PRUDENTIAL FINANCIAL INC | 2013 | FY | 3


20.    FAIR VALUE OF ASSETS AND LIABILITIES

Fair Value MeasurementFair value represents 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. The authoritative fair value guidance establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. 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. The Company's Level 1 assets and liabilities primarily include certain cash equivalents and short term investments, equity securities and derivative contracts that trade on an active exchange market.

 

Level 2—Fair value is based on significant inputs, other than quoted prices included in Level 1, 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 (mutual funds, which do not actively trade and are priced based on a net asset value), certain commercial mortgage loans, short-term investments and certain cash equivalents (primarily commercial paper), and certain over-the-counter derivatives.

 

Level 3—Fair value is based on at least one or more significant unobservable inputs for the asset or liability. The assets and liabilities in this category may require significant judgment or estimation in determining the fair value. 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, certain highly structured over-the-counter derivative contracts, certain commercial mortgage loans, certain consolidated real estate funds for which the Company is the general partner, and embedded derivatives resulting from certain products with guaranteed benefits.

 

Assets and Liabilities by Hierarchy Level - The tables below present the balances of assets and liabilities measured at fair value on a recurring basis, as of the dates indicated.

 

    As of December 31, 2013
    Level 1 Level 2 Level 3 Netting (1) Total
                  
    (in millions)
Fixed maturities, available-for-sale:               
U.S. Treasury securities and obligations of U.S. government               
 authorities and agencies $0 $15,400 $0 $  $15,400
Obligations of U.S. states and their political subdivisions  0  3,735  0     3,735
Foreign government bonds  0  82,787  1     82,788
Corporate securities  0  152,449  1,329     153,778
Asset-backed securities  0  7,147  3,442     10,589
Commercial mortgage-backed securities  0  13,708  165     13,873
Residential mortgage-backed securities  0  6,695  8     6,703
 Subtotal  0  281,921  4,945     286,866
Trading account assets: (2)               
U.S. Treasury securities and obligations of U.S. government               
 authorities and agencies  0  266  0     266
Obligations of U.S. states and their political subdivisions  0  190  0     190
Foreign government bonds  0  643  0     643
Corporate securities  0  16,865  115     16,980
Asset-backed securities  0  876  403     1,279
Commercial mortgage-backed securities  0  2,466  0     2,466
Residential mortgage-backed securities  0  1,828  2     1,830
Equity securities  1,309  225  842     2,376
All other (3)  591  7,899  6  (7,246)  1,250
 Subtotal  1,900  31,258  1,368  (7,246)  27,280
Equity securities, available-for-sale  6,938  2,668  304     9,910
Commercial mortgage and other loans  0  158  0     158
Other long-term investments  19  109  1,396  5  1,529
Short-term investments  6,139  1,046  0     7,185
Cash equivalents  2,461  4,521  0     6,982
Other assets  3  209  4     216
 Subtotal excluding separate account assets  17,460  321,890  8,017  (7,241)  340,126
Separate account assets (4)  49,182  213,275  22,603     285,060
 Total assets $66,642 $535,165 $30,620 $(7,241) $625,186
                  
Future policy benefits (5) $0 $0 $441 $  $441
Other liabilities   1  9,458  5  (7,257)  2,207
Notes of consolidated VIEs  0  0  3,254     3,254
 Total liabilities $1 $9,458 $3,700 $(7,257) $5,902

    As of December 31, 2012
    Level 1 Level 2 Level 3 Netting (1) Total
                  
    (in millions)
Fixed maturities, available-for-sale:               
U.S. Treasury securities and obligations of U.S. government               
 authorities and agencies $0 $17,386 $0 $  $17,386
Obligations of U.S. states and their political subdivisions  0  3,452  0     3,452
Foreign government bonds  0  88,290  0     88,290
Corporate securities  0  157,701  1,630     159,331
Asset-backed securities  0  7,633  3,703     11,336
Commercial mortgage-backed securities  0  11,813  124     11,937
Residential mortgage-backed securities  0  9,593  11     9,604
 Subtotal  0  295,868  5,468     301,336
Trading account assets: (2)               
U.S. Treasury securities and obligations of U.S. government               
 authorities and agencies  0  287  0     287
Obligations of U.S. states and their political subdivisions  0  259  0     259
Foreign government bonds  2  767  0     769
Corporate securities  0  13,609  134     13,743
Asset-backed securities  0  923  431     1,354
Commercial mortgage-backed securities  0  2,298  8     2,306
Residential mortgage-backed securities  0  2,024  2     2,026
Equity securities  1,198  181  1,098     2,477
All other (3)  664  13,371  25  (10,363)  3,697
 Subtotal  1,864  33,719  1,698  (10,363)  26,918
Equity securities, available-for-sale  5,518  2,429  330     8,277
Commercial mortgage and other loans  0  114  48     162
Other long-term investments  (57)  141  1,053  246  1,383
Short-term investments  3,519  2,871  0     6,390
Cash equivalents  3,105  10,495  0     13,600
Other assets  78  109  8     195
 Subtotal excluding separate account assets  14,027  345,746  8,605  (10,117)  358,261
Separate account assets (4)  39,362  192,760  21,132     253,254
 Total assets $53,389 $538,506 $29,737 $(10,117) $611,515
Future policy benefits (5) $0 $0 $3,348 $  $3,348
Other liabilities  0  8,121  0  (8,031)  90
Notes of consolidated VIEs  0  0  1,406     1,406
 Total liabilities $0 $8,121 $4,754 $(8,031) $4,844

       

The methods and assumptions the Company uses to estimate the fair value of assets and liabilities measured at fair value on a recurring basis are summarized below.

 

Fixed Maturity SecuritiesThe fair values of the Company's public fixed maturity securities are generally based on prices obtained from independent pricing services. Prices for each security are generally sourced from multiple pricing vendors, and a vendor hierarchy is maintained by asset type based on historical pricing experience and vendor expertise. The Company ultimately uses the price from the pricing service highest in the vendor hierarchy based on the respective asset type. The pricing hierarchy is updated for new financial products and recent pricing experience. Consistent with the fair value hierarchy described above, securities with validated quotes from pricing services are generally reflected within Level 2, as they are primarily based on observable pricing for similar assets and/or other market observable inputs. If the pricing information received from third party pricing services is not reflective of market activity or other inputs observable in the market, the Company may challenge the price through a formal process with the pricing service. If the pricing service updates the price to be more consistent with the presented market observations, the security remains within Level 2.

 

Internally-developed valuations or indicative broker quotes are also used to determine fair value in circumstances where vendor pricing is not available, or where the Company ultimately concludes that pricing information received from the independent pricing service is not reflective of market activity. If the Company concludes the values from both pricing services and brokers are not reflective of market activity, it may over-ride the information with an internally-developed valuation. As of December 31, 2013 and December 31, 2012, over-rides on a net basis were not material. Pricing service over-rides, internally-developed valuations and indicative broker quotes are generally included in Level 3 in the fair value hierarchy.

 

The fair value of private fixed maturities, which are comprised of investments in private placement securities, originated by internal private asset managers, are primarily determined using a discounted cash flow model. If the fair value is determined using pricing inputs that are observable in the market, the securities have been reflected within Level 2; otherwise a Level 3 classification is used.

  

Trading Account AssetsTrading account assets consist primarily of fixed maturity securities, equity securities and derivatives whose fair values are determined consistent with similar instruments described above under “Fixed Maturity Securities” and below under “Equity Securities” and “Derivative Instruments.”

