Prudential 2001 Annual Report Download - page 41

Prudential Financial, Inc.
either estimated profits or premiums, depending on the type of contract. For products with amortization based on
future premiums, the amortization rate is locked-in when the product is sold. However, for products with
amortization based on estimated profits, the amortization rate is periodically updated to reflect current period
experience or changes in assumptions that affect future profitability, such as lapse rates, investment returns,
mortality experience, expense margins and surrender charges. These changes result in adjustments to DAC balances
in the period that we change our assumptions as well as changes in prospective DAC amortization. For example,
adverse market conditions in 2001 resulted in declines in the market values of assets supporting our variable life
insurance and annuity products, which in turn resulted in lower expectations regarding our estimated future gross
profits from fee-based income. As a result, we recorded a higher level of DAC amortization in 2001 for these
products. DAC is also subject to periodic recoverability testing.
Reserves For Contingencies
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the
occurrence of future events. Under GAAP, reserves for contingencies are required to be established when the future
event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses
in connection with an unresolved legal matter. The initial reserve reflects management’s best estimate of the
probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and,
ultimately, when the matter is brought to closure. Another example is the actual execution of a definitive
management commitment to exit or restructure a business. When management formally commits to such an action,
reserves are established based on the estimated cost of executing the action. These would typically include
severance and employee benefit costs, facilities closure costs, and certain other direct incremental costs. For
example, we established such reserves in connection with our disposition of our former healthcare business (see
Note 3 to the Consolidated Financial Statements) and the restructuring of the capital markets business of Prudential
Securities (see Note 4 to the Consolidated Financial Statements). The initial establishment of these reserves
reflected management’s best estimate of the ultimate costs. Our results for subsequent periods reflected changes in
these estimates to the extent that the actual costs of carrying out the plans were different from our original estimates.
Other Significant Estimates
In addition to the items discussed above, the application of GAAP requires management to make other estimates and
assumptions. For example, accounting for pension and other postretirement and postemployment benefits requires
estimates of future returns on plan assets, expected increases in compensation levels and trends in health care costs.
These are discussed in Note 16 to the Consolidated Financial Statements. Another example is the recognition of
deferred tax assets, which depends on management’s assumption that future earnings will be sufficient to realize the
deferred benefit. This is discussed in Note 17 to the Consolidated Financial Statements.
Consolidated Results of Operations
In managing our business, we analyze our operating performance by separately considering our Financial Services
Businesses and our Closed Block Business. In addition, within the Financial Services Businesses, we analyze our
operating performance using a non-GAAP measure we call “adjusted operating income.” Prior to the date of
demutualization, we also analyzed results of our Traditional Participating Products segment based on this non-
GAAP measure. We calculate adjusted operating income by adjusting our income from continuing operations before
income taxes to exclude certain items. The items excluded are:
• realized investment gains, net of losses and related charges;
• sales practices remedies and costs;
• the gains, losses and contribution to income/loss of divested businesses that we have sold but that do not qualify
for “discontinued operations” accounting treatment under GAAP; and
• demutualization costs and expenses.
Wind-down businesses that we have not divested remain in adjusted operating income. We exclude our discontinued
healthcare operations from income from continuing operations before income taxes.
The excluded items are important to an understanding of our overall results of operations. You should not view
adjusted operating income as a substitute for net income determined in accordance with GAAP, and you should note
that our definition of adjusted operating income may differ from that used by other companies. However, we believe
that the presentation of adjusted operating income as we measure it for management purposes enhances the
understanding of our results of operations by highlighting the results from ongoing operations and the underlying
profitability of our businesses. We exclude realized investment gains, net of losses and related charges, from
Prudential Financial 2001 Annual Report 39