Prudential 2012 Annual Report Download - page 94

Given the size and liquidity profile of our investment portfolios, we believe that claim experience, including policyholder withdrawals
and surrenders, varying from our projections does not constitute a significant liquidity risk. Our asset/liability management process takes
into account the expected maturity of investments and expected claim payments as well as the specific nature and risk profile of the
liabilities. To the extent we need to pay claims in excess of projections, we may borrow temporarily or sell investments sooner than
anticipated to pay these claims, which may result in increased borrowing costs or realized investment gains or losses affecting results of
operations. The payment of claims and sale of investments earlier than anticipated would have an impact on the reported level of cash flow
from operating, investing, and financing activities, respectively, in our financial statements. Historically, there has been no significant
variation between the expected maturities of our investments and the payment of claims.
Liquidity associated with other activities
Hedging activities associated with living benefit guarantees
As discussed under “—Captive reinsurance companies” above, we reinsure living benefit guarantees on certain variable annuity and
retirement products from our domestic insurance companies to a captive reinsurance company, Pruco Re. Pruco Re requires access to
sufficient liquidity to support the hedging activities such as periodic settlements, purchases, maturities, terminations and breakage. The
liquidity needs can vary materially due to, among other items, changes in interest rates, equity markets, mortality and policyholder behavior.
Currently, we fund these liquidity needs with a combination of capital contributions and loans from Prudential Financial and affiliates.
Additionally, for certain of our domestic insurance companies to claim statutory reinsurance reserve credit for business ceded to Pruco
Re, Pruco Re must collateralize its obligations under the reinsurance arrangement. We satisfy this requirement today by depositing assets
into statutory reserve credit trusts. Funding needs for the statutory reserve credit trusts are separate and distinct from capital needs of Pruco
Re. However, assets pledged to the statutory reserve credit trusts may include assets supporting the capital of Pruco Re provided that they
meet eligibility requirements prescribed by the relevant insurance regulators. Reinsurance reserve credit requirements can move materially
in either direction due to changes in equity markets, interest rates, actuarial assumptions and other factors. Higher reinsurance reserve credit
requirements would necessitate depositing additional assets in the statutory reserve credit trusts, while lower reserve credit requirements
would allow assets to be removed from the statutory reserve credit trusts. As of December 31, 2012 and 2011, for the applicable domestic
insurance entities, the statutory reserve credit trusts required collateral of $2.2 billion and $1.2 billion respectively. The increase in
comparison to 2011 was primarily driven by actuarial assumption updates, reflecting lower long-term interest rates, partially offset by the
impact of higher equity markets.
The living benefits hedging activity in Pruco Re may also result in collateral postings on derivatives to or from counterparties. The
Company’s collateral position depends on changes in interest rates and equity markets related to the notional amount of the exposures
hedged. Depending on market conditions, the collateral posting requirements can result in material liquidity needs. As of December 31, 2012,
these derivatives were in a net receive position, for which $4.7 billion of collateral was posted to the Company by the external counterparties.
Foreign exchange hedging activities
We employ various hedging strategies to manage potential exposure to foreign currency exchange rate movements, including the
strategies discussed in “—Results of Operations for Financial Services Businesses by Segment—International Insurance Division.” These
hedging strategies include both internal and external hedging programs and may impact the liquidity of both Prudential Financial and our
international insurance subsidiaries.
The internal-only hedges are between a subsidiary of Prudential Financial and certain of our yen-based entities and serve to hedge a
portion of the value of U.S. dollar-denominated investments held on the books of these yen-based entities. These U.S. dollar-denominated
investments are part of our hedging strategy to mitigate the impact of foreign currency exchange rate movements on the value of our U.S.
dollar-equivalent investment in our Japanese subsidiaries. Absent an internal hedge, however, the changes in market value of these U.S.
dollar-denominated investments attributable to changes in the yen-dollar exchange rate would create volatility in the solvency margins of
these subsidiaries. To minimize this volatility, we enter into inter-company hedges. Cash settlements from these hedging activities result in
cash flows between Prudential Financial and these yen-based subsidiaries. The cash flows are dependent on changes in foreign currency
exchange rates and the notional amount of the exposures hedged. During 2012, Prudential Financial received $21 million of net cash
settlements related to the internal hedge program, which were paid by the yen-based subsidiaries. As of December 31, 2012, the market
value of the internal hedges was an asset of $50 million due from the yen-based subsidiaries. Absent any changes in forward exchange rates
from those expected as of December 31, 2012, the $50 million internal hedge asset represents the present value of the net cash flows to
Prudential Financial from these entities over the life of the hedging instruments, up to 30 years. A significant yen depreciation over an
extended period of time could result in net cash flows to Prudential Financial. Conversely, a significant yen appreciation could result in net
cash outflows from Prudential Financial.
Our external hedges primarily serve to hedge foreign currency-denominated future income of our foreign subsidiaries and equity
investments in certain of these subsidiaries. The external hedges are between a subsidiary of Prudential Financial and external parties. Cash
settlements on these activities result in cash flows between Prudential Financial and the external parties and are dependent on changes in
foreign currency exchange rates and the notional amount of the exposures hedged. During 2012, Prudential Financial paid $121 million for
these international insurance-related external hedge settlements. As of December 31, 2012, the net asset related to these external foreign
currency hedges was $103 million. A significant appreciation in the yen and other foreign currencies could result in net cash outflows.
Asset Management operations
The principal sources of liquidity for our fee-based asset management businesses include asset management fees and commercial
mortgage origination and servicing fees. The principal uses of liquidity include general and administrative expenses and distribution of
dividends and returns of capital to Prudential Financial. The primary liquidity risks for our fee-based asset management businesses relate to
92 Prudential Financial, Inc. 2012 Annual Report