Prudential 2006 Annual Report Download - page 169

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. SEGMENT INFORMATION (continued)
These items are important to an understanding of overall results of operations. Adjusted operating income is not a substitute for
income determined in accordance with U.S. GAAP, and the Company’s definition of adjusted operating income may differ from
that used by other companies. However, the Company believes that the presentation of adjusted operating income as measured for
management purposes enhances the understanding of results of operations by highlighting the results from ongoing operations and
the underlying profitability factors of the Financial Services Businesses.
Realized investment gains (losses), net, and related charges and adjustments. Adjusted operating income excludes realized
investment gains (losses), net, except as indicated below. A significant element of realized investment gains and losses are
impairments and credit-related and interest rate-related gains and losses. Impairments and losses from sales of credit-impaired
securities, the timing of which depends largely on market credit cycles, can vary considerably across periods. The timing of other
sales that would result in gains or losses, such as interest rate-related gains or losses, is largely subject to the Company’s discretion
and influenced by market opportunities, as well as the Company’s tax profile. Trends in the underlying profitability of the
Company’s businesses can be more clearly identified without the fluctuating effects of these transactions.
Charges that relate to realized investment gains (losses), net, are also excluded from adjusted operating income. The related
charges, which are offset against net realized investment gains and losses in the schedules below, relate to policyholder dividends;
amortization of deferred policy acquisition costs, VOBA, unearned revenue reserves and deferred sales inducements; interest
credited to policyholders’ account balances; reserves for future policy benefits; payments associated with the market value
adjustment features related to certain of the annuity products we sell; and minority interest in consolidated operating subsidiaries.
The related charges associated with policyholder dividends include a percentage of net realized investment gains on specified
Gibraltar Life assets that is required to be paid as dividends to Gibraltar Life policyholders. Deferred policy acquisition costs,
VOBA, unearned revenue reserves and deferred sales inducements for certain products are amortized based on estimated gross
profits, which include net realized investment gains and losses on the underlying invested assets. The related charge for these items
represent the portion of this amortization associated with net realized investment gains and losses. The related charges for interest
credited to policyholders’ account balances relate to certain group life policies that pass back certain realized investment gains and
losses to the policyholder. The reserves for certain policies are adjusted when cash flows related to these policies are affected by net
realized investment gains and losses, and the related charge for reserves for future policy benefits represents that adjustment.
Certain of our annuity products contain a market value adjustment feature that requires us to pay to the contractholder or entitles us
to receive from the contractholder, upon surrender, a market value adjustment based on the crediting rates on the contract
surrendered compared to crediting rates on newly issued contracts or based on an index rate at the time of purchase compared to an
index rate at time of surrender, as applicable. These payments mitigate the net realized investment gains or losses incurred upon the
disposition of the underlying invested assets. The related charge represents the payments or receipts associated with these market
value adjustment features. Minority interest expense is recorded for the earnings of consolidated subsidiaries owed to minority
investors. The related charge for minority interest in consolidated operating subsidiaries represents the portion of these earnings
associated with net realized investment gains and losses.
Adjustments to “Realized investment gains (losses), net,” for purposes of calculating adjusted operating income, include the
following:
Gains and losses pertaining to derivative contracts that do not qualify for hedge accounting treatment, other than derivatives
used in the Company’s capacity as a broker or dealer, are included in “Realized investment gains (losses), net.” This includes
mark-to-market adjustments of open contracts as well as periodic settlements. As discussed further below, adjusted operating
income includes a portion of realized gains and losses pertaining to certain derivative contracts.
Adjusted operating income of the International Insurance segment and International Investments segment, excluding the global
commodities group, reflect the impact of an intercompany arrangement with Corporate and Other operations pursuant to which the
segments’ non-U.S. dollar denominated earnings in all countries for a particular year, including its interim reporting periods, are
translated at fixed currency exchange rates. The fixed rates are determined in connection with a currency hedging program designed
to mitigate the risk that unfavorable rate changes will reduce the segments’ U.S. dollar equivalent earnings. Pursuant to this
program, the Company’s Corporate and Other operations execute forward currency contracts with third parties to sell the hedged
currency in exchange for U.S. dollars at a specified exchange rate. The maturities of these contracts correspond with the future
periods in which the identified non-U.S. dollar denominated earnings are expected to be generated. These contracts do not qualify
for hedge accounting under U.S. GAAP and, as noted above, all resulting profits or losses from such contracts are included in
“Realized investment gains (losses), net.” When the contracts are terminated in the same period that the expected earnings emerge,
the resulting positive or negative cash flow effect is included in adjusted operating income (gains of $42 million, losses of $55
million and losses of $84 million for the years ended December 31, 2006, 2005 and 2004, respectively). As of December 31, 2006
and 2005, the fair value of open contracts used for this purpose was a net asset of $105 million and net asset of $110 million,
respectively.
PRUDENTIAL FINANCIAL, INC. 2006 ANNUAL REPORT
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