 

Equity Securities—Equity securities consist principally of investments in common and preferred stock of publicly traded companies, perpetual preferred stock, privately traded securities, as well as mutual fund shares. The fair values of most publicly traded equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value hierarchy. Estimated fair values for most privately traded equity securities are determined using discounted cash flow, earnings multiple and other valuation models that require a substantial level of judgment around inputs and therefore are classified within Level 3. The fair values of mutual fund shares that transact regularly (but do not trade in active markets because they are not publicly available) are based on transaction prices of identical fund shares and are classified within Level 2 in the fair value hierarchy. The fair values of perpetual preferred stock are based on inputs obtained from independent pricing services that are primarily based on indicative broker quotes. As a result, the fair values of perpetual preferred stock are classified as Level 3.

 

Commercial Mortgage and Other Loans—The fair value of commercial mortgage loans held for investment and accounted for using the fair value option are determined based on the present value of the expected future cash flows discounted at the appropriate U.S. Treasury rate, adjusted for the current market spread for similar quality loans. The quality ratings for these loans, a primary determinant of the appropriate credit spread and a significant component of the pricing input, are based on internally-developed estimates. As a result, these loans are included in Level 3 in the fair value hierarchy.

 

The fair value of other loans held and accounted for using the fair value option is determined utilizing pricing indicators from the whole loan market, where investors are committed to purchase these loans at a pre-determined price, which is considered the principal exit market for these loans. The Company has evaluated the valuation inputs used for these assets, including the existence of pre-determined exit prices, the terms of the loans, prevailing interest rates and credit risk, and deemed that the primary pricing inputs are Level 2 inputs in the fair value hierarchy.

 

Other Long-Term InvestmentsOther long-term investments include limited partnerships which are consolidated because the Company is either deemed to exercise control or considered the primary beneficiary of a variable interest entity. These entities are considered investment companies and follow specialized industry accounting whereby their assets are carried at fair value. The investments held by these entities include various feeder fund investments in underlying master funds (whose underlying holdings generally include public fixed maturities, equity securities and mutual funds), as well as wholly-owned real estate held within other investment funds. The fair value is determined by reference to the underlying direct investments, with publicly traded equity securities based on quoted prices in active markets reflected in Level 1, and public fixed maturities and mutual funds priced via quotes from pricing services or observable data reflected in Level 2. The fair value of investments in funds that are subject to significant liquidity restrictions are reflected in Level 3.

 

The fair value of real estate held in consolidated investment funds is determined through an independent appraisal process. The appraisals generally utilize a discounted cash flow model, supplemented with replacement cost estimates and comparable recent sales data when available. These appraisals and the related assumptions are updated at least annually. Since many of the assumptions utilized are unobservable and are considered to be significant inputs to the valuation, the real estate investments within other long-term investments have been reflected within Level 3 in the fair value hierarchy.

 

The fair value of fund investments, where the fair value option has been elected, is primarily determined by the fund managers. Since the valuations may be based on unobservable market inputs and cannot be validated by the Company, these investments have been included within Level 3 in the fair value hierarchy.

  

 Derivative Instruments—Derivatives are recorded at fair value either as assets, within “Other trading account assets,” or “Other long-term investments,” or as liabilities, within “Other liabilities,” except for embedded derivatives which are recorded with the associated host contract. The fair values of derivative contracts can be affected by changes in interest rates, foreign exchange rates, commodity prices, credit spreads, market volatility, expected returns, non-performance risk, liquidity and other factors. Liquidity valuation adjustments are made to reflect the cost of exiting significant risk positions, and consider the bid-ask spread, maturity, complexity, and other specific attributes of the underlying derivative position.

 

The Company's exchange-traded futures and options include Treasury futures, Eurodollar futures, commodity futures, Eurodollar options and commodity options. Exchange-traded futures and options are valued using quoted prices in active markets and are classified within Level 1 in the fair value hierarchy.

 

The majority of the Company's derivative positions are traded in the over-the-counter (“OTC”) derivative market and are classified within Level 2 in the fair value hierarchy. OTC derivatives classified within Level 2 are valued using models that utilize actively quoted or observable market input values from external market data providers, third-party pricing vendors and/or recent trading activity. The Company's policy is to use mid-market pricing in determining its best estimate of fair value. The fair values of most OTC derivatives, including interest rate and cross currency swaps, currency forward contracts, commodity swaps, commodity forward contracts, single name credit default swaps, loan commitments held for sale and to-be-announced (or TBA) forward contracts on highly rated mortgage-backed securities issued by U.S. government sponsored entities are determined using discounted cash flow models. The fair values of European style option contracts are determined using Black-Scholes option pricing models. These models' key inputs include the contractual terms of the respective contract, along with significant observable inputs, including interest rates, currency rates, credit spreads, equity prices, index dividend yields, non-performance risk, volatility and other factors.

 

The Company's cleared interest rate swaps and credit derivatives linked to an index are valued using models that utilize actively quoted or observable market inputs, including Overnight Indexed Swap discount rates, obtained from external market data providers, third-party pricing vendors and/or recent trading activity. These derivatives are classified as Level 2 in the fair value hierarchy.

 

The vast majority of the Company's derivative agreements are with highly rated major international financial institutions. To reflect the market's perception of its own and the counterparty's non-performance risk, the Company incorporates additional spreads over LIBOR into the discount rate used in determining the fair value of OTC derivative assets and liabilities that are not otherwise collateralized.

 

Derivatives classified as Level 3 include look-back equity options and other structured products. These derivatives are valued based upon models, such as Monte Carlo simulation models and other techniques that utilize significant unobservable inputs. Level 3 methodologies are validated through periodic comparison of the Company's fair values to external broker-dealer values.

 

Cash Equivalents and Short-Term Investments—Cash equivalents and short-term investments include money market instruments, commercial paper and other highly liquid debt instruments. Certain money market instruments are valued using unadjusted quoted prices in active markets that are accessible for identical assets and are primarily classified as Level 1. The remaining instruments in this category are generally fair valued based on market observable inputs and these investments have primarily been classified within Level 2.

 

Separate Account Assets—Separate Account Assets include fixed maturity securities, treasuries, equity securities and real estate investments for which values are determined consistent with similar instruments described above under “Fixed Maturity Securities,” “Equity Securities” and “Other Long-Term Investments.”

 

Notes of Consolidated VIEsThe fair values of these notes are based on broker quotes and classified within Level 3. See Note 5 and the Fair Value Option section below for additional information.

 

Other LiabilitiesOther liabilities include certain derivative instruments, the fair values of which are determined consistent with similar derivative instruments described above under “Derivative Instruments.”

 

Future Policy Benefits—The liability for future policy benefits primarily includes general account liabilities for the optional living benefit features of the Company's variable annuity contracts, including guaranteed minimum accumulation benefits (“GMAB”), guaranteed minimum withdrawal benefits (“GMWB”) and guaranteed minimum income and withdrawal benefits (“GMIWB”), accounted for as embedded derivatives. The fair values of the GMAB, GMWB and GMIWB liabilities are calculated as the present value of future expected benefit payments to customers less the present value of assessed rider fees attributable to the embedded derivative feature. This methodology could result in either a liability or contra-liability balance, given changing capital market conditions and various actuarial assumptions. Since there is no observable active market for the transfer of these obligations, the valuations are calculated using internally-developed models with option pricing techniques. The models are based on a risk neutral valuation framework and incorporate premiums for risks inherent in valuation techniques, inputs, and the general uncertainty around the timing and amount of future cash flows. The determination of these risk premiums requires the use of management judgment.

