the changes in fair value of
these derivatives, excluding those that qualify for hedge accounting, are recorded in “Realized investment gains (losses), net.” For
additional information regarding the impact of changes in fair value of derivative instruments on our results of operations see “—Realized
Investment Gains and Losses” below.
Separate Account Assets
Separate account assets included in Level 3 primarily include real estate investments for which values are determined as described
above under “Other Long-Term Investments.” Separate account liabilities are reported at contract value and not fair value.
Variable Annuity Optional Living Benefit Features
Future policy benefits classified in Level 3 primarily include liabilities related to guarantees associated with the optional living benefit
features of certain variable annuity contracts offered by our Individual Annuities segment, including guaranteed minimum accumulation
benefits (“GMAB”), guaranteed minimum withdrawal benefits (“GMWB”) and guaranteed minimum income and withdrawal benefits
(“GMIWB”). These benefits are accounted for as embedded derivatives and carried at fair value with changes in fair value included in
“Realized investment gains (losses), net.” 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. These models utilize significant assumptions that are
primarily unobservable, including assumptions as to lapse rates, NPR, utilization rates, withdrawal rates, mortality rates and equity market
volatility. Future policy benefits classified as Level 3 were net liabilities of $3.3 billion and $2.9 billion as of December 31, 2012 and 2011,
respectively. For additional information see “—Results of Operations for Financial Services Businesses by Segment—U.S. Retirement
Solutions and Investment Management Division—Individual Annuities.”
For additional information about the key estimates and assumptions used in our determination of fair value, see Note 20 to the
Consolidated Financial Statements.
Realized Investment Gains and Losses
Realized investment gains and losses are generated from numerous sources, including the following significant items:
• sale of investments
• adjustments to the cost basis of investments for other-than-temporary impairments
• recognition of other-than-temporary impairments in earnings for foreign denominated securities that are approaching maturity and
are in an unrealized loss position due to foreign currency exchange rate movements
Prudential Financial, Inc. 2012 Annual Report 53