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Derivative Instruments
 6 Months Ended
Jun. 30, 2014
Derivative Instruments  
Derivative Instruments

5. DERIVATIVE INSTRUMENTS

 

Types of Derivative Instruments and Derivative Strategies

 

Interest Rate Contracts 

 

Interest rate swaps are used by the Company to reduce risks from changes in interest rates, 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 owns or anticipates acquiring or selling. 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 master agreements that provide 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.

 

Total return swaps are contracts whereby the Company agrees with other parties to exchange, at specified intervals, the difference between the return on an asset (or market index) and LIBOR based on a notional amount. The Company generally uses total return swaps to hedge the effect of adverse changes in equity indices.

 

Foreign Exchange Contracts

Currency derivatives, including 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 master agreements that provide 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, and in return receives a quarterly premium. With 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. If there is an event of default by the referenced name, 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 or pay the referenced amount less the auction recovery rate. See credit derivatives written section for discussion of guarantees related to credit derivatives written. 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.

Embedded Derivatives

The Company sells variable annuity products, which may include guaranteed benefit features that are accounted for as embedded derivatives. The Company has reinsurance agreements to transfer the risk related to certain of these benefit features to affiliates, Pruco Re and The Prudential Insurance Company of America (“Prudential Insurance”). The embedded derivatives related to the living benefit features and the related reinsurance agreements are carried at fair value. These embedded derivatives are marked to market through “Realized investment gains (losses), net” based on the change in value of the underlying contractual guarantees, which are determined using valuation models, as described in Note 4.

The fair value of the living benefit feature embedded derivatives included in "Future policy benefits" was a liability of $1,663 million and $778 million as of June 30, 2014 and December 31, 2013, respectively. The fair value of the embedded derivatives related to the reinsurance of certain of these benefits to Pruco Re and Prudential Insurance included in "Reinsurance recoverables" was an asset of $1,595 million and $748 million as of June 30, 2014 and December 31, 2013, respectively.

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

 

    June 30, 2014 December 31, 2013
      Notional Gross Fair Value  Notional Gross Fair Value
       Amount Assets Liabilities   Amount Assets Liabilities
  (in thousands)
Derivatives Designated as Hedge Accounting Instruments:                  
Currency/Interest Rate $ 82,247 $ 739 $ (4,852) $ 72,747 $ 940 $ (4,635)
Total Qualifying Hedges $ 82,247 $ 739 $ (4,852) $ 72,747 $ 940 $ (4,635)
                   
Derivatives Not Qualifying as Hedge Accounting Instruments:                  
Interest Rate                  
Interest Rate Swaps $ 1,792,750 $ 77,502 $ (49,373) $ 1,533,750 $ 59,872 $ (80,601)
Interest Rate Options   100,000   8,780   -   100,000   6,534   -
Currency/Interest Rate                  
Foreign Currency Swaps   57,015   29   (1,723)   55,919   19   (1,349)
Credit                  
Credit Default Swaps   1,200   -   (71)   6,050   -   (115)
Equity                  
Total Return Swaps   210,652   232   (1,004)   219,896   -   (4,712)
Equity Options   11,567,467   446   (108)   13,170,805   6,170   (3,168)
Total Non-Qualifying Hedges $ 13,729,084 $ 86,989 $ (52,279) $ 15,086,420 $ 72,595 $ (89,945)
                      
Total Derivatives (1) $ 13,811,331 $ 87,728 $ (57,131) $ 15,158,667 $ 73,535 $ (94,580)

(1) Excludes embedded derivatives which contain multiple underlyings. The fair value of these embedded derivatives was a liability of $1,663 million and $778 million as of June 30, 2014 and December 31, 2013, respectively, included in “Future policy benefits.” The fair value of the embedded derivatives related to the reinsurance of certain of these benefits to Pruco Re and Prudential Insurance included in "Reinsurance recoverables" was an asset of $1,595 million and $748 million as of June 30, 2014 and December 31, 2013, respectively.

Offsetting Assets and Liabilities

 

The following table presents recognized derivative instruments (including bifurcated embedded derivatives) that are offset in the balance sheet, and/or are subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in the balance sheet.

     June 30, 2014
        Gross Net      
     Gross Amounts Amounts      
     Amounts of Offset in the Presented in      
     Recognized Statement of the Statement Financial   
     Financial  Financial  of Financial  Instruments/ Net
     Instruments Position Position Collateral Amount
                   
     (in thousands)
Offsetting of Financial Assets:               
Derivatives $87,728 $(67,715) $20,013 $ (18,099) $ 1,914
                
Offsetting of Financial Liabilities:               
Derivatives $57,131 $(57,131) $ - $ - $ -
                
                   
     December 31, 2013
        Gross Net      
     Gross Amounts Amounts      
     Amounts of Offset in the Presented in      
     Recognized Statement of the Statement Financial   
     Financial  Financial  of Financial  Instruments/ Net
     Instruments Position Position Collateral Amount
                   
     (in thousands)
Offsetting of Financial Assets:               
Derivatives $73,535 $(73,535) $ - $ - $ -
                
Offsetting of Financial Liabilities:               
Derivatives $94,580 $(72,822) $21,758 $ (24,491) $ (2,733)

For information regarding the rights of offset associated with the derivative assets and liabilities in the table above see “Credit Risk” below.

