Derivative Instruments

6 Months Ended

Jun. 30, 2011

Derivative Instruments

Derivative Instruments

8. DERIVATIVE INSTRUMENTS

Types of Derivative Instruments and Derivative Strategies

Interest Rate Contracts

Interest rate swaps are used by the Company to manage interest rate exposures arising from mismatches between assets and liabilities (including duration mismatches) and to hedge against changes in the value of assets it anticipates acquiring and other anticipated transactions and commitments. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating rate interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the contract and no principal payments are made by either party. These transactions are entered into pursuant to a master agreement that provides for a single net payment to be made by one counterparty at each due date.

Equity Contracts

Equity index options are contracts which will settle in cash based on differentials in the underlying indices at the time of exercise and the strike price. The Company uses combinations of purchases and sales of equity index options to hedge the effects of adverse changes in equity indices within a predetermined range. These hedges do not qualify for hedge accounting.

Foreign Exchange Contracts

Currency swaps are used by the Company to reduce risks from changes in currency exchange rates with respect to investments denominated in foreign currencies that the Company either holds or intends to acquire or sell. Under currency swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between one currency and another at an exchange rate and calculated by reference to an agreed principal amount. Generally, the principal amount of each currency is exchanged at the beginning and termination of the currency swap by each party. These transactions are entered into pursuant to a master agreement that provides for a single net payment to be made by one counterparty for payments made in the same currency at each due date.

Credit Contracts

Credit derivatives are used by the Company to enhance the return on the Company's investment portfolio by creating credit exposure similar to an investment in public fixed maturity cash instruments. With credit derivatives the Company sells credit protection on an identified name, or a basket of names in a first to default structure, and in return receives a quarterly premium. With single name credit default derivatives, this premium or credit spread generally corresponds to the difference between the yield on the referenced name's public fixed maturity cash instruments and swap rates, at the time the agreement is executed. With first to default baskets, the premium generally corresponds to a high proportion of the sum of the credit spreads of the names in the basket. If there is an event of default by the referenced name or one of the referenced names in a basket, as defined by the agreement, then the Company is obligated to pay the counterparty the referenced amount of the contract and receive in return the referenced defaulted security or similar security.

Embedded Derivatives

The Company has sold variable annuity contracts that include certain optional living benefit features that are treated, for accounting purposes, as embedded derivatives. The Company has affiliated reinsurance agreements with Pruco Reinsurance, Ltd. ("Pruco Re") and The Prudential Insurance Company of America ("Prudential Insurance") to transfer the risk related to certain of these embedded derivatives. The embedded derivatives related to the living benefit features and the related reinsurance agreements are carried at fair value. Mark-to-market changes in the fair value of the underlying contractual guarantees are determined using valuation models as described in Note 7, and are recorded in "Realized investment gains/(losses), net."

The fair value of the living benefit feature embedded derivatives included in "Future policy benefits" was a liability of $95.6 million as of June 30, 2011 and liability of $164.3 million as of December 31, 2010. The fair value of the embedded derivatives related to the reinsurance of certain of these benefits to Pruco Re included in "Reinsurance Recoverable" was an asset of $118.6 million as of June 30, 2011 and an asset of $186.7 million as of December 31, 2010.

Primarily in the reinsurance affiliate, equity options and futures as well as interest rate derivatives are purchased to hedge the living benefit features accounted for as embedded derivatives against changes in equity markets, interest rates, and market volatility. Prior to the third quarter of 2010, the hedging strategy sought to generally match the sensitivities of the embedded derivative liability as defined by GAAP, excluding the impact of the market-perceived risk of non-performance, with capital market derivatives. In the third quarter of 2010, the hedging strategy was revised as, in a low interest rate environment, management of the company and reinsurance affiliates does not believe the GAAP value of the embedded derivative liability to be an appropriate measure for determining the hedge target. The new hedge target is grounded in a GAAP/capital markets valuation framework but incorporates modifications to the risk-free return assumption to account for the fact that the underlying customer separate account funds which support these living benefits are invested in assets that contain risk. The modifications include the removal of a volatility risk margin embedded in the valuation technique used to fair value the embedded derivative liability under GAAP, and the inclusion of a credit spread over the risk-free rate used to estimate future growth of bond investments in the customer separate account funds. This new strategy will result in differences each period between the change in the value of the embedded derivative liability as defined by GAAP and the change in the value of the hedge positions, potentially increasing volatility in GAAP earnings in the Company and the reinsurance affiliate, and increasing volatility in the amortization of deferred acquisition and other costs of the Company as a result of the gross profits impact. In addition, management of the Company and reinsurance affiliates evaluates hedge levels versus the target given the overall capital considerations of our ultimate parent Company, Prudential Financial Inc., and prevailing capital market conditions and may decide to temporarily hedge to an amount that differs from the hedge target definition.