 

The significant inputs to the valuation models for these embedded derivatives include capital market assumptions, such as interest rate levels and volatility assumptions, the Company's market-perceived risk of its own non-performance (“NPR”), as well as actuarially determined assumptions, including contractholder behavior, such as lapse rates, benefit utilization rates, withdrawal rates, and mortality rates. Since many of these assumptions are unobservable and are considered to be significant inputs to the liability valuation, the liability included in future policy benefits has been reflected within Level 3 in the fair value hierarchy.

 

Capital market inputs and actual policyholders' account values are updated each quarter based on capital market conditions as of the end of the quarter, including interest rates, equity markets and volatility. In the risk neutral valuation, the initial swap curve drives the total return used to grow the policyholders' account values. The Company's discount rate assumption is based on the LIBOR swap curve adjusted for an additional spread relative to LIBOR to reflect NPR.

 

Actuarial assumptions, including contractholder behavior and mortality, are reviewed at least annually, and updated based upon emerging experience, future expectations and other data, including any observable market data, such as available industry studies or market transactions such as acquisitions and reinsurance transactions. These assumptions are generally updated in the third quarter of each year unless a material change that the Company feels is indicative of a long term trend is observed in an interim period.

Transfers between Levels 1 and 2Periodically there are transfers between Level 1 and Level 2 for assets held in the Company's Separate Account. The fair value of foreign common stock held in the Company's Separate Account may reflect differences in market levels between the close of foreign trading markets and the close of U.S. trading markets for the respective day. Dependent on the existence of such a timing difference, the assets may move between Level 1 and Level 2. In addition, the classification of Separate Account funds may vary dependent on the availability of information to the public. Should a fund's net asset value become publicly observable, the fund would be transferred from Level 2 to Level 1. During the year ended December 31, 2013, $4.0 billion were transferred from Level 1 to Level 2 and $5.0 billion were transferred from Level 2 to Level 1. During the year ended December 31, 2012, $5.0 billion were transferred from Level 1 to Level 2 and $2.1 billion were transferred from Level 2 to Level 1.

Level 3 Assets and Liabilities by Price SourceThe table below presents the balances of Level 3 assets and liabilities measured at fair value with their corresponding pricing sources.

    As of December 31, 2013
    Internal (1) External (2) Total
            
    (in millions)
          
Foreign government bonds $0 $1 $1
Corporate securities  660  784  1,444
Asset-backed securities  283  3,562  3,845
Commercial mortgage-backed securities  14  151  165
Residential mortgage-backed securities  3  7  10
Equity securities  141  1,005  1,146
Other long-term investments  9  1,387  1,396
Other assets  10  0  10
 Subtotal excluding separate account assets (3)  1,120  6,897  8,017
Separate account assets  21,665  938  22,603
            
 Total assets $22,785 $7,835 $30,620
            
Future policy benefits $441 $0 $441
Other liabilities  5  0  5
Notes of consolidated VIEs  0  3,254  3,254
 Total liabilities $446 $3,254 $3,700

    As of December 31, 2012
    Internal (1) External (2) Total
            
    (in millions)
          
Corporate securities $889 $875 $1,764
Asset-backed securities  338  3,796  4,134
Commercial mortgage-backed securities  68  64  132
Residential mortgage-backed securities  3  10  13
Equity securities  101  1,327  1,428
Commercial mortgage and other loans  48  0  48
Other long-term investments  9  1,044  1,053
Other assets  33  0  33
 Subtotal excluding separate account assets (3)  1,489  7,116  8,605
Separate account assets  20,422  710  21,132
            
 Total assets $21,911 $7,826 $29,737
            
Future policy benefits $3,348 $0 $3,348
Notes of consolidated VIEs  0  1,406  1,406
 Total liabilities $3,348 $1,406 $4,754

       

 

Quantitative Information Regarding Internally-Priced Level 3 Assets and Liabilities – The table below represents quantitative information on significant internally-priced Level 3 assets and liabilities.

    As of December 31, 2013
    Fair Value Valuation Techniques Unobservable Inputs Minimum Maximum Weighted AverageImpact of Increase in Input on Fair Value (1)
                 
    (in millions)           
               
Assets:               
Corporate securities $660 Discounted cash flow Discount rate 1.25%-15% 8.52%Decrease
       Market comparables EBITDA multiples (2) 5.0X-8.0X 6.0XIncrease
       Liquidation Liquidation value 11.61%-100.0% 59.17%Increase
Asset-backed securities $283 Discounted cash flow Prepayment rate (3) 2.82%-27.41% 10.23%Increase
         Default rate (3) 0.49%-31.85% 2.62%Decrease
         Loss severity (3) 15.06%-45.00% 33.00%Decrease
         Liquidity premium 1.00%-2.00% 1.90%Decrease
         Average life (years) 0.16-14.76 5.05Increase
         Comparable spreads 0.19%-45.19% 3.65%Decrease
         Comparable security yields 0.61%-10.00% 6.52%Decrease
                 
Liabilities:               
Future policy              
benefits(4) $441 Discounted cash flow Lapse rate (5) 0%-11%  Decrease
         NPR spread (6) 0.08%-1.09%  Decrease
       Utilization rate (7) 70%-94%  Increase
         Withdrawal rate (8) 86%-100%  Increase
         Mortality rate (9) 0%-13%  Decrease
       Equity volatility curve 15%-28%  Increase

    As of December 31, 2012
    Fair Value Valuation Techniques Unobservable Inputs Minimum Maximum Weighted AverageImpact of Increase in Input on Fair Value (1)
                 
    (in millions)           
               
Assets:               
Corporate securities $889 Discounted cash flow Discount rate 1.7%-17.5% 9.92%Decrease
       Market comparables EBITDA multiples (2) 5.0X-8.5X 6.2XIncrease
       Cap at call price Call price 100%-101% 100.24%Increase
       Liquidation Liquidation value 49%-100.0% 83.06%Increase
Asset-backed securities $338 Discounted cash flow Prepayment rate (3) 2.8%-29.0% 9.84%Increase
         Default rate (3) 0.5%-2.52% 0.84%Decrease
         Loss severity (3) 35%-43.88% 35.76%Decrease
         Liquidity premium 1.0%-2.50% 1.83%Decrease
         Average life (years) 0.1-15 5.61Increase
         Comparable spreads 0.1%-20% 2.81%Decrease
         Comparable security yields 0.4%-15% 7.59%Decrease
                 
Liabilities:               
Future policy              
benefits(4) $3,348 Discounted cash flow Lapse rate (5) 0%-14%  Decrease
         NPR spread (6) 0.20%-1.60%  Decrease
       Utilization rate (7) 70%-94%  Increase
         Withdrawal rate (8) 85%-100%  Increase
         Mortality rate (9) 0%-13%  Decrease
       Equity volatility curve 19%-34%  Increase

       

 

Interrelationships Between Unobservable InputsIn addition to the sensitivities of fair value measurements to changes in each unobservable input in isolation, as reflected in the table above, interrelationships between these inputs may also exist, such that a change in one unobservable input may give rise to a change in another or multiple inputs. Examples of such interrelationships for significant internally-priced Level 3 assets and liabilities are as follows:

Corporate SecuritiesThe rate used to discount future cash flows reflects current risk-free rates plus credit and liquidity spread requirements that market participants would use to value an asset. The discount rate may be influenced by many factors, including market cycles, expectations of default, collateral, term, and asset complexity. Each of these factors can influence discount rates, either in isolation, or in response to other factors.