 

Cash Flow Hedges

 

The primary derivative instruments used by the Company in its cash flow hedge accounting relationships are currency swaps. These instruments are only designated for hedge accounting in instances where the appropriate criteria are met. The Company does not use futures, options, credit, equity or embedded derivatives in any of its cash flow hedge accounting relationships.

 

The following tables provide 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, 2014
      Realized Investment Gains/(Losses)  Net Investment Income  Other Income  Accumulated Other Comprehensive Income (Loss) (1)
     (in thousands)
Derivatives Designated as Hedging Instruments:           
Cash flow hedges           
    Currency/Interest Rate $ - $ (5) $ (15) $ (1,060)
    Total cash flow hedges   -   (5)   (15)   (1,060)
                
Derivatives Not Qualifying as Hedging Instruments:           
    Interest Rate   26,012   -   -   -
    Currency   -   -   -   -
    Currency/Interest Rate   (1,038)   -   (9)   -
    Credit   (4)   -   -   -
    Equity   (11,334)   -   -   -
    Embedded Derivatives  (17,902)   -   -   -
    Total non-qualifying hedges   (4,266)   -   (9)   -
Total$ (4,266) $ (5) $ (24) $ (1,060)
                
     Six Months Ended June 30, 2014
      Realized Investment Gains/(Losses)  Net Investment Income  Other Income  Accumulated Other Comprehensive Income (Loss) (1)
     (in thousands)
Derivatives Designated as Hedging Instruments:           
Cash flow hedges           
    Currency/Interest Rate $ -   (17)   (17)   (423)
    Total cash flow hedges   -   (17)   (17)   (423)
                
Derivatives Not Qualifying as Hedging Instruments:           
    Interest Rate   63,598   -   -   -
    Currency   -   -   -   -
    Currency/Interest Rate   (214)   -   8   -
    Credit   (11)   -   -   -
    Equity   (15,982)   -   -   -
    Embedded Derivatives  (52,635)   -   -   -
    Total non-qualifying hedges   (5,244)   -   8   -
Total$ (5,244)   (17)   (9)   (423)
                
     Three Months Ended June 30, 2013
      Realized Investment Gains/(Losses)  Net Investment Income  Other Income  Accumulated Other Comprehensive Income (Loss) (1)
     (in thousands)
Derivatives Designated as Hedging Instruments:           
Cash flow hedges           
    Currency/Interest Rate $ -   (16)   27   598
    Total cash flow hedges   -   (16)   27   598
                
Derivatives Not Qualifying as Hedging Instruments:           
    Interest Rate   (56,393)   -   -   -
    Currency   -   -   -   -
    Currency/Interest Rate   474   -   46   -
    Credit   (22)   -   -   -
    Equity   (10,976)   -   -   -
    Embedded Derivatives  18,078   -   -   -
    Total non-qualifying hedges   (48,839)   -   46   -
Total$ (48,839)   (16)   73   598
                
                
     Six Months Ended June 30, 2013
      Realized Investment Gains/(Losses)  Net Investment Income  Other Income  Accumulated Other Comprehensive Income (Loss) (1)
     (in thousands)
Derivatives Designated as Hedging Instruments:           
Cash flow hedges           
    Currency/Interest Rate $ -   (50)   32   2,343
    Total cash flow hedges   -   (50)   32   2,343
                
Derivatives Not Qualifying as Hedging Instruments:           
    Interest Rate   (82,230)   -   -   -
    Currency   -   -   -   -
    Currency/Interest Rate   1,784   -   41   -
    Credit   (59)   -   -   -
    Equity   (41,427)   -   -   -
    Embedded Derivatives  32,267   -   -   -
    Total non-qualifying hedges   (89,665)   -   41   -
Total$ (89,665)   (50)   73   2,343

(1) Amounts deferred in “Accumulated other comprehensive income (loss).”

For the three months ended June 30, 2014 and 2013, 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 rollforward of current period cash flow hedges in “Accumulated other comprehensive income (loss)” before taxes:

     (in thousands)
Balance, December 31, 2013   (3,653)
Net deferred gains (losses) on cash flow hedges from January 1 to June 30, 2014   (457)
Amount reclassified into current period earnings   34
       
Balance, June 30, 2014 $ (4,076)

As of June 30, 2014 and 2013, the Company did 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 19 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 Unaudited Interim Statements of Equity.

Credit Derivatives Written

 

The Company no longer has exposure from credit derivatives where it has written credit protection as of June 30, 2014 and December 31, 2013.

 

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, 2014 and December 31, 2013, the Company had $1 million and $6 million of outstanding notional amounts, respectively, reported at fair value as a liability of less than $1 million for both periods.

 

Credit Risk

 

The Company is exposed to credit-related losses in the event of non-performance by its counterparty to financial derivative transactions.

 

The Company has credit risk exposure to an affiliate, Prudential Global Funding, LLC (“PGF”), related to its over-the-counter (“OTC”) derivative transactions. PGF 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. Additionally, limits are set on single party credit exposures which are subject to periodic management review.

 

Under fair value measurements, the Company incorporates the market's perception 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.