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, 2008

 

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, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x   Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨

 

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 July 31, 2008, 425 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, 2008 and December 31, 2007

   1
    

Unaudited Interim Consolidated Statements of Operations for the three and six months ended June 30, 2008 and 2007

   2
    

Unaudited Interim Consolidated Statement of Stockholders’ Equity for the six months ended June 30, 2008

   3
    

Unaudited Interim Consolidated Statements of Cash Flows for the six months ended June 30, 2008 and 2007

   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, 2008 and December 31, 2007

   42
    

Unaudited Interim Supplemental Combining Statements of Operations for the three months ended June 30, 2008 and 2007

   43
    

Unaudited Interim Supplemental Combining Statements of Operations for the six months ended June 30, 2008 and 2007

   44
    

Notes to Unaudited Interim Supplemental Combining Financial Information

   45
  Item 2.   

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

   47
  Item 3.   

Quantitative and Qualitative Disclosures About Market Risk

   172
  Item 4.   

Controls and Procedures

   172
PART II   OTHER INFORMATION   
  Item 1.   

Legal Proceedings

   173
  Item 1A.   

Risk Factors

   173
  Item 2.   

Unregistered Sales of Equity Securities and Use of Proceeds

   174
  Item 4.   

Submission of Matters to a Vote of Security Holders

   174
  Item 6.   

Exhibits

   175
SIGNATURES    176

 

i


Table of Contents

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 fixed income, equity, 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, 2007 for discussion of certain risks relating to our businesses and investment in our securities.

 

ii


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, 2008 and December 31, 2007 (in millions, except share amounts)

 

     June 30,
2008
    December 31,
2007
 

ASSETS

    

Fixed maturities:

    

Available for sale, at fair value (amortized cost: 2008—$160,621; 2007—$160,137)

   $ 158,247     $ 162,162  

Held to maturity, at amortized cost (fair value: 2008—$3,490; 2007—$3,543)

     3,572       3,548  

Trading account assets supporting insurance liabilities, at fair value

     14,624       14,473  

Other trading account assets, at fair value

     3,129       3,613  

Equity securities, available for sale, at fair value (cost: 2008—$7,932; 2007—$7,895)

     8,095       8,580  

Commercial loans (includes $581 measured at fair value at June 30, 2008)

     32,464       30,047  

Policy loans

     9,587       9,337  

Securities purchased under agreements to resell

     184       129  

Other long-term investments

     6,931       6,431  

Short-term investments

     6,818       5,237  
                

Total investments

     243,651       243,557  

Cash and cash equivalents

     9,943       11,060  

Accrued investment income

     2,196       2,174  

Reinsurance recoverables

     1,961       2,119  

Deferred policy acquisition costs

     13,346       12,339  

Other assets

     24,191       18,982  

Separate account assets

     179,323       195,583  
                

TOTAL ASSETS

   $ 474,611     $ 485,814  
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

LIABILITIES

    

Future policy benefits

   $ 113,968     $ 111,468  

Policyholders’ account balances

     91,785       84,154  

Policyholders’ dividends

     1,906       3,661  

Reinsurance payables

     1,377       1,552  

Securities sold under agreements to repurchase

     8,166       11,441  

Cash collateral for loaned securities

     4,591       6,312  

Income taxes

     2,798       3,553  

Short-term debt

     13,776       15,657  

Long-term debt

     17,004       14,101  

Other liabilities

     18,348       14,875  

Separate account liabilities

     179,323       195,583  
                

Total liabilities

     453,042       462,357  
                

COMMITMENTS AND CONTINGENT LIABILITIES (See Note 12)

    

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; 604,902,108 and 604,901,479 shares issued as of June 30, 2008 and December 31, 2007, 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, 2008 and December 31, 2007, respectively)

     —         —    

Additional paid-in capital

     21,833       20,856  

Common Stock held in treasury, at cost (178,642,173 and 157,534,628 shares as of June 30, 2008 and December 31, 2007, respectively)

     (11,315 )     (9,693 )

Accumulated other comprehensive income (loss)

     (1,445 )     447  

Retained earnings

     12,490       11,841  
                

Total stockholders’ equity

     21,569       23,457  
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 474,611     $ 485,814  
                

 

See Notes to Unaudited Interim Consolidated Financial Statements

 

1


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Consolidated Statements of Operations

Three and Six Months Ended June 30, 2008 and 2007 (in millions, except per share amounts)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
     2008     2007     2008     2007

REVENUES

        

Premiums

   $ 3,927     $ 3,629     $ 7,885     $ 7,188

Policy charges and fee income

     824       785       1,649       1,570

Net investment income

     3,026       2,987       6,053       5,922

Realized investment gains (losses), net

     (898 )     117       (1,810 )     537

Asset management fees and other income

     830       907       1,496       1,983
                              

Total revenues

     7,709       8,425       15,273       17,200
                              

BENEFITS AND EXPENSES

        

Policyholders’ benefits

     4,011       3,733       8,046       7,418

Interest credited to policyholders’ account balances

     745       725       1,382       1,568

Dividends to policyholders

     158       605       717       1,316

General and administrative expenses

     2,160       2,219       4,439       4,328
                              

Total benefits and expenses

     7,074       7,282       14,584       14,630
                              

INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND EQUITY IN EARNINGS OF OPERATING JOINT VENTURES

     635       1,143       689       2,570
                              

Income tax expense

     66       324       95       747
                              

INCOME FROM CONTINUING OPERATIONS BEFORE EQUITY IN EARNINGS OF OPERATING JOINT VENTURES

     569       819       594       1,823

Equity in earnings of operating joint ventures, net of taxes

     24       56       67       133
                              

INCOME FROM CONTINUING OPERATIONS

     593       875       661       1,956

Income (loss) from discontinued operations, net of taxes

     (3 )     (29 )     (2 )     10
                              

NET INCOME

   $ 590     $ 846     $ 659     $ 1,966
                              

EARNINGS PER SHARE (See Note 6)

        

Financial Services Businesses

        

Basic:

        

Income from continuing operations per share of Common Stock

   $ 1.37     $ 1.89     $ 1.56     $ 4.04

Income (loss) from discontinued operations, net of taxes

     (0.01 )     (0.06 )     (0.01 )     0.01
                              

Net income per share of Common Stock

   $ 1.36     $ 1.83     $ 1.55     $ 4.05
                              

Diluted:

        

Income from continuing operations per share of Common Stock

   $ 1.35     $ 1.86     $ 1.53     $ 3.96

Income (loss) from discontinued operations, net of taxes

     —         (0.06 )     —         0.02
                              

Net income per share of Common Stock

   $ 1.35     $ 1.80     $ 1.53     $ 3.98
                              

Closed Block Business

        

Basic and Diluted:

        

Income (loss) from continuing operations per share of Class B Stock

   $ 0.50     $ (1.50 )   $ (9.50 )   $ 37.50

Income from discontinued operations, net of taxes

     —         —         —         1.00
                              

Net income (loss) per share of Class B Stock

   $ 0.50     $ (1.50 )   $ (9.50 )   $ 38.50
                              

 

See Notes to Unaudited Interim Consolidated Financial Statements

 

2


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Consolidated Statement of Stockholders’ Equity

Six Months Ended June 30, 2008 (in millions)

 

    Common
Stock
  Class B
Stock
  Additional
Paid-in
Capital
  Retained
Earnings
    Common
Stock
Held In
Treasury
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Stockholders’
Equity
 

Balance, December 31, 2007

  $ 6   $ —     $ 20,856   $ 11,841     $ (9,693 )   $ 447     $ 23,457  

Common Stock acquired

    —       —       —       —         (1,750 )     —         (1,750 )

Stock-based compensation programs

    —       —       —       (13 )     128       —         115  

Impact on Company’s investment in Wachovia Securities due to addition of A.G. Edwards business, net of tax

    —       —       977     —         —         —         977  

Cumulative effect of changes in accounting principles, net of taxes

    —       —       —       3       —         —         3  

Comprehensive income:

             

Net income

    —       —       —       659       —         —         659  

Other comprehensive loss, net of taxes

    —       —       —       —         —         (1,892 )     (1,892 )
                   

Total comprehensive income (loss)

    —       —       —       —         —         —         (1,233 )
                                                 

Balance, June 30, 2008

  $ 6   $ —     $ 21,833   $ 12,490     $ (11,315 )   $ (1,445 )   $ 21,569  
                                                 

 

See Notes to Unaudited Interim Consolidated Financial Statements

 

3


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Consolidated Statements of Cash Flows

Six Months Ended June 30, 2008 and 2007 (in millions)

 

     2008     2007  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 659     $ 1,966  

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

    

Realized investment (gains) losses, net

     1,810       (537 )

Policy charges and fee income

     (537 )     (473 )

Interest credited to policyholders’ account balances

     1,382       1,568  

Depreciation and amortization

     178       97  

Change in:

    

Deferred policy acquisition costs

     (513 )     (518 )

Future policy benefits and other insurance liabilities

     1,751       1,285  

Trading account assets supporting insurance liabilities and other trading account assets

     302       (16 )

Income taxes

     (465 )     34  

Other, net

     (962 )     (626 )
                

Cash flows from operating activities

     3,605       2,780  
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Proceeds from the sale/maturity/prepayment of:

    

Fixed maturities, available for sale

     46,923       44,192  

Fixed maturities, held to maturity

     111       135  

Trading account assets supporting insurance liabilities and other trading account assets

     11,952       —    

Equity securities, available for sale

     1,899       2,759  

Commercial loans

     1,162       2,474  

Policy loans

     716       640  

Other long-term investments

     525       536  

Short-term investments

     16,159       4,424  

Payments for the purchase/origination of:

    

Fixed maturities, available for sale

     (45,610 )     (42,845 )

Fixed maturities, held to maturity

     (24 )     (122 )

Trading account assets supporting insurance liabilities and other trading account assets

     (13,148 )     —    

Equity securities, available for sale

     (2,151 )     (2,751 )

Commercial loans

     (3,404 )     (3,003 )

Policy loans

     (737 )     (628 )

Other long-term investments

     (1,477 )     (943 )

Short-term investments

     (17,807 )     (6,273 )

Other, net

     (158 )     (92 )
                

Cash flows used in investing activities

     (5,069 )     (1,497 )
                

CASH FLOWS FROM FINANCING ACTIVITIES

    

Policyholders’ account deposits

     16,585       10,404  

Policyholders’ account withdrawals

     (10,603 )     (10,397 )

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

     (4,838 )     (2,409 )

Cash dividends paid on Common Stock

     (83 )     (80 )

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

     (1,244 )     578  

Common Stock acquired

     (1,717 )     (1,451 )

Common Stock reissued for exercise of stock options

     56       137  

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

     5,788       2,450  

Repayments of debt (maturities longer than 90 days)

     (3,444 )     (3,042 )

Excess tax benefits from share-based payment arrangements

     15       79  

Other, net

     (185 )     355  
                

Cash flows from (used in) financing activities

     330       (3,376 )
                

Effect of foreign exchange rate changes on cash balances

     17       (25 )

NET DECREASE IN CASH AND CASH EQUIVALENTS

     (1,117 )     (2,118 )

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR

     11,060       8,589  
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 9,943     $ 6,471  
                

NON-CASH TRANSACTIONS DURING THE PERIOD

    

Impact on Company’s investment in Wachovia Securities due to addition of A.G. Edwards business, net of tax

   $ 977     $ —    

Treasury Stock shares issued for convertible debt redemption

   $ —       $ 135  

Treasury Stock shares issued for stock-based compensation programs

   $ 87     $ 92  

 

See Notes to Unaudited Interim Consolidated Financial Statements

 

4


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 individual 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 services and administration, and investment management. In addition, the Company provides retail 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 policyholders’ 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 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 for the year ended December 31, 2007 included in the Company’s Current Report on Form 8-K dated May 16, 2008.

 

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 as of 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, valuation of investments including derivatives, future policy benefits including guarantees, pension and other postretirement benefits, provision for income taxes, reserves for contingent liabilities and reserves for losses in connection with unresolved legal matters.

 

5


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Reclassifications

 

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

 

2. ACCOUNTING POLICIES AND PRONOUNCEMENTS

 

Share-Based Payments

 

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 period, “the nominal vesting period,” or at the date the employee retires (as defined by the plan), if earlier. For awards granted between January 1, 2003 and 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 Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” on January 1, 2006, 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 to apply the non-substantive vesting period approach to all new share-based compensation awards granted on or 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.

 

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, 2008 would have been increased by $0.2 million and $1 million, respectively, with no reportable impact to the earnings per share of Common Stock, on both a basic and diluted basis. Net income of the Financial Services Businesses for the three months ended June 30, 2007 would have been increased by $2 million, with no reportable impact to the earnings per share of Common Stock, on both a basic and diluted basis. Net income of the Financial Services Businesses for the six months ended June 30, 2007 would have been increased by $5 million, or $0.01 per share of Common Stock, on both a basic and diluted basis.