Asset-Backed SecuritiesInterrelationships may exist between the prepayment rate, the default rate and/or loss severity, depending on specific market conditions. In stronger business cycles, prepayment rates are generally driven by overall market interest rates, and accompanied by lower default rates and loss severity. During weaker cycles, prepayments may decline, as default rates and loss severity increase. Additionally, the impact of these factors on average life varies with the structure and subordination.

Future Policy BenefitsThe unobservable contractholder behavior inputs related to the liability for the optional living benefit features of the Company's variable annuity contracts included in future policy benefits are generally based on emerging experience, future expectations and other data. While experience for these products is still emerging, the Company expects efficient benefit utilization and withdrawal rates to generally be correlated with lapse rates. However, behavior is generally highly dependent on the facts and circumstances surrounding the individual contractholder, such as their liquidity needs or tax situation, which could drive lapse behavior independent of other contractholder behavior assumptions. The dynamic lapse adjustment assumes lower lapses when the benefit amount is greater than the account value, as in-the-money contracts are less likely to lapse. Therefore, to the extent more efficient contractholder behavior results in greater in-the-moneyness at the contract level, the dynamic lapse function will reduce lapse rates for those contracts. Similarly, to the extent that increases in equity volatility are correlated with overall declines in the capital markets, the dynamic lapse function will lower overall lapse rates as contracts become more in-the-money.

Separate Account Assets—In addition to the significant internally-priced Level 3 assets and liabilities presented and described above, the Company also has internally-priced separate account assets reported within Level 3. Changes in the fair value of separate account assets are borne by customers and thus are offset by changes in separate account liabilities on the Company's Consolidated Statement of Financial Position. As a result, changes in value associated with these investments do not impact the Company's Consolidated Statement of Operations. In addition, fees earned by the Company related to the management of most separate account assets classified as Level 3 do not change due to changes in the fair value of these investments. Quantitative information about significant internally-priced Level 3 separate account assets is as follows:

 

Real Estate and Other Invested Assets—Separate account assets include $20,806 million and $19,518 million of investments in real estate as of December 31, 2013 and December 31, 2012, respectively, that are classified as Level 3 and reported at fair value. In general, these fair value estimates are based on property appraisal reports prepared by independent real estate appraisers. Key inputs and assumptions to the appraisal process include rental income and expense amounts, related growth rates, discount rates and capitalization rates. In cases where real estate investments are made through indirect investments, fair value is generally determined by the Company's equity in net assets of the entities. The debt associated with real estate, other invested assets and the Company's equity position in entities are externally valued. Because of the subjective nature of inputs and the judgment involved in the appraisal process, real estate investments and their corresponding debt are typically included in the Level 3 classification. Key unobservable inputs to real estate valuation include capitalization rates, which ranged from 4.15% to 11.00% (6.35% weighted average) as of December 31, 2013, and 4.75% to 10.50% (6.49% weighted average) as of December 31, 2012, and discount rates, which ranged from 6.00% to 15.00% (7.71% weighted average) as of December 31, 2013, and 6.25% to 15.00% (7.92% weighted average) as of December 31, 2012. Key unobservable inputs to real estate debt valuation include yield to maturity, which ranged from 1.13% to 6.85% (4.17% weighted average) as of December 31, 2013, and 3.59% to 7.62% (4.74% weighted average) as of December 31, 2012, and market spread over base rate, which ranged from 1.60% to 4.75% (2.87% weighted average) as of December 31, 2013, and 1.67% to 4.48% (3.22% weighted average) as of December 31, 2012.

 

Commercial Mortgage Loans—Separate account assets include $793 million and $833 million of commercial mortgage loans as of December 31, 2013 and December 31, 2012, respectively, that are classified as Level 3 and reported at fair value. Commercial mortgage loans are primarily valued internally using discounted cash flow techniques, as described further under “Fair Value of Financial Instruments.” The primary unobservable input used is the spread to discount cash flows, which ranged from 1.25% to 1.98% (1.47% weighted average) as of December 31, 2013, and 1.65% to 4.15% (1.87% weighted average) as of December 31, 2012. In isolation, an increase (decrease) in the value of this input would result in a lower (higher) fair value measurement.

 

Valuation Process for Fair Value Measurements Categorized within Level 3 - The Company has established an internal control infrastructure over the valuation of financial instruments that requires ongoing oversight by its various Business Groups. These management control functions are segregated from the trading and investing functions. For invested assets, the Company has established oversight teams, often in the form of Pricing Committees within each asset management group. The teams, which typically include representation from investment, accounting, operations, legal and other disciplines are responsible for overseeing and monitoring the pricing of the Company's investments and performing periodic due diligence reviews of independent pricing services. An actuarial valuation team oversees the valuation of optional living benefit features of the Company's variable annuity contracts.

 

The Company has also established policies and guidelines that require the establishment of valuation methodologies and consistent application of such methodologies. These policies and guidelines govern the use of inputs and price source hierarchies and provide controls around the valuation processes. These controls include appropriate review and analysis of investment prices against market activity or indicators of reasonableness, approval of price source changes, price overrides, methodology changes and classification of fair value hierarchy levels. For optional living benefit features of the Company's variable annuity products, the actuarial valuation unit periodically performs baseline testing of contract input data and actuarial assumptions are reviewed at least annually, and updated based upon emerging experience, future expectations and other data, including any observable market data, such as available industry studies. The valuation policies and guidelines are reviewed and updated as appropriate.

 

Within the trading and investing functions, the Company has established policies and procedures that relate to the approval of all new transaction types, transaction pricing sources and fair value hierarchy coding within the financial reporting system. For variable annuity product changes or new launches of optional living benefit features, the actuarial valuation unit validates input logic and new product features and agrees new input data directly to source documents.

 

Changes in Level 3 assets and liabilities The following tables provide summaries of the changes in fair values of Level 3 assets and liabilities as of the dates indicated, as well as the portion of gains or losses included in income attributable to unrealized gains or losses related to those assets and liabilities still held at the end of their respective periods.

      Year Ended December 31, 2013
      Fixed Maturities Available-For-Sale
                          
      U.S. Government U.S. States Foreign Government Corporate Asset-Backed Commercial Mortgage-Backed Residential Mortgage-Backed
  (in millions)
Fair Value, beginning of period $0 $0 $0 $1,630 $3,703 $124 $11
 Total gains (losses) (realized/unrealized):                     
  Included in earnings:                     
   Realized investment gains (losses), net  0  0  0  (30)  29  37  0
  Included in other comprehensive income (loss)  0  0  (1)  (18)  (8)  (19)  0
 Net investment income  0  0  0  (4)  35  0  0
 Purchases  0  0  4  477  2,412  438  0
 Sales  0  0  (1)  (126)  (320)  (51)  0
 Issuances  0  0  0  0  0  0  0
 Settlements  0  0  (2)  (579)  (1,227)  (41)  (3)
 Foreign currency translation  0  0  0  (127)  (110)  (9)  0
 Other(1)  0  0  0  0  (170)  0  0
 Transfers into Level 3(2)  0  0  13  573  10  0  0
 Transfers out of Level 3(2)  0  0  (12)  (467)  (912)  (314)  0
Fair Value, end of period $0 $0 $1 $1,329 $3,442 $165 $8
                          
Unrealized gains (losses) for assets still held (3):                     
  Included in earnings:                     
   Realized investment gains (losses), net $0 $0 $0 $(53) $13 $0 $0
                          
      Year Ended December 31, 2013
      Trading Account Assets
                          
      U.S Government Corporate Asset-Backed Commercial Mortgage-Backed Residential Mortgage-Backed Equity All Other Activity
                          
