Prudential 2007 Annual Report Download - page 174

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
20. SEGMENT INFORMATION (continued)
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 $78 million, gains of $42 million and losses of $55 million for the years ended December 31, 2007,
2006 and 2005, respectively). As of December 31, 2007 and 2006, the fair value of open contracts used for this purpose was a net asset of
$12 million and $105 million, respectively.
The Company uses interest rate and currency swaps and other derivatives to manage interest and currency exchange rate exposures
arising from mismatches between assets and liabilities, including duration mismatches. For the derivative contracts that do not qualify for
hedge accounting treatment, mark-to-market adjustments of open contracts as well as periodic settlements are included in “Realized
investment gains (losses), net.” However, the periodic swap settlements, as well as other derivative related yield adjustments, are included
in adjusted operating income to reflect the after-hedge yield of the underlying instruments. Adjusted operating income includes gains of
$76 million, $58 million and $54 million for the years ended December 31, 2007, 2006 and 2005, respectively, due to periodic settlements
and yield adjustments of such contracts.
Certain products the Company sells are accounted for as freestanding derivatives or contain embedded derivatives. Changes in the fair
value of these derivatives, along with any fees received or payments made relating to the derivative, are recorded in “Realized investment
gains (losses), net.” These “Realized investment gains (losses), net” are included in adjusted operating income in the period in which the
gain or loss is recorded. In addition, the changes in fair value of any associated derivative portfolio that is part of an economic hedging
program related to the risk of these products (but which do not qualify for hedge accounting treatment under U.S. GAAP) are also included
in adjusted operating income in the period in which the gains or losses on the derivative portfolio are recorded. Adjusted operating income
includes gains of $46 million, $15 million and $6 million for the years ended December 31, 2007, 2006 and 2005, respectively, related to
these products and any associated derivative portfolio.
The Company invests in fixed maturities that, in addition to a stated coupon, provide a return based upon the results of an underlying
portfolio of fixed income investments and related investment activity. The Company accounts for these investments as available for sale
fixed maturities containing embedded derivatives that are marked to market through “Realized investment gains (losses), net,” based upon
the change in value of the underlying portfolio. Adjusted operating income includes cumulative realized investment losses, and recoveries
of such losses, on the embedded derivative in the period they occur. Cumulative realized investment gains above the original fair value of
the embedded derivative are deferred and amortized into adjusted operating income over the remaining life of the investment. Adjusted
operating income includes losses of $148 million, $9 million and $11 million for the years ended December 31, 2007, 2006 and 2005,
respectively, related to these embedded derivatives.
Adjustments are also made for the purposes of calculating adjusted operating income for the following items:
Within the Company’s Asset Management segment, its commercial mortgage operations originate loans for sale, including through
securitization transactions. The “Realized investment gains (losses), net” associated with these loans, including related derivative results
and retained mortgage servicing rights, are a principal source of earnings for this business and are included in adjusted operating income.
Also within the Company's Asset Management segment, its proprietary investing business makes investments for sale or syndication to
other investors or for placement or co-investment in the Company’s managed funds and structured products. The “Realized investment
gains (losses), net” associated with the sale of these proprietary investments are a principal source of earnings for this business and are
included in adjusted operating income. In addition, “Realized investment gains (losses), net” from derivatives used to hedge certain foreign
currency-denominated proprietary investments are included in adjusted operating income. Net realized investment losses of $22 million,
and gains of $109 million and $108 million related to these businesses were included in adjusted operating income for the years ended
December 31, 2007, 2006 and 2005, respectively.
The Company’s Japanese insurance operations invest in “dual currency” fixed maturities and loans, which pay interest in U.S. dollars,
while the principal is payable in Japanese yen. For fixed maturities that are categorized as held to maturity, and loans where the Company’s
intent is to hold them to maturity, the change in value related to foreign currency fluctuations associated with the U.S. dollar interest
payments is recorded in “Asset management fees and other income.” Since these investments will be held until maturity, the foreign
exchange impact will ultimately be realized as net investment income as earned. Therefore the change in value related to foreign currency
fluctuations recorded within “Asset management fees and other income” is excluded from adjusted operating income and is reflected as an
adjustment to “Realized investment gains (losses), net.” These adjustments were a net loss of $22 million, a net loss of $7 million, and a net
gain of $19 million for the years ended December 31, 2007, 2006 and 2005, respectively.
172 Prudential Financial 2007 Annual Report