Prudential 2005 Annual Report Download - page 153

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. SEGMENT INFORMATION (continued)
expected earnings emerge, the resulting positive or negative cash flow effect is included in adjusted operating income (losses of $55
million, $84 million and $51 million for the years ended December 31, 2005, 2004 and 2003, respectively). As of December 31,
2005 and 2004, the fair value of open contracts used for this purpose was a net asset of $110 million and net liability of $230
million, respectively.
The Company uses interest and currency swaps and other derivatives to manage interest and currency exchange rate exposures
arising from mismatches between assets and liabilities, including duration mismatches. For the derivative contracts that do not
qualify for hedge accounting treatment, mark-to-market adjustments of open contracts as well as periodic settlements are included
in “Realized investment gains (losses), net.” However, the periodic swap settlements, as well as other derivative related yield
adjustments, are included in adjusted operating income to reflect the after-hedge yield of the underlying investments. Adjusted
operating income includes gains of $54 million, $14 million and $51 million for the years ended December 31, 2005, 2004 and
2003, respectively, due to periodic settlements and yield adjustments of such contracts.
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 that are marked to market through “Realized investment gains
(losses), net,” based upon the change in value of the underlying portfolio. Adjusted operating income includes a portion of the
cumulative realized investment gains on these embedded derivatives on an amortizing basis over the remaining life of the securities.
However, adjusted operating income includes any cumulative realized investment losses immediately. Adjusted operating income
includes losses of $11 million for the year ended December 31, 2005 related to these embedded derivatives. There were no
adjustments for the years ended December 31, 2004 and 2003.
Adjustments are also made for the purposes of calculating adjusted operating income for the following items:
Within the Company’s Asset Management segment, its commercial mortgage operations originate loans for sale, including
through securitization transactions. The “Realized investment gains (losses), net” associated with these loans, including related
derivative results and retained mortgage servicing rights, are a principal source of earnings for this business and are included in
adjusted operating income. Also within the Company’s Asset Management segment, its proprietary investing business makes
investments for sale or syndication to other investors or for placement or co-investment in the Company’s managed funds and
structured products. The “Realized investment gains (losses), net” associated with the sale of these proprietary investments are a
principal source of earnings for this business and are included in adjusted operating income. In addition, “Realized gains (losses),
net” from derivatives used to hedge certain foreign currency-denominated proprietary investments are included in adjusted
operating income. Net realized investment gains of $108 million, $72 million and $110 million related to these businesses were
included in adjusted operating income for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company’s Japanese insurance operations invest in “reverse dual currency” fixed maturities and loans, which pay interest
in U.S. dollars, while the principal is payable in Japanese Yen. For fixed maturities that are categorized as held to maturity, and
loans where the Company’s intent is to hold them to maturity, the change in value related to foreign currency fluctuations associated
with the U.S. dollar interest payments is recorded in “Asset management fees and other income.” Since these investments will be
held until maturity, the foreign exchange impact will ultimately be realized as net investment income as earned and therefore the
impact of currency fluctuations is excluded from current period adjusted operating income. This change in value related to foreign
currency fluctuations recorded within “Asset management fees and other income” is excluded from adjusted operating income as an
adjustment to “Realized investment gains (losses), net,” and was an increase of $16 million for the year ended December 31, 2005.
There were no adjustments for the years ended December 31, 2004 and 2003.
As part of the acquisition of CIGNA’s retirement business, the Company entered into reinsurance agreements with CIGNA,
including a modified-coinsurance-with-assumption arrangement that applies to the defined benefit guaranteed-cost contracts
acquired. The net results of these contracts are recorded in “Asset management fees and other income,” as a result of the reinsurance
arrangement, and such net results include realized investment gains and losses. These realized investment gains and losses are
excluded from adjusted operating income as an adjustment to “Realized investment gains (losses), net.” Net realized investment
gains of $13 million and $1 million were excluded for the years ended December 31, 2005 and 2004, respectively. There were no
adjustments for the year ended December 31, 2003.
Prudential Financial 2005 Annual Report 151