     (in millions)
Fair Value, beginning of period $0 $134 $431 $8 $2 $1,098 $25
 Total gains (losses) (realized/unrealized):                     
  Included in earnings:                     
   Realized investment gains (losses), net  0  0  0  0  0  0  (16)
   Asset management fees and other income  0  (8)  8  0  0  63  2
 Net investment income  0  0  5  1  0  0  0
 Purchases  0  23  319  75  0  17  0
 Sales  0  (13)  (3)  (1)  0  (140)  0
 Issuances  0  0  0  0  0  0  0
 Settlements  0  (49)  (231)  (2)  0  (43)  (5)
 Foreign currency translation  0  0  (8)  (1)  0  (153)  0
 Other(1)  0  0  (75)  0  0  0  0
 Transfers into Level 3(2)  0  52  4  0  0  0  0
 Transfers out of Level 3(2)  0  (24)  (47)  (80)  0  0  0
Fair Value, end of period $0 $115 $403 $0 $2 $842 $6
                          
Unrealized gains (losses) for assets still held (3):                     
  Included in earnings:                     
   Realized investment gains (losses), net $0 $0 $0 $0 $0 $0 $(16)
   Asset management fees and other income $0 $(7) $7 $0 $0 $50 $2
                          
               Year Ended December 31, 2013
              Equity Securities Available-For-Sale Commercial Mortgage and Other Loans Other Long-term Investments Other Assets
                          
           (in millions)
Fair Value, beginning of period $330 $48 $1,053 $8
 Total gains (losses) (realized/unrealized):               
  Included in earnings:               
   Realized investment gains (losses), net  13  5  0  (4)
   Asset management fees and other income  0  0  160  0
  Included in other comprehensive income (loss)  58  0  0  0
 Purchases  37  0  439  0
 Sales  (65)  0  0  0
 Issuances  0  0  0  0
 Settlements  (3)  (53)  (134)  0
 Foreign currency translation  (53)  0  (13)  0
 Other(1)  (18)  0  (109)  0
 Transfers into Level 3(2)  6  0  0  0
 Transfers out of Level 3(2)  (1)  0  0  0
Fair Value, end of period $304 $0 $1,396 $4
                          
Unrealized gains (losses) for assets still held (3):            
  Included in earnings:            
   Realized investment gains (losses), net $(5) $0 $(2) $(3)
   Asset management fees and other income $0 $0 $155 $0
                          
               Year Ended December 31, 2013
               Separate Account Assets (4) Future Policy Benefits Other Liabilities Notes of consolidated VIEs
                          
           (in millions)
Fair Value, beginning of period $21,132 $(3,348) $0 $(1,406)
 Total gains (losses) (realized/unrealized):            
  Included in earnings:            
   Realized investment gains (losses), net  2  3,741  (3)  17
   Interest credited to policyholders' account balances  2,649  0  0  0
 Net investment income  20  0  0  0
 Purchases  1,653  0  0  0
 Sales  (832)  0  0  0
 Issuances  0  (836)  0  (1,834)
 Settlements  (2,120)  0  0  (31)
 Foreign currency translation  0  2  0  0
 Other(1)  140  0  (2)  0
 Transfers into Level 3(2)  89  0  0  0
 Transfers out of Level 3(2)  (130)  0  0  0
Fair Value, end of period $22,603 $(441) $(5) $(3,254)
                          
Unrealized gains (losses) for assets/liabilities still held (3):            
  Included in earnings:            
   Realized investment gains (losses), net $0 $3,647 $(3) $17
   Interest credited to policyholders' account $1,652 $0 $0 $0

      Year Ended December 31, 2012
      Fixed Maturities Available-For-Sale
                          
      U.S. Government U.S. States Foreign Government Corporate Asset-Backed Commercial Mortgage-Backed Residential Mortgage-Backed
  (in millions)
Fair Value, beginning of period $66 $0 $25 $1,450 $2,528 $145 $16
 Total gains (losses) (realized/unrealized):                     
  Included in earnings:                     
   Realized investment gains (losses), net  0  0  0  (35)  21  25  0
  Included in other comprehensive income (loss)  0  0  0  195  102  11  0
 Net investment income  0  0  0  8  30  (1)  1
 Purchases  0  10  0  375  2,640  44  0
 Sales  0  0  0  (165)  (426)  (28)  0
 Issuances  0  0  0  0  0  0  0
 Settlements  (2)  0  0  (325)  (673)  (14)  (6)
 Foreign currency translation  0  0  0  (38)  (41)  (5)  0
 Other(1)  (64)  0  (8)  71  0  0  0
 Transfers into Level 3(2)  0  0  8  306  60  37  0
 Transfers out of Level 3(2)  0  (10)  (25)  (212)  (538)  (90)  0
Fair Value, end of period $0 $0 $0 $1,630 $3,703 $124 $11
                          
Unrealized gains (losses) for assets still held (3):                     
  Included in earnings:                     
   Realized investment gains (losses), net $0 $0 $0 $(1) $9 $0 $0
                          
      Year Ended December 31, 2012
      Trading Account Assets
                          
      U.S. Government Corporate Asset-Backed Commercial Mortgage-Backed Residential Mortgage-Backed Equity All Other Activity
                          
  (in millions)
Fair Value, beginning of period $9 $148 $416 $35 $4 $1,296 $93
 Total gains (losses) (realized/unrealized):                     
  Included in earnings:                     
   Realized investment gains (losses), net  0  0  0  0  0  0  (73)
   Asset management fees and other income  0  (7)  17  2  1  88  2
 Net investment income  0  0  6  1  0  0  0
 Purchases  0  22  182  16  2  21  0
 Sales  0  (12)  (12)  (5)  (3)  (170)  0
 Issuances  0  0  0  0  0  0  0
 Settlements  (2)  (25)  (112)  (4)  (1)  (89)  6
 Foreign currency translation  0  0  (4)  (1)  0  (70)  0
 Other(1)  (7)  7  1  0  (1)  3  (3)
 Transfers into Level 3(2)  0  5  4  82  0  20  0
 Transfers out of Level 3(2)  0  (4)  (67)  (118)  0  (1)  0
Fair Value, end of period $0 $134 $431 $8 $2 $1,098 $25
                          
Unrealized gains (losses) for assets still held (3):                     
  Included in earnings:                     
   Realized investment gains (losses), net $0 $0 $0 $0 $0 $(1) $(73)
   Asset management fees and other income $0 $(10) $14 $2 $0 $78 $2
                          
               Year Ended December 31, 2012
               Equity Securities Available-For-Sale Commercial Mortgage and Other Loans Other Long-term Investments Short-term Investments
           (in millions)
Fair Value, beginning of period $360 $86 $1,110 $0
 Total gains (losses) (realized/unrealized):            
  Included in earnings:            
   Realized investment gains (losses), net  (1)  2  1  (9)
   Asset management fees and other income  0  0  126  0
  Included in other comprehensive income (loss)  29  0  0  0
 Net investment income  0  0  6  0
 Purchases  69  0  186  9
 Sales  (22)  0  (25)  0
 Issuances  0  0  0  0
 Settlements  0  (40)  (296)  0
 Foreign currency translation  (18)  0  2  0
 Other(1)  0  0  7  0
 Transfers into Level 3(2)  5  0  0  0
 Transfers out of Level 3(2)  (92)  0  (64)  0
Fair Value, end of period $330 $48 $1,053 $0
                          
Unrealized gains (losses) for assets/liabilities still held (3):            
  Included in earnings:            
   Realized investment gains (losses), net $(1) $1 $1 $(9)
   Asset management fees and other income $0 $0 $56 $0
                          
