Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2006

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Transition Period from              to             

 

Commission File Number 001-16707

 


 

Prudential Financial, Inc.

(Exact Name of Registrant as Specified in its Charter)

 


 

New Jersey   22-3703799

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification Number)

 

751 Broad Street

Newark, New Jersey 07102

(973) 802-6000

(Address and Telephone Number of Registrant’s Principal Executive Offices)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x    No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x   Accelerated filer  ¨   Non-accelerated filer  ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

As of June 30, 2006, 485 million shares of the registrant’s Common Stock (par value $0.01) were outstanding. In addition, 2 million shares of the registrant’s Class B Stock, for which there is no established public trading market, were outstanding.

 



Table of Contents

TABLE OF CONTENTS

 

            

Page

Number


PART I

  FINANCIAL INFORMATION     
    Item 1.   Financial Statements:     
       

Unaudited Interim Consolidated Statements of Financial Position as of June 30, 2006 and December 31, 2005

   1
       

Unaudited Interim Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005

   2
       

Unaudited Interim Consolidated Statement of Stockholders’ Equity for the six months ended June 30, 2006

   3
       

Unaudited Interim Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005

   4
       

Notes to Unaudited Interim Consolidated Financial Statements

   5
       

Unaudited Interim Supplemental Combining Financial Information:

    
       

Unaudited Interim Supplemental Combining Statements of Financial Position as of June 30, 2006 and December 31, 2005

   34
       

Unaudited Interim Supplemental Combining Statements of Operations for the three months ended June 30, 2006 and 2005

   35
       

Unaudited Interim Supplemental Combining Statements of Operations for the six months ended June 30, 2006 and 2005

   36
       

Notes to Unaudited Interim Supplemental Combining Financial Information

   37
    Item 2.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   39
    Item 3.  

Quantitative and Qualitative Disclosures About Market Risk

   113
    Item 4.  

Controls and Procedures

   113

PART II

  OTHER INFORMATION     
    Item 1.   Legal Proceedings    114
    Item 1A.   Risk Factors    115
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    115
    Item 4.   Submission of Matters to a Vote of Security Holders    116
    Item 6.   Exhibits    116

SIGNATURES

           117

 

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FORWARD-LOOKING STATEMENTS

 

Certain of the statements included in this Quarterly Report on Form 10-Q, including but not limited to those in Management’s Discussion and Analysis of Financial Condition and Results of Operations, constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Words such as “expects,” “believes,” “anticipates,” “includes,” “plans,” “assumes,” “estimates,” “projects,” “intends,” “should,” “will,” “shall” or variations of such words are generally part of forward-looking statements. Forward-looking statements are made based on management’s current expectations and beliefs concerning future developments and their potential effects upon Prudential Financial, Inc. and its subsidiaries. There can be no assurance that future developments affecting Prudential Financial, Inc. and its subsidiaries will be those anticipated by management. These forward-looking statements are not a guarantee of future performance and involve risks and uncertainties, and there are certain important factors that could cause actual results to differ, possibly materially, from expectations or estimates reflected in such forward-looking statements, including, among others: (1) general economic, market and political conditions, including the performance and fluctuations of stock, real estate and other financial markets; (2) interest rate fluctuations; (3) reestimates of our reserves for future policy benefits and claims; (4) differences between actual experience regarding mortality, morbidity, persistency, surrender experience, interest rates or market returns and the assumptions we use in pricing our products, establishing liabilities and reserves or for other purposes; (5) changes in our assumptions related to deferred policy acquisition costs, valuation of business acquired or goodwill; (6) changes in our claims-paying or credit ratings; (7) investment losses and defaults; (8) competition in our product lines and for personnel; (9) changes in tax law; (10) economic, political, currency and other risks relating to our international operations; (11) fluctuations in foreign currency exchange rates and foreign securities markets; (12) regulatory or legislative changes; (13) adverse determinations in litigation or regulatory matters and our exposure to contingent liabilities, including in connection with our divestiture or winding down of businesses; (14) domestic or international military actions, natural or man-made disasters including terrorist activities or pandemic disease, or other events resulting in catastrophic loss of life; (15) ineffectiveness of risk management policies and procedures in identifying, monitoring and managing risks; (16) effects of acquisitions, divestitures and restructurings, including possible difficulties in integrating and realizing the projected results of acquisitions; (17) changes in statutory or U.S. GAAP accounting principles, practices or policies; (18) changes in assumptions for retirement expense; (19) Prudential Financial, Inc.’s primary reliance, as a holding company, on dividends or distributions from its subsidiaries to meet debt payment obligations and continue share repurchases, and the applicable regulatory restrictions on the ability of the subsidiaries to pay such dividends or distributions; and (20) risks due to the lack of legal separation between our Financial Services Businesses and our Closed Block Business. Prudential Financial, Inc. does not intend, and is under no obligation, to update any particular forward-looking statement included in this document. See “Risk Factors” included in the Annual Report on Form 10-K for the year ended December 31, 2005 for discussion of certain risks relating to our businesses and investment in our securities.

 

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Table of Contents

Throughout this Quarterly Report on Form 10-Q, “Prudential Financial” and the “Registrant” refer to Prudential Financial, Inc., the ultimate holding company for all of our companies. “Prudential Insurance” refers to The Prudential Insurance Company of America, before and after its demutualization on December 18, 2001. “Prudential,” the “Company,” “we” and “our” refer to our consolidated operations before and after demutualization.

 

PART I—FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

 

PRUDENTIAL FINANCIAL, INC.

Unaudited Interim Consolidated Statements of Financial Position

June 30, 2006 and December 31, 2005 (in millions, except share amounts)

 

    

June 30,

2006


   

December 31,

2005


 

ASSETS

                

Fixed maturities:

                

Available for sale, at fair value (amortized cost: 2006—$155,546; 2005—$148,706)

   $ 156,317     $ 154,434  

Held to maturity, at amortized cost (fair value: 2006—$3,416; 2005—$3,228)

     3,555       3,249  

Trading account assets supporting insurance liabilities, at fair value

     14,239       13,781  

Other trading account assets, at fair value

     4,561       1,443  

Equity securities, available for sale, at fair value (cost: 2006—$5,352; 2005—$4,951)

     6,190       5,843  

Commercial loans

     25,260       24,441  

Policy loans

     8,660       8,370  

Securities purchased under agreements to resell

     2,242       413  

Other long-term investments

     5,877       5,468  

Short-term investments

     3,957       3,959  
    


 


Total investments

     230,858       221,401  
    


 


Cash and cash equivalents

     8,411       7,799  

Accrued investment income

     2,148       2,067  

Reinsurance recoverables

     1,869       3,548  

Deferred policy acquisition costs

     10,316       9,438  

Other assets

     20,338       15,962  

Separate account assets

     166,735       157,561  
    


 


TOTAL ASSETS

   $ 440,675     $ 417,776  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY

                

LIABILITIES

                

Future policy benefits

   $ 105,911     $ 102,039  

Policyholders’ account balances

     79,681       75,492  

Policyholders’ dividends

     2,536       4,413  

Reinsurance payables

     1,351       3,069  

Securities sold under agreements to repurchase

     15,057       12,517  

Cash collateral for loaned securities

     6,208       5,818  

Income taxes payable

     2,124       2,214  

Securities sold but not yet purchased

     2,152       223  

Short-term debt

     11,461       11,114  

Long-term debt

     9,270       8,270  

Other liabilities

     16,695       12,283  

Separate account liabilities

     166,735       157,561  
    


 


Total liabilities

     419,181       395,013  
    


 


COMMITMENTS AND CONTINGENT LIABILITIES (See Note 10)

                

STOCKHOLDERS’ EQUITY

                

Preferred Stock ($.01 par value; 10,000,000 shares authorized; none issued)

     —         —    

Common Stock ($.01 par value; 1,500,000,000 shares authorized; 604,899,300 and 604,899,046 shares issued as of June 30, 2006 and December 31, 2005, respectively)

     6       6  

Class B Stock ($.01 par value; 10,000,000 shares authorized; 2,000,000 shares issued and outstanding as of June 30, 2006 and December 31, 2005, respectively)

     —         —    

Additional paid-in capital

     20,549       20,501  

Common Stock held in treasury, at cost (120,332,076 and 107,405,004 shares as of June 30, 2006 and December 31, 2005, respectively)

     (6,026 )     (4,925 )

Accumulated other comprehensive income (loss)

     (145 )     1,234  

Retained earnings

     7,110       5,947  
    


 


Total stockholders’ equity

     21,494       22,763  
    


 


TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 440,675     $ 417,776  
    


 


 

See Notes to Unaudited Interim Consolidated Financial Statements

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Consolidated Statements of Operations

Three and Six Months Ended June 30, 2006 and 2005 (in millions, except per share amounts)

 

    

Three Months
Ended

June 30,


   

Six Months

Ended

June 30,


 
     2006

    2005

    2006

    2005

 

REVENUES

                                

Premiums

   $ 3,515     $ 3,552     $ 6,967     $ 6,918  

Policy charges and fee income

     674       615       1,338       1,229  

Net investment income

     2,776       2,584       5,515       5,135  

Realized investment gains (losses), net

     (318 )     521       (142 )     994  

Asset management fees and other income

     785       1,063       1,675       1,788  
    


 


 


 


Total revenues

     7,432       8,335       15,353       16,064  
    


 


 


 


BENEFITS AND EXPENSES

                                

Policyholders’ benefits

     3,636       3,564       7,116       7,018  

Interest credited to policyholders’ account balances

     582       803       1,205       1,356  

Dividends to policyholders

     527       724       1,151       1,332  

General and administrative expenses

     2,029       1,928       4,182       3,724  
    


 


 


 


Total benefits and expenses

     6,774       7,019       13,654       13,430  
    


 


 


 


INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES

     658       1,316       1,699       2,634  
    


 


 


 


Income tax expense

     190       389       495       777  
    


 


 


 


INCOME FROM CONTINUING OPERATIONS

     468       927       1,204       1,857  
    


 


 


 


Loss from discontinued operations, net of taxes

     (15 )     (44 )     (18 )     (45 )
    


 


 


 


NET INCOME

   $ 453     $ 883     $ 1,186     $ 1,812  
    


 


 


 


EARNINGS PER SHARE (See Note 6)

                                

Financial Services Businesses

                                

Basic:

                                

Income from continuing operations per share of Common Stock

   $ 0.93     $ 1.59     $ 2.34     $ 3.10  

Loss from discontinued operations, net of taxes

     (0.03 )     (0.09 )     (0.03 )     (0.09 )
    


 


 


 


Net income per share of Common Stock

   $ 0.90     $ 1.50     $ 2.31     $ 3.01  
    


 


 


 


Diluted:

                                

Income from continuing operations per share of Common Stock

   $ 0.92     $ 1.56     $ 2.30     $ 3.04  

Loss from discontinued operations, net of taxes

     (0.03 )     (0.08 )     (0.03 )     (0.08 )
    


 


 


 


Net income per share of Common Stock

   $ 0.89     $ 1.48     $ 2.27     $ 2.96  
    


 


 


 


Closed Block Business

                                

Net income per share of Class B Stock – basic and diluted

   $ 6.50     $ 53.50     $ 26.00     $ 124.00  
    


 


 


 


 

See Notes to Unaudited Interim Consolidated Financial Statements

 

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PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Consolidated Statement of Stockholders’ Equity

Six Months Ended June 30, 2006 (in millions)

 

     Common
Stock


  

Class B

Stock


  

Additional

Paid-in

Capital


  

Retained

Earnings

(Deficit)


   

Common

Stock
Held In
Treasury


   

Accumulated
Other

Comprehensive

Income / (Loss)


   

Total
Stockholders’

Equity


 

Balance, December 31, 2005

   $ 6    $ —      $ 20,501    $ 5,947     $ (4,925 )   $ 1,234     $ 22,763  

Common Stock acquired

     —        —        —        —         (1,248 )     —         (1,248 )

Stock-based compensation programs

     —        —        48      (23 )     147       —         172  

Comprehensive income (loss):

                                                     

Net income

     —        —        —        1,186       —         —         1,186  

Other comprehensive loss, net of taxes

     —        —        —        —         —         (1,379 )     (1,379 )
                                                 


Total comprehensive income (loss)

     —        —        —        —         —         —         (193 )
    

  

  

  


 


 


 


Balance, June 30, 2006

   $ 6    $ —      $ 20,549    $ 7,110     $ (6,026 )   $ (145 )   $ 21,494  
    

  

  

  


 


 


 


 

 

See Notes to Unaudited Interim Consolidated Financial Statements

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Consolidated Statements of Cash Flows

Six Months Ended June 30, 2006 and 2005 (in millions)

 

     2006

    2005

 

CASH FLOWS FROM OPERATING ACTIVITIES

                

Net income

   $ 1,186     $ 1,812  

Adjustments to reconcile net income to net cash provided by operating activities:

                

Realized investment (gains) losses, net

     142       (994 )

Policy charges and fee income

     (437 )     (429 )

Interest credited to policyholders’ account balances

     1,205       1,356  

Depreciation and amortization, including premiums and discounts

     136       257  

Change in:

                

Deferred policy acquisition costs

     (455 )     (393 )

Future policy benefits and other insurance liabilities

     1,249       1,573  

Trading account assets supporting insurance liabilities and other trading account assets

     (946 )     (509 )

Income taxes payable

     461       142  

Securities sold but not yet purchased

     (119 )     (283 )

Other, net

     (2,483 )     28  
    


 


Cash flows from (used in) operating activities

     (61 )     2,560  
    


 


CASH FLOWS FROM INVESTING ACTIVITIES

                

Proceeds from the sale/maturity/prepayment of:

                

Fixed maturities, available for sale

     52,798       43,426  

Fixed maturities, held to maturity

     164       233  

Equity securities, available for sale

     2,152       1,414  

Commercial loans

     2,383       2,920  

Policy loans

     587       667  

Other long-term investments

     778       615  

Short-term investments

     6,952       6,619  

Payments for the purchase of:

                

Fixed maturities, available for sale

     (56,344 )     (50,326 )

Fixed maturities, held to maturity

     (290 )     (830 )

Equity securities, available for sale

     (2,259 )     (1,592 )

Commercial loans

     (2,780 )     (1,880 )

Policy loans

     (692 )     (567 )

Other long-term investments

     (629 )     (277 )

Short-term investments

     (6,710 )     (6,804 )

Acquisition of businesses, net of cash acquired

     724       —    

Other, net

     (169 )     404  
    


 


Cash flows used in investing activities

     (3,335 )     (5,978 )
    


 


CASH FLOWS FROM FINANCING ACTIVITIES

                

Policyholders’ account deposits

     11,576       10,010  

Policyholders’ account withdrawals

     (10,487 )     (9,427 )

Net change in securities sold under agreements to repurchase and cash collateral for loaned securities

     2,920       353  

Cash dividends paid on Common Stock

     (51 )     (43 )

Net change in financing arrangements (maturities 90 days or less)

     142       2,600  

Common Stock acquired

     (1,231 )     (832 )

Common Stock reissued for exercise of stock options

     79       96  

Proceeds from the issuance of debt (maturities longer than 90 days)

     1,642       1,493  

Repayments of debt (maturities longer than 90 days)

     (604 )     (747 )

Cash payments to or in respect of eligible policyholders

     (93 )     (121 )

Excess tax benefits from share-based payment arrangements

     42       —    

Other, net

     (6 )     256  
    


 


Cash flows from financing activities

     3,929       3,638  
    


 


Effect of foreign exchange rate changes on cash balances

     79       (7 )

NET INCREASE IN CASH AND CASH EQUIVALENTS

     612       213  

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR

     7,799       8,072  
    


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 8,411     $ 8,285  
    


 


 

See Notes to Unaudited Interim Consolidated Financial Statements

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements

 

1. BUSINESS AND BASIS OF PRESENTATION

 

Prudential Financial, Inc. (“Prudential Financial”) and its subsidiaries (collectively, “Prudential” or the “Company”) provide a wide range of insurance, investment management, and other financial products and services to both retail and institutional customers throughout the United States and in many other countries. Principal products and services provided include life insurance, annuities, mutual funds, pension and retirement related investments and administration, and asset management. In addition, the Company provides securities brokerage services indirectly through a minority ownership in a joint venture. The Company has organized its principal operations into the Financial Services Businesses and the Closed Block Business. The Financial Services Businesses operate through three operating divisions: Insurance, Investment, and International Insurance and Investments. The Company’s real estate and relocation services business as well as businesses that are not sufficiently material to warrant separate disclosure and businesses to be divested are included in Corporate and Other operations within the Financial Services Businesses. The Closed Block Business, which includes the Closed Block (see Note 4), is managed separately from the Financial Services Businesses. The Closed Block Business was established on the date of demutualization and includes the Company’s in force participating insurance and annuity products and assets that are used for the payment of benefits and policyholder dividends on these products, as well as other assets and equity that support these products and related liabilities. In connection with the demutualization, the Company has ceased offering these participating products.