 

Income Taxes

 

The Company’s liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the Internal Revenue Service or other taxing jurisdictions. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards (“tax attributes”), the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the liability for income taxes. The statute of limitations for the 2002 and 2003 tax years is set to expire in 2009. It is reasonably possible that the total amount of unrecognized tax benefits will decrease anywhere from $0 to $295 million within the next 12 months due to the expiration of the statute of limitations.

 

6


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Accounting Pronouncements Adopted

 

In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” This statement provides companies with an option to report selected financial assets and liabilities at fair value, with the associated changes in fair value reflected in the Consolidated Statements of Operations. The Company adopted this guidance effective January 1, 2008.

 

Upon the adoption of SFAS No. 159, the Company elected the fair value option for certain investments held within the commercial mortgage operations of the Asset Management segment. Specifically, the fair value option was elected for funded commercial loans held for sale originated beginning January 1, 2008. In addition, the Company elected the fair value option for fixed rate commercial loans held for investment that were held at December 31, 2007 and for such loans originated beginning January 1, 2008. The Company elected the fair value option for the loan programs mentioned above primarily to eliminate the need for hedge accounting under SFAS No. 133, while still achieving an offset in earnings from the associated interest rate derivative hedges.

 

Due to volatility in the credit markets, the Company experienced unexpected volatility in the fair value of the aforementioned fixed rate commercial loans held for investment that was not substantially offset by the associated interest rate derivative hedges during the quarter ended March 31, 2008. Therefore, the Company decided to no longer elect the fair value option on loans held for investment that were originated after March 31, 2008, and has applied hedge accounting under SFAS No. 133. See Note 10 for more information on SFAS No. 159.

 

The Company does not have material commercial loans held for sale outside of the commercial mortgage operations. The fair value option has not been elected for the Company’s other fixed rate commercial loans held for investment (primarily held by the general account), as the underlying business drivers and economics are different for these loans in that they are part of a diverse portfolio backing insurance liabilities.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement does not change which assets and liabilities are required to be recorded at fair value, but the application of this statement could change practices in determining fair value. The Company adopted this guidance effective January 1, 2008. See Note 10 for more information on SFAS No. 157.

 

In November 2007, the staff of the SEC issued Staff Accounting Bulletin (“SAB”) No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings.” SAB 109 revises and rescinds portions of SAB 105, “Application of Accounting Principles to Loan Commitments.” Specifically, SAB 109 states that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 109 is effective for all written loan commitments recorded at fair value that are entered into, or substantially modified, in fiscal quarters beginning after December 15, 2007. The Company adopted SAB 109 effective January 1, 2008 for its loan commitments that are recorded at fair value through earnings. 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 April 2007, the FASB issued FASB Staff Position (“FSP”) FIN 39-1, “Amendment of FASB Interpretation No. 39.” FSP FIN 39-1 modifies FIN No. 39, “Offsetting of Amounts Related to Certain Contracts,” and permits companies to offset cash collateral receivables or payables with net derivative positions under certain circumstances. This FSP is effective for fiscal years beginning after November 15, 2007 and is required to be applied retrospectively to financial statements for all periods presented. The Company’s adoption of this guidance effective January 1, 2008 did not have a material effect on the Company’s consolidated financial position or results of operations.

 

7


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

In January 2008, the FASB issued Statement No. 133 Implementation Issue No. E23, “Hedging—General: Issues Involving the Application of the Shortcut Method under Paragraph 68.” Implementation Issue No. E23 amends Statement No. 133, paragraph 68 with respect to the conditions that must be met in order to apply the shortcut method for assessing hedge effectiveness. This implementation guidance was effective for hedging relationships designated on or after January 1, 2008. The Company’s adoption of this guidance effective January 1, 2008 did not have a material effect on the Company’s consolidated financial position or results of operations.

 

Recent Accounting Pronouncements

 

In June 2008, the FASB Emerging Issues Task Force (“EITF”) reached consensus on the following issues contained in EITF Issue No. 07-5, “Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity’s Own Stock:” (1) how an entity should evaluate whether an instrument (or embedded feature) is indexed to the entity’s own stock; (2) how the currency in which the strike price of an equity-linked financial instrument (or embedded equity-linked feature) is denominated affects the determination of whether the instrument is indexed to the entity’s own stock; (3) how an issuer should account for market-based employee stock option valuation instruments. This guidance clarifies what instruments qualify as indexed to an entity’s own stock and are thereby exempt from requirements of FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and eligible for equity classification under EITF Issue No. 00-19, “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other then Employees.” This guidance is effective for fiscal years and interim periods beginning after December 15, 2008. Early application is not permitted. The Company is currently assessing the impact of EITF Issue No. 07-5 on the Company’s consolidated financial statements.

 

In June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” This FSP states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share (EPS) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, “Earnings per Share.” This FSP is effective for fiscal years and interim periods beginning after December 15, 2008, and must be applied retrospectively to all EPS data presented. The Company is currently assessing the impact of FSP EITF 03-6-1 on the Company’s calculation of EPS and the EPS data presented within the Company’s consolidated financial statements.

 

In May 2008, the FASB issued FSP APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement).” This FSP, which is effective for fiscal years and interim periods beginning after December 15, 2008 and must be applied retrospectively, addresses the accounting for certain convertible debt instruments including those that have been issued by the Company. It requires bifurcation of the instrument into a debt component that is initially recorded at fair value and an equity component. The difference between the fair value of the debt component and the initial proceeds from issuance of the instrument is recorded as a component of equity within additional paid-in capital. The liability component of the debt instrument is accreted to par using the effective yield method, with the accretion being reported as a component of interest expense. Bond issuance costs are allocated to the debt and equity components in proportion to the debt proceeds. The Company is currently assessing the impact of FSP APB 14-1 on the Company’s consolidated financial statements.

 

In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the list of factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under SFAS No. 142. The new guidance

 

8


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

applies to (1) intangible assets that are acquired individually or with a group of other assets and (2) intangible assets acquired in both business combinations and asset acquisitions. This FSP is effective for fiscal years and interim periods beginning after December 15, 2008, with the guidance for determining the useful life of a recognized intangible asset being applied prospectively to intangible assets acquired after the effective date and the disclosure requirements being applied prospectively to all intangible assets recognized as of, and after, the effective date. The Company is currently assessing the impact of this FSP on the Company’s consolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” an amendment of FASB Statement No. 133. This statement amends and expands the disclosure requirements for derivative instruments and hedging activities by requiring companies to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This statement is effective for fiscal years and interim periods beginning after November 15, 2008. The Company is currently assessing the impact of SFAS No. 161 on the notes to the consolidated financial statements.

 

In February 2008, the FASB issued FSP FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” The FSP provides recognition and derecognition guidance for a repurchase financing transaction, which is a repurchase agreement that relates to a previously transferred financial asset between the same counterparties, that is entered into contemporaneously with or in contemplation of, the initial transfer. The FSP is effective for fiscal years beginning after November 15, 2008. The FSP is to be applied prospectively to new transactions entered into after the adoption date. The Company will adopt this guidance effective January 1, 2009. The Company is currently assessing the impact of this FSP on the Company’s consolidated financial position and results of operations.

 

In February 2008, the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157.” This FSP applies to nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP FAS 157-2 delays the effective date of SFAS No. 157 for these items to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The Company is currently assessing the impact of this FSP on the Company’s consolidated financial position and results of operations.

 

In December 2007, the FASB issued SFAS No. 141R, “Business Combinations.” This statement, which addresses the accounting for business acquisitions, is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited, and generally applies to business acquisitions completed after December 31, 2008. Among other things, the new standard requires that all acquisition-related costs be expensed as incurred, and that all restructuring costs related to acquired operations be expensed as incurred. This new standard also addresses the current and subsequent accounting for assets and liabilities arising from contingencies acquired or assumed and, for acquisitions both prior and subsequent to December 31, 2008, requires the acquirer to recognize changes in the amount of its deferred tax benefits that are recognizable because of a business combination either in income from continuing operations in the period of the combination or directly in contributed capital, depending on the circumstances. The Company is currently assessing the impact of SFAS No. 141R on the Company’s consolidated financial position and results of operations.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements.” SFAS No. 160 will change the accounting for minority interests, which will be recharacterized as noncontrolling interests and classified by the parent company as a component of equity. This statement is effective

 

9


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. Upon adoption, SFAS No. 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests and prospective adoption for all other requirements. The Company is currently assessing the impact of SFAS No. 160 on the Company’s consolidated financial position and results of operations.

 

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” an amendment of FASB Statements No. 87, 88, 106 and 132(R). This statement requires an employer on a prospective basis to recognize the overfunded or underfunded status of its defined benefit pension and postretirement plans as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through other comprehensive income. The Company adopted this requirement, along with the required disclosures, on December 31, 2006. SFAS No. 158 also requires an employer on a prospective basis to measure the funded status of its plans as of its fiscal year-end. This requirement is effective for fiscal years ending after December 15, 2008. The Company will adopt this guidance on December 31, 2008 and anticipates that the impact of changing from a September 30 measurement date to a December 31 measurement date will not have a material effect on the Company’s consolidated financial position.

 

3. ACQUISITIONS AND DISPOSITIONS

 

Acquisition of Hyundai Investment and Securities Co., Ltd.

 

In 2004, the Company acquired an 80 percent interest in Hyundai Investment and Securities Co., Ltd., a Korean asset management firm, from an agency of the Korean government, for $301 million in cash, including $210 million used to repay debt assumed. Subsequent to the acquisition, the company was renamed Prudential Investment & Securities Co., Ltd. On January 25, 2008, the Company acquired the remaining 20 percent for $90 million.

 

Additional Investment in UBI Pramerica

 

On January 18, 2008, the Company made an additional investment of $154 million in its UBI Pramerica operating joint venture in Italy, which is accounted for under the equity method. This additional investment was necessary to maintain the Company’s ownership interest at 35 percent and was a result of the merger of the Company’s joint venture partner with another Italian bank, and their subsequent consolidation of their asset management companies into the UBI Pramerica joint venture.

 

Discontinued Operations

 

Income (loss) from discontinued businesses, including charges upon disposition, are as follows:

 

     Three Months
Ended June 30,
    Six Months
Ended June 30,
 
     2008     2007     2008     2007  
     (in millions)  

Equity sales, trading and research operations

   $ (1 )   $ (105 )   $ (2 )   $ (103 )

Real estate investments sold or held for sale

     —         44       1       62  

International securities operations

     (3 )     4       (2 )     1  

Healthcare operations

     —         —         —         5  
                                

Income (loss) from discontinued operations before income taxes

     (4 )     (57 )     (3 )     (35 )

Income tax expense (benefit)

     (1 )     (28 )     (1 )     (45 )
                                

Income (loss) from discontinued operations, net of taxes

   $ (3 )   $ (29 )   $ (2 )   $ 10  
                                

 

10


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The six months ended June 30, 2007 includes a $28 million tax benefit associated with a discontinued international business. Real estate investments sold or held for sale reflects the income from discontinued real estate investments.

 

The Company’s Unaudited Interim Consolidated Statements of Financial Position include total assets and total liabilities related to discontinued businesses of $137 million and $4 million, respectively, as of June 30, 2008 and $242 million and $98 million, respectively, as of December 31, 2007. 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

 

11


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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 December 31, 2007, the Company recognized a policyholder dividend obligation of $732 million to Closed Block policyholders for the excess of actual cumulative earnings over the expected cumulative earnings. Additionally, net unrealized investment gains (losses) that arose subsequent to the establishment of the Closed Block were reflected as an adjustment to the policyholder dividend obligation of $1.047 billion as of December 31, 2007, with an offsetting amount reported in “Accumulated other comprehensive income (loss).” As of June 30, 2008, the excess of actual cumulative earnings over the expected cumulative earnings was $83 million. However, due to the accumulation of net unrealized investment losses that have arisen subsequent to the establishment of the Closed Block, the policyholder dividend obligation balance as of June 30, 2008 was reduced to zero. See the table below for changes in the components of the policyholder dividend obligation for the six months ended June 30, 2008.

