Prudential 2015 Annual Report Download - page 187

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
The fair value of fund investments, where the fair value option has been elected, is primarily determined by the fund managers and is
measured at fair value using NAV as a practical expedient. Since the valuations may be based on unobservable market inputs and cannot be
validated by the Company, these investments have been included within Level 3 in the fair value hierarchy.
Other Assets—Other assets reflected in Level 3 include reinsurance recoverables which are carried at fair value and consist of the
reinsurance of the Company’s living benefit guarantees on certain variable annuity contracts. The methods and assumptions used to
estimate the fair value are consistent with those described in “Future Policy Benefits”. The reinsurance agreements covering these
guarantees are derivatives with fair value determined in the same manner as the living benefit guarantee.
Derivative Instruments—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,” except for embedded derivatives which are recorded with the associated
host contract. The fair values of derivative contracts can be affected by changes in interest rates, foreign exchange rates, commodity prices,
credit spreads, market volatility, expected returns, NPR, liquidity and other factors. For derivative positions included within Level 3 of the
fair value hierarchy, liquidity valuation adjustments are made to reflect the cost of exiting significant risk positions, and consider the bid-
ask spread, maturity, complexity, and other specific attributes of the underlying derivative position.
The Company’s exchange-traded futures and options include Treasury futures, Eurodollar futures, commodity futures, Eurodollar
options and commodity options. Exchange-traded futures and options are valued using quoted prices in active markets and are classified
within Level 1 in the fair value hierarchy.
The majority of the Company’s derivative positions are traded in the OTC derivative market and are classified within Level 2 in the
fair value hierarchy. OTC derivatives classified within Level 2 are valued using models that utilize actively quoted or observable market
input values from external market data providers, third-party pricing vendors and/or recent trading activity. The Company’s policy is to use
mid-market pricing in determining its best estimate of fair value. The fair values of most OTC derivatives, including interest rate and cross-
currency swaps, currency forward contracts, commodity swaps, commodity forward contracts, single name credit default swaps, loan
commitments held for sale and “to be announced” (“TBA”) forward contracts on highly rated mortgage-backed securities issued by U.S.
government sponsored entities are determined using discounted cash flow models. The fair values of European style option contracts are
determined using Black-Scholes option pricing models. These models’ key inputs include the contractual terms of the respective contract,
along with significant observable inputs, including interest rates, currency rates, credit spreads, equity prices, index dividend yields, NPR,
volatility and other factors.
The Company’s cleared interest rate swaps and credit derivatives linked to an index are valued using models that utilize actively
quoted or observable market inputs, including Overnight Indexed Swap discount rates, obtained from external market data providers, third-
party pricing vendors and/or recent trading activity. These derivatives are classified as Level 2 in the fair value hierarchy.
The vast majority of the Company’s derivative agreements are with highly rated major international financial institutions. To reflect
the market’s perception of its own and the counterparty’s NPR, the Company incorporates additional spreads over LIBOR into the discount
rate used in determining the fair value of OTC derivative assets and liabilities that are not otherwise collateralized.
Derivatives classified as Level 3 include look-back equity options and other structured products. These derivatives are valued based
upon models, such as Monte Carlo simulation models and other techniques that utilize significant unobservable inputs. Level 3
methodologies are validated through periodic comparison of the Company’s fair values to external broker-dealer values.
Cash Equivalents and Short-Term Investments—Cash equivalents and short-term investments include money market instruments,
commercial paper and other highly liquid debt instruments. Certain money market instruments are valued using unadjusted quoted prices in
active markets that are accessible for identical assets and are primarily classified as Level 1. The remaining instruments in this category are
generally fair valued based on market observable inputs and these investments have primarily been classified within Level 2.
Separate Account Assets—Separate account assets include fixed maturity securities, treasuries, equity securities, mutual funds and
real estate investments for which values are determined consistent with similar instruments described above under “Fixed Maturity
Securities,” “Equity Securities” and “Other Long-Term Investments.”
Notes issued by Consolidated VIEs—The fair values of these notes are based on indicative broker quotes and classified within Level
3. See Note 5 and “Fair Value Option” below for additional information.
Other Liabilities—Other liabilities include certain derivative instruments, the fair values of which are determined consistent with
similar derivative instruments described above under “Derivative Instruments.”
Future Policy Benefits—The liability for future policy benefits is related to guarantees primarily associated with the living benefit
features of certain variable annuity contracts offered by the Company’s Individual Annuities segment, including GMAB, GMWB and
GMIWB, accounted for as embedded derivatives. The fair values of these liabilities are calculated as the present value of future expected
benefit payments to customers less the present value of future expected 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 actuarial
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. The models are based on a risk neutral valuation framework and incorporate premiums
for risks inherent in valuation techniques, inputs, and the general uncertainty around the timing and amount of future cash flows. The
determination of these risk premiums requires the use of management’s judgment.
Prudential Financial, Inc. 2015 Annual Report 185