 

Basis of Presentation

 

The Unaudited Interim Consolidated Financial Statements include the accounts of Prudential Financial, entities over which the Company exercises control, including majority-owned subsidiaries and minority-owned entities such as limited partnerships in which the Company is the general partner, and variable interest entities in which the Company is considered the primary beneficiary. The Unaudited Interim Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) on a basis consistent with reporting interim financial information in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (“SEC”). Intercompany balances and transactions have been eliminated.

 

In the opinion of management, all adjustments necessary for a fair statement of the financial position and results of operations have been made. All such adjustments are of a normal, recurring nature. Interim results are not necessarily indicative of the results that may be expected for the full year. These financial statements should be read in conjunction with the Company’s audited Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

The most significant estimates include those used in determining deferred policy acquisition costs, goodwill, valuation of business acquired, investments, future policy benefits, pension and other postretirement benefits, provision for income taxes, reserves for contingent liabilities and reserves for losses in connection with unresolved legal matters.

 

Reclassifications

 

Certain amounts in prior periods have been reclassified to conform to the current period presentation.

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

2. ACCOUNTING POLICIES AND PRONOUNCEMENTS

 

Accounting Pronouncements Adopted

 

In November 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” This FSP provides impairment models for determining whether to record impairment losses associated with investments in certain equity and debt securities, primarily by referencing existing accounting guidance. It also requires income to be accrued on a level-yield basis following an impairment of debt securities, where reasonable estimates of the timing and amount of future cash flows can be made. The Company adopted this guidance effective January 1, 2006, and it did not have a material effect on the Company’s consolidated results of operations.

 

In June 2005, the Emerging Issues Task Force (“EITF”) of the FASB reached a consensus on Issue No. 04-5, “Investor’s Accounting for an Investment in a Limited Partnership When the Investor Is the Sole General Partner and the Limited Partners Have Certain Rights.” This Issue first presumes that general partners in a limited partnership control that partnership and should therefore consolidate that partnership, and then provides that the general partners may overcome the presumption of control if the limited partners have: (1) the substantive ability to dissolve or liquidate the limited partnership, or otherwise to remove the general partners without cause or (2) the ability to participate effectively in significant decisions that would be expected to be made in the ordinary course of the limited partnership’s business. This guidance became effective for new or amended arrangements after June 29, 2005, and became effective January 1, 2006 for all arrangements existing as of June 29, 2005 that remain unmodified. The Company’s adoption of this guidance did not have a material effect on the Company’s consolidated financial position or results of operations.

 

In June 2005, the FASB issued Statement No. 133 Implementation Issue No. B39, “Embedded Derivatives: Application of Paragraph 13(b) to Call Options That are Exercisable Only by the Debtor.” Implementation Issue No. B39 indicates that debt instruments where the right to accelerate the settlement of debt can be exercised only by the debtor do not meet the criteria of Paragraph 13(b) of Statement No. 133, and therefore should not individually lead to such options being considered embedded derivatives. Such options must still be evaluated under paragraph 13(a) of Statement No. 133. This implementation guidance is effective for the first fiscal quarter beginning after December 15, 2005. The Company’s adoption of this guidance effective January 1, 2006 did not have a material effect on the Company’s consolidated financial position or results of operations as the guidance is consistent with the Company’s existing accounting policy.

 

Adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”

 

The Company adopted SFAS No. 123(R), “Share-Based Payment” on January 1, 2006. This standard requires that the cost resulting from all share-based payments be recognized in the financial statements and requires all entities to apply the fair value based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. As described more fully below, the Company had previously adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended, prospectively for all new stock options granted to employees on or after January 1, 2003. Upon adoption of SFAS No. 123(R), there were no unvested stock options issued prior to January 1, 2003, and, therefore, the adoption of SFAS No. 123(R) had no impact to the Company’s consolidated financial condition or results of operations. Upon the adoption of SFAS No. 123(R), the Company revised its approach to the recognition of compensation costs for awards granted to retirement-eligible employees and awards that vest when an employee becomes retirement-eligible, as described more fully below.

 

The Company issues employee share-based compensation awards, under a plan authorized by the Board of Directors, that are subject to specific vesting conditions; generally the awards vest ratably over a three-year

 

6


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

period, “the nominal vesting period,” or at the date the employee retires (as defined by the plan), if earlier. For awards granted prior to January 1, 2006 that specify an employee vests in the award upon retirement, the Company accounts for those awards using the nominal vesting period approach. Under this approach, the Company records compensation expense over the nominal vesting period. If the employee retires before the end of the nominal vesting period, any remaining unrecognized compensation cost is recognized at the date of retirement.

 

Upon the adoption of SFAS No. 123(R), the Company revised its approach to apply the non-substantive vesting period approach to all new share-based compensation awards granted after January 1, 2006. Under this approach, all compensation cost is recognized on the date of grant for awards issued to retirement-eligible employees, or over the period from the grant date to the date retirement eligibility is achieved, if that is expected to occur during the nominal vesting period. The Company continues to apply the nominal vesting period approach for the portion of unvested outstanding awards issued prior to the adoption of SFAS No. 123(R).

 

If the Company had accounted for all share-based compensation awards granted after January 1, 2003 under the non-substantive vesting period approach, net income of the Financial Services Businesses for the three and six months ended June 30, 2006 would have been increased by $3 million, or $0.01 per share of Common Stock, on both a basic and diluted basis, and $6 million, or $0.01 per share of Common Stock, on both a basic and diluted basis, respectively. Net income of the Financial Services Businesses for the three and six months ended June 30, 2005 would have been decreased by $3 million, or $0.01 per share of Common Stock, on both a basic and diluted basis, and $6 million, or $0.01 per share of Common Stock, on both a basic and diluted basis, respectively.

 

7


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

As noted above, effective January 1, 2003, the Company changed its accounting for employee stock options to adopt the fair value recognition provisions of SFAS No. 123, as amended, prospectively for all new stock options granted to employees on or after January 1, 2003. Prior to January 1, 2003, the Company accounted for employee stock options using the intrinsic value method of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under this method, the Company did not recognize any stock-based compensation expense for employee stock options as all options granted had an exercise price equal to the market value of the underlying Common Stock on the date of grant. If the Company had accounted for all employee stock options granted prior to January 1, 2003 under the fair value-based measurement method of SFAS No. 123, net income and earnings per share for the three and six months ended June 30, 2006 would have been unchanged, since, as of January 1, 2006, there were no unvested employee stock options issued prior to January 1, 2003. Net income and earnings per share for the three and six months ended June 30, 2005, would have been as follows:

 

    

Three Months Ended

June 30, 2005


  

Six Months Ended

June 30, 2005


     Financial
Services
Businesses


    Closed
Block
Business


   Financial
Services
Businesses


    Closed
Block
Business


     (in millions, except per share amounts)

Net income, as reported

   $ 754     $ 129    $ 1,520     $ 292

Add: Total employee stock option compensation expense included in reported net income, net of taxes

     8       —        14       —  

Deduct: Total employee stock option compensation expense determined under the fair value based method for all awards, net of taxes

     (12 )     —        (23 )     —  
    


 

  


 

Pro forma net income

   $ 750     $ 129    $ 1,511     $ 292
    


 

  


 

Earnings per share:

                             

Basic—as reported

   $ 1.50     $ 53.50    $ 3.01     $ 124.00
    


 

  


 

Basic—pro forma

   $ 1.49     $ 53.50    $ 3.00     $ 124.00
    


 

  


 

Diluted—as reported

   $ 1.48     $ 53.50    $ 2.96     $ 124.00
    


 

  


 

Diluted—pro forma

   $ 1.47     $ 53.50    $ 2.95     $ 124.00
    


 

  


 

 

The fair value of each option issued prior to January 1, 2003 for purposes of the pro forma information presented above was estimated on the date of grant using a Black-Scholes option-pricing model. For options issued on or after January 1, 2003, the fair value of each option was estimated on the date of grant using a binomial option-pricing model.

 

The Company accounts for non-employee stock options using the fair value method in accordance with EITF No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees” and related interpretations in accounting for its non-employee stock options.

 

Recent Accounting Pronouncements

 

In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes” an interpretation of FASB Statement No. 109. This Interpretation prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that a company has taken or expects to take on a tax return. This Interpretation is effective for fiscal

 

8


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

years beginning after December 15, 2006. The Company will adopt FIN No. 48 on January 1, 2007. The Company is currently assessing the impact of FIN No. 48 on the Company’s consolidated financial position, results of operations and notes to the consolidated financial statements.

 

In July 2006, the FASB issued FSP No. 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction” an amendment of FASB Statement No. 13. This Staff Position indicates that a change or projected change in the timing of cash flows relating to income taxes generated by a leveraged lease would require a recalculation of cumulative and prospective income recognition associated with the transaction. This Staff Position is effective for fiscal years beginning after December 15, 2006. The Company will adopt FSP No. 13-2 on January 1, 2007. The Company is currently assessing the impact of FSP No. 13-2 on the Company’s consolidated financial position and results of operations.

 

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets.” This statement requires that servicing assets or liabilities are to be initially measured at fair value, with subsequent changes in value reported based on either a fair value or amortized cost approach. Under the previous guidance, such servicing assets or liabilities were initially measured at historical cost and the amortized cost method was required for subsequent reporting. The Company plans to adopt this guidance effective January 1, 2007. The Company is currently assessing the impact of SFAS No. 156 on the Company’s consolidated financial position and results of operations.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments.” This statement provides an election, on an instrument by instrument basis, to measure at fair value an entire hybrid financial instrument that contains an embedded derivative requiring bifurcation, rather than measuring only the embedded derivative on a fair value basis. This statement also removes an exception from the requirement to bifurcate an embedded derivative feature from a beneficial interest in securitized financial assets. The Company has used this exception for investments the Company has made in securitized financial assets in the normal course of operations, and thus has not previously had to consider whether such investments contain an embedded derivative. The new requirement to identify embedded derivatives in beneficial interest will be applied on a prospective basis only to beneficial interest acquired, issued, or subject to certain remeasurement conditions after the adoption date of the new guidance. The Company plans to adopt this guidance effective January 1, 2007. The Company is in the process of determining whether there are any hybrid instruments for which the Company will elect the fair value option.

 

In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.” SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract, and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company will adopt SOP 05-1 on January 1, 2007. The Company is currently assessing the impact of SOP 05-1 on the Company’s consolidated financial position and results of operations.

 

9


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

3. ACQUISITIONS AND DISPOSITIONS

 

Acquisition of The Allstate Corporation’s Variable Annuity Business

 

On June 1, 2006 (the “date of acquisition”), the Company acquired the variable annuity business of The Allstate Corporation (“Allstate”) through a reinsurance transaction for $635 million of total consideration, consisting primarily of a $628 million ceding commission. The reinsurance arrangements with Allstate include a coinsurance arrangement associated with the general account liabilities assumed and a modified coinsurance arrangement associated with the separate account liabilities assumed. The assets acquired and liabilities assumed have been included in the Company’s consolidated financial statements as of the date of acquisition. The Company’s results of operations include the results of the acquired variable annuity business beginning from the date of acquisition. The assets acquired included primarily cash of $1.4 billion that was subsequently used to purchase investments; valuation of business acquired (“VOBA”) of $674 million that represents the present value of future profits embedded in the acquired contracts; and $101 million of goodwill. The liabilities assumed included primarily a liability for variable annuity contractholders’ account balances of $1.5 billion associated with the coinsurance agreement. The assets acquired and liabilities assumed also included a reinsurance receivable from Allstate and a reinsurance payable to Allstate, each in the amount of $14.8 billion. The reinsurance payable, which represents the Company’s obligation under the modified coinsurance arrangement, is netted with the reinsurance receivable in the Company’s Statement of Financial Position. Pro forma information for this acquisition is omitted as the impact is not material.

 

Acquisition of CIGNA Corporation’s (“CIGNA”) Retirement Business

 

The Company acquired the retirement business of CIGNA for cash consideration of $2.1 billion on April 1, 2004 and the results of this business have been included in the Company’s consolidated results since the date of acquisition. As an element of the acquisition, the Company had the right, beginning two years after the acquisition, to commute the modified-coinsurance-with-assumption arrangement related to the acquired defined benefit guaranteed-cost contracts in exchange for cash consideration from CIGNA. Effective April 1, 2006, the Company reached an agreement with CIGNA to convert the modified-coinsurance-with-assumption arrangement to an indemnity coinsurance arrangement, effectively retaining the economics of the defined benefit guaranteed-cost contracts for the life of the block of business. Upon conversion, the Company extinguished its reinsurance receivable and payable with CIGNA related to the modified-coinsurance-with-assumption arrangement. Concurrently, the Company assumed $1.7 billion of liabilities from CIGNA under the indemnity coinsurance arrangement and received the related assets.