 

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,
2008
    December 31,
2007
 
     (in millions)  

Closed Block Liabilities

    

Future policy benefits

   $ 51,471     $ 51,208  

Policyholders’ dividends payable

     1,204       1,212  

Policyholder dividend obligation

     —         1,779  

Policyholders’ account balances

     5,586       5,555  

Other Closed Block liabilities

     6,743       10,649  
                

Total Closed Block Liabilities

     65,004       70,403  
                

Closed Block Assets

    

Fixed maturities, available for sale, at fair value

     39,860       45,459  

Other trading account assets, at fair value

     145       142  

Equity securities, available for sale, at fair value

     3,454       3,858  

Commercial loans

     8,004       7,353  

Policy loans

     5,380       5,395  

Other long-term investments

     1,290       1,311  

Short-term investments

     1,146       1,326  
                

Total investments

     59,279       64,844  

Cash and cash equivalents

     1,082       1,310  

Accrued investment income

     617       630  

Other Closed Block assets

     536       581  
                

Total Closed Block Assets

     61,514       67,365  
                

Excess of reported Closed Block Liabilities over Closed Block Assets

     3,490       3,038  

Portion of above representing accumulated other comprehensive income:

    

Net unrealized investment gains (losses)

     (558 )     1,006  

Allocated to policyholder dividend obligation

     83       (1,047 )
                

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

   $ 3,015     $ 2,997  
                

 

12


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Information regarding the policyholder dividend obligation is as follows:

 

     Six Months Ended
June 30, 2008
 
     (in millions)  

Balance, January 1, 2008

   $ 1,779  

Impact from earnings allocable to policyholder dividend obligation

     (649 )

Change in net unrealized investment gains (losses)

     (1,130 )
        

Balance, June 30, 2008

   $ —    
        

 

Closed Block revenues and benefits and expenses for the three and six months ended June 30, 2008 and 2007 were as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
         2008             2007         2008     2007
     (in millions)

Revenues

        

Premiums

   $ 965     $ 945     $ 1,821     $ 1,783

Net investment income

     800       866       1,641       1,725

Realized investment gains (losses), net

     (349 )     (7 )     (444 )     193

Other income

     8       11       27       24
                              

Total Closed Block revenues

     1,424       1,815       3,045       3,725
                              

Benefits and Expenses

        

Policyholders’ benefits

     1,093       1,074       2,065       2,023

Interest credited to policyholders’ account balances

     35       35       70       71

Dividends to policyholders

     155       576       657       1,259

General and administrative expenses

     160       177       332       348
                              

Total Closed Block benefits and expenses

     1,443       1,862       3,124       3,701
                              

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

     (19 )     (47 )     (79 )     24
                              

Income tax expense (benefit)

     (9 )     (58 )     (61 )     5
                              

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

     (10 )     11       (18 )     19

Income from discontinued operations, net of taxes

     —         —         —         2
                              

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

   $ (10 )   $ 11     $ (18 )   $ 21
                              

 

13


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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, 2007

   604.9    157.5     447.4     2.0

Common Stock issued

   —      —       —       —  

Common Stock acquired

   —      23.2     (23.2 )   —  

Stock-based compensation programs(1)

   —      (2.1 )   2.1     —  
                     

Balance, June 30, 2008

   604.9    178.6     426.3     2.0
                     

 

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

 

Common Stock Held in Treasury

 

In November 2007, Prudential Financial’s Board of Directors authorized the Company to repurchase at the discretion of management up to $3.5 billion of its outstanding Common Stock in calendar year 2008. The timing and amount of any repurchases under this authorization will be determined by management based upon market conditions and other considerations, and the repurchases may be effected in the open market, through derivative, accelerated repurchase and other negotiated transactions and through prearranged trading plans complying with Rule 10b5-1(c) under the Securities Exchange Act of 1934, as amended (“the Exchange Act”). The 2008 stock repurchase program supersedes all previous repurchase programs. During the six months ended June 30, 2008, the Company acquired 23.2 million shares of its Common Stock at a total cost of $1.750 billion.

 

Comprehensive Income

 

The components of comprehensive income are as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2008             2007         2008     2007  
     (in millions)  

Net income

   $  590     $ 846     $ 659     $ 1,966  

Other comprehensive income (loss), net of taxes:

        

Change in foreign currency translation adjustments

     8       (111 )     261       (151 )

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

     (926 )     (741 )     (2,164 )     (540 )

Change in pension and postretirement unrecognized net periodic benefit

     12       12       11       24  
                                

Other comprehensive income (loss)(2)

     (906 )     (840 )     (1,892 )     (667 )
                                

Comprehensive income (loss)

   $ (316 )   $ 6     $ (1,233 )   $ 1,299  
                                

 

(1) Includes cash flow hedges of $23 million and $(5) million for the three months ended June 30, 2008 and 2007, respectively, and $(53) million and $(2) million for the six months ended June 30, 2008 and 2007, respectively.
(2) Amounts are net of tax expense (benefit) of $(625) million and $(345) million for the three months June 30, 2008 and 2007, respectively and $(1,156) million and $(214) million for the six months ended June 30, 2008 and 2007, respectively.

 

14


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The balance of and changes in each component of “Accumulated other comprehensive income (loss)” for the six months ended June 30, 2008 are as follows (net of taxes):

 

     Accumulated Other Comprehensive Income (Loss)  
     Foreign
Currency
Translation
Adjustments
   Net
Unrealized
Investment
Gains
(Losses)(1)
    Pension and
Postretirement
Unrecognized
Net Periodic
Benefit (Cost)
    Total
Accumulated
Other
Comprehensive
Income (Loss)
 
     (in millions)  

Balance, December 31, 2007

   $  312    $ 400     $ (265 )   $ 447  

Change in component during period

     261      (2,164 )     11       (1,892 )
                               

Balance, June 30, 2008

   $ 573    $ (1,764 )   $ (254 )   $ (1,445 )
                               
         

 

(1) Includes cash flow hedges of $(226) million and $(173) million as of June 30, 2008 and December 31, 2007, respectively.

 

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.

 

15


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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,
    2008   2007
    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

  $ 578       $ 864    

Direct equity adjustment

    14         14    
                   

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

  $ 592   431.9   $ 1.37   $ 878   463.7   $ 1.89
                               

Effect of dilutive securities and compensation programs

           

Stock options

    3.6       5.8  

Deferred and long-term compensation programs

    2.2       2.5  

Convertible senior notes

    —         0.8  
               

Diluted earnings per share

           

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

  $ 592   437.7   $ 1.35   $ 878   472.8   $ 1.86
                               
    Six Months Ended June 30,
    2008   2007
    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

  $ 654       $ 1,852    

Direct equity adjustment

    26         29    
                   

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

  $ 680   437.0   $ 1.56   $ 1,881   466.0   $ 4.04
                               

Effect of dilutive securities and compensation programs

           

Stock options

    3.7       5.8  

Deferred and long-term compensation programs

    2.4       2.7  

Convertible senior notes

    —         0.4  
               

Diluted earnings per share

           

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

  $ 680   443.1   $ 1.53   $ 1,881   474.9   $ 3.96
                               

 

16


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

For the three months ended June 30, 2008 and 2007, 7.0 million and 1.6 million options, respectively, weighted for the portion of the period they were outstanding, with a weighted average exercise price of $79.62 and $91.66 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, 2008 and 2007, 5.6 million and 1.4 million options, respectively, weighted for the portion of the period they were outstanding, with a weighted average exercise price of $81.03 and $91.53 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.

 

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 $2.0 billion November 2005 issuance was called for redemption in May 2007, as discussed in Note 7 below. These notes were dilutive to earnings per share for the three and six months ended June 30, 2007 by 0.8 million and 0.4 million shares, respectively, for the period prior to the conversion date, as the average market price of the Common Stock was above $90.00, the initial conversion price. The $2.0 billion December 2006 issuance will be dilutive to earnings per share if the average market price of the Common Stock for a particular period is above the initial conversion price of $104.21. The $3.0 billion December 2007 issuance will be dilutive to earnings per share if the average market price of the Common Stock for a particular period is above the initial conversion price of $132.39.

 

Class B Stock

 

Income (loss) from continuing operations per share of Class B Stock was $0.50 and $(1.50) for the three months ended June 30, 2008 and 2007, respectively, and $(9.50) and $37.50 for the six months ended June 30, 2008 and 2007, respectively.

 

The income (loss) from continuing operations attributable to the Closed Block Business available to holders of Class B Stock after direct equity adjustment for the three months ended June 30, 2008 and 2007 amounted to $1 million and $(3) million, respectively. The direct equity adjustment resulted in a decrease in the income (loss) from continuing operations attributable to the Closed Block Business applicable to holders of Class B Stock for earnings per share purposes of $14 million for both the three months ended June 30, 2008 and 2007. The income (loss) from continuing operations attributable to the Closed Block Business available to holders of Class B Stock after direct equity adjustment for the six months ended June 30, 2008 and 2007 amounted to $(19) million and $75 million, respectively. The direct equity adjustment resulted in a decrease in the income (loss) from continuing operations attributable to the Closed Block Business applicable to holders of Class B Stock for earnings per share purposes of $26 million and $29 million for the six months ended June 30, 2008 and 2007, respectively. For the three and six months ended June 30, 2008 and 2007, the weighted average number of shares of Class B Stock used in the calculation of earnings per share amounted to 2.0 million. There are no potentially dilutive shares associated with the Class B Stock.

 

7. DEBT

 

Junior Subordinated Notes

 

In June 2008, Prudential Financial issued $600 million of 8.875% fixed-to-floating rate junior subordinated notes to institutional investors. Also in June 2008, Prudential Financial issued $800 million of junior subordinated notes to retail investors with a fixed interest rate of 9.0% paid quarterly. Both issuances are considered hybrid equity securities, which receive enhanced equity treatment from the rating agencies. Both series of notes have a scheduled maturity of June 15, 2038 and a final maturity of June 15, 2068. Prudential Financial is required to use commercially reasonable efforts, subject to market disruption events, to raise sufficient proceeds from the issuance of specified qualifying capital securities, which include hybrid equity

 

17


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

securities, to repay the principal of the notes at their scheduled maturity. For the institutional notes, interest is payable semi-annually at a fixed rate of 8.875% until June 15, 2018, from which date interest is payable quarterly at a floating rate of 3-month LIBOR plus 5.00%. Prudential Financial may redeem the institutional notes, subject to the terms of the replacement capital covenant, or RCC, as discussed below, in whole or in part, on or after June 15, 2018 at their principal amount plus accrued and unpaid interest or prior to June 15, 2018 at a make-whole price. Prudential Financial may redeem the retail notes, subject to the terms of the RCC as discussed below, on or after June 15, 2013, in whole or in part, at their principal amount plus accrued and unpaid interest or prior to June 15, 2013, in whole, at a make-whole price. Both series of notes may also be redeemed in whole upon the occurrence of certain defined events. Prudential Financial has the right to defer interest payments on either or both series of notes for a period up to ten years, during which time interest will be compounded. If Prudential Financial were to exercise its right to defer interest it will be required, commencing on the earlier of (i) the first interest payment date on which current interest is paid after the deferral period or (ii) the fifth anniversary of the deferral period, to issue specified alternative payment securities, which include but are not limited to Common Stock, to satisfy its obligation with respect to the deferred interest. In connection with the issuance of both series of notes, Prudential Financial entered into a RCC for the benefit of holders of debt that is senior to the junior subordinated notes. Under the RCC, Prudential Financial agreed that it will not repay, redeem, defease, or purchase the notes prior to June 15, 2048, unless it has received proceeds from the issuance of specified replacement capital securities, which include but are not limited to hybrid equity securities as well as Common Stock. The RCC will terminate upon the occurrence of certain events, including acceleration due to an event of default. Interest expense on the notes was $2 million for the three and six months ended June 30, 2008. On July 11, 2008, Prudential Financial issued an additional $120 million of retail junior subordinated notes following the underwriters’ exercise of their over-allotment option.

 

Convertible Senior Notes

 

On May 21, 2007, the Company called for redemption the $2 billion of outstanding floating rate convertible senior notes issued in 2005. Prior to redemption by the Company, substantially all holders elected to convert their senior notes as provided under their terms. The senior notes required net settlement in shares; therefore, upon conversion, the holders received cash equal to the par amount of the senior notes surrendered for conversion plus accrued interest and shares of Prudential Financial Common Stock for the portion of the settlement amount in excess of the par amount. The settlement amount in excess of the par amount was based upon the excess of the closing market price of Prudential Financial Common Stock for a 10-day period defined under the terms of the senior notes, or $100.80 per share, over the initial conversion price of $90 per share. Accordingly, at conversion the Company issued 2,367,887 shares of Common Stock from treasury. The conversion had no impact on our results of operations and resulted in a net increase to shareholders’ equity of $44 million, reflecting the tax benefit associated with the conversion of the senior notes.

 

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 an account balance that takes into consideration age, service and earnings during their career.

 

The Company provides certain health care and life insurance 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.