In the second quarter of 2009, the Company began the expansion of our hedging program to include a portion of the market exposure related to our overall capital position including the impact of certain statutory reserve exposures. These capital hedges primarily consisted of equity-based total return swaps that were designed to partially offset changes in our capital position resulting from market driven changes in certain living and death benefit features of our variable annuity products. During the second quarter of 2010, the capital hedge program was terminated in lieu of a new program managed at the Prudential Financial level that more broadly addresses equity market exposure of the overall statutory capital of Prudential Financial and its subsidiaries, as a whole under stress scenarios. A portion of the derivatives related to the new program were purchased by the Company.

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. Such embedded derivatives are marked to market through "Realized investment gains (losses), net," based upon the change in value of the underlying portfolio.

The table below provides a summary of the gross notional amount and fair value of derivatives contracts, excluding embedded derivatives which are recorded with the associated host, by the primary underlying. Many derivative instruments contain multiple underlyings.

	June 30, 2011							December 31, 2010
	Notional		Fair Value					Notional		Fair Value
	Amount		Assets		Liabilities			Amount		Assets		Liabilities
	(in thousands)
Qualifying Hedge Relationships
Currency/Interest Rate	$	36,071	$	—	$	(4,223	)	$	36,072	$	152	$	(2,606	)
Total Qualifying Hedge Relationships	$	36,071	$	—	$	(4,223	)	$	36,072	$	152	$	(2,606	)
Non-qualifying Hedge Relationships
Interest Rate	$	1,685,450	$	70,557	$	(14,060	)	$	913,700	$	56,896	$	(6,727	)
Credit		399,050		2,547		(2,688	)		350,050		2,810		(3,104	)
Currency/Interest Rate		58,150		72		(6,825	)		60,439		1,622		(6,829	)
Equity		13,142,043		27,435		(18,746	)		10,374,514		30,278		(21,492	)
Total Non-Qualifying Hedge Relationships	$	15,284,693	$	100,611	$	(42,319	)	$	11,698,703	$	91,606	$	(38,152	)
Total Derivatives (1)	$	15,320,764	$	100,611	$	(46,542	)	$	11,734,775	$	91,758	$	(40,758	)

(1) Excludes embedded derivatives which contain multiple underlyings. The fair value of these embedded derivatives was a liability of $97.8 million as of June 30, 2011 and a liability of $166.8 million as of December 31, 2010 included in "Future policy benefits" and "Fixed maturities available for sale."

Cash Flow Hedges

The Company uses currency swaps in its cash flow hedge accounting relationships. This instrument is only designated for hedge accounting in instances where the appropriate criteria are met. The Company does not use futures, options, credit, and equity or embedded derivatives in any of its cash flow hedge accounting relationships.