            Year Ended December 31, 2012
            Other Assets Separate Account Assets (4) Future Policy Benefits Other Liabilities Notes of consolidated VIEs
        (in millions)
Fair Value, beginning of period $9 $19,358 $(2,886) $(3) $(282)
 Total gains (losses) (realized/unrealized):               
  Included in earnings:               
   Realized investment gains (losses), net  0  0  231  (23)  (4)
   Asset management fees and other income  2  0  0  0  0
   Interest credited to policyholders' account balances  0  1,932  0  0  0
 Purchases  0  4,230  0  0  0
 Sales  (3)  (1,697)  0  0  0
 Issuances  0  0  (694)  0  (1,412)
 Settlements  0  (2,272)  0  26  0
 Foreign currency translation  0  0  1  0  0
 Other(1)  0  0  0  0  292
 Transfers into Level 3(2)  0  326  0  0  0
 Transfers out of Level 3(2)  0  (745)  0  0  0
Fair Value, end of period $8 $21,132 $(3,348) $0 $(1,406)
                          
Unrealized gains (losses) for assets/liabilities still held (3):               
  Included in earnings:               
   Realized investment gains (losses), net $0 $0 $146 $(23) $(4)
   Asset management fees and other income $2 $0 $0 $0 $0
   Interest credited to policyholders' account $0 $1,013 $0 $0 $0

         Year Ended December 31, 2011
         Fixed Maturities Available-For-Sale
                          
         U.S. Government Foreign Government Corporate Asset-Backed  Commercial Mortgage-Backed Residential Mortgage-Backed
     (in millions)
Fair Value, beginning of period $0 $ 27 $ 1,187 $ 1,753 $ 130 $ 23
 Total gains (losses) (realized/unrealized):                  
  Included in earnings:                  
   Realized investment gains (losses), net  0  0  (31)  38  (41)  0
  Included in other comprehensive income (loss)  0  2  (139)  (14)  8  (1)
 Net investment income  0  0  9  24  (1)  0
 Purchases  66  0  556  1,473  5  1
 Sales  0  (1)  (144)  (558)  (30)  (1)
 Issuances  0  0  33  0  0  0
 Settlements  0  0  (387)  (373)  (36)  (5)
 Foreign currency translation  0  0  7  54  8  0
 Other(1)  0  0  143  502  31  (1)
 Transfers into Level 3(2)  0  0  893  252  76  0
 Transfers out of Level 3(2)  0  (3)  (677)  (623)  (5)  0
Fair Value, end of period $66 $25 $1,450 $2,528 $145 $16
                          
Unrealized gains (losses) for assets still held (3):                  
  Included in earnings:                  
   Realized investment gains (losses), net $0 $0 $(39) $7 $(55) $0
                          
      Year Ended December 31, 2011
      Trading Account Assets
                          
      U.S. Government Corporate Asset-Backed  Commercial Mortgage-Backed Residential Mortgage-Backed Equity Securities All Other Activity
                          
  (in millions)
Fair Value, beginning of period $0 $ 117 $ 280 $ 24 $ 36 $ 30 $ 134
 Total gains (losses) (realized/unrealized):                     
  Included in earnings:                     
   Realized investment gains (losses), net  0  0  0  0  0  0  (31)
   Asset management fees and other income  0  7  (3)  2  0  (69)  3
 Net investment income  0  0  5  2  0  0  0
 Purchases  9  82  305  10  0  39  0
 Sales  0  (18)  (41)  (13)  (2)  (107)  0
 Issuances  0  0  0  0  0  0  0
 Settlements  0  (39)  (106)  (5)  (2)  (126)  (18)
 Foreign currency translation  0  0  5  1  1  25  0
 Other(1)  0  (1)  17  13  (29)  1,302  0
 Transfers into Level 3(2)  0  44  39  24  0  202  5
 Transfers out of Level 3(2)  0  (44)  (85)  (23)  0  0  0
Fair Value, end of period $9 $148 $416 $35 $4 $1,296 $93
                          
Unrealized gains (losses) for assets still held (3):                     
  Included in earnings:                     
   Realized investment gains (losses), net $0 $0 $0 $0 $0 $0 $(31)
   Asset management fees and other income $0 $5 $(7) $(1) $0 $(80) $3
                          
      Year Ended December 31, 2011
      Equity Securities Available-For-Sale Commercial Mortgage and Other Loans Other Long-term Investments Other Assets Separate Account Assets (4) Future Policy Benefits Other Liabilities and notes of consolidated VIEs (5)
                          
  (in millions)
Fair Value, beginning of period $ 355 $ 212 $ 768 $ 9 $ 15,792 $ 204 $ (3)
 Total gains (losses) (realized/unrealized):                     
  Included in earnings:                     
   Realized investment gains (losses), net  (16)  15  2  0  0  (2,554)  (16)
   Asset management fees and other income  0  0  (1)  0  0  0  0
   Interest credited to policyholders' account balance  0  0  0  0  2,868  0  0
  Included in other comprehensive income (loss)  27  0  0  0  0  0  0
 Net investment income  0  0  (27)  0  0  0  0
 Purchases  63  0  280  0  3,111  0  0
 Sales  (66)  0  (25)  0  (1,462)  0  0
 Issuances  0  0  0  0  3  (506)  (284)
 Settlements  (46)  (141)  (168)  0  (1,156)  (1)  18
 Foreign currency translation  75  0  14  0  0  1  0
 Other(1)  (853)  0  267  0  0  (30)  0
 Transfers into Level 3(2)  823  0  0  0  864  0  0
 Transfers out of Level 3(2)  (2)  0  0  0  (662)  0  0
Fair Value, end of period $360 $86 $1,110 $9 $19,358 $(2,886) $(285)
                          
Unrealized gains (losses) for assets still held (3):                     
  Included in earnings:                     
   Realized investment gains (losses), net $(25) $15 $2 $0 $0 $(2,566) $(17)
   Asset management fees and other income $0 $0 $24 $0 $0 $0 $0
   Interest credited to policyholders' account balances $0 $0 $0 $0 $1,823 $0 $0

       

 

Transfers Transfers into Level 3 are generally the result of unobservable inputs utilized within valuation methodologies and the use of indicative broker quotes for assets that were previously valued using observable inputs. Transfers out of Level 3 are generally due to the use of observable inputs in valuation methodologies as well as the utilization of pricing service information for certain assets that the Company is able to validate.

 

For the year ended December 31, 2012, the majority of the Equity Securities Available-for-Sale transfers out of Level 3 were due to the determination that the pricing inputs for certain equity securities did not have a material liquidity discount and therefore, should be classified as Level 1, not Level 3.

 

For the year ended December 31, 2011, the majority of Equity Securities Available-for-Sale and Trading Account Assets – Equity Securities transfers into Level 3 were due to the determination that the pricing inputs for perpetual preferred stocks provided by third party pricing services were primarily based on indicative broker quotes which could not always be verified against directly observable market information.

 

Derivative Fair Value Information

 

The following tables present the balance of derivative assets and liabilities measured at fair value on a recurring basis, as of the date indicated, by primary underlying. These tables exclude embedded derivatives which are typically recorded with the associated host contract. The derivative assets and liabilities shown below are included in “Other trading account assets, “Other long-term investments” or “Other liabilities” in the tables presented previously in this note, under the headings “Assets and Liabilities by Hierarchy Level” and “Changes in Level 3 Assets and Liabilities.