 

18


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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

 

     Three Months Ended June 30,  
     Pension Benefits     Other Postretirement
Benefits
 
     2008     2007         2008             2007      
     (in millions)  

Components of net periodic (benefit) cost

        

Service cost

   $ 38     $ 42     $ 3     $ 3  

Interest cost

     117       108       31       34  

Expected return on plan assets

     (180 )     (192 )     (40 )     (23 )

Amortization of prior service cost

     11       7       (3 )     (1 )

Amortization of actuarial (gain) loss, net

     4       7       —         4  

Special termination benefits

     —         2       —         —    
                                

Net periodic (benefit) cost

   $ (10 )   $ (26 )   $ (9 )   $ 17  
                                
     Six Months Ended June 30,  
     Pension Benefits     Other Postretirement
Benefits
 
     2008     2007         2008             2007      
     (in millions)  

Components of net periodic (benefit) cost

        

Service cost

   $ 77     $ 84     $ 6     $ 6  

Interest cost

     234       216       62       68  

Expected return on plan assets

     (360 )     (384 )     (80 )     (46 )

Amortization of prior service cost

     22       14       (6 )     (2 )

Amortization of actuarial (gain) loss, net

     8       14       —         7  

Special termination benefits

     2       2       —         —    
                                

Net periodic (benefit) cost

   $ (17 )   $ (54 )   $ (18 )   $ 33  
                                

 

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 eight 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. Collectively, the businesses that comprise the three operating divisions and Corporate and Other are referred to as the Financial Services Businesses.

 

In 2008, the Company classified its commercial mortgage securitization operations as a divested business, reflecting its decision to exit this business. As a result of this decision, these operations, which involved the origination and purchase of commercial mortgage loans that we in turn would aggregate and sell into commercial mortgage-backed securitization transactions, together with related hedging activities, previously reported within the Asset Management segment, have been classified within divested businesses and are reflected in the Company’s Corporate and Other operations. Accordingly, these results are excluded from adjusted operating

 

19


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

income, with prior period results being adjusted to reflect such reclassification. These operations had pre-tax losses of $16 million and $123 million for the three and six months ended June 30, 2008, respectively, and pre-tax gains of $23 million and $32 million for the three and six months ended June 30, 2007, respectively. The Company retained and continues the remainder of its commercial mortgage origination, servicing and other commercial mortgage related activities, which remain a part of the Asset Management segment.

 

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 and equity in earnings of operating joint ventures” 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 and equity in earnings of operating joint ventures” for the following items, which are described in greater detail below:

 

   

realized investment gains (losses), net, 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;

 

   

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; and

 

   

equity in earnings of operating joint ventures.

 

These 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.

 

Effective with the first quarter of 2008, the Company amended its definition of adjusted operating income as it relates to certain externally managed investments in the European market held within the general account portfolio. These investments are medium term notes that are collateralized by investment portfolios primarily consisting of investment grade European fixed income securities, including corporate bonds and asset-backed securities, and derivatives, as well as varying degrees of leverage. The notes have a stated coupon and provide a return based on the performance of the underlying portfolios and the level of leverage. The Company invests in these notes to earn a coupon through maturity, consistent with its investment purpose for other debt securities. The notes are accounted for under U.S. GAAP as available for sale fixed maturity securities with bifurcated embedded derivatives (total return swaps). Changes in the value of the fixed maturity securities are reported in Stockholders’ Equity under the heading “Accumulated Other Comprehensive Income” and changes in the market value of the embedded total return swaps are included in current period earnings in “Realized investment gains (losses), net.” Historically, adjusted operating income included cumulative losses and recoveries of such losses on the embedded derivatives in the period they occurred, while cumulative net gains on the embedded derivatives were deferred and amortized into adjusted operating income over the remaining life of the notes.

 

20


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Adjusted operating income under the amended definition excludes any amounts related to changes in the market value of the embedded derivatives. Adjusted operating income for all periods presented has been revised to conform with the amended definition. The Company views adjusted operating income under the amended definition as a more meaningful presentation of its results for purposes of analyzing the operating performance of, and allocating resources to, its business segments, as the amended definition presents the results of these investments on a basis generally consistent with similar investments held directly within the general account portfolio. The Company believes the mark to market losses discussed below, resulting primarily from unprecedented credit spread widening, are not representative of the fundamental value of the underlying investments over the long term. Adjusted operating income continues to include the coupon on these notes, which reflects the market based interest rate and spread of securities comparable to the underlying securities that existed at the time the Company entered into the investments. The accounting for these investments under U.S. GAAP has not changed.

 

For the three months ended June 30, 2008 and 2007, the Company recorded gains of $22 million and $3 million, respectively, and for the six months ended June 30, 2008 and 2007, the Company recorded a loss of $186 million and a gain of $11 million, respectively, within “Realized investment gains (losses), net” related to the change in value on the embedded derivatives associated with these investments, which are excluded from adjusted operating income under the amended definition. Adjusted operating income under the former definition included gains of $2 million and $3 million, respectively, for the three and six months ended June 30, 2007, which represented the amortization of cumulative deferred gains.

 

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 investment gains and losses are impairments and credit-related and interest rate-related gains and losses. Impairments and losses from sales of credit-impaired securities, the timing of which depends largely on market credit cycles, can vary considerably across periods. The timing of other sales that would result in gains or losses, such as interest rate-related 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 are associated with: policyholder dividends; amortization of deferred policy acquisition costs, valuation of business acquired (“VOBA”), unearned revenue reserves and deferred sales inducements; 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 the Company sells; and minority interest in consolidated operating subsidiaries. The related charges associated with policyholder dividends include a percentage of the net increase in the fair value of specified assets included in Gibraltar Life’s reorganization plan that is required to be paid as a special dividend to Gibraltar Life policyholders. Deferred policy acquisition costs, VOBA, unearned revenue reserves and deferred sales inducements 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 the Company’s 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

 

21


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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 commodities group, 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 identified non-U.S. dollar denominated 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 (net gains of $3 million and $25 million for the three months ended June 30, 2008 and 2007, respectively, and net gains of $4 million and $46 million for the six months ended June 30, 2008 and 2007, respectively). As of June 30, 2008 and December 31, 2007, the fair value of open contracts used for this purpose was a net asset of $36 million and a net asset of $12 million, respectively.

 

The Company uses interest rate 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, 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 net gains of $17 million and $20 million for the three months ended June 30, 2008 and 2007, respectively, and net gains of $29 million and $43 million for the six months ended June 30, 2008 and 2007, 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 U.S.

 

22


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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 net losses of $2 million and net gains of $13 million for the three months ended June 30, 2008 and 2007, respectively, and net losses of $45 million and net gains of $28 million for the six months ended June 30, 2008 and 2007, respectively, related to these products and any associated derivative portfolio.

 

Adjustments are also made for the purposes of calculating adjusted operating income for the following items:

 

The Company conducts certain activities for which “Realized investment gains (losses), net” are a principal source of earnings for its businesses and therefore included in adjusted operating income, particularly within the Company’s Asset Management segment. For example, Asset Management’s 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, including related derivative results, are a principal source of earnings for this business and included in adjusted operating income. In addition, the “Realized investment gains (losses), net” associated with loans originated by the Company’s commercial mortgage operations, including related derivative results and retained mortgage servicing rights, are a principal source of earnings for this business and included in adjusted operating income. Net realized investment losses of $44 million and gains of $39 million for the three months ended June 30, 2008 and 2007, respectively, and losses of $83 million and gains of $58 million for the six months ended June 30, 2008 and 2007, respectively, related to these and other businesses were included in adjusted operating income as an adjustment to “Realized investment gains (losses), net.”

 

The Company has certain investments supporting insurance liabilities in its general account portfolio that are classified as trading. These trading investments are carried at fair value and included in “Other trading account assets, at fair value” on the Company’s statements of financial position. Realized and unrealized gains and losses for these investments are recorded in “Asset management fees and other income,” and interest and dividend income for these investments is recorded in “Net investment income.” Consistent with the exclusion of realized investment gains and losses with respect to other investments supporting insurance liabilities managed on a consistent basis, the net gains or losses on these investments, which is recorded within “Asset management fees and other income,” is excluded from adjusted operating income and is reflected as an adjustment to “Realized investment gains (losses), net.” These adjustments were net gains of $15 million for the three months ended June 30, 2008 and $18 million for the six months ended June 30, 2008. There was no adjustment for the three and six months ended June 30, 2007.

 

The Company has certain assets and liabilities for which, under GAAP, the change in value due to changes in foreign currency exchange rates during the period is recorded in “Asset management fees and other income.” To the extent the foreign currency exposure on these assets and liabilities is economically hedged, the change in value included in “Asset management fees and other income” is excluded from adjusted operating income and is reflected as an adjustment to “Realized investment gains (losses), net.” These adjustments were a net loss of $18 million and net gain of $13 million for the three months ended June 30, 2008 and 2007, respectively, and net gains of $47 million and $25 million for the six months ended June 30, 2008 and 2007, 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 and International Insurance segments are experience-rated in that investment results associated with these products will ultimately accrue to contractholders. The investments supporting these experience-rated products, excluding commercial loans, are classified as trading and are carried at fair value. These trading investments are reflected on the statements of financial position as “Trading account assets supporting insurance

 

23


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

liabilities, at fair value.” Realized and unrealized gains and losses for these investments are reported in “Asset management fees and other income.” Interest and dividend income for these investments is reported in “Net investment income.” Commercial 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. In addition, to be consistent with the historical treatment of charges related to realized investment 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 commercial 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.

 

Equity in earnings of operating joint ventures. Equity in earnings of operating joint ventures, on a pre-tax basis, are included in adjusted operating income as these results are a principal source of earnings. These earnings are reflected on a GAAP basis on an after-tax basis as a separate line on the Company’s Unaudited Interim Consolidated Statements of Operations.

 

24


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The summary below reconciles adjusted operating income before income taxes for the Financial Services Businesses to income from continuing operations before income taxes and equity in earnings of operating joint ventures:

 

     Three Months
Ended
June 30,
    Six Months
Ended
June 30,
 
     2008     2007     2008     2007  
     (in millions)  

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

        

Individual Life

   $ 103     $ 141     $ 199     $ 242  

Individual Annuities

     154       180       269       346  

Group Insurance

     80       69       170       120  
                                

Total Insurance Division

     337       390       638       708  
                                

Asset Management

     190       167       309       342  

Financial Advisory

     23       72       67       169  

Retirement

     141       138       265       286  
                                

Total Investment Division

     354       377       641       797  
                                

International Insurance

     453       410       866       822  

International Investments

     26       43       52       105  
                                

Total International Insurance and Investments Division

     479       453       918       927  
                                

Corporate Operations

     (2 )     (26 )     (14 )     (14 )

Real Estate and Relocation Services

     (3 )     18       (26 )     15  
                                

Total Corporate and Other

     (5 )     (8 )     (40 )     1  
                                

Adjusted Operating Income before income taxes for Financial Services Businesses

     1,165       1,212       2,157       2,433  

Reconciling items:

        

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

     (527 )     41       (1,192 )     188  

Charges related to realized investment gains (losses), net

     41       (7 )     28       (13 )

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

     (123 )     (108 )     (385 )     (26 )

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

     94       72       294       10  

Divested businesses

     (13 )     18       (125 )     46  

Equity in earnings of operating joint ventures

     (40 )     (100 )     (100 )     (220 )
                                

Income from continuing operations before income taxes and equity in earnings of operating joint ventures for Financial Services Businesses

     597       1,128       677       2,418  

Income from continuing operations before income taxes and equity in earnings of operating joint ventures for Closed Block Business

     38       15       12       152  
                                

Income from continuing operations before income taxes and equity in earnings of operating joint ventures

   $ 635     $ 1,143     $ 689     $ 2,570  
                                

 

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.

 

25


Table of Contents

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,
 
         2008             2007             2008             2007      
     (in millions)  

Financial Services Businesses:

        

Individual Life

   $ 676     $ 629     $ 1,356     $ 1,260  

Individual Annuities

     622       632       1,195       1,236  

Group Insurance

     1,218       1,211       2,475       2,416  
                                

Total Insurance Division

     2,516       2,472       5,026       4,912  
                                

Asset Management

     564       590       1,112       1,135  

Financial Advisory

     36       94       87       205  

Retirement

     1,207       1,150       2,474       2,313  
                                

Total Investment Division

     1,807       1,834       3,673       3,653  
                                

International Insurance

     2,329       2,055       4,654       4,108  

International Investments

     154       169       330       346  
                                

Total International Insurance and Investments Division

     2,483       2,224       4,984       4,454  
                                

Corporate Operations

     25       58       78       158  

Real Estate and Relocation Services

     63       81       109       140  
                                

Total Corporate and Other

     88       139       187       298  
                                

Total

     6,894       6,669       13,870       13,317  
                                

Reconciling items:

        

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

     (527 )     41       (1,192 )     188  

Charges related to realized investment gains (losses), net

     15       2       16       3  

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

     (123 )     (108 )     (385 )     (26 )

Divested businesses

     (6 )     28       (103 )     54  

Equity in earnings of operating joint ventures

     (40 )     (100 )     (100 )     (220 )
                                

Total Financial Services Businesses

     6,213       6,532       12,106       13,316  
                                

Closed Block Business

     1,496       1,893       3,167       3,884  
                                

Total per Unaudited Interim Consolidated Financial Statements

   $ 7,709     $ 8,425     $ 15,273     $ 17,200  
                                

 

The Asset Management segment revenues include intersegment revenues of $87 million and $91 million for the three months ended June 30, 2008 and 2007, respectively, and $180 million and $182 million for the six months ended June 30, 2008 and 2007, 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.

