Prudential 2005 Annual Report Download - page 149

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PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
19. DERIVATIVE INSTRUMENTS (continued)
Forward contracts are used by the Company to manage market risks relating to interest rates. The Company also uses “to be
announced” (“TBA”) forward contracts to gain exposure to the investment risk and return of mortgage-backed securities. TBA
transactions can help the Company to achieve better diversification and to enhance the return on its investment portfolio. TBAs
provide a more liquid and cost effective method of achieving these goals than purchasing or selling individual mortgage-backed
pools. Typically, the price is agreed upon at the time of the contract and payment for such a contract is made at a specified future
date.
When the Company has cash flows that it has allocated for investment in equity securities or plans to sell investments in equity
securities, it may enter into equity derivatives as a temporary hedge against an increase or decrease in the price of the securities it
intends to purchase or sell. These hedges are intended to permit such investment transactions to be executed with less adverse
market impacts. The Company also uses equity-based derivatives to hedge the equity risks embedded in some of its annuity
products.
Embedded Derivatives
As described in Note 8, the Company sells variable annuity products which contain embedded derivatives. These embedded
derivatives are marked to market through “Realized investment gains (losses), net” based on the change in value of the underlying
contractual guarantees which are determined using pricing models.
The Company invests in fixed maturities that, in addition to a stated coupon, provide a return based upon the results of an
underlying portfolio of fixed income investments and related investment activity. The Company accounts for these investments as
available for sale fixed maturities containing embedded derivatives. Such embedded derivatives are marked to market through
“Realized investment gains (losses), net,” based upon the change in value of the underlying portfolio.
Cash Flow, Fair Value and Net Investment Hedges
The primary derivative instruments used by the Company in its fair value, cash flow, and net investment hedge accounting
relationships are interest rate swaps, currency swaps and currency forwards. As noted above, these instruments are only designated
for hedge accounting in instances where the appropriate criteria are met. The Company does not use futures, options, credit or
equity derivatives in any of its fair value, cash flow or net investment hedge accounting relationships.
The ineffective portion of derivatives accounted for using hedge accounting in the years ended December 31, 2005, 2004 and
2003 was not material to the results of operations of the Company. In addition, there were no instances in which the Company
discontinued cash flow hedge accounting because the forecasted transaction did not occur by the anticipated date or within the
additional time period permitted by SFAS No. 133.
Presented below is a roll forward of current period cash flow hedges in “Accumulated other comprehensive income (loss)”
before taxes:
(in millions)
Balance, December 31, 2002 .............................................................................. $ (3)
Net deferred losses on cash flow hedges from January 1 to December 31, 2003 ....................................... (90)
Amount reclassified into current period earnings ............................................................... (18)
Balance, December 31, 2003 .............................................................................. (111)
Net deferred losses on cash flow hedges from January 1 to December 31, 2004 ....................................... (146)
Amount reclassified into current period earnings ............................................................... 47
Balance, December 31, 2004 .............................................................................. (210)
Net deferred gains on cash flow hedges from January 1 to December 31, 2005 ....................................... 116
Amount reclassified into current period earnings ............................................................... (28)
Balance, December 31, 2005 .............................................................................. $(122)
Prudential Financial 2005 Annual Report 147