 

    As of December 31, 2013
    Level 1 Level 2 Level 3  Netting (1) Total
                  
    (in millions)
Derivative assets:               
 Interest Rate $10 $6,122 $8 $0 $6,140
 Currency  0  593  0  0  593
 Credit  0  3  0  0  3
 Currency/Interest Rate  0  647  0  0  647
 Equity  14  376  0  0  390
 Commodity  1  0  0  0  1
 Netting (1)  0  0  0  (7,241)  (7,241)
  Total derivative assets $25 $7,741 $8 $(7,241) $533
Derivative liabilities:               
 Interest Rate $5 $7,597 $5 $0 $7,607
 Currency  0  425  0  0  425
 Credit  0  49  0  0  49
 Currency/Interest Rate  0  857  0  0  857
 Equity  1  474  0  0  475
 Commodity  0  0  0  0  0
 Netting (1)  0  0  0  (7,257)  (7,257)
  Total derivative liabilities $6 $9,402 $5 $(7,257) $2,156
                  
    As of December 31, 2012
    Level 1 Level 2 Level 3  Netting (1) Total
                  
    (in millions)
Derivative assets:               
 Interest Rate $11 $11,675 $5 $0 $11,691
 Currency  0  432  0  0  432
 Credit  0  19  0  0  19
 Currency/Interest Rate  0  450  0  0  450
 Equity  63  518  19  0  600
 Commodity  0  0  0  0  0
 Netting (1)  0  0  0  (10,117)  (10,117)
  Total derivative assets $74 $13,094 $24 $(10,117) $3,075
Derivative liabilities:               
 Interest Rate $11 $6,783 $2 $0 $6,796
 Currency  0  517  0  0  517
 Credit  0  84  0  0  84
 Currency/Interest Rate  0  578  0  0  578
 Equity  165  198  0  0  363
 Commodity  0  0  0  0  0
 Netting (1)  0  0  0  (8,031)  (8,031)
  Total derivative liabilities $176 $8,160 $2 $(8,031) $307

       

 

Changes in Level 3 derivative assets and liabilities - The following tables provide a summary of the changes in fair value of Level 3 derivative assets and liabilities for the year ended December 31, 2013, as well as the portion of gains or losses included in income for the year ended December 31, 2013, attributable to unrealized gains or losses related to those assets and liabilities still held at December 31, 2013.

 

 

       
      Year Ended December 31, 2013
      Derivative Derivative Derivative
      Assets -  Assets -  Assets -
      Equity Credit Interest Rate
  (in millions)
Fair Value, beginning of period $19 $0 $3
 Total gains or (losses) (realized/unrealized):         
  Included in earnings:         
   Realized investment gains (losses), net  (15)  0  0
   Asset management fees and other income  0  0  0
 Purchases  0  0  0
 Sales  0  0  0
 Issuances  0  0  0
 Settlements  (4)  0  0
 Transfers into Level 3(1)  0  0  0
 Transfers out of Level 3(1)  0  0  0
Fair Value, end of period $0 $0 $3
              
Unrealized gains (losses) for the period relating to those level 3         
 assets that were still held at the end of the period:         
  Included in earnings:         
   Realized investment gains (losses), net $(15) $0 $0
   Asset management fees and other income $0 $0 $0
              
          
      Year Ended December 31, 2012
      Derivative Derivative Derivative
      Assets -  Assets -  Assets -
      Equity Credit Interest Rate
              
  (in millions)
Fair Value, beginning of period $83 $1 $(1)
 Total gains or (losses) (realized/unrealized):         
  Included in earnings:         
   Realized investment gains (losses), net  (70)  (1)  4
   Asset management fees and other income  0  0  0
 Purchases  6  0  0
 Sales  0  0  0
 Issuances  0  0  0
 Settlements  0  0  0
 Transfers into Level 3(1)  0  0  0
 Transfers out of Level 3(1)  0  0  0
Fair Value, end of period $19 $0 $3
              
Unrealized gains (losses) for the period relating to those level 3         
 assets that were still held at the end of the period:         
  Included in earnings:         
   Realized investment gains (losses), net $(70) $(1) $ 4
   Asset management fees and other income $0 $0 $0

       

 

Nonrecurring Fair Value Measurements - Certain assets and liabilities are measured at fair value on a nonrecurring basis. Nonrecurring fair value reserve adjustments resulted in a net loss of $9 million for the year ended December 31, 2013 on certain commercial mortgage loans. The carrying value of these loans as of December 31, 2013 was $27 million. Valuation reserve adjustments on certain commercial mortgage loans for the year ended December 31, 2012 resulted in a net gain of $2 million and a net loss of $7 million for the year ended December 31, 2011. The adjustments were based on discounted cash flows utilizing market rates or the fair value of the underlying real estate collateral and the underlying assets were classified as Level 3 in the hierarchy.

 

There were no intangible asset impairments recorded for the years ended December 31, 2013 and 2011. Impairments of $46 million were recorded related to the write off of intangible assets for the year ended December 31, 2012. The impairments were primarily based on discounted cash flow models, using assumptions and inputs specific to the Company, and those underlying assets are therefore, classified as Level 3 in the valuation hierarchy. For certain cost method investments, impairments of $21 million, $4 million and $8 million were recorded for the years ended December 31, 2013, 2012 and 2011, respectively. The methodologies utilized were primarily discounted future cash flow and, where appropriate, valuations provided by the general partners taking into consideration investment related expenses. These cost method investments are classified as Level 3 in the valuation hierarchy.

 

For mortgage servicing rights, valuation reserves decreased, resulting in a gain of $16 million for the year ended December 31, 2013. Similarly, valuation reserve increases of $14 million and $9 million were recorded for the years ended December 31, 2012 and 2011, respectively, for mortgage servicing rights. Mortgage servicing rights are valued based on internal models and classified as Level 3 in the valuation hierarchy. For real estate and property and equipment related investments, no impairments were recorded for the year ended December 31, 2013. Impairments of $4 million and $22 million for the years ended December 31, 2012 and 2011, respectively, were recorded for real estate investments, some of which were classified as discontinued operations. The impairments for these real estate investments were based primarily on appraisal values and the assets were therefore classified as Level 3 in the valuation hierarchy.

 

Fair Value Option - The following table presents information regarding changes in fair values recorded in earnings for commercial mortgage loans, other long-term investments and notes issued by consolidated variable interest entities, where the fair value option has been elected.

     Years Ended December 31,
    2013 2012 2011
            
    (in millions)
Assets:         
 Commercial mortgage loans:         
  Changes in instrument-specific credit risk $0 $0 $1
  Other changes in fair value  0  (1)  4
 Other long-term investments:         
  Changes in fair value  68  40  (5)
            
Liabilities:         
 Notes issued by consolidated variable interest entities:         
  Changes in fair value $(17) $2 $0

Changes in fair value are reflected in “Realized investment gains (losses), net” for commercial mortgage loans and “Asset management fees and other income” for other long-term investments and notes issued by consolidated variable interest entities. 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.

 

Interest income on commercial mortgage loans is included in net investment income. For the years ended December 31, 2013, 2012 and 2011, the Company recorded $10 million, $13 million and $12 million of interest income, respectively, on these fair value option 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 mortgage loans, for which the fair value option has been elected, were $158 million and $154 million, respectively, as of December 31, 2013, and $162 million and $156 million, respectively, as December 31, 2012. As of December 31, 2013, there were no loans in non-accrual status and none of the loans are more than 90 days past due and still accruing.

 

The fair value of other long-term investments was $873 million and $465 million as of December 31, 2013 and 2012, respectively.