 

26


Table of Contents

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,
2008
   December 31,
2007
     (in millions)

Individual Life

   $ 35,574    $ 36,124

Individual Annuities

     74,513      76,685

Group Insurance

     30,857      32,913
             

Total Insurance Division

     140,944      145,722
             

Asset Management

     41,379      40,592

Financial Advisory

     2,884      1,294

Retirement

     126,764      132,614
             

Total Investment Division

     171,027      174,500
             

International Insurance

     68,591      65,387

International Investments

     11,114      7,711
             

Total International Insurance and Investments Division

     79,705      73,098
             

Corporate Operations

     13,754      17,430

Real Estate and Relocation Services

     1,171      1,281
             

Total Corporate and Other

     14,925      18,711
             

Total Financial Services Businesses

     406,601      412,031
             

Closed Block Business

     68,010      73,783
             

Total per Unaudited Interim Consolidated Financial Statements

   $ 474,611    $ 485,814
             

 

10. FAIR VALUE

 

Transition Impact—As discussed in Note 2, the Company adopted SFAS No. 157 and SFAS No. 159 effective January 1, 2008. As a result of adopting SFAS No. 157, the Company eliminated the deferral of gains at inception of certain derivatives contracts whose fair value was not evidenced by market-observable data. The elimination of the deferral of these gains resulted in a net after-tax increase to retained earnings of $3 million.

 

Also as discussed in Note 2, in conjunction with the adoption of SFAS No. 159, the Company elected the fair value option for fixed rate commercial loans held for investment that were held at December 31, 2007. This election resulted in $399 million of commercial loans being reported at fair value, with no material impact on the Company’s consolidated financial position. In addition, SFAS No. 159 requires entities to classify cash receipts and cash payments related to items measured at fair value according to their nature and purpose on the Statement of Cash Flows. As a result, cash flows related to trading account assets supporting insurance liabilities and certain other assets are classified as investing rather than operating as of the adoption date of this guidance.

 

27


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Fair Value Measurement—Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS No. 157 establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:

 

Level 1—Fair value is based on unadjusted quoted prices in active markets that are accessible to the Company for identical assets or liabilities. These generally provide the most reliable evidence and are used to measure fair value whenever available. The Company’s Level 1 assets and liabilities primarily include certain cash equivalents, equity securities and derivative contracts that are traded in an active exchange market. Prices are obtained from readily available sources for market transactions involving identical assets or liabilities.

 

Level 2—Fair value is based on significant inputs, other than Level 1 inputs, that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets and liabilities, quoted market prices in markets that are not active for identical or similar assets or liabilities and other market observable inputs. The Company’s Level 2 assets and liabilities include: fixed maturities (corporate public and private bonds, most government securities, certain asset-backed and mortgage-backed securities, etc.), certain equity securities and commercial loans, short-term investments and certain cash equivalents (primarily commercial paper), and certain over-the-counter derivatives. Valuations are generally obtained from third party pricing services for identical or comparable assets or liabilities (and validated through comparison to internal pricing information and economic indicators as well as backtesting to trade data or other data to confirm that the pricing service significant inputs are observable) or determined through use of valuation methodologies using observable market inputs. Under certain conditions, the Company may conclude the prices received from independent third party pricing services are not reasonable or reflective of market activity. In those instances, the Company may choose to over-ride the pricing information received and apply internally developed values to the related assets or liabilities. In such cases, the valuations are generally classified as Level 3. As of June 30, 2008 such over-rides on a net basis resulted in lower pricing levels being used and in aggregate were not materially different from the prices received from the independent pricing services.

 

Level 3—Fair value is based on significant unobservable inputs for the asset or liability. These inputs reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability. The Company’s Level 3 assets and liabilities primarily include: certain private fixed maturities and equity securities, certain manually priced public equity securities and fixed maturities, including certain asset-backed securities, certain highly structured over-the-counter derivative contracts, certain commercial loans, certain consolidated real estate funds for which the Company is the general partner, and embedded derivatives resulting from certain products with guaranteed benefits. Prices are determined using valuation methodologies such as option pricing models, discounted cash flow models and other similar techniques.

 

28


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis, as of June 30, 2008.

 

     As of June 30, 2008
     Level 1    Level 2    Level 3    Netting(2)     Total
     (in millions)

Fixed maturities, available for sale

   $ 5    $ 156,383    $ 1,859    $ —       $ 158,247

Trading account assets supporting insurance liabilities

     1,141      13,326      157      —         14,624

Other trading account assets

     674      4,168      640      (2,353 )     3,129

Equity securities, available for sale

     5,596      2,361      138      —         8,095

Commercial loans

     —        511      70      —         581

Other long-term investments

     379      216      928      —         1,523

Short term investments

     3,860      1,258      —        —         5,118

Cash and cash equivalents

     1,757      6,184      —        —         7,941

Other assets

     33      3,977      —        —         4,010
                                   

Sub-total excluding separate account assets

     13,445      188,384      3,792      (2,353 )     203,268

Separate account assets(1)

     85,460      69,304      24,559      —         179,323
                                   

Total assets

   $ 98,905    $ 257,688    $ 28,351    $ (2,353 )   $ 382,591
                                   

Future policy benefits

     —        —        327      —         327

Long-term debt

     —        —        211      —         211

Other liabilities

     28      2,641      88      (1,980 )     777
                                   

Total liabilities

   $ 28    $ 2,641    $ 626    $ (1,980 )   $ 1,315
                                   

 

(1) Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account assets classified as Level 3 consist primarily of real estate and real estate investment funds. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Unaudited Interim Consolidated Statement of Financial Position.
(2) “Netting” amounts represent cash collateral and the impact of offsetting asset and liability positions held with the same counterparty as permitted by FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts and FSP FIN 39-1, Amendment of FASB Interpretation No. 39.

 

29


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

The following tables provide a summary of the changes in fair value of Level 3 assets and liabilities for the three and six months ended June 30, 2008, as well as the portion of gains or losses included in income for the three and six months ended June 30, 2008 attributable to unrealized gains or losses related to those assets and liabilities still held at June 30, 2008.

 

    Three Months Ended June 30, 2008  
    Fixed
Maturities,
Available For
Sale
    Trading
Account
Assets
Supporting
Insurance
Liabilities
    Other
Trading
Account
Assets
    Equity
Securities,
Available
for Sale
    Commercial
Loans
 
    (in millions)  

Fair value, beginning of period

  $ 3,099     $ 193     $ 626     $ 187     $ —    

Total gains or (losses) (realized/unrealized):

         

Included in earnings:

         

Realized investment gains (losses), net

    (85 )     —         (67 )     (1 )     (5 )

Asset management fees and other income

    —         —         1       —         —    

Included in other comprehensive income (loss)

    (7 )     —         —         (9 )     —    

Net investment income

    1       (1 )     —         —         —    

Purchases, sales, issuances, and settlements

    (306 )     (7 )     81       22       (6 )

Foreign currency translation

    —         —         (1 )     (1 )     —    

Transfers into (out of) Level 3(1)

    (843 )     (28 )     —         (60 )     81  
                                       

Fair value, end of period

  $ 1,859     $ 157     $ 640     $ 138     $ 70  
                                       

Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period(2):

         

Included in earnings:

         

Realized investment gains (losses), net

  $ (92 )   $ —       $ (68 )   $ (2 )   $ (4 )

Asset management fees and other income

  $ —       $ (2 )   $ 2     $ —       $ —    

Included in other comprehensive income (loss)

  $ (7 )   $ —       $ —       $ (9 )   $ —    

 

30


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

    Three Months Ended June 30, 2008  
    Other
Long-term
Investments
  Separate
Account
Assets(3)
    Future
Policy
Benefits
    Long-
Term
Debt
    Other
Liabilities
 
    (in millions)  

Fair value, beginning of period

  $ 877   $ 22,108     $ (452 )   $ (184 )   $ (118 )

Total gains or (losses) (realized/unrealized):

         

Included in earnings:

         

Realized investment gains (losses), net

    —       —         147       —         30  

Asset management fees and other income

    8     —         —         —         —    

Interest credited to policyholders’ account

balances

    —       (240 )     —         —         —    

Included in other comprehensive income

    —       —         —         —         —    

Net investment income

    1     —         —         —         —    

Purchases, sales, issuances, and settlements

    42     956       (22 )     (27 )     —    

Transfers into (out of) Level 3(1)

    —       1,735       —         —         —    
                                     

Fair value, end of period

  $ 928   $ 24,559     $ (327 )   $ (211 )   $ (88 )
                                     

Unrealized gains (losses) for the period relating to those Level 3 assets and liabilities that were still held by the Company at the end of the period(2):

         

Included in earnings:

         

Realized investment gains (losses), net

  $ —     $ —       $ 134     $ —       $ 31  

Asset management fees and other income

  $ 9   $ —       $ —       $ (1 )   $ —    

Interest credited to policyholders’ account balances

  $ —     $ (112 )   $ —       $ —       $ —    

 

(1) Transfers into or out of level 3 are generally reported as the value as of the beginning of the quarter in which the transfer occurs.
(2) Unrealized gains or losses related to assets still held at the end of the period do not include amortization or accretion of premiums and discounts.
(3) Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Unaudited Interim Consolidated Statement of Financial Position.

 

Transfers—Transfers out of Level 3 for Fixed Maturities Available for Sale and Equity Securities Available for Sale totaled $843 million and $60 million, respectively, during the three months ended June 30, 2008. This activity was a result of the use of pricing service information that the Company was able to validate in the second quarter of 2008 but which was not available in the first quarter of 2008. The amount of Separate Account Assets transferred into Level 3 in the second quarter total $1,735 million. This resulted from further review of valuation methodologies for certain assets that had been previously classified as Level 2. In addition, for certain assets, third party prices with backtesting were not available in the current quarter and the use of broker quotes required a transfer to Level 3. Transfers of Commercial Loans into Level 3 totaled $81 million and resulted from a reduction in the availability of market available prices during the second quarter due to market illiquidity.

 

31


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

    Six Months Ended June 30, 2008  
    Fixed
Maturities,
Available
For Sale
    Trading
Account
Assets
Supporting
Insurance
Liabilities
    Other
Trading
Account
Assets
    Equity
Securities,
Available
for Sale
    Commercial
Loans
 
    (in millions)  

Fair value, beginning of period

  $ 2,890     $ 291     $ 497     $ 190     $ —    

Total gains or (losses) (realized/unrealized):

         

Included in earnings:

         

Realized investment gains (losses), net

    (229 )     —         32       (2 )     (5 )

Asset management fees and other income

    —         1       (4 )     —         —    

Included in other comprehensive income (loss)

    (129 )     —         —         (21 )     —    

Net investment income

    4       (1 )     —         —         —    

Purchases, sales, issuances, and settlements

    (364 )     (16 )     115       20       (6 )

Foreign currency translation

    —         —         —         —         —    

Transfers into (out of) Level 3(1)

    (313 )     (118 )     —         (49 )     81  
                                       

Fair value, end of period

  $ 1,859     $ 157     $ 640     $ 138     $ 70  
                                       

Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period(2):

         

Included in earnings:

         

Realized investment gains (losses), net

  $ (232 )   $ —       $ 32     $ (3 )   $ (4 )

Asset management fees and other income

  $ —       $ (11 )   $ (4 )   $ —       $ —    

Included in other comprehensive income (loss)

  $ (125 )   $ —       $ —       $ (21 )   $ —    

 

32


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

     Six Months Ended June 30, 2008  
     Other
Long-term
Investments
   Separate
Account
Assets(3)
    Future
Policy
Benefits
    Long-
Term
Debt
    Other
Liabilities
 
     (in millions)  

Fair value, beginning of period

   $ 824    $ 21,815     $ (168 )   $ (152 )   $ (77 )

Total gains or (losses) (realized/unrealized):

           

Included in earnings:

           

Realized investment gains (losses), net

     —        —         (118 )     —         (11 )

Asset management fees and other income

     90      —         —         1       —    

Interest credited to policyholders’ account balances

     —        (71 )     —         —         —    

Included in other comprehensive income

     —        —         —         —         —    

Net investment income

     3      —         —         —         —    

Purchases, sales, issuances, and settlements

     11      1,118       (41 )     (60 )     —    

Transfers into (out of) Level 3(1)

     —        1,697       —         —         —    
                                       

Fair value, end of period

   $ 928    $ 24,559     $ (327 )   $ (211 )   $ (88 )
                                       

Unrealized gains (losses) for the period relating to those Level 3 assets and liabilities that were still held by the Company at the end of the period(2):

           

Included in earnings:

           

Realized investment gains (losses), net

   $ —      $ —       $ (133 )   $ —       $ (11 )

Asset management fees and other income

   $ 59    $ —       $ —       $ 1     $ —    

Interest credited to policyholders’ account balances

   $ —      $ (234 )   $ —       $ —       $ —    

 

(1) Transfers into or out of level 3 are generally reported as the value as of the beginning of the quarter in which the transfer occurs.
(2) Unrealized gains or losses related to assets still held at the end of the period do not include amortization or accretion of premiums and discounts.
(3) Separate account assets represent segregated funds that are invested for certain customers. Investment risks associated with market value changes are borne by the customers, except to the extent of minimum guarantees made by the Company with respect to certain accounts. Separate account liabilities are not included in the above table as they are reported at contract value and not fair value in the Company’s Unaudited Interim Consolidated Statement of Financial Position.