The following table provides the financial statement classification and impact of derivatives used in qualifying and non-qualifying hedge relationships, excluding the offset of the hedged item in an effective hedge relationship:

	Three Months Ended
	June 30,
	2011			2010
	(in thousands)
Qualifying
Cash Flow Hedges
Currency/Interest Rate
Net investment income	$	(31	)	$	17
Other income		(15	)		26
Accumulated other comprehensive income (loss) (1)		(674	)		2,460
Total cash flow hedges	$	(720	)	$	2,503
Non-qualifying hedges
Realized investment gains (losses), net
Interest Rate	$	17,592		$	47,870
Currency/Interest Rate		(1,019	)		6,881
Credit		323			(183	)
Equity		(4,311	)		34,367
Embedded Derivatives (2)		(17,917	)		(35,349	)
Total non-qualifying hedges	$	(5,332	)	$	53,586
Total Derivative Impact	$	(6,052	)	$	56,089

(1) Amounts deferred in Equity

(2) Primarily includes the following: 1) mark-to-market on embedded derivatives of $144.1 million; 2) fees ceded of $68.7 million; offset by 3) change in reinsurance recoverable of $138.5 million; and 4) fees attributed to embedded derivative of $56.3 million as of June 30, 2011.

	Six Months Ended June 30,
	2011			2010
	(in thousands)
Qualifying
Cash Flow Hedges
Currency/Interest Rate
Net investment income	$	(39	)	$	24
Other income		(51	)		24
Accumulated other comprehensive income (loss) (1)		(1,738	)		2,191
Total cash flow hedges	$	(1,828	)	$	2,239
Non-qualifying hedges
Realized investment gains (losses), net
Interest Rate	$	15,428		$	59,852
Currency/Interest Rate		(2,795	)		7,411
Credit		611			(222	)
Equity		(13,916	)		18,648
Embedded Derivatives (2)		(21,608	)		(38,803	)
Total non-qualifying hedges	$	(22,280	)	$	46,886
Total Derivative Impact	$	(24,108	)	$	49,125

(1) Amounts deferred in Equity

(2) Primarily includes the following: 1) mark-to-market on embedded derivatives of $(68.7) million; 2) fees ceded of $125.1 million; offset by 3) change in reinsurance recoverable of $(68.1) million; and 4) fees attributed to embedded derivative of $111.1 million as of June 30, 2011.

For the three and six months ended June 30, 2011 the ineffective portion of derivatives accounted for using hedge accounting was not material to the Company's results of operations and there were no material amounts reclassified into earnings relating to instances in which the Company discontinued cash flow hedge accounting because the forecasted transaction did not occur by the anticipated date or within the additional time period permitted by the authoritative guidance for the accounting for derivatives and hedging.

Presented below is a roll forward of current period cash flow hedges in "Accumulated other comprehensive income (loss)" before taxes:

	(in thousands)
Balance, December 31, 2010	$	(2,462	)
Net deferred gains on cash flow hedges from January 1 to June 30, 2011		(1,828	)
Amount reclassified into current period earnings		90
Balance, June 30, 2011	$	(4,200	)

As of June 30, 2011, the Company does not have any qualifying cash flow hedges of forecasted transactions other than those related to the variability of the payment or receipt of interest or foreign currency amounts on existing financial instruments. The maximum length of time for which these variable cash flows are hedged is 6 years. Income amounts deferred in "Accumulated Other Comprehensive Income (Loss))" as a result of cash flow hedges are included in "Net unrealized investment gains (losses)" in the Statements of Equity.

Credit Derivatives Written

The following tables set forth the Company's exposure from credit derivatives where the Company has written credit protection, excluding embedded derivatives contained in externally-managed investments in European markets, by NAIC rating of the underlying credits as of the dates indicated.

NAIC Designation (1)	Rating Agency Equivalent	June 30, 2011
		Single Name
		Notional		Fair Value
		(in thousands)
1	Aaa, Aa, A	$	344,000	$	2,223
2	Baa		25,000		310
	Subtotal Investment Grade		369,000		2,533
3	Ba		—		—
4	B		—		—
5	C and Lower		—		—
6	In or near default		—		—
	Subtotal Below Investment Grade		—		—
	Total	$	369,000	$	2,533

(1) First-to-default credit swap baskets, which may include credits of varying qualities, are grouped above based on the lowest credit in the basket. However, such basket swaps may entail greater credit risk than the rating level of the lowest credit.