 

Discontinued Operations

 

Loss from discontinued businesses, including charges upon disposition, are as follows:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Philippine insurance operations

   $ (15 )   $ —       $ (15 )   $ —    

Dryden Wealth Management

     (2 )     (41 )     (4 )     (50 )

International securities operations

     (3 )     (8 )     (5 )     (12 )

Healthcare operations

     —         —         —         18  
    


 


 


 


Loss from discontinued operations before income taxes

     (20 )     (49 )     (24 )     (44 )

Income tax expense (benefit)

     (5 )     (5 )     (6 )     1  
    


 


 


 


Loss from discontinued operations, net of taxes

   $ (15 )   $ (44 )   $ (18 )   $ (45 )
    


 


 


 


 

10


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The Company’s Unaudited Interim Consolidated Statements of Financial Position include total assets and total liabilities related to discontinued businesses of $183 million and $118 million, respectively, as of June 30, 2006 and $258 million and $207 million, respectively, as of December 31, 2005. Charges recorded in connection with the disposals of businesses include estimates that are subject to subsequent adjustment. It is possible that such adjustments might be material to future net results of operations of a particular quarterly or annual period.

 

4. CLOSED BLOCK

 

On the date of demutualization, Prudential Insurance established a Closed Block for certain individual life insurance policies and annuities issued by Prudential Insurance in the U.S. The recorded assets and liabilities were allocated to the Closed Block at their historical carrying amounts. The Closed Block forms the principal component of the Closed Block Business.

 

The policies included in the Closed Block are specified individual life insurance policies and individual annuity contracts that were in force on the effective date of the Plan of Reorganization and for which Prudential Insurance is currently paying or expects to pay experience-based policy dividends. Assets have been allocated to the Closed Block in an amount that has been determined to produce cash flows which, together with revenues from policies included in the Closed Block, are expected to be sufficient to support obligations and liabilities relating to these policies, including provision for payment of benefits, certain expenses, and taxes and to provide for continuation of the policyholder dividend scales in effect in 2000, assuming experience underlying such scales continues. To the extent that, over time, cash flows from the assets allocated to the Closed Block and claims and other experience related to the Closed Block are, in the aggregate, more or less favorable than what was assumed when the Closed Block was established, total dividends paid to Closed Block policyholders in the future may be greater than or less than the total dividends that would have been paid to these policyholders if the policyholder dividend scales in effect in 2000 had been continued. Any cash flows in excess of amounts assumed will be available for distribution over time to Closed Block policyholders and will not be available to stockholders. If the Closed Block has insufficient funds to make guaranteed policy benefit payments, such payments will be made from assets outside of the Closed Block. The Closed Block will continue in effect as long as any policy in the Closed Block remains in force unless, with the consent of the New Jersey insurance regulator, it is terminated earlier.

 

The excess of Closed Block Liabilities over Closed Block Assets at the date of the demutualization (adjusted to eliminate the impact of related amounts in “Accumulated other comprehensive income (loss)”) represented the estimated maximum future earnings at that date from the Closed Block expected to result from operations attributed to the Closed Block after income taxes. In establishing the Closed Block, the Company developed an actuarial calculation of the timing of such maximum future earnings. If actual cumulative earnings of the Closed Block from inception through the end of any given period are greater than the expected cumulative earnings, only the expected earnings will be recognized in income. Any excess of actual cumulative earnings over expected cumulative earnings will represent undistributed accumulated earnings attributable to policyholders, which are recorded as a policyholder dividend obligation. The policyholder dividend obligation represents amounts to be paid to Closed Block policyholders as an additional policyholder dividend unless otherwise offset by future Closed Block performance that is less favorable than originally expected. If the actual cumulative earnings of the Closed Block from its inception through the end of any given period are less than the expected cumulative earnings of the Closed Block, the Company will recognize only the actual earnings in income. However, the Company may reduce policyholder dividend scales in the future, which would be intended to increase future actual earnings until the actual cumulative earnings equaled the expected cumulative earnings. At June 30, 2006, the Company recognized a policyholder dividend obligation of $251 million to Closed Block policyholders for the excess of actual cumulative earnings over the expected cumulative earnings. Additionally, net unrealized investment gains that have arisen subsequent to the establishment of the Closed Block were

 

11


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

reflected as a policyholder dividend obligation of $628 million at June 30, 2006 to be paid to Closed Block policyholders unless otherwise offset by future experience, with an offsetting amount reported in “Accumulated other comprehensive income (loss).”

 

Closed Block Liabilities and Assets designated to the Closed Block, as well as maximum future earnings to be recognized from Closed Block Liabilities and Closed Block Assets, are as follows:

 

    

June 30,

2006


    December 31,
2005


 
     (in millions)  

Closed Block Liabilities

                

Future policy benefits

   $ 50,391     $ 50,112  

Policyholders’ dividends payable

     1,095       1,089  

Policyholder dividend obligation

     879       2,628  

Policyholders’ account balances

     5,559       5,568  

Other Closed Block liabilities

     9,778       9,676  
    


 


Total Closed Block Liabilities

     67,702       69,073  
    


 


Closed Block Assets

                

Fixed maturities, available for sale, at fair value

     44,301       45,403  

Equity securities, available for sale, at fair value

     3,309       3,128  

Commercial loans

     6,730       6,750  

Policy loans

     5,407       5,403  

Other long-term investments

     783       923  

Short-term investments

     1,145       1,340  
    


 


Total investments

     61,675       62,947  

Cash and cash equivalents

     1,810       2,167  

Accrued investment income

     663       658  

Other Closed Block assets

     547       286  
    


 


Total Closed Block Assets

     64,695       66,058  
    


 


Excess of reported Closed Block Liabilities over Closed Block Assets

     3,007       3,015  

Portion of above representing accumulated other comprehensive income:

                

Net unrealized investment gains

     687       2,402  

Allocated to policyholder dividend obligation

     (628 )     (2,302 )
    


 


Future earnings to be recognized from Closed Block Assets and Closed Block Liabilities

   $ 3,066     $ 3,115  
    


 


 

Information regarding the policyholder dividend obligation is as follows:

 

     Six Months Ended
June 30, 2006


 
     (in millions)  

Balance, January 1, 2006

   $ 2,628  

Impact on income before gains allocable to policyholder dividend obligation

     (75 )

Change in unrealized investment gains

     (1,674 )
    


Balance, June 30, 2006

   $ 879  
    


 

12


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Closed Block revenues and benefits and expenses were as follows:

 

    

Three Months Ended

June 30,


  

Six Months Ended

June 30,


         2006    

        2005    

       2006    

        2005    

     (in millions)

Revenues

                             

Premiums

   $ 957     $ 964    $ 1,803     $ 1,809

Net investment income

     836       862      1,700       1,711

Realized investment gains (losses), net

     (23 )     208      36       412

Other income

     14       11      27       26
    


 

  


 

Total Closed Block revenues

     1,784       2,045      3,566       3,958
    


 

  


 

Benefits and Expenses

                             

Policyholders’ benefits

     1,072       1,076      2,004       2,018

Interest credited to policyholders’ account balances

     35       32      71       68

Dividends to policyholders

     503       619      1,106       1,190

General and administrative expenses

     186       182      369       362
    


 

  


 

Total Closed Block benefits and expenses

     1,796       1,909      3,550       3,638
    


 

  


 

Closed Block revenues, net of Closed Block benefits and expenses, before income taxes

     (12 )     136      16       320
    


 

  


 

Income tax expense (benefit)

     (48 )     25      (33 )     119
    


 

  


 

Closed Block revenues, net of Closed Block benefits and expenses and income taxes

   $ 36     $ 111    $ 49     $ 201
    


 

  


 

 

5. STOCKHOLDERS’ EQUITY

 

The Company has outstanding two classes of common stock: the Common Stock and the Class B Stock. The changes in the number of shares issued, held in treasury and outstanding are as follows for the periods indicated:

 

     Common Stock

    Class B Stock

     Issued

   Held In
Treasury


    Outstanding

    Issued and
Outstanding


     (in millions)

Balance, December 31, 2005

   604.9    107.4     497.5     2.0

Common Stock issued

   —      —       —       —  

Common Stock acquired

   —      16.4     (16.4 )   —  

Stock-based compensation programs(1)

   —      (3.5 )   3.5     —  
    
  

 

 

Balance, June 30, 2006

   604.9    120.3     484.6     2.0
    
  

 

 

(1) Represents net shares issued from Treasury pursuant to the Company’s stock-based compensation program.

 

Common Stock Held in Treasury

 

In November 2005, Prudential Financial’s Board of Directors authorized the Company to repurchase up to $2.5 billion of its outstanding Common Stock in calendar year 2006. The timing and amount of any repurchases under this authorization are determined by management based upon market conditions and other considerations, and the repurchases may be effected in the open market or through negotiated transactions. The 2006 stock repurchase program supersedes all previous repurchase programs. During the first six months of 2006, the Company acquired 16.4 million shares of its Common Stock at a total cost of $1.248 billion.

 

13


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Comprehensive Income

 

The components of comprehensive income are as follows:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Net income

   $ 453     $ 883     $ 1,186     $ 1,812  

Other comprehensive income (loss), net of taxes:

                                

Change in foreign currency translation adjustments

     136       (85 )     198       (150 )

Change in net unrealized investments gains (losses)(1)

     (873 )     746       (1,573 )     232  

Additional pension liability adjustment

     (3 )     3       (4 )     1  
    


 


 


 


Other comprehensive income (loss)(2)

     (740 )     664       (1,379 )     83  
    


 


 


 


Comprehensive income (loss)

   $ (287 )   $ 1,547     $ (193 )   $ 1,895  
    


 


 


 



(1) Includes cash flow hedges of $(34) million and $29 million for the three months ended June 30, 2006 and 2005, respectively, and $(41) million and $43 million for the six months ended June 30, 2006 and 2005, respectively.
(2) Amounts are net of taxes of $(452) million and $342 million for the three months ended June 30, 2006 and 2005, respectively, and $(797) million and $81 million for the six months ended June 30, 2006 and 2005, respectively.

 

The balance of and changes in each component of “Accumulated other comprehensive income” for the six months ended June 30, 2006 are as follows (net of taxes):

 

     Accumulated Other Comprehensive Income (Loss)

 
    

Foreign

Currency

Translation

Adjustments


   

Net

Unrealized

Investment

Gains (Losses)(1)


   

Pension

Liability

Adjustment


   

Total

Accumulated

Other

Comprehensive

Income (Loss)


 
     (in millions)  

Balance, December 31, 2005

   $ (75 )   $ 1,576     $ (267 )   $ 1,234  

Change in component during period

     198       (1,573 )     (4 )     (1,379 )
    


 


 


 


Balance, June 30, 2006

   $ 123     $ 3     $ (271 )   $ (145 )
    


 


 


 



(1) Includes cash flow hedges of $(119) million and $(78) million at June 30, 2006 and December 31, 2005, respectively.

 

14


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

6. EARNINGS PER SHARE

 

The Company has outstanding two separate classes of common stock. The Common Stock reflects the performance of the Financial Services Businesses and the Class B Stock reflects the performance of the Closed Block Business. Accordingly, earnings per share is calculated separately for each of these two classes of common stock.

 

Net income for the Financial Services Businesses and the Closed Block Business is determined in accordance with U.S. GAAP and includes general and administrative expenses charged to each of the respective businesses based on the Company’s methodology for the allocation of such expenses. Cash flows between the Financial Services Businesses and the Closed Block Business related to administrative expenses are determined by a policy servicing fee arrangement that is based upon insurance and policies in force and statutory cash premiums. To the extent reported administrative expenses vary from these cash flow amounts, the differences are recorded, on an after tax basis, as direct equity adjustments to the equity balances of the businesses. The direct equity adjustments modify the earnings available to each of the classes of common stock for earnings per share purposes.

 

Common Stock

 

A reconciliation of the numerators and denominators of the basic and diluted per share computations is as follows:

 

     Three Months Ended June 30,

     2006

   2005

     Income

   Weighted
Average
Shares


  

Per

Share

Amount


   Income

   Weighted
Average
Shares


  

Per

Share

Amount


     (in millions, except per share amounts)

Basic earnings per share

                                     

Income from continuing operations attributable to the Financial Services Businesses

   $ 439                $ 798            

Direct equity adjustment

     16                  22            
    

              

           

Income from continuing operations attributable to the Financial Services Businesses available to holders of Common Stock after direct equity adjustment

   $ 455    488.2    $ 0.93    $ 820    516.5    $ 1.59
    

  
  

  

  
  

Effect of dilutive securities and compensation programs

                                     

Stock options

          6.1                  5.8       

Deferred and long-term compensation programs

          2.8                  2.9       
           
                
      

Diluted earnings per share

                                     

Income from continuing operations attributable to the Financial Services Businesses available to holders of Common Stock after direct equity adjustment

   $ 455    497.1    $ 0.92    $ 820    525.2    $ 1.56
    

  
  

  

  
  

 

15


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

     Six Months Ended June 30,

     2006

   2005

     Income

   Weighted
Average
Shares


  

Per

Share

Amount


   Income

   Weighted
Average
Shares


  

Per

Share

Amount


     (in millions, except per share amounts)

Basic earnings per share

                                     

Income from continuing operations attributable to the Financial Services Businesses

   $ 1,117                $ 1,565            

Direct equity adjustment

     35                  44            
    

              

           

Income from continuing operations attributable to the Financial Services Businesses available to holders of Common Stock after direct equity adjustment

   $ 1,152    491.4    $ 2.34    $ 1,609    519.2    $ 3.10
    

  
  

  

  
  

Effect of dilutive securities and compensation programs

                                     

Stock options

          6.3                  5.6       

Deferred and long-term compensation programs

          2.9                  2.8       
           
                
      

Diluted earnings per share

                                     

Income from continuing operations attributable to the Financial Services Businesses available to holders of Common Stock after direct equity adjustment

   $ 1,152    500.6    $ 2.30    $ 1,609    527.6    $ 3.04
    

  
  

  

  
  

 

The Company’s convertible senior notes provide for the Company to issue shares of its Common Stock as a component of the conversion of the notes. The notes will be dilutive to earnings per share if the average market price of the Common Stock for a particular period is above $90.00.

 

For the three months ended June 30, 2006 and 2005, 2.2 million and 4.1 million options, respectively, weighted for the portion of the period they were outstanding, with a weighted average exercise price of $76.12 and $55.86 per share, respectively, were excluded from the computation of diluted earnings per share because the options, based on application of the treasury stock method, were antidilutive. For the six months ended June 30, 2006 and 2005, 1.8 million and 3.2 million options, respectively, weighted for the portion of the period they were outstanding, with a weighted average exercise price of $76.07 and $55.81 per share, respectively, were excluded from the computation of diluted earnings per share because the options, based on application of the treasury stock method, were antidilutive.

 

Class B Stock

 

Net income per share of Class B Stock was $6.50 and $53.50 for the three months ended June 30, 2006 and 2005, respectively, and $26.00 and $124.00 for the six months ended June 30, 2006 and 2005, respectively.