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis. As of June 30, 2008, the Company has written down certain commercial loans that are carried at the lower of cost or market, to their fair value of $203 million. This resulted in charges of $21 million and $44 million for the three and six months ended June 30, 2008, respectively. The fair value measurements at June 30, 2008 were classified as Level 3 in the valuation hierarchy. The inputs utilized for these valuations are pricing indicators from the whole loan market, which the Company considers its principal market for these loans. The fair value measurements at March 31, 2008 were classified as Level 2 in the valuation hierarchy. This change in valuation level was a result of a reduction in the availability of market available prices during the second quarter due to market illiquidity.

 

In addition, as of June 30, 2008, $113 million of equity and cost method investments had been written down to fair value, resulting in impairments of $11 million and $13 million for the three and six months ended June 30, 2008. These fair value measurements were classified as Level 3 in the valuation hierarchy. The inputs utilized were primarily discounted estimated future cash flows and valuations provided by the general partners taken into consideration with deal and management fee expenses.

 

33


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Fair Value Option—As discussed above, SFAS No. 159 provides a fair value option election that allows the Company to irrevocably elect fair value as the measurement attribute for certain financial assets and liabilities. The following table presents information regarding changes in fair values recorded in earnings, including gains or losses on sales, for commercial loans where the fair value option has been elected.

 

     Three Months Ended
June 30, 2008
    Six Months Ended
June 30, 2008
 
     Reported in Realized Investment Gains
(Losses), net
 
     (in millions)  

Assets:

    

Commercial Loans:

    

Changes in instrument-specific credit risk

   $ (2 )   $ (21 )

Other changes in fair value

   $ (15 )   $ (1 )

 

Changes in fair value due to instrument-specific credit risk are estimated based on changes in credit spreads and quality ratings for the period reported.

 

None of the loans where the fair value option has been selected are more than 90 days past due or in non-accrual status. Interest income on commercial loans is included in net investment income. For the three and six months ended June 30, 2008, the Company recorded $11 million and $21 million, respectively of interest income on these loans. Interest income on these loans is recorded based on the effective interest rates as determined at the closing of the loan.

 

The fair values and aggregate contractual principal amounts of commercial loans, for which the fair value option has been elected, were $581 million and $599 million, respectively, as of June 30, 2008.

 

11. INVESTMENT IN WACHOVIA SECURITIES

 

On July 1, 2003, the Company combined its retail securities brokerage and clearing operations with those of Wachovia Corporation (“Wachovia”) and formed Wachovia Securities Financial Holdings, LLC (“Wachovia Securities”), a joint venture headquartered in St. Louis, Missouri. As of December 31, 2007, the Company had a 38% ownership interest in the joint venture with Wachovia owning the remaining 62%. The transaction included certain assets and liabilities of the Company’s securities brokerage operations; however, the Company retained certain assets and liabilities related to the contributed businesses, including liabilities for certain litigation and regulatory matters. The Company and Wachovia have each agreed to indemnify the other for certain losses, including losses resulting from litigation and regulatory matters relating to certain events arising from the operations of their respective contributed businesses prior to March 31, 2004.

 

On October 1, 2007, Wachovia completed the acquisition of A.G. Edwards, Inc. (“A.G. Edwards”) for $6.8 billion and on January 1, 2008 combined the retail securities brokerage business of A.G. Edwards with Wachovia Securities.

 

The Company has elected the “lookback” option under the terms of the agreements relating to the joint venture. The “lookback” option permits the Company to delay for two years following the combination of the A.G. Edwards business with Wachovia Securities the Company’s decision to make or not to make payments to avoid or limit dilution of its ownership interest in the joint venture. During this “lookback” period, the Company’s share in the earnings of the joint venture and one-time costs associated with the combination of the A.G. Edwards business with Wachovia Securities is based on the Company’s diluted ownership level, which is in

 

34


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

the process of being determined. Any payments at the end of the “lookback” period to restore all or part of the Company’s ownership interest in the joint venture will be based on the appraised or agreed value of the joint venture excluding the A.G. Edwards business as well as the A.G. Edwards business. In such event, the Company would also need to make a true-up payment of one-time costs incurred during the “lookback” period associated with the combination to reflect the incremental increase in its ownership interest in the joint venture. Alternatively, at the end of the “lookback” period, the Company may “put” its joint venture interests to Wachovia based on the appraised value of the joint venture, excluding the A.G. Edwards business, as of January 1, 2008, the date of the combination of the A.G. Edwards business with Wachovia Securities.

 

The Company also retains its separate right to “put” its joint venture interests to Wachovia at any time after July 1, 2008 based on the appraised value of the joint venture, including the A.G. Edwards business, determined as if it were a public company and including a control premium such as would apply in the case of a sale of 100% of its common equity. However, if in connection with the “lookback” option the Company elects at the end of the “lookback” period to make payments to avoid or limit dilution, the Company may not exercise this “put” option prior to the first anniversary of the end of the “lookback” period. The agreement between Prudential Financial and Wachovia also gives the Company put rights, and Wachovia call rights, in certain other specified circumstances, at prices determined in accordance with the agreement.

 

The Company and Wachovia are currently negotiating possible modifications to the terms of the existing agreements relating to the joint venture. Based upon the existing agreements and our estimates of the values of the A.G. Edwards business and the joint venture excluding the A.G. Edwards business, the Company adjusted the carrying value of its ownership interest in the joint venture effective as of January 1, 2008 to reflect the addition of that business and the dilution of its 38% ownership level and to record the value of the above described rights under the “lookback” option. As a result, effective January 1, 2008, the Company recognized an increase to “Additional paid-in capital” of $977 million, net of tax. The Company’s recorded share of pre-tax earnings from the joint venture of $86 million for the six months ended June 30, 2008 reflects its estimated diluted ownership level based upon the existing agreements and its estimates of the values of the A.G. Edwards business and the joint venture excluding the A.G. Edwards business. As noted above, the Company and Wachovia are negotiating possible modifications to the terms of the existing agreements relating to the joint venture. Such modifications, if agreed to, as well as the establishment of definitive agreed or appraised values for the A.G. Edwards business and the joint venture excluding the A.G. Edwards business, will result in an adjustment to the credit to equity and a true-up to the earnings from the joint venture for any difference between the diluted ownership percentage used to record earnings for the six months ended June 30, 2008 and the finally determined diluted ownership percentage. The Company does not anticipate any such adjustment to have a material effect on its reported results of operations.

 

Earnings of the joint venture included in the results of the Financial Advisory segment are subject to certain risks pertaining to the joint venture operations, including customer claims, litigation and regulatory investigations affecting Wachovia Securities’ businesses. Such customer claims, litigation and regulatory matters include matters typical for retail securities brokerage and clearing operations and matters unique to the joint venture operations. In recent months, following the failure in early 2008 of the auctions which set the rates for most auction rate securities, Wachovia Securities has become the subject of customer complaints, legal actions, including a putative class action, and investigations by securities regulators and agencies relating to Wachovia Securities’ role in the underwriting, sale and auction of auction rate securities.

 

35


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

12. 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 product 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.

 

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 the Company’s businesses and operations that are specific to it and proceedings that are typical of the businesses in which it 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. The outcome of a litigation or regulatory matter, and the amount or range of potential loss at any particular time, is often inherently uncertain.

 

Insurance and Annuities

 

From November 2002 to March 2005, eleven separate complaints were filed against the Company and the law firm of Leeds Morelli & Brown in New Jersey state court. The cases were consolidated for pre-trial proceedings in New Jersey Superior Court, Essex County and captioned Lederman v. Prudential Financial, Inc., et al. The complaints allege that an alternative dispute resolution agreement entered into among Prudential Insurance, over 350 claimants who are current and former Prudential Insurance employees, and Leeds Morelli & Brown (the law firm representing the claimants) was illegal and that Prudential Insurance conspired with Leeds Morelli & Brown to commit fraud, malpractice, breach of contract, and violate racketeering laws by advancing legal fees to the law firm with the purpose of limiting Prudential’s liability to the claimants. In 2004, the Superior Court sealed these lawsuits and compelled them to arbitration. In May 2006, the Appellate Division reversed the trial court’s decisions, held that the cases were improperly sealed, and should be heard in court rather than arbitrated. In November 2006, plaintiffs filed a motion seeking to permit over 200 individuals to join the cases as additional plaintiffs, to authorize a joint trial on liability issues for all plaintiffs, and to add a claim under the New Jersey discrimination law. In March 2007, the court granted plaintiffs’ motion to amend the complaint to add over 200 additional plaintiffs and a claim under the New Jersey discrimination law but denied without prejudice plaintiffs’ motion for a joint trial on liability issues. In June 2007, Prudential Financial and Prudential Insurance moved to dismiss the complaint. In November 2007, the court granted the motion, in part, and dismissed the commercial bribery and conspiracy to commit malpractice claims and denied the motion with respect to other claims. In December 2007, the Prudential defendants answered the complaints and asserted counterclaims against each plaintiff for breach of contract and cross-claims against Leeds Morelli & Brown for breach of contract and the covenant of good faith and fair dealing, fraudulent inducement, indemnification and contribution. In January 2008, plaintiffs filed a demand pursuant to New Jersey law stating that they were seeking damages in the amount of $6.5 billion.

 

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

 

36


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

(“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 in an effort to resolve the inquiries into this matter. In December 2006, Prudential Insurance reached a resolution of the NYAG investigation. Under the terms of the settlement, Prudential Insurance paid a $2.5 million penalty and established a $16.5 million fund for policyholders, adopted business reforms and agreed, among other things, to continue to cooperate with the NYAG in any litigation, ongoing investigations or other proceedings. Prudential Insurance also settled the litigation brought by the California Department of Insurance and agreed to business reforms and disclosures as to group insurance contracts insuring customers or residents in California and to pay certain costs of investigation. In addition, in April 2008, Prudential Insurance reached a settlement of proceedings regarding these matters with the District Attorneys of San Diego, Los Angeles and Alameda counties. Pursuant to this settlement, Prudential Insurance paid $350,000 in penalties and costs. 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. In August and September 2007, the court dismissed the anti-trust and RICO claims. In January 2008, the court dismissed the ERISA claims with prejudice. In February 2008, the court dismissed the state law claims without prejudice. Plaintiffs have appealed to the Third Circuit Court of Appeals. The above settlements may adversely affect the existing litigation or cause additional litigation and result in adverse publicity and other potentially adverse impacts to the Company’s business.

 

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. 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, Prudential Annuities Life Assurance Corporation (formerly known as American Skandia Life Assurance Corporation), is in the final stages of its 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.

 

37


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

Securities

 

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 current 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.” In December 2006, the United States Court of Appeals for the Second Circuit vacated that decision and remanded the case to the district court for further proceedings. 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 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 district court denied class certification. In September 2007, the Second Circuit Court of Appeals reversed the district court’s decision denying class certification and remanded the case to the district court for further proceedings. 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. In June 2008, the CHS Electronics and Gillet matters were settled by all defendants. Prudential Securities’ share of the settlement amount was not material.

