Prudential 2006 Annual Report Download - page 86

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Risk Management, Market Risk and Derivative Instruments
Risk management includes the identification and measurement of various forms of risk, the establishment of risk thresholds and the
creation of processes intended to maintain risks within these thresholds while optimizing returns on the underlying assets or liabilities. We
consider risk management an integral part of managing our core businesses.
Market risk is the risk of change in the value of financial instruments as a result of absolute or relative changes in interest rates,
foreign currency exchange rates or equity or commodity prices. To varying degrees, the investment and trading activities supporting all of
our products and services generate exposure to market risk. The market risk incurred and our strategies for managing this risk varies by
product.
With respect to non-variable life insurance products, fixed rate annuities, the fixed rate options in our variable life insurance and
annuity products, and other finance businesses, we incur market risk primarily in the form of interest rate risk. We manage this risk through
asset/liability management strategies that seek to match the interest rate sensitivity of the assets to that of the underlying liabilities. Our
overall objective in these strategies is to limit the net change in value of assets and liabilities arising from interest rate movements. While it
is more difficult to measure the interest sensitivity of our insurance liabilities than that of the related assets, to the extent that we can
measure such sensitivities we believe that interest rate movements will generate asset value changes that substantially offset changes in the
value of the liabilities relating to the underlying products.
For variable annuities and variable life insurance products, excluding the fixed rate options in these products, mutual funds and most
separate accounts, our main exposure to the market is the risk that asset based fees decrease as a result of declines in assets under
management due to changes in prices of securities. We also run the risk that asset management fees calculated by reference to performance
could be lower. For variable annuity and variable life insurance products with minimum guaranteed death benefits and variable annuity
products with living benefits such as guaranteed minimum income, withdrawal, and accumulation benefits, we also face the risk that
declines in the value of underlying investments as a result of changes in prices of securities may increase our net exposure to such benefits
under these contracts. As part of our risk management strategy, we hedge the living benefit features of our variable annuity contracts, with
the exception of guaranteed minimum income benefits, using interest rate and equity based derivatives. See Note 19 to the Consolidated
Financial Statements for a discussion of our use of interest rate and equity based derivatives. See Note 9 to our Consolidated Financial
Statements for additional information about the guaranteed minimum death benefits associated with our variable life and variable annuity
contracts, and the guaranteed minimum income, withdrawal, and accumulation benefits associated with the variable annuity contracts we
issue. For a discussion of asset based fees associated with our variable life products and our variable annuity contracts as well as the impact
of our guaranteed minimum death and other benefits on the results of our Individual Life and Individual Annuities segments; see
“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations for Financial Services
Businesses by Segment—Insurance Division—Individual Life” and “Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Results of Operations for Financial Services Businesses by Segment—Insurance Division—Individual Annuities.”
We manage our exposure to equity price risk relating to our general account investments primarily by seeking to match the risk profile
of equity investments against risk-adjusted equity market benchmarks. We measure benchmark risk levels in terms of price volatility in
relation to the market in general.
The sources of our exposure to market risk can be divided into two categories, “other than trading” activities conducted primarily in
our insurance and annuity operations, and “trading” activities conducted primarily in our equity and derivatives trading operations. As part
of our management of both “other than trading” and “trading” market risks, we use a variety of risk management tools and techniques.
These include sensitivity and Value-at-Risk, or VaR, measures, position and other limits based on type of risk, and various hedging
methods.
Other Than Trading Activities
We hold the majority of our assets for “other than trading” activities in our segments that offer insurance and annuities products. We
incorporate asset/liability management techniques and other risk management policies and limits into the process of investing our assets.
We use derivatives for hedging purposes in the asset/liability management process.
Insurance and Annuities Products Asset/Liability Management
We seek to maintain interest rate and equity exposures within established ranges, which we periodically adjust based on market
conditions and the design of related products sold to customers. Our risk managers establish investment risk limits for exposures to any
issuer, geographic region, type of security or industry sector and oversee efforts to manage risk within policy constraints set by
management and approved by the Investment Committee of the Board of Directors.
We use duration and convexity analyses to measure price sensitivity to interest rate changes. Duration measures the relative sensitivity
of the fair value of a financial instrument to changes in interest rates. Convexity measures the rate of change of duration with respect to
changes in interest rates. We seek to manage our interest rate exposure by legal entity by matching the relative sensitivity of asset and
liability values to interest rate changes, or controlling “duration mismatch” of assets and liabilities. We have target duration mismatch
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