Prudential 2007 Annual Report Download - page 95

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
constraints for each entity. In certain markets, primarily outside the U.S., capital market limitations that hinder our ability to closely
approximate the duration of some of our liabilities are considered in setting the constraint limits. As of December 31, 2007 and 2006, the
difference between the pre-tax duration of assets and the target duration of liabilities in our duration managed portfolios was within our
constraint limits. We consider risk-based capital implications in our asset/liability management strategies.
We also perform portfolio stress testing as part of our U.S. regulatory cash flow testing for major product lines that are subject to risk
from changes in interest rates. In this testing, we evaluate the impact of altering our interest-sensitive assumptions under various
moderately adverse interest rate environments. These interest-sensitive assumptions relate to the timing and amount of redemptions and
prepayments of fixed-income securities and lapses and surrenders of insurance products and the potential impact of any guaranteed
minimum interest rates. We evaluate any shortfalls that this cash flow testing reveals to determine if we need to increase statutory reserves
or adjust portfolio management strategies.
Market Risk Related to Interest Rates
Our “other than trading” assets that subject us to interest rate risk include primarily fixed maturity securities, commercial loans and
policy loans. In the aggregate, the carrying value of these assets represented 76% of our consolidated assets, other than assets that we held
in separate accounts, as of December 31, 2007 and 77% as of December 31, 2006.
With respect to “other than trading” liabilities, we are exposed to interest rate risk through policyholder account balances relating to
interest-sensitive life insurance, annuity and other investment-type contracts, collectively referred to as investment contracts, and through
outstanding short-term and long-term debt.
We assess interest rate sensitivity for “other than trading” financial assets, financial liabilities and derivatives using hypothetical test
scenarios that assume either upward or downward 100 basis point parallel shifts in the yield curve from prevailing interest rates. The
following tables set forth the net estimated potential loss in fair value from a hypothetical 100 basis point upward shift as of December 31,
2007 and 2006, because this scenario results in the greatest net exposure to interest rate risk of the hypothetical scenarios tested at those
dates. While the test scenario is for illustrative purposes only and does not reflect our expectations regarding future interest rates or the
performance of fixed-income markets, it is a near-term, reasonably possible hypothetical change that illustrates the potential impact of such
events. These test scenarios do not measure the changes in value that could result from non-parallel shifts in the yield curve, which we
would expect to produce different changes in discount rates for different maturities. As a result, the actual loss in fair value from a 100
basis point change in interest rates could be different from that indicated by these calculations.
As of December 31, 2007
Notional
Amount of
Derivatives
Fair
Value
Hypothetical Fair
Value After + 100
Basis Point Parallel
Yield Curve Shift
Hypothetical
Change in
Fair Value
(in millions)
Financial assets with interest rate risk:
Fixed maturities ...................................................... $179,940 $169,374 $(10,566)
Commercial loans .................................................... 28,323 27,123 (1,200)
Mortgage bank-loan inventory(1) ........................................ 2,298 2,248 (50)
Policy loans ......................................................... 10,751 10,055 (696)
Derivatives:
Swaps .......................................................... $59,266 (525) (944) (419)
Futures ......................................................... 4,812 (7) 19 26
Options ........................................................ 4,759 627 557 (70)
Forwards ....................................................... 8,851 72 71 (1)
Variable Annuity Living Benefit Feature Embedded Derivatives ........... (168) 17 185
Financial liabilities with interest rate risk:
Short-term and long-term debt ...................................... (29,737) (28,597) 1,140
Investment contracts .............................................. (66,574) (65,330) 1,244
Bank customer liabilities ........................................... (1,334) (1,329) 5
Net estimated potential loss ................................................. $(10,402)
Prudential Financial 2007 Annual Report 93