 

Other Matters

 

Mutual Fund Market Timing Practices

 

In August 2006, Prudential Equity Group, LLC (“PEG”), a wholly owned subsidiary of the Company, reached a resolution of the previously disclosed regulatory and criminal investigations into deceptive market related activities involving PEG’s former Prudential Securities operations. The settlements relate to conduct that generally occurred between 1999 and 2003 involving certain former Prudential Securities brokers in Boston and certain other branch offices in the U.S., their supervisors, and other members of the Prudential Securities control structure with responsibilities that related to the market timing activities, including certain former members of Prudential Securities senior management. The Prudential Securities operations were contributed to a joint venture with Wachovia Corporation in July 2003, but PEG retained liability for the market timing related activities. In connection with the resolution of the investigations, PEG entered into separate settlements with each of the United States Attorney for the District of Massachusetts (“USAO”), the Secretary of the Commonwealth of Massachusetts, Securities Division, the SEC, the National Association of Securities Dealers, the New York Stock Exchange, the New Jersey Bureau of Securities and the New York Attorney Generals Office. These settlements resolve the investigations by the above named authorities into these matters as to all Prudential entities without further regulatory proceedings or filing of charges so long as the terms of the settlement are followed and provided, in the case of the settlement agreement reached with the USAO, that the USAO has reserved the right to prosecute PEG if there is a material breach by PEG of that agreement during its five year term and in certain other specified events. Under the terms of the settlements, PEG paid $270 million into a Fair Fund administered by the SEC to compensate those harmed by the market timing activities. In addition, $330 million was paid in fines and penalties. Pursuant to the settlements, PEG retained, at PEG’s ongoing cost and expense, the services of an Independent Distribution Consultant acceptable to certain of the authorities to develop a proposed distribution plan for the distribution of Fair Fund amounts according to a methodology developed in consultation with and

 

38


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

acceptable to certain of the authorities. In addition, as part of the settlements, PEG has agreed, among other things, to continue to cooperate with the above named authorities in any litigation, ongoing investigations or other proceedings relating to or arising from their investigations into these matters. In connection with the settlements, the Company has agreed with the USAO, among other things, to cooperate with the USAO and to maintain and periodically report on the effectiveness of its compliance procedures. The settlement documents include findings and admissions that may adversely affect existing litigation or cause additional litigation and result in adverse publicity and other potentially adverse impacts to the Company’s businesses.

 

In addition to the regulatory proceedings described above that were settled in 2006, in October 2004, the Company and Prudential Securities 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, but remained a defendant in other actions in the consolidated proceeding. In June 2008, the Company was dismissed with prejudice from the remaining actions consolidated in In re: Mutual Fund Investment Litigation, other than Saunders v. Putnam American Government Income Fund, et al. In July 2006, in Saunders, the United States District Court for the District of Maryland had granted plaintiffs leave to refile their federal securities law claims against Prudential Securities. In August 2006, the second amended complaint was filed alleging federal securities law claims on behalf of a purported nationwide class of mutual fund investors seeking compensatory and punitive damages in unspecified amounts. In July 2008, the Company moved for summary judgment and plaintiffs moved for class certification in Saunders.

 

Commencing in 2003, the Company received formal requests for information from the SEC and NYAG relating to market timing in variable annuities by certain Prudential Annuities entities. In connection with these investigations, with the approval of Skandia Insurance Company Ltd. (publ) (“Skandia”), an offer was made by Prudential Annuities to the authorities investigating its companies, the SEC and NYAG, to settle these matters by paying restitution and a civil penalty of $95 million in the aggregate. While not assured, the Company believes these discussions are likely to lead to settlements with these authorities. Any regulatory settlement involving a Prudential Annuities entity would be subject to the indemnification provisions of the acquisition agreement pursuant to which the Company purchased the Prudential Annuities entities in May 2003 from Skandia. If achieved, settlement of the matters relating to Prudential Annuities 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.

 

Other

 

In October 2007, Prudential Retirement Insurance and Annuity Co. (“PRIAC”) filed an action in the United States District Court for the Southern District of New York, Prudential Retirement Insurance & Annuity Co. v. State Street Global Advisors, in PRIAC’s fiduciary capacity and on behalf of certain defined benefit and defined contribution plan clients of PRIAC, against an unaffiliated asset manager, State Street Global Advisors (“SSgA”) and SSgA’s affiliate, State Street Bank and Trust Company (“State Street”). This action seeks, among other relief, restitution of certain losses attributable to certain investment funds sold by SSgA as to which PRIAC believes SSgA employed investment strategies and practices that were misrepresented by SSgA and failed to exercise the standard of care of a prudent investment manager. PRIAC also intends to vigorously pursue any other available remedies against SSgA and State Street in respect of this matter. Given the unusual circumstances surrounding the management of these SSgA funds and in order to protect the interests of the affected plans and

 

39


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

their participants while PRIAC pursues these remedies, PRIAC implemented a process under which affected plan clients that authorized PRIAC to proceed on their behalf have received payments from funds provided by PRIAC for the losses referred to above. The Company’s consolidated financial statements, and the results of the Retirement segment included in the Company’s Investment Division, for the year ended December 31, 2007 include a pre-tax charge of $82 million, reflecting these payments to plan clients and certain related costs.

 

In September and October 2005, five purported class action lawsuits were filed against the Company, Prudential Securities and PEG claiming that stockbrokers were improperly classified as exempt employees under state and federal wage and hour laws, were improperly denied overtime pay and that improper deductions were made from the stockbrokers’ wages. Two of the stockbrokers’ 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 stockbrokers complaints filed in California Superior Court, Dewane v. 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. The Carayanis complaint was subsequently withdrawn without prejudice in May 2006. 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 stockbrokers in violation of state and federal law and that improper deductions were made from the stockbrokers’ wages in violation of state law. In September 2006, Prudential Securities was sued in Badain v. Wachovia Securities, et al., a purported nationwide class action filed in the United States District Court for the Western District of New York. The complaint alleges that Prudential Securities failed to pay overtime to stockbrokers in violation of state and federal law and that improper deductions were made from the stockbrokers’ wages in violation of state law. In December 2006, these cases were transferred to the United States District Court for the Central District of California by the Judicial Panel on Multidistrict Litigation for coordinated or consolidated pre-trial proceedings. The complaints seek back overtime pay and statutory damages, recovery of improper deductions, interest, and attorneys’ fees. In October 2006, a purported class action lawsuit, Bouder v. Prudential Financial, Inc. and Prudential Insurance Company of America, was filed in the United States District Court for the District of New Jersey, claiming that the Company failed to pay overtime to insurance agents who were registered representatives in violation of federal and state law, and that improper deductions were made from these agents’ wages in violation of state law. In March 2008, the court granted plaintiffs’ motion to conditionally certify a nationwide class. In March 2008, a purported nationwide class action lawsuit was filed in the United States District Court for the Southern District of California, Wang v. Prudential Financial, Inc. and Prudential Insurance, on behalf of agents who sold the Company’s financial products. The complaint alleges claims that the Company failed to pay overtime and provide other benefits in violation of state and federal law and seeks compensatory and punitive damages in unspecified amounts.

 

40


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Notes to Unaudited Interim Consolidated Financial Statements—(Continued)

 

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. In light of the unpredictability of the Company’s litigation and regulatory matters, it is also possible that in certain cases an ultimate unfavorable resolution of one or more pending litigation or regulatory matters could have a material adverse effect on the Company’s financial position. Management believes, however, that, based on information currently known to it, the ultimate outcome of all pending litigation and regulatory matters, after consideration of applicable reserves and rights to indemnification, is not likely to have a material adverse effect on the Company’s financial position.

 

41


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Supplemental Combining Statements of Financial Position

June 30, 2008 and December 31, 2007 (in millions)

 

    June 30, 2008     December 31, 2007
    Financial
Services
Businesses
    Closed
Block
Business
    Consolidated     Financial
Services
Businesses
  Closed
Block
Business
    Consolidated

ASSETS

           

Fixed maturities:

           

Available for sale, at fair value

  $ 114,541     $ 43,706     $ 158,247     $ 112,748   $ 49,414     $ 162,162

Held to maturity, at amortized cost

    3,572       —         3,572       3,548     —         3,548

Trading account assets supporting insurance liabilities, at fair value

    14,624       —         14,624       14,473     —         14,473

Other trading account assets, at fair value

    2,984       145       3,129       3,471     142       3,613

Equity securities, available for sale, at fair value

    4,567       3,528       8,095       4,640     3,940       8,580

Commercial loans

    23,837       8,627       32,464       22,093     7,954       30,047

Policy loans

    4,207       5,380       9,587       3,942     5,395       9,337

Securities purchased under agreements to resell

    184       —         184       129     —         129

Other long-term investments

    5,683       1,248       6,931       5,163     1,268       6,431

Short-term investments

    5,601       1,217       6,818       3,852     1,385       5,237
                                           

Total investments

    179,800       63,851       243,651       174,059     69,498       243,557

Cash and cash equivalents

    8,762       1,181       9,943       9,624     1,436       11,060

Accrued investment income

    1,531       665       2,196       1,496     678       2,174

Reinsurance recoverables

    1,961       —         1,961       2,119     —         2,119

Deferred policy acquisition costs

    12,203       1,143       13,346       11,396     943       12,339

Other assets

    23,021       1,170       24,191       17,754     1,228       18,982

Separate account assets

    179,323       —         179,323       195,583     —         195,583
                                           

TOTAL ASSETS

  $ 406,601     $ 68,010     $ 474,611     $ 412,031   $ 73,783     $ 485,814
                                           

LIABILITIES AND ATTRIBUTED EQUITY LIABILITIES

           

Future policy benefits

  $ 62,503     $ 51,465     $ 113,968     $ 60,259   $ 51,209     $ 111,468

Policyholders’ account balances

    86,199       5,586       91,785       78,599     5,555       84,154

Policyholders’ dividends

    702       1,204       1,906       670     2,991       3,661

Reinsurance payables

    1,377       —         1,377       1,552     —         1,552

Securities sold under agreements to repurchase

    4,307       3,859       8,166       5,281     6,160       11,441

Cash collateral for loaned securities

    2,808       1,783       4,591       3,041     3,271       6,312

Income taxes

    2,798       —         2,798       3,402     151       3,553

Short-term debt

    12,955       821       13,776       14,514     1,143       15,657

Long-term debt

    15,254       1,750       17,004       12,351     1,750       14,101

Other liabilities

    17,873       475       18,348       14,609     266       14,875

Separate account liabilities

    179,323       —         179,323       195,583     —         195,583
                                           

Total liabilities

    386,099       66,943       453,042       389,861     72,496       462,357
                                           

COMMITMENTS AND CONTINGENT LIABILITIES

           

ATTRIBUTED EQUITY

           

Accumulated other comprehensive income (loss)

    (1,231 )     (214 )     (1,445 )     459     (12 )     447

Other attributed equity

    21,733       1,281       23,014       21,711     1,299       23,010
                                           

Total attributed equity

    20,502       1,067       21,569       22,170     1,287       23,457
                                           

TOTAL LIABILITIES AND ATTRIBUTED EQUITY

  $ 406,601     $ 68,010     $ 474,611     $ 412,031   $ 73,783     $ 485,814
                                           

 

See Notes to Unaudited Interim Supplemental Combining Financial Information

 

42


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Supplemental Combining Statements of Operations

Three Months Ended June 30, 2008 and 2007 (in millions)

 

     Three Months Ended June 30,  
     2008     2007  
     Financial
Services
Businesses
    Closed
Block
Business
    Consolidated     Financial
Services
Businesses
    Closed
Block
Business
    Consolidated  

REVENUES

            

Premiums

   $ 2,962     $ 965     $ 3,927     $ 2,684     $ 945     $ 3,629  

Policy charges and fee income

     824       —         824       785       —         785  

Net investment income

     2,155       871       3,026       2,041       946       2,987  

Realized investment gains (losses), net

     (550 )     (348 )     (898 )     125       (8 )     117  

Asset management fees and other income

     822       8       830       897       10       907  
                                                

Total revenues

     6,213       1,496       7,709       6,532       1,893       8,425  
                                                

BENEFITS AND EXPENSES

            

Policyholders’ benefits

     2,918       1,093       4,011       2,659       1,074       3,733  

Interest credited to policyholders’ account balances

     710       35       745       690       35       725  

Dividends to policyholders

     3       155       158       29       576       605  

General and administrative expenses

     1,985       175       2,160       2,026       193       2,219  
                                                

Total benefits and expenses

     5,616       1,458       7,074       5,404       1,878       7,282  
                                                

INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND EQUITY IN EARNINGS OF OPERATING JOINT VENTURES

     597       38       635       1,128       15       1,143  
                                                

Income tax expense

     43       23       66       320       4       324  
                                                

INCOME FROM CONTINUING OPERATIONS BEFORE EQUITY IN EARNINGS OF OPERATING JOINT VENTURES

     554       15       569       808       11       819  

Equity in earnings of operating joint ventures, net of taxes

     24       —         24       56       —         56  
                                                

INCOME FROM CONTINUING OPERATIONS

     578       15       593       864       11       875  

Income (loss) from discontinued operations, net of taxes

     (3 )     —         (3 )     (29 )     —         (29 )
                                                

NET INCOME

   $ 575     $ 15     $ 590     $ 835     $ 11     $ 846  
                                                

 

See Notes to Unaudited Interim Supplemental Combining Financial Information

 

43


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

Unaudited Interim Supplemental Combining Statements of Operations

Six Months Ended June 30, 2008 and 2007 (in millions)

 

