Prudential 2005 Annual Report Download - page 78

Market Risk Related to Equity Prices
We actively manage investment equity price risk against benchmarks in respective markets. We benchmark our return on equity
holdings against a blend of market indices, mainly the S&P 500 and Russell 2000, and we target price sensitivities that approximate those
of the benchmark indices. We estimate our equity price risk from a hypothetical 10% decline in equity benchmark market levels and
measure this risk in terms of the decline in fair market value of equity securities we hold. Using this methodology, our estimated equity
price risk as of December 31, 2005 was $563 million, representing a hypothetical decline in fair market value of equity securities we held
at that date from $5.634 billion to $5.071 billion. Our estimated equity price risk using this methodology as of December 31, 2004 was
$477 million, representing a hypothetical decline in fair market value of equity securities we held at that date from $4.772 billion to $4.295
billion. In calculating these amounts, we exclude equity securities related to products for which the investment risk is borne primarily by
the contractholder rather than by us. While these scenarios are for illustrative purposes only and do not reflect our expectations regarding
future performance of equity markets or of our equity portfolio, they represent near term reasonably possible hypothetical changes that
illustrate the potential impact of such events.
Market Risk Related to Foreign Currency Exchange Rates
We are exposed to foreign currency exchange rate risk in our domestic general account investment portfolios, other proprietary
investment portfolios and through our operations in foreign countries.
Our exposure to foreign currency risk within the domestic general account investment portfolios supporting our U.S. insurance
operations and other domestic proprietary investment portfolios arises primarily from investments that are denominated in foreign
currencies. We generally hedge substantially all domestic general account foreign currency-denominated fixed-income investments and
other domestic proprietary foreign currency investments into U.S. dollars in order to mitigate the risk that the cash flows or fair value of
these investments fluctuates as a result of changes in foreign exchange rates. We generally do not hedge all of the foreign currency risk of
our investments in equity securities of unaffiliated foreign entities.
Our operations in foreign countries create the following three additional sources of foreign currency risk:
• First, we reflect the operating results of our foreign operations in our financial statements based on the average exchange rates
prevailing during the period. We hedge some of these foreign currency operating results as part of our overall risk management
strategy. We generally hedge our anticipated exposure to adjusted operating income fluctuations resulting from changes in foreign
currency exchange rates relating to our International operations primarily in Japan, Korea, Taiwan and Europe.
• Second, we translate our equity investment in foreign operations into U.S. dollars using the foreign currency exchange rate at the
financial statement period-end date. For our equity investments in our International operations, other than in Japan, we generally
hedge a significant portion of this exposure, which we accomplish through the use of foreign currency forward contracts. For our
equity investments in our Japanese operations we generally hedge this exposure by holding U.S. dollar denominated securities in
the investment portfolios of these operations.
• Third, our international insurance operations may hold investments denominated in currencies other than the functional currency of
those operations on an unhedged basis in addition to the aforementioned equity hedges resulting from foreign subsidiaries’
investing in U.S. dollar denominated investments. Most significantly, our Japanese operations hold U.S. dollar denominated
investments in their investment portfolios in excess of our equity investment in such operations. For a discussion of our Japanese
operations’ U.S. dollar denominated investment holdings, see “Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Realized Investment Gains and General Account Investments—General Account Investments—Portfolio
Composition.”
We manage our investment foreign currency exchange rate risks, described above, within specified limits. Foreign exchange risks for
our domestic general account investment portfolio and the unhedged portion of our equity investment in foreign subsidiaries are managed
using VaR-based analysis. This statistical technique estimates, at a specified confidence level, the potential pre-tax loss in portfolio market
value that could occur over an assumed time horizon due to adverse market movements.
The estimated VaR as of December 31, 2005 for foreign exchange risks in our domestic general account portfolio and the unhedged
portion of equity investment in foreign subsidiaries, measured at a 95% confidence level and using a one-month time horizon, was $20
million, representing a hypothetical decline in fair market value of these foreign currency assets from $967 million to $947 million. The
estimated VaR as of December 31, 2004 for foreign exchange risks in our domestic general account portfolio and the unhedged portion of
equity investment in foreign subsidiaries, measured at a 95% confidence level and using a one-month time horizon, was $35 million,
representing a hypothetical decline in fair market value of these foreign currency assets from $1.241 billion to $1.206 billion. The average
VaR for foreign exchange risks in our domestic general account portfolio and the unhedged portion of equity investment in foreign
subsidiaries, from foreign currency exchange rate movements, measured monthly at a 95% confidence level over a one month time horizon,
was $32 million during 2005 and $35 million during 2004. These calculations use historical price volatilities and correlation data at a 95%
confidence level. We discuss limitations of VaR models below.
The estimated VaR for instruments used to hedge our anticipated exposure to adjusted operating income fluctuations resulting from
changes in foreign currency exchange rates relating to our International operations, measured at a 95% confidence level and using a
one-month time horizon, was $75 million as of December 31, 2005 and $110 million as of December 31, 2004.
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