Prudential 2006 Annual Report Download - page 21

adverse or favorable effect on our results of operations. For a discussion of DAC adjustments related to our Individual Life segment for the
years ended December 31, 2006, 2005 and 2004, see “—Results of Operations for Financial Services Businesses by Segment—Insurance
Division—Individual Life.” For variable annuity contracts, DAC is more sensitive to the effects of changes in our estimates of gross profits
due primarily to the significant portion of our gross profits that is dependent upon the total rate of return on assets held in separate account
investment options, and the shorter average life of the contracts. This rate of return influences the fees we earn, costs we incur associated
with minimum death benefit and other contractual guarantees specific to our variable annuity contracts, as well as other sources of profit.
This is also true, to a lesser degree, for our variable life policies.
The future rate of return assumptions used in evaluating DAC for our domestic annuity and variable life insurance products are
derived using a reversion to mean approach, a common industry practice. Under this approach, we consider actual returns over a period of
time and project returns for the future period so that the assets grow at the expected rate of return for the entire period. If the projected
future rate of return is greater than our maximum future rate of return, we use our maximum reasonable future rate of return. As part of our
approach for variable annuity contracts, if the estimated gross profits under the previously projected rate of return are greater than or less
than a range of estimated gross profits determined by statistically generated rate of returns, we change our future assumption to reflect the
result of the reversion to the mean approach. For variable annuities products, our expected rate of return is 8% per annum, which reflects an
expected rate of return of 8.9% per annum for equity type assets. The future equity rate of return used varies by product, but was under
8.9% per annum for all of our variable annuity products for our evaluation of deferred policy acquisition costs as of December 31, 2006.
The DAC balance associated with our domestic variable annuity contracts was $1.6 billion as of December 31, 2006. The following
table provides a demonstration of the sensitivity of that DAC balance relative to our future rate of return assumptions by quantifying the
adjustments that we would be required to consider, subject to the range of estimated gross profits determined by the statistically generated
rate of returns described above, assuming both an increase and decrease in our future rate of return by 100 basis points. This information
considers only the effect of changes in our future rate of return and not changes in any other assumptions such as persistency, mortality, or
expenses included in our evaluation of DAC.
December 31, 2006
Increase/(Reduction) in
DAC
(in millions)
Increase in future rate of return by 100 basis points .............................................................. $25
Decrease in future rate of return by 100 basis points .............................................................. $(25)
For a discussion of DAC adjustments related to our Individual Annuities segment for the years ended December 31, 2006, 2005 and
2004, see “—Results of Operations for Financial Services Businesses by Segment—Insurance Division—Individual Annuities.”
In addition to DAC, we also recognize assets for capitalized sales inducements and valuation of business acquired, or VOBA. The
deferred sales inducements are amortized using the same methodology and assumptions used to amortize deferred policy acquisition costs.
For additional information about our deferred sales inducements, see Note 9 to the Consolidated Financial Statements. VOBA represents
the present value of future profits embedded in acquired businesses. For additional information about VOBA including its bases for
amortization, see Note 2 to the Consolidated Financial Statements.
Goodwill
We test goodwill for impairment on an annual basis as of December 31 of each year and more frequently if events occur or
circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Impairment
testing requires us to compare the fair value of each reporting unit to its carrying amount, including goodwill, and record an impairment
charge if the carrying amount of a reporting unit exceeds its estimated fair value. The determination of a reporting unit’s fair value is based
on management’s best estimate, which generally considers the unit’s expected future earnings and market-based earning multiples of peer
companies. As of December 31, 2006, we have $935 million of goodwill reflected on our statements of financial position. During 2004, we
recorded a goodwill impairment of $53 million relating to our Dryden Wealth Management business. There were no goodwill impairment
charges during 2006 or 2005.
Pension and Other Postretirement Benefits
We sponsor pension and other postretirement benefit plans covering employees who meet specific eligibility requirements. Our net
periodic costs for these plans consider an assumed discount (interest) rate, an expected rate of return on plan assets and expected increases
in compensation levels and trends in health care costs. Of these assumptions, our expected rate of return assumptions, and to a lesser extent
our discount rate assumptions, have historically had the most significant effect on our net period costs associated with these plans.
We determine our expected return on plan assets based upon the arithmetical average of prospective returns, which is based upon a
risk free rate as of the measurement date adjusted by a risk premium that considers historical statistics and expected investment manager
performance, for equity, debt and real estate markets applied on a weighted average basis to our asset portfolio. See Note 16 to our
Consolidated Financial Statements for our actual asset allocations by asset category and the asset allocation ranges prescribed by our
investment policy guidelines for both our pension and other postretirement benefit plans. Our assumed long-term rate of return for 2006
was 8.00% for our pension plans and 9.25% for our other postretirement benefit plans. Given the amount of plan assets as of September 30,
2005, the beginning of the measurement year, if we had assumed an expected rate of return for both our pension and other postretirement
PRUDENTIAL FINANCIAL, INC. 2006 ANNUAL REPORT
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