     Six Months Ended June 30,
     2008     2007
     Financial
Services
Businesses
    Closed
Block
Business
    Consolidated     Financial
Services
Businesses
   Closed
Block
Business
   Consolidated

REVENUES

              

Premiums

   $ 6,064     $ 1,821     $ 7,885     $ 5,405    $ 1,783    $ 7,188

Policy charges and fee income

     1,649       —         1,649       1,570      —        1,570

Net investment income

     4,276       1,777       6,053       4,043      1,879      5,922

Realized investment gains (losses), net

     (1,352 )     (458 )     (1,810 )     338      199      537

Asset management fees and other income

     1,469       27       1,496       1,960      23      1,983
                                            

Total revenues

     12,106       3,167       15,273       13,316      3,884      17,200
                                            

BENEFITS AND EXPENSES

              

Policyholders’ benefits

     5,981       2,065       8,046       5,395      2,023      7,418

Interest credited to policyholders’ account balances

     1,312       70       1,382       1,497      71      1,568

Dividends to policyholders

     60       657       717       57      1,259      1,316

General and administrative expenses

     4,076       363       4,439       3,949      379      4,328
                                            

Total benefits and expenses

     11,429       3,155       14,584       10,898      3,732      14,630
                                            

INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND EQUITY IN EARNINGS OF OPERATING JOINT VENTURES

     677       12       689       2,418      152      2,570
                                            

Income tax expense

     90       5       95       699      48      747
                                            

INCOME FROM CONTINUING OPERATIONS BEFORE EQUITY IN EARNINGS OF OPERATING JOINT VENTURES

     587       7       594       1,719      104      1,823

Equity in earnings of operating joint ventures, net of taxes

     67       —         67       133      —        133
                                            

INCOME FROM CONTINUING OPERATIONS

     654       7       661       1,852      104      1,956

Income (loss) from discontinued operations, net of taxes

     (2 )     —         (2 )     8      2      10
                                            

NET INCOME

   $ 652     $ 7     $ 659     $ 1,860    $ 106    $ 1,966
                                            

 

See Notes to Unaudited Interim Supplemental Combining Financial Information

 

44


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.

 

The Financial Services Businesses and Closed Block Business participate in separate internal short-term cash management facilities, pursuant to which they invest cash from securities lending and repurchase activities as well as certain trading and operating activities. The net funds invested in these facilities are generally held in investments that are short term, including mortgage- and asset-backed securities. As of June 30, 2008, the Financial Services Business and the Closed Block Business held $6.4 billion and $7.4 billion, respectively, in their short-term cash management facilities. Historically, a proportionate interest in each security held in a commingled portfolio was allocated to the Financial Services Businesses and the Closed Block Business as of the balance sheet date, based upon their proportional cash contributions to a single facility. Participation in the commingled facility by the Financial Services Businesses and the Closed Block Business was dependent on cash flows arising from the activities noted above, which in turn, under the historical allocation methodology, could change the allocation of the facility’s assets between the two Businesses. A proportionate share of any realized investment gain or loss was recorded by each Business based upon their respective ownership percentages in the

 

45


Table of Contents

PRUDENTIAL FINANCIAL, INC.

 

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

 

commingled facility as of the date of the realized gain or loss. Beginning April 1, 2008, management implemented changes in order to permit each Business to hold discrete ownership of its investments in separate facilities without affecting or being affected by the level of participation of the other Business. With these changes, any realized investment gain or loss are recorded by the respective Business based upon their discrete ownership of investments in their facility. Beginning in the third quarter of 2007, pending the implementation of these changes, the commingled facility was managed so that the proportionate interests of the Financial Services Businesses and Closed Block Business in the entire facility were maintained at approximately the same proportions held as of June 30, 2007 (approximately 49% and 51%, respectively).

 

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.

 

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.

 

46


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, 2008, compared with December 31, 2007, and its consolidated results of operations for the three and six months ended June 30, 2008 and 2007. You should read the following analysis of our consolidated financial condition and results of operations in conjunction with the “Risk Factors” section included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 and the MD&A and the audited Consolidated Financial Statements for the year ended December 31, 2007 included in the Company’s Current Report on Form 8-K dated May 16, 2008, as well as the “Risk Factors” section, 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 eight segments, and our Corporate and Other operations. The Insurance division consists of our Individual Life, Individual 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

 

47


Table of Contents

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 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.

 

The Closed Block Business is not a separate legal entity from the Financial Services Businesses; however, they are operated as separate entities and are separated for financial reporting purposes. The Financial Services Businesses are not obligated to pay dividends on Closed Block policies. Dividends on Closed Block policies reflect the experience of the Closed Block over time and are subject to adjustment by Prudential Insurance’s Board of Directors. Further, our plan of demutualization provides that we are not required to pay dividends on policies within the Closed Block from assets that are not within the Closed Block and that the establishment of the Closed Block does not represent a guarantee that any certain level of dividends will be maintained.

 

Executive Summary

 

Prudential Financial, one of the largest financial services companies in the U.S., offers individual and institutional clients a wide array of financial products and services, including life insurance, annuities, mutual funds, pension and retirement-related services and administration, investment management, 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.

 

During the latter half of 2007 and continuing through the second quarter of 2008, dislocations in the credit and capital markets, initially driven by broad market concerns over the impact of sub-prime mortgage holdings of financial institutions, have generally resulted in increased cost of credit for financial institutions in the marketplace. While credit has generally become more expensive, Prudential Financial’s ability to access the capital markets has not been materially impacted.

 

The first six months of 2008 reflect our continued efforts to redeploy capital effectively to seek enhanced returns, including the continuation of our share repurchase program. In the first six months of 2008, we repurchased 23.2 million shares of Common Stock at a total cost of $1.750 billion under a stock repurchase program authorized by Prudential Financial’s Board of Directors in November 2007. Although currently authorized to repurchase up to an additional $1.750 billion of Common Stock during the second half of 2008, such repurchases are at the discretion of management. We currently intend to repurchase an additional $750 million of Common Stock during the second half of 2008 for a total repurchase in calendar year 2008 of $2.5 billion under the program. See “—Liquidity and Capital Resources—Uses of Capital—Share Repurchases” for factors which could impact our share repurchase program.

 

48


Table of Contents

Our consolidated net income for the first six months of 2008 of $659 million, a decrease from $1.966 billion for the first six months of 2007, primarily reflects other-than-temporary impairments taken on fixed maturities and equity securities due to the impact of current market conditions on the results of our segments and investment portfolio.

 

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.

 

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, 2008 and 2007 and a reconciliation of adjusted operating income of our segments and Corporate and Other operations to income from continuing operations before income taxes and equity in earnings of operating joint ventures.

 

     Three Months
Ended
June 30,
    Six Months
Ended
June 30,
 
     2008     2007     2008     2007  
     (in millions)  

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

        

Individual Life

   $ 103     $ 141     $ 199     $ 242  

Individual Annuities

     154       180       269       346  

Group Insurance

     80       69       170       120  

Asset Management

     190       167       309       342  

Financial Advisory

     23       72       67       169  

Retirement

     141       138       265       286  

International Insurance

     453       410       866       822  

International Investments

     26       43       52       105  

Corporate and Other

     (5 )     (8 )     (40 )     1  

Reconciling Items:

        

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

     (527 )     41       (1,192 )     188  

Charges related to realized investment gains (losses), net

     41       (7 )     28       (13 )

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

     (123 )     (108 )     (385 )     (26 )

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

     94       72       294       10  

Divested businesses

     (13 )     18       (125 )     46  

Equity in earnings of operating joint ventures

     (40 )     (100 )     (100 )     (220 )
                                

Income from continuing operations before income taxes and equity in earnings of operating joint ventures for Financial Services Businesses

     597       1,128       677       2,418  

Income from continuing operations before income taxes and equity in earnings of operating joint ventures for Closed Block Business

     38       15       12       152  
                                

Consolidated income from continuing operations before income taxes and equity in earnings of operating joint ventures

   $ 635     $ 1,143     $ 689     $ 2,570  
                                

 

Results for the three and six months ended June 30, 2008 presented above reflect the following:

 

   

Individual Life segment results for the second quarter of 2008 declined from the second quarter of 2007 primarily reflecting less favorable mortality experience, net of reinsurance, as well as a net increase in amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, due to less favorable equity market performance. Results for the first six months of 2008

 

49


Table of Contents
 

declined from the first six months of 2007 reflecting a net increase in amortization of deferred policy acquisition costs net of related amortization of unearned revenue reserves, due to less favorable equity market performance.

 

   

Individual Annuities segment results for the second quarter and first six months of 2008 declined in comparison to the corresponding prior year periods. Results for the second quarter reflect an unfavorable variance in the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features and increased interest expense from higher borrowings used to finance our policy acquisition costs, reflecting growth of the business. Results for the first six months primarily reflect an unfavorable variance in the mark-to-market of embedded derivatives and related hedge positions associated with our living benefit features as well as a quarterly adjustment for current period experience, which resulted in an increase in amortization of deferred policy acquisition and other costs, and greater costs associated with guaranteed minimum death and income benefits, due to less favorable than expected experience.

 

   

Group Insurance segment results improved in both the second quarter of 2008 and the first six months of 2008, reflecting more favorable claims experience in our group life business. Group Insurance segment results for the first six months of 2008 also benefited from growth in our group disability business, as well as a $20 million benefit from a premium adjustment for updated data on a large group life insurance case.

 

   

Asset Management segment results for the second quarter of 2008 increased in comparison to the second quarter of 2007, largely attributable to favorable results from the segment’s proprietary investing business primarily related to investment results in a fixed income fund, as well as higher asset management fees. These items were partially offset by a decrease in performance based incentive fees, primarily related to institutional real estate funds. Results for the first six months of 2008 decreased due to less favorable results from the segment’s proprietary investing business primarily related to investment results in a fixed income fund, partially offset by higher asset management fees.

 

   

Financial Advisory segment results for the second quarter of 2008 and the first six months of 2008 decreased in comparison to the corresponding prior year periods primarily due to lower income from our share of the retail brokerage joint venture with Wachovia. These results reflect transition costs in the second quarter and first six months of 2008 of $47 million and $93 million, respectively, associated with the January 1, 2008 combination of the A.G. Edwards business with Wachovia Securities. Our reported share of earnings and transition costs for the first six months of 2008 are based on our estimate of our diluted ownership percentage subsequent to this combination.

 

   

Retirement segment results for the second quarter of 2008 increased slightly compared to the second quarter of 2007, as more favorable case experience was largely offset by a loss from the acquired retirement business of Union Bank of California, N.A., which included transition costs and expenses associated with an interim service agreement. Results for the first six months of 2008 declined in comparison to the first six months of 2007, as higher general and administrative expenses, including transition costs and expenses associated with an interim service agreement related to the acquired retirement business of Union Bank of California, N.A., were partially offset by more favorable case experience.

 

   

The International Insurance segment is comprised of its Life Planner and Gibraltar Life operations. Results from the segment’s Life Planner operations improved for both the second quarter and first six months of 2008 primarily reflecting continued growth of our Japanese and Korean Life Planner operations. Results from the segment’s Gibraltar Life operation benefited in both the second quarter and first six months of 2008 from more favorable mortality experience and improved investment income margins. The benefit of these items in Gibraltar was more than offset by higher amortization of deferred policy acquisition costs and a higher level of expenses in the first six months of 2008.

 

   

International Investments segment results declined in both the second quarter and first six months of 2008 primarily due to less favorable results in our Korean asset management operation and global commodities group.

 

50


Table of Contents
   

Corporate and Other results for the second quarter of 2008 produced a smaller loss, on an adjusted operating income basis, than the second quarter of 2007, reflecting lower employee benefit costs driven largely by lower deferred compensation costs, which were partially offset by less favorable results from our real estate and relocation business. Results for the first six months of 2008 decreased by $41 million due to losses in our real estate and relocation business.

 

   

Realized investment gains (losses), net, and related adjustments for the Financial Services Businesses in the second quarter and first six months of 2008 amounted to $(527) million and $(1,192) million, respectively. Results for the second quarter and first six months of 2008 relate primarily to other-than-temporary impairments of fixed maturity and equity securities.

 

   

Income from continuing operations before income taxes in the Closed Block Business increased $23 million in the second quarter of 2008 compared to the second quarter of 2007, reflecting higher net realized investment losses and a decrease in net investment income, which was more than offset by the resulting decrease in the cumulative earnings policyholder dividend obligation expense. Income from continuing operations before income taxes decreased $140 million for the first six months of 2008 compared to the first six months of 2007, also reflecting a decrease in net realized investment gains and net investment income, partially offset by the resulting decrease in the cumulative earnings policyholder dividend obligation expense.

 

Accounting Policies & Pronouncements

 

Application of Critical Accounting Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or U.S. GAAP, requires the application of accounting policies that often involve a significant degree