 

The net income attributable to the Closed Block Business available to holders of Class B Stock after direct equity adjustment for the three months ended June 30, 2006 and 2005 amounted to $13 million and $107 million, respectively. The direct equity adjustment resulted in a decrease in the net income attributable to the Closed Block Business applicable to holders of Class B Stock for earnings per share purposes of $16 million and $22 million for the three months ended June 30, 2006 and 2005, respectively. The net income attributable to the Closed Block Business available to holders of Class B Stock after direct equity adjustment for the six months ended June 30, 2006 and 2005 amounted to $52 million and $248 million, respectively. The direct equity adjustment resulted in a decrease in the net income attributable to the Closed Block Business applicable to

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

holders of Class B Stock for earnings per share purposes of $35 million and $44 million for the six months ended June 30, 2006 and 2005, respectively. For the three and six months ended June 30, 2006 and 2005, the weighted average number of shares of Class B Stock used in the calculation of earnings per share amounted to two million. There are no potentially dilutive shares associated with the Class B Stock.

 

7. SHARE-BASED PAYMENTS

 

In March 2003, the Company’s Board of Directors adopted the Prudential Financial, Inc. Omnibus Incentive Plan (the “Omnibus Plan”). Upon adoption of the Omnibus Plan, the Prudential Financial, Inc. Stock Option Plan previously adopted by the Company on January 9, 2001 (the “Option Plan”) was merged into the Omnibus Plan. The nature of stock based awards provided under the Omnibus Plan are stock options, stock appreciation rights, restricted stock shares, restricted stock units, and equity-based performance awards (“performance shares”). Dividend equivalents are provided on restricted stock shares, restricted stock units and performance shares. Generally, the requisite service period is the vesting period.

 

As of June 30, 2006, 46,225,706 authorized shares remain available for grant under the Omnibus Plan including previously authorized but unissued shares under the Option Plan.

 

The Company’s policy is to issue shares from Common Stock held in treasury upon exercise of employee and non-employee stock options as well as for the vesting of restricted stock shares, restricted stock units, and performance shares.

 

Compensation Costs

 

Compensation cost for employee stock options is based on the fair values estimated on the grant date, while compensation cost for non-employee stock options is re-estimated at each period-end through the vesting date, using the approach and assumptions described below. Compensation cost for restricted stock shares, restricted stock units and performance shares granted to employees is measured by the share price of the underlying Common Stock at the date of grant. Compensation cost for restricted stock shares and restricted stock units granted to non-employees is measured by the share price as of the balance sheet date for unvested shares and the share price at the vesting date for vested shares.

 

The fair value of each stock option award is estimated on the date of grant for stocks options issued to employees and the balance sheet date or vesting date for stock options issued to non-employees using a binomial option valuation model that uses the following assumptions:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
     2006

    2005

    2006

    2005

 

Expected volatility

   20.65 %   23.77 %   20.65 %   23.77 %

Expected dividend yield

   1.20 %   1.20 %   1.20 %   1.20 %

Expected term

   5.14 years     5.19 years     5.14 years     5.19 years  

Risk-free interest rate

   4.97 %   3.92 %   4.58 %   3.73 %

 

Expected volatilities are based on implied volatilities from traded options on the Company’s Common Stock, historical volatility of the Company’s Common Stock and other factors. The Company uses historical data to estimate option exercises and employee terminations within the valuation model. The expected term of options granted is derived from the output of the valuation model and represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The following chart summarizes the compensation cost recognized and the related income tax benefit for stock options, restricted stock shares, restricted stock units, and performance share awards for the three and six months ended June 30, 2006:

 

    

Three Months Ended

June 30, 2006


  

Six Months Ended

June 30, 2006


     Total Compensation
Cost Recognized


   Income Tax
Benefit


   Total Compensation
Cost Recognized


   Income Tax
Benefit


     (in millions)

Employee stock options

   $ 12    $ 4    $ 37    $ 13

Non-employee stock options

     —        —        2      1

Employee restricted stock shares, restricted stock units, and performance shares

     29      10      55      19

Non-employee restricted stock shares and restricted stock units

     2      1      2      1
    

  

  

  

Total

   $ 43    $ 15    $ 96    $ 34
    

  

  

  

 

Stock Options

 

Each stock option granted has an exercise price no less than the fair market value of the Company’s Common Stock on the date of grant and has a maximum term of 10 years. Generally, one third of the option grant vests in each of the first three years. Participants are employees and non-employees (i.e., statutory agents who perform services for the Company and participating subsidiaries).

 

Stock options outstanding under the Omnibus Plan as of December 31, 2005 and changes during the six months ended June 30, 2006 were as follows:

 

     Employee Stock Options

   Non-employee Stock Options

     Shares

    Weighted Average
Exercise Price


   Shares

    Weighted Average
Exercise Price


Outstanding at December 31, 2005

   19,806,454     $ 38.82    601,870     $ 35.66

Granted

   2,885,530       76.15    60,559       76.29

Exercised

   (2,160,627 )     35.51    (85,593 )     31.69

Forfeited

   (262,377 )     58.65    (19,740 )     31.09

Expired

   (34,614 )     30.51    (4,995 )     28.60

Transferred

   —         —      —         —  
    

        

     

Outstanding at June 30, 2006

   20,234,366     $ 44.25    552,101     $ 40.96
    

 

  

 

Vested and expected to vest at June 30, 2006

   19,515,131     $ 43.46    525,209     $ 39.82
    

 

  

 

Exercisable at June 30, 2006

   13,490,292     $ 35.40    330,004     $ 29.05
    

 

  

 

 

The weighted average grant date fair value of employee stock options granted during the three months ended June 30, 2006 and 2005 was $18.61 and $14.49, respectively. The weighted average grant date fair value of employee stock options granted during the six months ended June 30, 2006 and 2005 was $17.84 and $12.92, respectively.

 

The total intrinsic value of employee stock options exercised during the three months ended June 30, 2006 and 2005 was $33 million and $41 million, respectively. The total intrinsic value of employee stock options exercised during the six months ended June 30, 2006 and 2005 was $88 million and $76 million, respectively.

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

There were no non-employee stock options granted during the three months ended June 30, 2006 and 2005. The weighted average balance sheet date fair value for non-employee stock options granted during the six months ended June 30, 2006 and 2005 was $18.94 and $18.16, respectively.

 

The total intrinsic value of non-employee options exercised during the three months ended June 30, 2006 and 2005 was $1 million and $2 million, respectively. The total intrinsic value of non-employee options exercised during the six months ended June 30, 2006 and 2005 was $4 million and $5 million, respectively.

 

The weighted average remaining contractual term and the aggregate intrinsic value of stock options outstanding and exercisable as of June 30, 2006 is as follows:

 

     June 30, 2006

     Employee Stock Options

   Non-employee Stock Options

     Weighted Average
Remaining
Contractual Term


   Aggregate
Intrinsic
Value


   Weighted Average
Remaining
Contractual Term


   Aggregate
Intrinsic
Value


     (in years)    (in millions)    (in years)    (in millions)

Outstanding

   7.36    $ 677    7.00    $ 20
    
  

  
  

Vested and expected to vest

   7.30    $ 668    6.90    $ 20
    
  

  
  

Exercisable

   6.63    $ 571    5.92    $ 16
    
  

  
  

 

Restricted Stock Shares, Restricted Stock Units, and Performance Share Awards

 

A restricted stock share represents a grant of Common Stock to employee and non-employee participants that is subject to certain transfer restrictions and forfeiture provisions for a specified period of time. A restricted stock unit is an unfunded, unsecured right to receive a share of Common Stock at the end of a specified period of time, which is also subject to forfeiture and transfer restrictions. Generally, the restrictions on restricted stock shares and restricted stock units will lapse on the third anniversary of the date of grant. Restricted stock shares subject to the transfer restrictions and forfeiture provisions are considered nonvested shares and are not reflected as outstanding shares until the restrictions expire. Performance share awards are awards of units denominated in Common Stock. The number of units is determined over the performance period, and may be adjusted based on the satisfaction of certain performance goals. Performance share awards are payable in Common Stock.

 

Employee restricted stock shares, restricted stock units and performance shares as of December 31, 2005 and changes during the six months ended June 30, 2006 were as follows:

 

    Restricted
Stock Shares


    Weighted
Average Grant
Date Fair Value


  Restricted
Stock Units


    Weighted
Average Grant
Date Fair Value


  Performance
Shares(1)


    Weighted
Average Grant
Date Fair Value


Restricted at December 31, 2005

  2,391,757     $ 39.03   1,213,644     $ 53.67   1,139,696     $ 46.63

Granted

  —         —     1,589,546       76.31   322,764       76.15

Forfeited

  (46,647 )     44.91   (109,850 )     68.25   (11,438 )     56.40

Performance adjustment(2)

  —         —     —         —     118,467       33.61

Released

  (1,345,465 )     34.69   (128,351 )     34.57   (355,400 )     33.61
   

       

       

     

Restricted at June 30, 2006

  999,645     $ 44.73   2,564,989     $ 68.02   1,214,089     $ 56.93
   

       

       

     

(1) Performance shares reflect the target awarded, reduced for cancellations and vestings to date. The actual number of shares to be awarded at the end of each performance period will range between 50% and 150% of this target based upon a measure of the reported performance for the Company’s Financial Services Businesses relative to stated goals.
(2) Represents additional shares issued based upon the attainment of performance goals for the Company’s Financial Services Businesses.

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The fair value of employee share awards released for the three months ended June 30, 2006 and 2005 was $7 million and $4 million, respectively. The fair value of employee share awards released for the six months ended June 30, 2006 and 2005 was $138 million and $7 million, respectively.

 

Non-employee restricted stock shares and restricted stock units as of December 31, 2005 and changes during the six months ended June 30, 2006 were as follows:

 

     Restricted
Stock Shares


    Weighted Average
Balance Sheet Date
Fair Value


   Restricted
Stock Units


    Weighted Average
Balance Sheet Date
Fair Value


Restricted at December 31, 2005

   21,019     $ 73.19    12,504     $ 73.19

Granted

   —         —      128,267       76.40

Forfeited

   (389 )     38.56    (4,463 )     75.08

Released

   (11,617 )     33.61    —         —  
    

        

     

Restricted at June 30, 2006

   9,013     $ 77.70    136,308     $ 77.70
    

        

     

 

There were no non-employee awards released during the three months ended June 30, 2006 and 2005. The fair value of non-employee share awards released for the six months ended June 30, 2006 was $1 million. There were no non-employee awards released during the six months ended June 30, 2005.

 

Unrecognized Compensation Cost

 

Unrecognized compensation cost for employee stock options as of June 30, 2006 was $64 million with a weighted average recognition period of 1.90 years. Unrecognized compensation cost for employee restricted stock awards, restricted stock units, and performance share awards as of June 30, 2006 was $344 million with a weighted average recognition period of 2.03 years.

 

Unrecognized compensation cost for non-employee stock options as of June 30, 2006 was $2 million with a weighted average recognition period of 1.30 years. Unrecognized compensation cost for non-employee restricted stock awards and restricted stock units as of June 30, 2006 was $8 million with a weighted average recognition period of 2.55 years.

 

Cash Received Upon Exercise of Stock Options and Tax Benefits Realized

 

Cash received for the exercise of 822,076 shares of employee and non-employee stock options for the three months ended June 30, 2006 was $28 million. Cash received for the exercise of 2,246,220 shares of employee and non-employee stock options for the six months ended June 30, 2006 was $79 million.

 

The tax benefit realized for exercises of employee and non-employee stock options during the three months ended June 30, 2006 was $7 million. The tax benefit realized for exercises of employee and non-employee stock options during the six months ended June 30, 2006 was $23 million.

 

The tax benefit realized upon vesting of restricted stock shares, restricted stock units, and performance shares for the three months ended June 30, 2006 was $2 million. The tax benefit realized upon vesting of restricted stock shares, restricted stock units, and performance shares for the six months ended June 30, 2006 was $40 million.

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

8. EMPLOYEE BENEFIT PLANS

 

The Company has funded and non-funded contributory and non-contributory defined benefit pension plans, which cover substantially all of its employees. For some employees, benefits are based on final average earnings and length of service, while benefits for other employees are based on a notional account balance that increases based on age, service and salary during their career.

 

The Company provides certain life insurance and health care benefits for its retired employees, their beneficiaries and covered dependents (“other postretirement benefits”). The health care plan is contributory; the life insurance plan is non-contributory. Substantially all of the Company’s U.S. employees may become eligible to receive other postretirement benefits if they retire after age 55 with at least 10 years of service or under certain circumstances after age 50 with at least 20 years of continuous service.

 

Net periodic (benefit) cost included in “General and administrative expenses” includes the following components:

 

     Three Months Ended June 30,

 
     Pension Benefits

    Other Postretirement
Benefits


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Components of net periodic (benefit) cost

                                

Service cost

   $ 40     $ 41     $ 3     $ 3  

Interest cost

     104       104       32       36  

Expected return on plan assets

     (185 )     (199 )     (22 )     (20 )

Amortization of prior service cost

     6       6       (2 )     (1 )

Amortization of actuarial (gain) loss, net

     12       6       5       9  

Special termination benefits

     1       1       —         —    
    


 


 


 


Net periodic (benefit) cost

   $ (22 )   $ (41 )   $ 16     $ 27  
    


 


 


 


 

     Six Months Ended June 30,

 
     Pension Benefits

    Other Postretirement
Benefits


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Components of net periodic (benefit) cost

                                

Service cost

   $ 80     $ 82     $ 6     $ 6  

Interest cost

     208       208       64       72  

Expected return on plan assets

     (370 )     (398 )     (44 )     (40 )

Amortization of prior service cost

     12       12       (4 )     (2 )

Amortization of actuarial (gain) loss, net

     24       12       9       18  

Special termination benefits

     3       7       —         —    
    


 


 


 


Net periodic (benefit) cost

   $ (43 )   $ (77 )   $ 31     $ 54  
    


 


 


 


 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

9. SEGMENT INFORMATION

 

Segments

 

The Company has organized its principal operations into the Financial Services Businesses and the Closed Block Business. Within the Financial Services Businesses, the Company operates through three divisions, which together encompass seven reportable segments. The Company’s real estate and relocation services business as well as businesses that are not sufficiently material to warrant separate disclosure and businesses to be divested are included in Corporate and Other operations within the Financial Services Businesses.

 

Adjusted Operating Income

 

In managing the Financial Services Businesses, the Company analyzes the operating performance of each segment using “adjusted operating income.” Adjusted operating income does not equate to “income from continuing operations before income taxes” or “net income” as determined in accordance with U.S. GAAP but is the measure of segment profit or loss used by the Company to evaluate segment performance and allocate resources, and, consistent with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” is the measure of segment performance presented below.

 

Adjusted operating income is calculated by adjusting each segment’s “income from continuing operations before income taxes” to exclude the following items, which are described in greater detail below:

 

    realized investment gains (losses), net, except as indicated below, and related charges and adjustments;

 

    net investment gains and losses on trading account assets supporting insurance liabilities and changes in experience-rated contractholder liabilities due to asset value changes; and

 

    the contribution to income/loss of divested businesses that have been or will be sold or exited but that did not qualify for “discontinued operations” accounting treatment under U.S. GAAP.

