Download Derivatives Market Risk Related to Certain Variable

We manage our foreign currency exchange rate risks within specified limits, and using VaR-based analysis. This statistical technique
estimates, at a specified confidence level, the potential pre-tax loss in portfolio market value that could occur over an assumed time horizon
due to adverse market movements. For the unhedged portions of our equity investment in international subsidiaries and the foreign
currency-denominated investments held in our domestic general account portfolio, we estimate the hypothetical decline in VaR, as well as
the average VaR, each measured at a 95% confidence level and using a one-month time horizon. These calculations use historical price
volatilities and correlation data at a 95% confidence level. The following table sets forth these measures as of the periods indicated.
As of December 31, 2012
As of December 31, 2011
Fair
Estimated Average
Fair
Estimated Average
Value
VaR
VaR
Value
VaR
VaR
(in millions)
Unhedged portion of equity investment in international subsidiaries and foreign
currency-denominated investments in domestic general account portfolio(1) . . . . .
$4,373
$(79)
$(101)
$4,322
$(176)
$(137)
(1) Excludes assets and liabilities subject to the impact of foreign exchange rate movements that are hedged with externally-purchased derivatives or are
economically matched, as discussed above.
The decrease in VaR as of December 31, 2012 was driven by a lower level of foreign exchange rate volatility. For derivatives used to hedge
the anticipated level of U.S. dollar-equivalent earnings of our international operations, the estimated hypothetical decline in VaR, measured at a
95% confidence level and using a one-month time horizon was $81 million and $135 million as of December 31, 2012 and December 31, 2011,
respectively. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—
General Account Investments—Portfolio Composition,” and “Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Results of Operations for Financial Services Businesses by Segment—International Insurance Division.”
Although VaR models are a recognized tool for risk management, they have inherent limitations, including reliance on historical data
that may not be indicative of future market conditions or trading patterns. Accordingly, VaR models should not be viewed as a predictor of
future results. We may incur losses that could be materially in excess of the amounts indicated by the models on a particular trading day or
over a period of time, and there have been instances when results have fallen outside the values generated by our VaR models. A VaR
model does not estimate the greatest possible loss. The results of these models and analysis thereof are subject to the judgment of our risk
management personnel.
Derivatives
We use derivative financial instruments primarily to reduce market risk from changes in interest rates, equity prices and foreign
currency exchange rates, including to alter interest rate or foreign currency exposures arising from mismatches between assets and
liabilities. Our derivatives primarily include swaps, futures, options and forward contracts that are exchange-traded or contracted in the
over-the-counter market.
Our derivatives also include interest rate guarantees we provide on our synthetic GIC products. Synthetic GICs simulate the
performance of traditional insurance-related GICs but, under U.S. GAAP, are accounted for as derivatives due to the fact that the
policyholders own the underlying assets, and we only provide a book value “wrap” on the customers’ funds, which are held in a clientowned trust. Since these wraps provide payment of guaranteed principal and interest to the customer, changes in interest rates create risk
that declines in the market value of customers’ funds would increase our net exposure to these guarantees. However, this risk is minimal
due to several mitigating factors. Our obligation is limited to payments that are in excess of the existing customers’ fund value.
Additionally, we have the ability to periodically reset crediting rates, subject to a 0% minimum floor, as well as the ability to increase
prices. Further, our contract provisions provide that, although participants may withdraw funds at book value, contractholder withdrawals
may only occur at market value immediately or at book value over time. These factors, among others, result in these contracts experiencing
minimal changes in fair value, despite a more significant notional value.
Our derivatives also include those that are embedded in certain financial instruments, and primarily relate to certain optional living
benefit features associated with our variable annuity products, as discussed in more detail in “Market Risk Related to Certain Variable
Annuity Products” below.
The notional amount of derivative instruments increased $72 billion in 2012, from $223 billion as of December 31, 2011 to $295
billion as of December 31, 2012. The increase was related to sales of investment-only stable value synthetic GIC products, our variable
annuity hedging activities, and our capital hedge program. For additional information on our derivative activities, see Note 21 to the
Consolidated Financial Statements.
Market Risk Related to Certain Variable Annuity Products
The primary risk exposures of our variable annuity contracts relate to actual deviations from, or changes to, the assumptions used in
the original pricing of these products, including capital markets assumptions, such as equity market returns, interest rates and market
volatility, and actuarial assumptions. For our capital markets assumptions, we hedge or limit our exposure to the risk created by capital
markets fluctuations through a combination of product design elements, such as an automatic rebalancing element and inclusion of certain
optional living benefits in our living benefits hedging program. Certain variable annuity products with optional living benefit features are
accounted for as an embedded derivative and recorded at fair value. The market risk sensitivities associated with U.S. GAAP values of both
the embedded derivatives and the related derivatives used to hedge the changes in fair value of these embedded derivatives is provided
under “Market Risk Related to Interest Rates” and “Market Risk Related to Equity Prices” above.
For additional information regarding our risk management strategies, including our living benefit hedging program and other product
design elements, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations for
Financial Services Businesses by Segment—Individual Annuities.”
Prudential Financial, Inc. 2012 Annual Report
103