NAIC Designation (1)	Rating Agency Equivalent	December 31, 2010
		Single Name
		Notional		Fair Value
		(in thousands)
1	Aaa, Aa, A	$	290,000	$	2,297
2	Baa		25,000		374
	Subtotal Investment Grade		315,000		2,671
3	Ba		—		—
4	B		—		—
5	C and Lower		—		—
6	In or near default		—		—
	Subtotal Below Investment Grade		—		—
	Total	$	315,000	$	2,671

(1) First-to-default credit swap baskets, which may include credits of varying qualities, are grouped above based on the lowest credit in the basket. However, such basket swaps may entail greater credit risk than the rating level of the lowest credit.

The following table sets forth the composition of the Company's credit derivatives where it has written credit protection, excluding embedded derivatives contained in externally-managed investments in European markets, by industry category as of the dates indicated.

	June 30, 2011				December 31, 2010
Industry	Notional		Fair Value		Notional		Fair Value
	(in thousands)
Corporate Securities:
Manufacturing	$	40,000	$	258	$	40,000	$	249
Finance		54,000		186		—		—
Services		20,000		96		20,000		101
Energy		20,000		186		20,000		220
Transportation		25,000		157		25,000		203
Retail and Wholesale		20,000		162		20,000		189
Other		190,000		1,488		190,000		1,709
First to Default Baskets (1)		—		—		—		—
Total Credit Derivatives	$	369,000	$	2,533	$	315,000	$	2,671

(1) Credit default baskets may include various industry categories.

The Company writes credit derivatives under which the Company is obligated to pay a related party counterparty the referenced amount of the contract and receive in return the defaulted security or similar security. The Company's maximum amount at risk under these credit derivatives, assuming the value of the underlying referenced securities become worthless, is $369.0 million notional of credit default swap ("CDS") selling protection at June 30, 2011. These credit derivatives generally have maturities of five years or less.

The Company holds certain externally-managed investments in the European market which contain embedded derivatives whose fair value are primarily driven by changes in credit spreads. These investments are medium term notes that are collateralized by investment portfolios primarily consisting of investment grade European fixed income securities, including corporate bonds and asset-backed securities, and derivatives, as well as varying degrees of leverage. The notes have a stated coupon and provide a return based on the performance of the underlying portfolios and the level of leverage. The Company invests in these notes to earn a coupon through maturity, consistent with its investment purpose for other debt securities. The notes are accounted for under U.S. GAAP as available for sale fixed maturity securities with bifurcated embedded derivatives (total return swaps). Changes in the value of the fixed maturity securities are reported in Stockholders' Equity under the heading "Accumulated Other Comprehensive Income (Loss)" and changes in the market value of the embedded total return swaps are included in current period earnings in "Realized investment gains (losses), net." The Company's maximum exposure to loss from these investments was $7.8 million and $7.5 million at June 30, 2011 and December 31, 2010, respectively.

In addition to selling credit protection, the Company has purchased credit protection using credit derivatives in order to hedge specific credit exposures in the Company's investment portfolio. As of June 30, 2011 the Company had $30.0 million of outstanding notional amounts reported at fair value as a liability of $2.7 million.

Credit Risk

The Company is exposed to credit-related losses in the event of non-performance by counterparties to financial derivative transactions. Generally, the credit exposure of the Company's over-the-counter (OTC) derivative transactions is represented by the contracts with a positive fair value (market value) at the reporting date after taking into consideration the existence of netting agreements.

The Company has credit risk exposure to an affiliate, Prudential Global Funding, LLC related to its over-the-counter derivative transactions. Prudential Global Funding, LLC manages credit risk with external counterparties by entering into derivative transactions with highly rated major international financial institutions and other creditworthy counterparties, and by obtaining collateral where appropriate, see Note 5.

Under fair value measurements, the Company incorporates the market's perceptions of its own and the counterparty's non-performance risk in determining the fair value of the portion of its OTC derivative assets and liabilities that are uncollateralized. Credit spreads are applied to the derivative fair values on a net basis by counterparty. To reflect the Company's own credit spread a proxy based on relevant debt spreads is applied to OTC derivative net liability positions. Similarly, the Company's counterparty's credit spread is applied to OTC derivative net asset positions.