 

The excluded items are important to an understanding of overall results of operations. Adjusted operating income is not a substitute for income determined in accordance with U.S. GAAP, and the Company’s definition of adjusted operating income may differ from that used by other companies. However, the Company believes that the presentation of adjusted operating income as measured for management purposes enhances the understanding of results of operations by highlighting the results from ongoing operations and the underlying profitability factors of the Financial Services Businesses.

 

Realized investment gains (losses), net, and related charges and adjustments. Adjusted operating income excludes realized investment gains (losses), net, except as indicated below. A significant element of realized losses is impairments and losses from sales of credit-impaired securities, the timing of which depends largely on market credit cycles and can vary considerably across periods. The timing of other sales that would result in gains or losses is largely subject to the Company’s discretion and influenced by market opportunities, as well as the Company’s tax profile. Trends in the underlying profitability of the Company’s businesses can be more clearly identified without the fluctuating effects of these transactions.

 

Charges that relate to realized investment gains (losses), net, are also excluded from adjusted operating income. The related charges, which are offset against net realized investment gains and losses in the schedules below, relate to policyholder dividends; amortization of deferred policy acquisition costs, valuation of business acquired (“VOBA”) and unearned revenue reserves; interest credited to policyholders’ account balances; reserves for future policy benefits; payments associated with the market value adjustment features related to certain of the annuity products we sell; and minority interest in consolidated operating subsidiaries. The related charges

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

associated with policyholder dividends include a percentage of net realized investment gains on specified Gibraltar Life assets that is required to be paid as dividends to Gibraltar Life policyholders. Deferred policy acquisition costs, VOBA and unearned revenue reserves for certain products are amortized based on estimated gross profits, which include net realized investment gains and losses on the underlying invested assets. The related charge for these items represent the portion of this amortization associated with net realized investment gains and losses. The related charges for interest credited to policyholders’ account balances relate to certain group life policies that pass back certain realized investment gains and losses to the policyholder. The reserves for certain policies are adjusted when cash flows related to these policies are affected by net realized investment gains and losses, and the related charge for reserves for future policy benefits represents that adjustment. Certain of our annuity products contain a market value adjustment feature that requires us to pay to the contractholder or entitles us to receive from the contractholder, upon surrender, a market value adjustment based on the crediting rates on the contract surrendered compared to crediting rates on newly issued contracts or based on an index rate at the time of purchase compared to an index rate at time of surrender, as applicable. These payments mitigate the net realized investment gains or losses incurred upon the disposition of the underlying invested assets. The related charge represents the payments or receipts associated with these market value adjustment features. Minority interest expense is recorded for the earnings of consolidated subsidiaries owed to minority investors. The related charge for minority interest in consolidated operating subsidiaries represents the portion of these earnings associated with net realized investment gains and losses.

 

Adjustments to “Realized investment gains (losses), net,” for purposes of calculating adjusted operating income, include the following:

 

Gains and losses pertaining to derivative contracts that do not qualify for hedge accounting treatment, other than derivatives used in the Company’s capacity as a broker or dealer, are included in “Realized investment gains (losses), net.” This includes mark-to-market adjustments of open contracts as well as periodic settlements. As discussed further below, adjusted operating income includes a portion of realized gains and losses pertaining to certain derivative contracts.

 

Adjusted operating income of the International Insurance segment and International Investments segment, excluding the global derivatives business, 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 non-U.S. 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 $8 million and losses of $20 million for the three months ended June 30, 2006 and 2005, respectively, and gains of $14 million and losses of $56 million for the six months ended June 30, 2006 and 2005, respectively). As of June 30, 2006 and December 31, 2005, the fair value of open contracts used for this purpose was a net asset of $28 million and a net asset of $110 million, respectively.

 

The Company uses interest 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,

 

23


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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 $15 million and gains of $18 million for the three months ended June 30, 2006 and 2005, respectively, and gains of $20 million and gains of $36 million for the six months ended June 30, 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 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 losses of $13 million and losses of $3 million for the three months ended June 30, 2006 and 2005, respectively, and losses of $10 million and losses of $3 million for the six months ended June 30, 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 a portion of the cumulative realized investment gains on these embedded derivatives on an amortizing basis over the remaining life of the securities. However, adjusted operating income includes any cumulative realized investment losses immediately. Adjusted operating income includes losses of $8 million and losses of $13 million for the three months ended June 30, 2006 and 2005, respectively, and losses of $9 million and losses of $13 million for the six months ended June 30, 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 gains (losses), net” from derivatives used to hedge certain foreign currency-denominated proprietary investments are included in adjusted operating income. Net realized investment gains of $29 million and $11 million related to these businesses were included in adjusted operating income for the three months ended June 30, 2006 and 2005, respectively. Net realized investment gains of $72 million and $54 million related to these businesses were included in adjusted operating income for the six months ended June 30, 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

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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 and therefore the impact of currency fluctuations is excluded from current period adjusted operating income. This change in value related to foreign currency fluctuations recorded within “Asset management fees and other income” is excluded from adjusted operating income as an adjustment to “Realized investment gains (losses), net,” and was a decrease of $13 million and an increase of $3 million for the three months ended June 30, 2006 and 2005, respectively, and was a decrease of $22 million and an increase of $3 million for the six months ended June 30, 2006 and 2005, respectively.

 

As part of the acquisition of CIGNA’s retirement business, the Company entered into reinsurance agreements with CIGNA, including a modified-coinsurance-with-assumption arrangement that applied to the defined benefit guaranteed-cost contracts acquired. The net results of these contracts were recorded in “Asset management fees and other income,” as a result of the reinsurance arrangement, and such net results included realized investment gains and losses. These realized investment gains and losses were excluded from adjusted operating income as an adjustment to “Realized investment gains (losses), net.” There were no adjustments for the three and six months ended June 30, 2006. Net realized investment gains of $1 million and $13 million were excluded for the three and six months ended June 30, 2005, respectively.

 

Investment gains and losses on trading account assets supporting insurance liabilities and changes in experience-rated contractholder liabilities due to asset value changes. Certain products included in the retirement business acquired from CIGNA, as well as certain products included in the International Insurance segment, are experience-rated in that investment results associated with these products will ultimately accrue to contractholders. The investments supporting these experience-rated products, excluding mortgage loans, are classified as trading. These trading investments are reflected on the statements of financial position as “Trading account assets supporting insurance liabilities, at fair value.” Realized and unrealized gains and losses for these investments are reported in “Asset management fees and other income.” Investment income for these investments is reported in “Net investment income.” Mortgage loans that support these experience-rated products are carried at unpaid principal, net of unamortized discounts and an allowance for losses, and are reflected on the statements of financial position as “Commercial loans.”

 

Adjusted operating income excludes net investment gains and losses on trading account assets supporting insurance liabilities. This is consistent with the exclusion of realized investment gains and losses with respect to other investments supporting insurance liabilities managed on a consistent basis, as discussed above. In addition, to be consistent with the historical treatment of charges related to realized gains and losses on available for sale securities, adjusted operating income also excludes the change in contractholder liabilities due to asset value changes in the pool of investments (including mortgage loans) supporting these experience-rated contracts, which are reflected in “Interest credited to policyholders’ account balances.” The result of this approach is that adjusted operating income for these products includes only net fee revenue and interest spread the Company earns on these experience-rated contracts, and excludes changes in fair value of the pool of investments, both realized and unrealized, that accrue to the contractholders.

 

Divested businesses. The contribution to income/loss of divested businesses that have been or will be sold or exited, but that did not qualify for “discontinued operations” accounting treatment under U.S. GAAP, are excluded from adjusted operating income as the results of divested businesses are not relevant to understanding the Company’s ongoing operating results.

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The summary below reconciles adjusted operating income to income from continuing operations before income taxes:

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Adjusted Operating Income before income taxes for Financial Services Businesses by Segment:

                                

Individual Life and Annuities

   $ 218     $ 220     $ 469     $ 437  

Group Insurance

     29       46       76       84  
    


 


 


 


Total Insurance Division

     247       266       545       521  
    


 


 


 


Asset Management

     137       105       306       239  

Financial Advisory

     37       (97 )     (29 )     (82 )

Retirement

     142       142       279       297  
    


 


 


 


Total Investment Division

     316       150       556       454  
    


 


 


 


International Insurance

     324       327       662       612  

International Investments

     34       19       78       44  
    


 


 


 


Total International Insurance and Investments Division

     358       346       740       656  
    


 


 


 


Corporate Operations

     8       28       24       34  

Real Estate and Relocation Services

     29       31       39       42  
    


 


 


 


Total Corporate and Other

     37       59       63       76  
    


 


 


 


Adjusted Operating Income before income taxes for Financial Services Businesses

     958       821       1,904       1,707  
    


 


 


 


Items excluded from Adjusted Operating Income:

                                

Realized investment gains (losses), net, and related adjustments

     (334 )     322       (283 )     579  

Charges related to realized investment gains (losses), net

     23       (73 )     23       (94 )

Investment gains (losses) on trading account assets supporting insurance liabilities, net

     (151 )     190       (265 )     58  

Change in experience-rated contractholder liabilities due to asset value changes

     130       (145 )     196       (57 )

Divested businesses

     (6 )     3       2       (2 )
    


 


 


 


Income from continuing operations before income taxes for Financial Services Businesses

     620       1,118       1,577       2,191  

Income from continuing operations before income taxes for Closed Block Business

     38       198       122       443  
    


 


 


 


Income from continuing operations before income taxes

   $ 658     $ 1,316     $ 1,699     $ 2,634  
    


 


 


 


 

The Insurance division results reflect deferred policy acquisition costs as if the individual annuity business and group insurance business were stand-alone operations. The elimination of intersegment costs capitalized in accordance with this policy is included in consolidating adjustments within Corporate and Other operations.

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The summary below presents revenues for the Company’s reportable segments:

 

    

Three Months Ended

June 30,


  

Six Months Ended

June 30,


 
         2006    

        2005    

       2006    

        2005    

 
     (in millions)  

Financial Services Businesses:

                               

Individual Life and Annuities

   $ 1,054     $ 968    $ 2,066     $ 1,924  

Group Insurance

     1,117       1,060      2,226       2,112  
    


 

  


 


Total Insurance Division

     2,171       2,028      4,292       4,036  
    


 

  


 


Asset Management

     469       401      971       819  

Financial Advisory

     128       95      306       207  

Retirement

     1,049       1,012      2,103       1,955  
    


 

  


 


Total Investment Division

     1,646       1,508      3,380       2,981  
    


 

  


 


International Insurance

     1,934       1,912      3,883       3,828  

International Investments

     146       106      296       234  
    


 

  


 


Total International Insurance and Investments Division

     2,080       2,018      4,179       4,062  
    


 

  


 


Corporate Operations

     58       56      157       70  

Real Estate and Relocation Services

     85       86      153       156  
    


 

  


 


Total Corporate and Other

     143       142      310       226  
    


 

  


 


Total

     6,040       5,696      12,161       11,305  
    


 

  


 


Items excluded from Adjusted Operating Income:

                               

Realized investment gains (losses), net, and related adjustments

     (334 )     322      (283 )     579  

Charges related to realized investment gains (losses), net

     7       —        9       (3 )

Investment gains (losses) on trading account assets supporting insurance liabilities, net

     (151 )     190      (265 )     58  

Divested businesses

     21       10      31       27  
    


 

  


 


Total Financial Services Businesses

     5,583       6,218      11,653       11,966  
    


 

  


 


Closed Block Business

     1,849       2,117      3,700       4,098  
    


 

  


 


Total per Unaudited Interim Consolidated Financial Statements

   $ 7,432     $ 8,335    $ 15,353     $ 16,064  
    


 

  


 


 

The Asset Management segment revenues include intersegment revenues of $85 million and $87 million for the three months ended June 30, 2006 and 2005, respectively, and $176 million and $180 million for the six months ended June 30, 2006 and 2005, respectively, primarily consisting of asset-based management and administration fees. Management has determined the intersegment revenues with reference to market rates. Intersegment revenues are eliminated in consolidation in Corporate and Other.

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The summary below presents total assets for the Company’s reportable segments as of the periods indicated:

 

    

June 30,

2006


   December 31,
2005


     (in millions)

Individual Life and Annuities

   $ 95,209    $ 89,313

Group Insurance

     32,077      27,466
    

  

Total Insurance Division

     127,286      116,779
    

  

Asset Management

     40,182      29,600

Financial Advisory

     2,065      1,929

Retirement

     118,717      119,259
    

  

Total Investment Division

     160,964      150,788
    

  

International Insurance

     57,885      54,186

International Investments

     6,024      4,915
    

  

Total International Insurance and Investments Division

     63,909      59,101
    

  

Corporate Operations

     16,329      17,570

Real Estate and Relocation Services

     1,133      1,053
    

  

Total Corporate and Other

     17,462      18,623
    

  

Total Financial Services Businesses

     369,621      345,291
    

  

Closed Block Business

     71,054      72,485
    

  

Total per Unaudited Interim Consolidated Financial Statements

   $ 440,675    $ 417,776
    

  

 

10. CONTINGENT LIABILITIES AND LITIGATION AND REGULATORY MATTERS

 

Contingent Liabilities

 

On an ongoing basis, the Company’s internal supervisory and control functions review the quality of sales, marketing and other customer interface procedures and practices and may recommend modifications or enhancements. From time to time, this review process results in the discovery of administration, servicing or other errors, including errors relating to the timing or amount of payments or contract values due to customers. In certain cases, if appropriate, the Company may offer customers remediation and may incur charges, including the cost of such remediation, administrative costs and regulatory fines.

 

It is possible that the results of operations or the cash flow of the Company in a particular quarterly or annual period could be materially affected as a result of payments in connection with the matters discussed above or other matters depending, in part, upon the results of operations or cash flow for such period. Management believes, however, that ultimate payments in connection with these matters, after consideration of applicable reserves and rights to indemnification, should not have a material adverse effect on the Company’s financial position.

 

Litigation and Regulatory Matters

 

The Company is subject to legal and regulatory actions in the ordinary course of its businesses. Pending legal and regulatory actions include proceedings relating to aspects of our businesses and operations that are specific to the Company and proceedings that are typical of the businesses in which the Company operates, including in both cases businesses that have either been divested or placed in wind-down status. Some of these proceedings have been brought on behalf of various alleged classes of complainants. In certain of these matters, the plaintiffs are seeking large and/or indeterminate amounts, including punitive or exemplary damages.

