Prudential 2005 Annual Report Download - page 95

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Asset Management Fees and Other Income
Asset management fees and other income principally includes asset management fees and securities and commodities
commission revenues which are recognized in the period in which the services are performed, as well as earnings from our
investment in operating joint ventures, including our investment in Wachovia. Realized and unrealized gains from investments
classified as “Trading account assets supporting insurance liabilities” and “Other trading account assets” are also included in “Asset
management fees and other income.”
Derivative Financial Instruments
Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or
the values of securities or commodities. Derivative financial instruments generally used by the Company include swaps, futures,
forwards and options and may be exchange-traded or contracted in the over-the-counter market. Derivative positions are carried at
fair value, generally by obtaining quoted market prices or through the use of pricing models. Values can be affected by changes in
interest rates, foreign exchange rates, financial indices, values of securities or commodities, credit spreads, market volatility,
expected returns and liquidity. Values can also be affected by changes in estimates and assumptions, including those related to
counterparty behavior, used in pricing models.
Derivatives are used in a non-dealer capacity in our insurance, investment and international businesses as well as our treasury
operations to manage the characteristics of the Company’s asset/liability mix, manage the interest rate and currency characteristics
of assets or liabilities and to mitigate the risk of a diminution, upon translation to U.S. dollars, of expected non-U.S. earnings and
net investments in foreign operations resulting from unfavorable changes in currency exchange rates. Additionally, derivatives may
be used to seek to reduce exposure to interest rate, foreign currency and equity risks associated with assets held or expected to be
purchased or sold, and liabilities incurred or expected to be incurred.
Derivatives are also used in a derivative dealer or broker capacity in the Company’s securities operations to meet the needs of
clients by structuring transactions that allow clients to manage their exposure to interest rates, foreign exchange rates, indices or
prices of securities and commodities and similarly in a dealer or broker capacity through the operation of hedge portfolios in a
limited-purpose subsidiary. Realized and unrealized changes in fair value of derivatives used in these dealer related operations as
well as derivatives used in the mortgage banking business are included in “Asset management fees and other income” in the periods
in which the changes occur. Cash flows from such derivatives are reported in the operating activities section of the Consolidated
Statements of Cash Flows.
Derivatives are recorded either as assets, within “Other trading account assets,” or “Other long-term investments,” or as
liabilities, within “Other liabilities,” in the Consolidated Balance Sheets, except for embedded derivatives which are recorded in the
consolidated balance sheet with the associated host contract. As discussed in detail below and in Note 19, all realized and unrealized
changes in fair value of non-dealer related derivatives, with the exception of the effective portion of cash flow hedges and effective
hedges of net investments in foreign operations, are recorded in current earnings. Cash flows from these derivatives are reported in
the operating or investing activities section in the Consolidated Statements of Cash Flows.
For non-dealer related derivatives the Company designates derivatives as either (1) a hedge of the fair value of a recognized
asset or liability or unrecognized firm commitment (“fair value” hedge); (2) a hedge of a forecasted transaction or of the variability
of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge); (3) a foreign-currency fair value or
cash flow hedge (“foreign currency” hedge); (4) a hedge of a net investment in a foreign operation; or (5) a derivative that does not
qualify for hedge accounting.
To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated risk of the hedged
item. Effectiveness of the hedge is formally assessed at inception and throughout the life of the hedging relationship. Even if a
derivative qualifies for hedge accounting treatment, there may be an element of ineffectiveness of the hedge. Under such
circumstances, the ineffective portion of adjusting the derivative to fair value is recorded in “Realized investment gains (losses),
net.”
When consummated, the Company formally documents all relationships between hedging instruments and hedged items, as
well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all
derivatives designated as fair value, cash flow, or foreign currency, hedges to specific assets and liabilities on the balance sheet or to
specific firm commitments or forecasted transactions. Hedges of a net investment in a foreign operation are linked to the specific
foreign operation.
Prudential Financial 2005 Annual Report 93