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Insurance and Annuities

 

In August 2000, plaintiffs filed a purported national class action in the District Court of Valencia County, New Mexico, Azar, et al. v. Prudential Insurance, based upon the alleged failure to adequately disclose the increased costs associated with payment of life insurance premiums on a “modal” basis, i.e., more frequently than once a year. Similar actions have been filed in New Mexico against over a dozen other insurance companies. The complaint asserts claims for breach of the common law duty to disclose material information, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty, unjust enrichment and fraudulent concealment and seeks injunctive relief, compensatory and punitive damages, both in unspecified amounts, restitution, treble damages, interest, costs and attorneys’ fees. In March 2001, the court entered an order granting partial summary judgment to plaintiffs as to liability. In January 2003, the New Mexico Court of Appeals reversed this finding and dismissed the claims for breach of the covenant of good faith and fair dealing and breach of fiduciary duty. The case was remanded to the trial court and in November 2004, it held that, as to the named plaintiffs, the non-disclosure was material. In July 2005, the court certified a class of New Mexico only policyholders denying plaintiffs’ motion to include purchasers from 35 additional states. In September 2005, plaintiffs sought to amend the court’s order on class certification with respect to eight additional states. In March 2006, the court reiterated its denial of a multi-state class and maintained the certification of a class of New Mexico resident purchasers of Prudential life insurance. The Court also indicated it would enter judgment on liability against Prudential for the New Mexico class.

 

The Company, along with a number of other insurance companies, received formal requests for information from the State of New York Attorney General’s Office (NYAG), the Securities and Exchange Commission (SEC), the Connecticut Attorney General’s Office, the Massachusetts Office of the Attorney General, the Department of Labor, the United States Attorney for the Southern District of California, the District Attorney of the County of San Diego, and various state insurance departments relating to payments to insurance intermediaries and certain other practices that may be viewed as anti-competitive. The Company may receive additional requests from these and other regulators and governmental authorities concerning these and related subjects. The Company is cooperating with these inquiries and has had discussions with certain authorities, including the NYAG, in an effort to resolve the inquiries into this matter. These matters are also the subject of litigation brought by private plaintiffs, including purported class actions that have been consolidated in the multidistrict litigation in the United States District Court for the District of New Jersey, In re Employee Benefit Insurance Brokerage Antitrust Litigation, and two shareholder derivative actions, Gillespie v. Ryan and Kahn v. Agnew, and the California Department of Banking and Insurance. Both derivative actions were dismissed without prejudice. In Gillespie, the plaintiff entered into a tolling agreement with the Company to permit a Special Evaluation Committee of the Board of Directors to investigate and evaluate his demand that the Company take action regarding these matters. The Committee’s investigation is in progress.

 

In April 2005, the Company voluntarily commenced a review of the accounting for its reinsurance arrangements to confirm that it complied with applicable accounting rules. This review included an inventory and examination of current and past arrangements, including those relating to the Company’s wind down and divested businesses and discontinued operations. Subsequent to commencing this voluntary review, the Company received a formal request from the Connecticut Attorney General for information regarding its participation in reinsurance transactions generally and a formal request from the SEC for information regarding certain reinsurance contracts entered into with a single counterparty since 1997 as well as specific contracts entered into with that counterparty in the years 1997 through 2002 relating to the Company’s property and casualty insurance operations that were sold in 2003. The Company accounts for these property and casualty contracts as reinsurance. However, if as a result of these examinations deposit accounting rather than reinsurance accounting were required to be applied to these property and casualty contracts, there would be no impact on the consolidated financial statements of the Company for any interim or annual period subsequent to December 31,

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

2002 and consolidated net income (loss) from continuing operations before extraordinary gain on acquisition and cumulative effect of accounting change would be decreased by approximately $25 million in 2002 and $49 million in 2001. These examinations are ongoing and not yet complete and it is possible that the Company may receive additional requests from regulators relating to reinsurance arrangements. The Company intends to cooperate with all such requests.

 

The Company’s subsidiary, American Skandia Life Assurance Corporation, has commenced a remediation program to correct errors in the administration of approximately 11,000 annuity contracts issued by that company. The owners of these contracts did not receive notification that the contracts were approaching or past their designated annuitization date or default annuitization date (both dates referred to as the “contractual annuity date”) and the contracts were not annuitized at their contractual annuity dates. Some of these contracts also were affected by data integrity errors resulting in incorrect contractual annuity dates. The lack of notice and data integrity errors, as reflected on the annuities administrative system, all occurred before the acquisition of the American Skandia entities by the Company. The remediation and administrative costs of the remediation program are subject to the indemnification provisions of the acquisition agreement pursuant to which the Company purchased the American Skandia entities in May 2003 from Skandia.

 

Securities

 

In 1999, a class action lawsuit, Burns, et al. v. Prudential Securities, Inc., et al., was filed in the Marion County, Ohio Court of Common Pleas against Jeffrey Pickett (a former Prudential Securities Financial Advisor) and Prudential Securities alleging that Pickett transferred, without authorization, his clients’ equity mutual funds into fixed income mutual funds in October 1998. The claims were based on theories of conversion, breach of contract, breach of fiduciary duty and negligent supervision. In October 2002, the case was tried and the jury returned a verdict against Prudential Securities and Pickett for $11.7 million in compensatory damages and against Prudential Securities for $250 million in punitive damages. In July 2003, the court denied Prudential Securities’ motion to set aside or reduce the jury verdict and sustained the judgment in the amount of $269 million, including prejudgment interest and attorneys fees. In July 2006, the Court of Appeals, Third Appellate District, affirmed the award of $11.7 million in compensatory damages against Prudential Securities and Pickett and reduced the award of punitive damages against Prudential Securities from $250 million to $6.8 million and affirmed the award for pre and post judgment interest and attorneys fees. The opinion provides that the plaintiffs may either accept the reduced amount of punitive damages or have a new trial.

 

Prudential Securities has been named as a defendant in a number of industry-wide purported class actions in the United States District Court for the Southern District of New York relating to its former securities underwriting business. Plaintiffs in one consolidated proceeding, captioned In re: Initial Public Offering Securities Litigation, allege, among other things, that the underwriters engaged in a scheme involving tying agreements, undisclosed compensation arrangements and research analyst conflicts to manipulate and inflate the prices of shares sold in initial public offerings in violation of the federal securities laws. Certain issuers of these securities and their and former officers and directors have also been named as defendants. In October 2004, the district court granted plaintiffs’ motion for class certification in six “focus cases.” The underwriter defendants appealed that ruling to the United States Court of Appeals for the Second Circuit, which heard argument in March 2006. In June 2004, plaintiffs entered into a settlement agreement with the issuers, officers and directors named as defendants in the lawsuits, which the district court preliminarily approved in February 2005. In August 2000, Prudential Securities was named as a defendant, along with other underwriters, in a purported class action, captioned CHS Electronics Inc. v. Credit Suisse First Boston Corp. et al., which alleges on behalf of issuers of securities in initial public offerings that the defendants conspired to fix at 7% the discount that underwriting syndicates receive from issuers in violation of federal antitrust laws. Plaintiffs moved for class certification in

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

September 2004 and for partial summary judgment in November 2005. The summary judgment motion has been deferred pending disposition of the class certification motion. In April 2006, the court denied class certification. In August 2006, the United States Court of Appeals for the Second Circuit granted plaintiffs’ petition for review of that decision. In a related action, captioned Gillet v. Goldman Sachs et al., plaintiffs allege substantially the same antitrust claims on behalf of investors, though only injunctive relief is currently being sought.

 

Other Matters

 

Mutual Fund Market Timing Practices

 

Commencing in 2003, the Company received formal requests for information relating to the purchase and sale of mutual fund shares and variable annuities from regulators and law enforcement authorities, including the United States Attorney, District of Massachusetts (USAM), the Secretary of the Commonwealth of Massachusetts, Securities Division (MSD), the Securities and Exchange Commission (SEC), the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE), the New Jersey Bureau of Securities (NJBS) and the New York Attorney General’s Office (NYAG). The matters remaining under investigation principally concern the retail brokerage operations of the former Prudential Securities (PSI) and the business of certain American Skandia entities. The Company is cooperating with all investigations.

 

In 2003, in connection with these investigations, the SEC filed a civil action against individual PSI brokers and a branch manager; the MSD filed administrative complaints against both PSI and certain brokers and branch managers. The MSD’s complaint against PSI alleged that it knew or should have known about alleged deceptive market timing and late trading in mutual funds in its Boston branch, failed reasonably to supervise the conduct of the brokers in that branch, and failed to implement controls designed to prevent and detect violation of Massachusetts securities law. The SEC and MSD complaints against former PSI brokers and branch managers were based on allegations related to market timing similar to those the MSD asserted against PSI. These actions remain pending.

 

In August and September 2005, two former PSI brokers pled guilty to criminal charges brought by the USAM based on their participation in deceptive practices relating to market timing activities, and it is possible that additional civil and/or criminal charges may be brought against these and other former PSI personnel.

 

The investigations by the USAM, MSD, SEC, NASD, NYSE, NJBS and NYAG of market timing activities at PSI continue, with each evaluating PSI and its former personnel from the perspective of federal and state laws and regulations and rules of the self-regulatory organizations relevant to its jurisdiction. These investigations focus on former PSI brokers in Boston and a few other branch offices in the U.S., their supervisors, and other members of the PSI control structure with responsibilities that related to the market timing activities, including certain former members of PSI senior management. The Company continues to seek global resolution with all of the above noted authorities. While not assured, the Company expects to achieve a settlement without material additions to the Company’s reserve for estimated settlement costs. Such a settlement, if achieved, would resolve the pending regulatory and criminal investigations of market timing activities at PSI without further regulatory proceedings or filing of charges, subject to continued compliance with its terms over a number of years, and would include, among other things, fines and penalties, continuing reporting with respect to compliance practices, admissions that may adversely affect existing litigation or cause additional litigation, adverse publicity and other potentially adverse impacts to the Company’s businesses.

 

In connection with American Skandia, with the approval of Skandia Insurance Company Ltd. (publ) (“Skandia”), an offer was made by American Skandia to the authorities investigating its companies, the SEC and NYAG, to settle the matters relating to market timing in variable annuities by paying restitution and a civil penalty of $95 million in the aggregate. While not assured, the Company believes these discussions are likely to

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

lead to settlements with these authorities. Any regulatory settlement involving an American Skandia entity would be subject to the indemnification provisions of the acquisition agreement pursuant to which the Company purchased the American Skandia entities in May 2003 from Skandia. If achieved, settlement of the matters relating to American Skandia also could involve continuing monitoring, changes to and/or supervision of business practices, findings that may adversely affect existing or cause additional litigation, adverse publicity and other adverse impacts to the Company’s businesses.

 

In addition to these regulatory proceedings, in October 2004, the Company and PSI were named as defendants in several class actions brought on behalf of purchasers and holders of shares in a number of mutual fund complexes. The actions are consolidated as part of a multi-district proceeding, In re: Mutual Fund Investment Litigation, pending in the United States District Court for the District of Maryland. The complaints allege that the purchasers and holders were harmed by dilution of the funds’ values and excessive fees, caused by market timing and late trading, and seek unspecified damages. In August 2005, the Company was dismissed from several of the actions, without prejudice to repleading the state claims, but remains a defendant in other actions in the consolidated proceeding. In July 2006, in one of the consolidated mutual fund actions, Saunders v. Putnam American Government Income Fund, et al., the United States District Court for the District of Maryland granted plaintiffs leave to refile their federal securities law claims against PSI. Motions to dismiss the other actions are pending.

 

Other

 

In November 2003, an action was commenced in the United States Bankruptcy Court for the Southern District of New York, Enron Corp. v. J.P. Morgan Securities, Inc., et al., against approximately 100 defendants, including Prudential Insurance and related entities, which invested in Enron’s commercial paper. The complaint alleges that Enron’s October 2001 prepayment of its commercial paper is a voidable preference under the bankruptcy laws and constitutes a fraudulent conveyance and that the Company and related entities received prepayment of $125 million. A motion by all defendants to dismiss the complaint was denied in June 2005. Defendants’ motion for leave to appeal is pending.

 

In August 1999, a Prudential Insurance employee and several Prudential Insurance retirees filed an action in the United States District Court for the Southern District of Florida, Dupree, et al., v. Prudential Insurance, et al., against Prudential Insurance and its Board of Directors in connection with a group annuity contract entered into in 1989 between the Prudential Retirement Plan and Prudential Insurance. The suit alleged that the annuitization of certain retirement benefits violated ERISA and that, in the event of demutualization, Prudential Insurance would retain shares distributed under the annuity contract in violation of ERISA’s fiduciary duty requirements. In July 2001, plaintiffs filed an amended complaint dropping three counts, and we filed an answer denying the essential allegations of the complaint. The amended complaint seeks injunctive and monetary relief, including the return of what are claimed to be excess investment and advisory fees paid by the Retirement Plan to Prudential. In March 2002, the court dismissed certain of the claims against the individual defendants. A non-jury trial was concluded in January 2005. The court has not yet issued its decision.

 

In September and October 2005, five purported class action lawsuits were filed against the Company, PSI and Prudential Equity Group LLC claiming that stock brokers were improperly classified as exempt employees under state and federal wage and hour laws and, therefore, were improperly denied overtime pay. The complaints seek back overtime pay and statutory damages, interest, and attorneys’ fees. Two of the complaints, Janowsky v. Wachovia Securities, LLC and Prudential Securities Incorporated and Goldstein v. Prudential Financial, Inc., were filed in the United States District Court for the Southern District of New York. The Goldstein complaint purports to have been filed on behalf of a nationwide class. The Janowsky complaint alleges a class of New York brokers. Motions to dismiss and compel arbitration were filed in the Janowsky and Goldstein matters, which have been consolidated for pre-trial purposes. The three complaints filed in California Superior Court, Dewane v.

 

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PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Prudential Equity Group, Prudential Securities Incorporated, and Wachovia Securities LLC; DiLustro v. Prudential Securities Incorporated, Prudential Equity Group Inc. and Wachovia Securities; and Carayanis v. Prudential Equity Group LLC and Prudential Securities Inc., purport to have been brought on behalf of classes of California brokers. In June 2006, a purported New York state class action complaint was filed in the United States District Court for the Eastern District of New York, Panesenko v. Wachovia Securities, et al., alleging that the Company failed to pay overtime to brokers in violation of state and federal law.

 

Discontinued Operations

 

In November 1996, plaintiffs filed a purported class action lawsuit against Prudential Insurance, the Prudential Home Mortgage Company, Inc. and several other subsidiaries in the Superior Court of New Jersey, Essex County, Capitol Life Insurance Company v. Prudential Insurance, et al., in connection with the sale of certain subordinated mortgage securities sold by a subsidiary of Prudential Home Mortgage. In February 1999, the court entered an order dismissing all counts without prejudice with leave to refile after limited discovery. In May 2000, plaintiffs filed a second amended complaint that alleges violations of the New Jersey securities and RICO statutes, fraud, conspiracy and negligent misrepresentation, and seeks compensatory as well as treble and punitive damages. Defendants filed a motion to dismiss that was denied in October 2001. In October 2002, plaintiffs’ motion for class certification was denied. Since that time, the court has permitted nine additional investors to intervene as plaintiffs. In August 2005, the court dismissed the New Jersey Securities Act and RICO claims and the negligent misrepresentation claim. Plaintiffs’ application for interlocutory appeal of this ruling was denied.

 

In 2000, a nationwide class action, Shane v. Humana, et al., was brought on behalf of provider physicians and physician groups in the United States District Court for the Southern District of Florida. The complaint alleges that Prudential Insurance and other health care companies engaged in an industry-wide conspiracy to defraud physicians by failing to pay under provider agreements and by unlawfully coercing providers to enter into agreements with unfair and unreasonable terms. An amended complaint, naming additional plaintiffs, including three state medical associations, and an additional defendant, was filed in March 2001, and alleges claims of breach of contract, quantum meruit, unjust enrichment, violations of the Racketeer Influenced and Corrupt Organizations Act, or RICO, conspiracy to violate RICO, aiding and abetting RICO violations, and violations of state prompt pay statutes and the California unfair business practices statute. The amended complaint sought compensatory and punitive damages in unspecified amounts, treble damages pursuant to RICO, and attorneys’ fees. In September 2002, the district court granted plaintiffs’ motion for class certification of a nationwide class of provider physicians which was affirmed in September 2004 by the United States Court of Appeals for the Eleventh Circuit with respect only to the federal claims for conspiracy to violate RICO and aiding and abetting RICO violations. In September 2005, the district court entered a final order approving the settlement of these claims by Prudential Insurance, which provides for payment to plaintiffs in the amount of $22 million. Two members of the plaintiff class appealed the final order. In February 2006, the appeals were dismissed. One appeal was reinstated in April 2006 and dismissed in June 2006. The matter has settled.

 

Summary

 

The Company’s litigation and regulatory matters are subject to many uncertainties, and given its complexity and scope, their outcome cannot be predicted. It is possible that results of operations or cash flow of the Company in a particular quarterly or annual period could be materially affected by an ultimate unfavorable resolution of pending litigation and regulatory matters depending, in part, upon the results of operations or cash flow for such period. Management believes, however, that the ultimate outcome of all pending litigation and regulatory matters, after consideration of applicable reserves and rights to indemnification, should not have a material adverse effect on the Company’s financial position.

 

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PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Supplemental Combining Statements of Financial Position

June 30, 2006 and December 31, 2005 (in millions)

 

    June 30, 2006

    December 31, 2005

    Financial
Services
Businesses


    Closed
Block
Business


  Consolidated

   

Financial

Services
Businesses


 

Closed

Block

Business


  Consolidated

ASSETS

                                       

Fixed maturities:

                                       

Available for sale, at fair value

  $ 108,150     $ 48,167   $ 156,317     $ 105,188   $ 49,246   $ 154,434

Held to maturity, at amortized cost

    3,555       —       3,555       3,249     —       3,249

Trading account assets supporting insurance liabilities, at fair value

    14,239       —       14,239       13,781     —       13,781

Other trading account assets, at fair value

    4,561       —       4,561       1,443     —       1,443

Equity securities, available for sale, at fair value

    2,801       3,389     6,190       2,627     3,216     5,843

Commercial loans

    18,018       7,242     25,260       17,177     7,264     24,441

Policy loans

    3,253       5,407     8,660       2,967     5,403     8,370

Securities purchased under agreements to resell

    2,242       —       2,242       413     —       413

Other long-term investments

    5,049       828     5,877       4,495     973     5,468

Short-term investments

    2,768       1,189     3,957       2,565     1,394     3,959
   


 

 


 

 

 

Total investments

    164,636       66,222     230,858       153,905     67,496     221,401

Cash and cash equivalents

    6,521       1,890     8,411       5,493     2,306     7,799

Accrued investment income

    1,433       715     2,148       1,358     709     2,067

Reinsurance recoverables

    1,869       —       1,869       3,548     —       3,548

Deferred policy acquisition costs

    9,239       1,077     10,316       8,357     1,081     9,438

Other assets

    19,188       1,150     20,338       15,069     893     15,962

Separate account assets

    166,735       —       166,735       157,561     —       157,561
   


 

 


 

 

 

TOTAL ASSETS

  $ 369,621     $ 71,054   $ 440,675     $ 345,291   $ 72,485   $ 417,776
   


 

 


 

 

 

LIABILITIES AND ATTRIBUTED EQUITY

                                       

LIABILITIES

                                       

Future policy benefits

  $ 55,520     $ 50,391   $ 105,911     $ 51,926   $ 50,113   $ 102,039

Policyholders’ account balances

    74,122       5,559     79,681       69,924     5,568     75,492

Policyholders’ dividends

    562       1,974     2,536       696     3,717     4,413

Reinsurance payables

    1,351       —       1,351       3,069     —       3,069

Securities sold under agreements to repurchase

    9,564       5,493     15,057       6,801     5,716     12,517

Cash collateral for loaned securities

    3,834       2,374     6,208       3,425     2,393     5,818

Income taxes payable

    1,969       155     2,124       2,136     78     2,214

Securities sold but not yet purchased

    2,152       —       2,152       223     —       223

Short-term debt

    9,723       1,738     11,461       9,447     1,667     11,114

Long-term debt

    7,520       1,750     9,270       6,520     1,750     8,270

Other liabilities

    16,145       550     16,695       11,909     374     12,283

Separate account liabilities

    166,735       —       166,735       157,561     —       157,561
   


 

 


 

 

 

Total liabilities

    349,197       69,984     419,181       323,637     71,376     395,013
   


 

 


 

 

 

COMMITMENTS AND CONTINGENT LIABILITIES

                                       

ATTRIBUTED EQUITY

                                       

Accumulated other comprehensive income (loss)

    (180 )     35     (145 )     1,108     126     1,234

Other attributed equity

    20,604       1,035     21,639       20,546     983     21,529
   


 

 


 

 

 

Total attributed equity

    20,424       1,070     21,494       21,654     1,109     22,763
   


 

 


 

 

 

TOTAL LIABILITIES AND ATTRIBUTED EQUITY

  $ 369,621     $ 71,054   $ 440,675     $ 345,291   $ 72,485   $ 417,776
   


 

 


 

 

 

 

See Notes to Unaudited Interim Supplemental Combining Financial Information

 

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PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Supplemental Combining Statements of Operations

For the three months ended June 30, 2006 and 2005 (in millions)

 

    Three Months Ended June 30,

 
    2006

    2005

 
    Financial
Services
Businesses


    Closed
Block
Business


    Consolidated

    Financial
Services
Businesses


    Closed
Block
Business


  Consolidated

 

REVENUES

                                             

Premiums

  $ 2,558     $ 957     $ 3,515     $ 2,588     $ 964   $ 3,552  

Policy charges and fee income

    674       —         674       615       —       615  

Net investment income

    1,870       906       2,776       1,652       932     2,584  

Realized investment gains (losses), net

    (290 )     (28 )     (318 )     311       210     521  

Asset management fees and other income

    771       14       785       1,052       11     1,063  
   


 


 


 


 

 


Total revenues

    5,583       1,849       7,432       6,218       2,117     8,335  
   


 


 


 


 

 


BENEFITS AND EXPENSES

                                             

Policyholders’ benefits

    2,564       1,072       3,636       2,488       1,076     3,564  

Interest credited to policyholders’ account balances

    547       35       582       771       32     803  

Dividends to policyholders

    24       503       527       105       619     724  

General and administrative expenses

    1,828       201       2,029       1,736       192     1,928  
   


 


 


 


 

 


Total benefits and expenses

    4,963       1,811       6,774       5,100       1,919     7,019  
   


 


 


 


 

 


INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES

    620       38       658       1,118       198     1,316  
   


 


 


 


 

 


Income tax expense

    181       9       190       320       69     389  
   


 


 


 


 

 


INCOME FROM CONTINUING OPERATIONS

    439       29       468       798       129     927  
   


 


 


 


 

 


Loss from discontinued operations, net of taxes

    (15 )     —         (15 )     (44 )     —       (44 )
   


 


 


 


 

 


NET INCOME

  $ 424     $ 29     $ 453     $ 754     $ 129   $ 883  
   


 


 


 


 

 


 

See Notes to Unaudited Interim Supplemental Combining Financial Information

 

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PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Supplemental Combining Statements of Operations

For the six months ended June 30, 2006 and 2005 (in millions)

 

    Six Months Ended June 30,

 
    2006

    2005

 
    Financial
Services
Businesses


    Closed
Block
Business


  Consolidated

    Financial
Services
Businesses


    Closed
Block
Business


  Consolidated

 

REVENUES

                                           

Premiums

  $ 5,164     $ 1,803   $ 6,967     $ 5,109     $ 1,809   $ 6,918  

Policy charges and fee income

    1,338       —       1,338       1,229       —       1,229  

Net investment income

    3,677       1,838     5,515       3,285       1,850     5,135  

Realized investment gains (losses), net

    (174 )     32     (142 )     581       413     994  

Asset management fees and other income

    1,648       27     1,675       1,762       26     1,788  
   


 

 


 


 

 


Total revenues

    11,653       3,700     15,353       11,966       4,098     16,064  
   


 

 


 


 

 


BENEFITS AND EXPENSES

                                           

Policyholders’ benefits

    5,112       2,004     7,116       5,000       2,018     7,018  

Interest credited to policyholders’ account balances

    1,134       71     1,205       1,288       68     1,356  

Dividends to policyholders

    45       1,106     1,151       142       1,190     1,332  

General and administrative expenses

    3,785       397     4,182       3,345       379     3,724  
   


 

 


 


 

 


Total benefits and expenses

    10,076       3,578     13,654       9,775       3,655     13,430  
   


 

 


 


 

 


INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES

    1,577       122     1,699       2,191       443     2,634  
   


 

 


 


 

 


Income tax expense

    460       35     495       626       151     777  
   


 

 


 


 

 


INCOME FROM CONTINUING OPERATIONS

    1,117       87     1,204       1,565       292     1,857  
   


 

 


 


 

 


Loss from discontinued operations, net of taxes

    (18 )     —       (18 )     (45 )     —       (45 )
   


 

 


 


 

 


NET INCOME

  $ 1,099     $ 87   $ 1,186     $ 1,520     $ 292   $ 1,812  
   


 

 


 


 

 


 

See Notes to Unaudited Interim Supplemental Combining Financial Information

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Supplemental Combining Financial Information

 

1. BASIS OF PRESENTATION

 

The supplemental combining financial information presents the consolidated financial position and results of operations for Prudential Financial, Inc. and its subsidiaries (together, the “Company”), separately reporting the Financial Services Businesses and the Closed Block Business. The Financial Services Businesses and the Closed Block Business are both fully integrated operations of the Company and are not separate legal entities. The supplemental combining financial information presents the results of the Financial Services Businesses and the Closed Block Business as if they were separate reporting entities and should be read in conjunction with the consolidated financial statements.

 

The Company has outstanding two classes of common stock. The Common Stock reflects the performance of the Financial Services Businesses and the Class B Stock reflects the performance of the Closed Block Business.

 

The Closed Block Business was established on the date of demutualization and includes the assets and liabilities of the Closed Block (see Note 4 to the Unaudited Interim Consolidated Financial Statements for a description of the Closed Block). It also includes assets held outside the Closed Block necessary to meet insurance regulatory capital requirements related to products included within the Closed Block; deferred policy acquisition costs related to the Closed Block policies; the principal amount of the IHC debt (as discussed in Note 2 below) and related unamortized debt issuance costs, as well as an interest rate swap related to the IHC debt; and certain other related assets and liabilities. The Financial Services Businesses consist of the Insurance, Investment, and International Insurance and Investments divisions and Corporate and Other operations.

 

2. ALLOCATION OF RESULTS

 

This supplemental combining financial information reflects the assets, liabilities, revenues and expenses directly attributable to the Financial Services Businesses and the Closed Block Business, as well as allocations deemed reasonable by management in order to fairly present the financial position and results of operations of the Financial Services Businesses and the Closed Block Business on a stand alone basis. While management considers the allocations utilized to be reasonable, management has the discretion to make operational and financial decisions that may affect the allocation methods and resulting assets, liabilities, revenues and expenses of each business. In addition, management has limited discretion over accounting policies and the appropriate allocation of earnings between the two businesses. The Company is subject to agreements which provide that, in most instances, the Company may not change the allocation methodology or accounting policies for the allocation of earnings between the Financial Services Businesses and Closed Block Business without the prior consent of the Class B Stock holders or IHC debt bond insurer.

 

General corporate overhead not directly attributable to a specific business that has been incurred in connection with the generation of the businesses’ revenues is generally allocated between the Financial Services Businesses and the Closed Block Business based on the general and administrative expenses of each business as a percentage of the total general and administrative expenses for all businesses.

 

Prudential Holdings, LLC, a wholly owned subsidiary of Prudential Financial, Inc., has outstanding senior secured notes (the “IHC debt”), of which net proceeds of $1.66 billion were allocated to the Financial Services Businesses concurrent with the demutualization on December 18, 2001. The IHC debt is serviced by the cash flows of the Closed Block Business, and the results of the Closed Block Business reflect interest expense associated with the IHC debt.

 

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Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Supplemental Combining Financial Information—(Continued)

 

Income taxes are allocated between the Financial Services Businesses and the Closed Block Business as if they were separate companies based on the taxable income or losses and other tax characterizations of each business. If a business generates benefits, such as net operating losses, it is entitled to record such tax benefits to the extent they are expected to be utilized on a consolidated basis.

 

Holders of Common Stock have no interest in a separate legal entity representing the Financial Services Businesses; holders of the Class B Stock have no interest in a separate legal entity representing the Closed Block Business; and holders of each class of common stock are subject to all of the risks associated with an investment in the Company.

 

In the event of a liquidation, dissolution or winding-up of the Company, holders of Common Stock and holders of Class B Stock would be entitled to receive a proportionate share of the net assets of the Company that remain after paying all liabilities and the liquidation preferences of any preferred stock.

 

The results of the Financial Services Businesses are subject to certain risks pertaining to the Closed Block. These include any expenses and liabilities from litigation affecting the Closed Block policies as well as the consequences of certain potential adverse tax determinations. In connection with the sale of the Class B Stock and IHC debt, the cost of indemnifying the investors with respect to certain matters will be borne by the Financial Services Businesses.

 

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Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the consolidated financial condition of Prudential Financial as of June 30, 2006, compared with December 31, 2005, and its consolidated results of operations for the three months and six months ended June 30, 2006 and June 30, 2005. You should read the following analysis of our consolidated financial condition and results of operations in conjunction with the MD&A, the “Risk Factors” section and the audited Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, as well as the statements under “Forward-Looking Statements” and the Unaudited Interim Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.

 

Overview

 

Prudential Financial has two classes of common stock outstanding. The Common Stock, which is publicly traded (NYSE:PRU), reflects the performance of the Financial Services Businesses, while the Class B Stock, which was issued through a private placement and does not trade on any exchange, reflects the performance of the Closed Block Business. The Financial Services Businesses and the Closed Block Business are discussed below.

 

Financial Services Businesses

 

Our Financial Services Businesses consist of three operating divisions, which together encompass seven segments, and our Corporate and Other operations. The Insurance division consists of our Individual Life and Annuities and Group Insurance segments. The Investment division consists of our Asset Management, Financial Advisory, and Retirement segments. The International Insurance and Investments division consists of our International Insurance and International Investments segments. Our Corporate and Other operations include our real estate and relocation services business, as well as corporate items and initiatives that are not allocated to business segments. Corporate and Other operations also include businesses that have been or will be divested and businesses that we have placed in wind-down status.

 

We attribute financing costs to each segment based on the amount of financing used by each segment, excluding financing costs associated with corporate debt. The net investment income of each segment includes earnings on the amount of equity that management believes is necessary to support the risks of that segment.

 

We seek growth internally and through acquisitions, joint ventures or other forms of business combinations or investments. Our principal acquisition focus is in our current business lines, both domestic and international.

 

Closed Block Business

 

In connection with the demutualization, we ceased offering domestic participating products. The liabilities for our traditional domestic in force participating products were segregated, together with assets, in a regulatory mechanism referred to as the “Closed Block.” The Closed Block is designed generally to provide for the reasonable expectations for future policy dividends after demutualization of holders of participating individual life insurance policies and annuities included in the Closed Block by allocating assets that will be used exclusively for payment of benefits, including policyholder dividends, expenses and taxes with respect to these products. See Note 4 to the Unaudited Interim Consolidated Financial Statements for more information on the Closed Block. At the time of demutualization, we determined the amount of Closed Block assets so that the Closed Block assets initially had a lower book value than the Closed Block liabilities. We expect that the Closed Block assets will generate sufficient cash flow, together with anticipated revenues from the Closed Block policies, over the life of the Closed Block to fund payments of all expenses, taxes, and policyholder benefits to be paid to, and the reasonable dividend expectations of, holders of the Closed Block policies. We also segregated for accounting purposes the assets that we need to hold outside the Closed Block to meet capital requirements related

 

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Table of Contents

to the Closed Block policies. No policies sold after demutualization will be added to the Closed Block, and its in force business is expected to ultimately decline as we pay policyholder benefits in full. We also expect the proportion of our business represented by the Closed Block to decline as we grow other businesses.

 

Concurrently with our demutualization, Prudential Holdings, LLC, a wholly owned subsidiary of Prudential Financial that owns the capital stock of Prudential Insurance, issued $1.75 billion in senior secured notes, which we refer to as the IHC debt. The net proceeds from the issuances of the Class B Stock and IHC debt, except for $72 million used to purchase a guaranteed investment contract to fund a portion of the bond insurance cost associated with that debt, were allocated to the Financial Services Businesses. However, we expect that the IHC debt will be serviced by the net cash flows of the Closed Block Business over time, and we include interest expenses associated with the IHC debt when we report results of the Closed Block Business.

 

The Closed Block Business consists principally of the Closed Block, assets that we must hold outside the Closed Block to meet capital requirements related to the Closed Block policies, invested assets held outside the Closed Block that represent the difference between the Closed Block assets and Closed Block liabilities and the interest maintenance reserve, deferred policy acquisition costs related to Closed Block policies, the principal amount of the IHC debt and related hedging activities, and certain other related assets and liabilities.

 

Executive Summary

 

Prudential Financial, one of the largest financial services firms in the U.S., offers clients a wide array of financial products and services, including life insurance, mutual funds, annuities, pension and retirement-related services and administration, asset management, banking and trust services, real estate brokerage and relocation services, and, through a joint venture, retail securities brokerage services. We offer these products and services through one of the largest distribution networks in the financial services industry.

 

Significant developments and events in the first six months of 2006 reflect our continued efforts to redeploy capital effectively to seek enhanced returns. These developments included:

 

    The continuation of our share repurchase program. In the first six months of 2006, we repurchased 16.4 million shares of Common Stock at a total cost of $1.2 billion and are authorized, under a stock repurchase program authorized by Prudential Financial’s Board of Directors in November 2005, to repurchase up to an additional $1.3 billion of Common Stock during 2006.

 

    On June 1, 2006, we acquired the variable annuity business of The Allstate Corporation through a reinsurance transaction for $635 million of total consideration, consisting primarily of a $628 million ceding commission. Our initial investment in the business is $600 million, consisting of the total consideration, offset by the related tax benefits, plus an additional contribution of $94 million to meet regulatory capital requirements. See Note 3 to the Unaudited Interim Consolidated Financial Statements for further discussion of this acquisition.

 

We analyze performance of the segments and Corporate and Other operations of the Financial Services Businesses using a measure called adjusted operating income. See “—Consolidated Results of Operations” for a definition of adjusted operating income and a discussion of its use as a measure of segment operating performance.

 

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Table of Contents

Shown below are the contributions of each segment and Corporate and Other operations to our adjusted operating income for the three and six months ended June 30, 2006 and 2005 and a reconciliation of adjusted operating income of our segments and Corporate and Other operations to income from continuing operations before income taxes.

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Adjusted operating income before income taxes for segments of the Financial Services Businesses:

                                

Individual Life and Annuities

   $ 218     $ 220     $ 469     $ 437  

Group Insurance

     29       46       76       84  

Asset Management

     137       105       306       239  

Financial Advisory

     37       (97 )     (29 )     (82 )

Retirement

     142       142       279       297  

International Insurance

     324       327       662       612  

International Investments

     34       19       78       44  

Corporate and Other

     37       59       63       76  

Items excluded from adjusted operating income:

                                

Realized investment gains (losses), net, and related adjustments

     (334 )     322       (283 )     579  

Charges related to realized investment gains (losses), net

     23       (73 )     23       (94 )

Investment gains (losses) on trading account assets supporting insurance liabilities, net

     (151 )     190       (265 )     58  

Change in experience-rated contractholder liabilities due to asset value changes

     130       (145 )     196       (57 )

Divested businesses

     (6 )     3       2       (2 )
    


 


 


 


Income from continuing operations before income taxes for Financial Services Businesses

     620       1,118       1,577       2,191  

Income from continuing operations before income taxes for Closed Block Business

     38       198       122       443  
    


 


 


 


Consolidated income from continuing operations before income taxes

   $ 658     $ 1,316     $ 1,699     $ 2,634  
    


 


 


 


 

Results for the three and six months ended June 30, 2006 presented above reflect the following:

 

    Results of our international insurance operations for the current quarter were essentially unchanged from the second quarter of 2005 as the improved results from our international insurance operations other than Gibraltar Life, or Life Planner operations, were more than offset by a decline from our Gibraltar Life operation. Results for the first six months of 2006 improved $50 million, from $612 million in the first six months of 2005, including an $88 million increase from our Life Planner operations. The improved results of our Life Planner operations in both periods came primarily from continued growth of our Japanese and Korean Life Planner businesses. Gibraltar Life’s current year results reflected less favorable mortality experience than that of a year earlier, and refinements for policy liabilities and reserves reduced current year results and benefited prior year results.

 

   

Individual life results for the second quarter of 2006 were lower than the year-ago quarter primarily due to less favorable mortality experience, net of reinsurance, as well as greater amortization of acquisition costs reflecting unfavorable market performance in the current period and updates to estimated gross profit assumptions implemented in late 2005. Results for the first six months of 2006 were lower than the year-ago period as increased amortization of acquisition costs, reflecting updates to estimated gross profit assumptions implemented in late 2005, more than offset growth in fees. Individual annuities results improved due to higher fee income reflecting higher average asset balances from market

 

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appreciation and positive net flows in our variable annuity account values, as well as a contribution of $8 million from the business acquired from The Allstate Corporation on June 1, 2006.

 

    Improved results from our Asset Management segment, reflecting higher asset based fees as a result of increased asset values, increased revenues from our commercial mortgage operations and increased income from proprietary investing.

 

    Improved results in the current quarter from our International Investments segment attributable to higher earnings from the segment’s sales and trading operations and asset management operations. Results for the six months ended June 30, 2006 also benefited from $15 million of income that represented market value changes on securities held relating to trading exchange memberships.

 

    Retirement segment results for the current quarter were unchanged from a year ago, and results for the first six months of 2006 declined from the year-ago period. The effect of reserve releases due to updates of client census data, mortgage prepayment income, the collection of investment income on a previously defaulted bond in 2005 and expenses to expand our full service retirement capabilities more than offset growth of fee income due to higher full service retirement account balances, improved investment results from a larger base of invested assets in our institutional investment products business and lower transition costs in 2006.

 

    Results from our Group Insurance segment were lower than the previous year due to less favorable claims experience in our group life insurance business, which was partially offset by more favorable claims experience in our group disability business and an increased contribution from investment results, reflecting growth in invested assets and increased interest rates on shorter-term investments.

 

    Improved results from our Financial Advisory segment, reflecting increased fee income from our 38% share of the retail brokerage joint venture with Wachovia, as well as lower expenses related to obligations and costs we retained in connection with the contributed businesses, primarily for litigation and regulatory matters.

 

    Realized investment gains (losses), net, and related adjustments for the Financial Services Businesses amounted to losses of $334 million and $283 million in the three and six months ended June 30, 2006, respectively, reflecting in both periods net losses on sales and maturities of fixed maturity securities and fluctuations in the value of hedging instruments covering our foreign currency risk and investments.

 

    Income from continuing operations before income taxes in the Closed Block Business decreased $160 million from the prior year quarter, principally due to a decrease in net realized investment gains of $238 million. Results for the second quarter of 2006 include net losses on sales and maturities of fixed maturity securities and net losses in the value of hedging instruments used to manage the duration of our fixed maturity portfolio and hedge our foreign currency investments compared to net gains on sales and maturities of fixed maturity securities and net gains in the value of hedging instruments used to manage the duration of our fixed maturity portfolio in the prior year quarter.

 

Accounting Policies & Pronouncements

 

Accounting Pronouncements Adopted

 

See Note 2 to the Unaudited Interim Consolidated Financial Statements for a discussion of recently adopted accounting pronouncements, including the standard on accounting for share-based payments, FASB Statement No. 123(R) (revised 2004), “Share-Based Payment,” which was implemented effective January 1, 2006.

 

Recent Accounting Pronouncements

 

See Note 2 to the Unaudited Interim Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.

 

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Consolidated Results of Operations

 

The following table summarizes income from continuing operations for the Financial Services Businesses and the Closed Block Business as well as other components comprising net income.

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Financial Services Businesses by segment:

                                

Individual Life and Annuities

   $ 155     $ 215     $ 385     $ 454  

Group Insurance

     11       65       65       129  
    


 


 


 


Total Insurance Division

     166       280       450       583  

Asset Management

     137       105       306       239  

Financial Advisory

     37       (97 )     (29 )     (82 )

Retirement

     42       224       126       402  
    


 


 


 


Total Investment Division

     216       232       403       559  

International Insurance

     278       400       642       702  

International Investments

     34       18       79       42  
    


 


 


 


Total International Insurance and Investments Division

     312       418       721       744  

Corporate and Other

     (74 )     188       3       305  
    


 


 


 


Income from continuing operations before income taxes for Financial Services Businesses

     620       1,118       1,577       2,191  

Income from continuing operations before income taxes for Closed Block Business

     38       198       122       443  
    


 


 


 


Income from continuing operations before income taxes

     658       1,316       1,699       2,634  

Income tax expense

     190       389       495       777  
    


 


 


 


Income from continuing operations

     468       927       1,204       1,857  

Loss from discontinued operations, net of taxes

     (15 )     (44 )     (18 )     (45 )
    


 


 


 


Net income

   $ 453     $ 883     $ 1,186     $ 1,812  
    


 


 


 


 

In managing our business, we analyze operating performance separately for our Financial Services Businesses and our Closed Block Business. For the Financial Services Businesses, we analyze our segments’ operating performance using “adjusted operating income.” Results of the Closed Block Business for all periods are evaluated and presented only in accordance with GAAP. Adjusted operating income does not equate to “income from continuing operations before income taxes” or “net income” as determined in accordance with GAAP but is the measure of segment profit or loss we use to evaluate segment performance and allocate resources, and consistent with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” is our measure of segment performance. Adjusted operating income is calculated for the segments of the Financial Services Businesses by adjusting each segment’s “income from continuing operations before income taxes” to exclude the following items:

 

    realized investment gains (losses), net, except as indicated below, and related charges and adjustments;

 

    net investment gains and losses on trading account assets supporting insurance liabilities and changes in experience-rated contractholder liabilities due to asset value changes; and

 

    the contribution to income/loss of divested businesses that have been or will be sold or exited that do not qualify for “discontinued operations” accounting treatment under GAAP.

 

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The excluded items are important to an understanding of our overall results of operations. Adjusted operating income is not a substitute for income determined in accordance with GAAP, and our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability of the Financial Services Businesses. Adjusted operating income excludes “Realized investment gains (losses), net,” except as indicated below, and related charges and adjustments. A significant element of realized investment losses is impairments and losses from sales of credit-impaired securities, the timing of which depends largely on market credit cycles and can vary considerably across periods. The timing of other sales that would result in gains or losses is largely subject to our discretion and influenced by market opportunities, as well as our tax profile. Trends in the underlying profitability of our businesses can be more clearly identified without the fluctuating effects of these transactions. Similarly, adjusted operating income excludes investment gains and losses on trading account assets supporting insurance liabilities and changes in experience-rated contractholder liabilities due to asset value changes, because these recorded changes in asset and liability values will ultimately accrue to the contractholders. Adjusted operating income excludes the results of divested businesses because they are not relevant to understanding our ongoing operating results. The contributions to income/loss of wind-down businesses that we have not divested remain in adjusted operating income. See Note 9 to the Unaudited Interim Consolidated Financial Statements for further information on the presentation of segment results.

 

As noted above, certain “Realized investment gains (losses), net,” are included in adjusted operating income. We include in adjusted operating income the portion of our realized investment gains and losses on derivatives that arise from the termination of contracts used to hedge our foreign currency earnings in the same period that the expected earnings emerge. Similarly, we include in adjusted operating income the portion of our realized investment gains and losses on derivatives that represent current period yield adjustments. The realized investment gains or losses from products that are free standing derivatives, or contain embedded derivatives, along with the realized investment gains or losses from associated derivative portfolios that are part of an economic hedging program related to the risk of these products, are included in adjusted operating income. Adjusted operating income also includes for certain embedded derivatives, as current period yield adjustments, a portion of the cumulative realized investment gains, on an amortized basis over the remaining life of the related security, or cumulative realized investment losses in the period incurred. Adjusted operating income also include those realized investment gains and losses that represent profit or loss of certain of our businesses which primarily originate investments for sale or syndication to unrelated investors.

 

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Results of Operations for Financial Services Businesses by Segment

 

Insurance Division

 

Individual Life and Annuities

 

Operating Results

 

The following table sets forth the Individual Life and Annuities segment’s operating results for the periods indicated.

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
         2006    

        2005    

        2006    

        2005    

 
     (in millions)  

Operating results:

                                

Revenues:

                                

Individual Life

   $ 585     $ 548     $ 1,144     $ 1,080  

Individual Annuities

     469       420       922       844  
    


 


 


 


       1,054       968       2,066       1,924  
    


 


 


 


Benefits and expenses:

                                

Individual Life

     489       429       915       844  

Individual Annuities

     347       319       682       643  
    


 


 


 


       836       748       1,597       1,487  
    


 


 


 


Adjusted operating income:

                                

Individual Life

     96       119       229       236  

Individual Annuities

     122       101       240