 

The fair value and aggregate contractual principal amounts of notes issued by consolidated variable interest entities, for which the fair value option has been elected, were $3,254 million and $3,276 million, respectively, as of December 31, 2013, and $1,406 million and $1,422 million, respectively, as December 31, 2012. Interest expense recorded for these liabilities was $106 million and $21 million for the years ended December 31, 2013 and 2012, respectively.

 

Fair Value of Financial Instruments

 

The table below presents the carrying amount and fair value by fair value hierarchy level of certain financial instruments that are not reported at fair value. However, in some cases, as described below, the carrying amount equals or approximates fair value.

    December 31, 2013 December 31, 2012
    Fair Value Carrying Amount (1) Fair Value Carrying Amount
    Level 1 Level 2 Level 3 Total Total Total Total
                        
  (in millions)
Assets:                     
 Fixed maturities, held-to-maturity $0 $2,065 $1,488 $3,553 $3,312 $4,511 $4,268
 Commercial mortgage and other loans  0  639  42,010  42,649  40,850  39,554  36,570
 Policy loans  0  0  11,766  11,766  11,766  14,592  11,575
 Other long term investments  0  0  2,470  2,470  2,203  2,159  1,995
 Short-term investments  0  518  0  518  518  57  57
 Cash and cash equivalents  3,661  796  0  4,457  4,457  4,500  4,500
 Accrued investment income  0  3,089  0  3,089  3,089  3,127  3,127
 Other assets  162  2,147  252  2,561  2,561  2,601  2,601
  Total assets $3,823 $9,254 $57,986 $71,063 $68,756 $71,101 $64,693
                        
Liabilities:                     
 Policyholders' account balances                     
  -investment contracts $0 $39,347 $57,253 $96,600 $95,476 $104,200 $101,232
 Securities sold under agreements                     
  to repurchase  0  7,898  0  7,898  7,898  5,818  5,818
 Cash collateral for loaned securities  0  5,040  0  5,040  5,040  3,941  3,941
 Short-term debt  0  2,718  0  2,718  2,669  2,506  2,484
 Long-term debt  1,078  19,453  5,038  25,569  23,553  27,497  24,729
 Notes of consolidated VIEs  0  0  39  39  48  149  171
 Other liabilities  0  5,803  266  6,069  6,069  6,356  6,356
 Separate account liabilities                     
  -investment contracts  0  82,071  22,163  104,234  104,234  96,561  96,561
  Total liabilities $1,078 $162,330 $84,759 $248,167 $244,987 $247,028 $241,292

       

 

The fair values presented above have been determined by using available market information and by applying market valuation methodologies, as described in more detail below.

 

Fixed Maturities, Held-to-Maturity

 

 The fair values of public fixed maturity securities are generally based on prices from third-party pricing services, which are reviewed to validate reasonableness. However, for certain public fixed maturity securities and investments in private placement fixed maturity securities, this information is either not available or not reliable. For these public fixed maturity securities, the fair value is based on indicative broker quotes, if available, or determined using a discounted cash flow model or internally-developed values. For private fixed maturities, fair value is determined using a discounted cash flow model. In determining the fair value of certain fixed maturity securities, the discounted cash flow model may also use unobservable inputs, which reflect the Company's own assumptions about the inputs market participants would use in pricing the security.

 

Commercial Mortgage and Other Loans

 

The fair value of most commercial mortgage loans is based upon the present value of the expected future cash flows discounted at the appropriate U.S. Treasury rate or foreign government bond rate (for non-U.S. dollar-denominated loans) plus an appropriate credit spread for similar quality loans. The quality ratings for these loans, a primary determinant of the credit spreads and a significant component of the pricing process, are based on an internally-developed methodology.

 

Certain commercial mortgage loans are valued incorporating other factors, including the terms of the loans, the principal exit strategies for the loans, prevailing interest rates and credit risk. Other loan valuations are primarily based upon the present value of the expected future cash flows discounted at the appropriate local government bond rate and local market swap rates or credit default swap spreads, plus an appropriate credit spread and liquidity premium. The credit spread and liquidity premium are a significant component of the pricing inputs, and are based upon an internally-developed methodology, which takes into account, among other factors, the credit quality of the loans, the property type of the collateral, the weighted average coupon and the weighted average life of the loans.

 

Policy Loans

 

During the fourth quarter of 2013, the Company changed the valuation technique used to fair value policy loans. For the period ended December 31, 2013, the fair value of policy loans was determined by discounting expected cash flows at the current loan coupon rate. As a result, the carrying value of the policy loans approximates the fair value for the year ended December 31, 2013. Prior to this change, the fair value of U.S. insurance policy loans was calculated by discounting expected cash flows based upon current U.S. Treasury rates and historical loan repayment patterns, while Japanese insurance policy loans used the risk-free proxy based on the yen LIBOR.

 

Other Long-term Investments

 

Other long-term investments include investments in joint ventures and limited partnerships. The estimated fair values of these cost method investments are generally based on the Company's share of the net asset value (“NAV”) as provided in the financial statements of the investees. In certain circumstances, management may adjust the NAV by a premium or discount when it has sufficient evidence to support applying such adjustments. For the year end December 31, 2013 and 2012, no such adjustments were made.

 

Short-Term Investments, Cash and Cash Equivalents, Accrued Investment Income and Other Assets

       

The Company believes that due to the short-term nature of certain assets, the carrying value approximates fair value. These assets include: certain short-term investments which are not securities, are recorded at amortized cost and include quality loans; cash and cash equivalent instruments; accrued investment income; and other assets that meet the definition of financial instruments, including receivables, such as reinsurance recoverables, unsettled trades, accounts receivable and restricted cash.

 

Policyholders' Account Balances – Investment Contracts

 

Only the portion of policyholders' account balances related to products that are investment contracts (those without significant mortality or morbidity risk) are reflected in the table above. For fixed deferred annuities, single premium endowments, payout annuities and other similar contracts without life contingencies, fair values are derived using discounted projected cash flows based on interest rates that are representative of the Company's financial strength ratings, and hence reflect the Company's own non-performance risk. For guaranteed investment contracts, funding agreements, structured settlements without life contingencies and other similar products, fair values are derived using discounted projected cash flows based on interest rates being offered for similar contracts with maturities consistent with those of the contracts being valued. For those balances that can be withdrawn by the customer at any time without prior notice or penalty, the fair value is the amount estimated to be payable to the customer as of the reporting date, which is generally the carrying value. For defined contribution and defined benefit contracts and certain other products, the fair value is the market value of the assets supporting the liabilities.

 

Securities Sold Under Agreements to Repurchase

 

The Company receives collateral for selling securities under agreements to repurchase, or pledges collateral under agreements to resell. Repurchase and resale agreements are also generally short-term in nature, and therefore, the carrying amounts of these instruments approximate fair value.

 

Cash Collateral for Loaned Securities

 

Cash collateral for loaned securities represents the collateral received or paid in connection with loaning or borrowing securities, similar to the securities sold under agreement to repurchase above. For these transactions, the carrying value of the related asset or liability approximates fair value, as they equal the amount of cash collateral received/paid.

 

Debt

 

The fair value of short-term and long-term debt, as well as notes issued by consolidated VIEs, is generally determined by either prices obtained from independent pricing services, which are validated by the Company, or discounted cash flow models. With the exception of the notes issued by consolidated VIEs for which recourse is limited to the assets of the respective VIE and does not extend to the general credit of the Company, the fair values of these instruments consider the Company's own non-performance risk. Discounted cash flow models predominately use market observable inputs such as the borrowing rates currently available to the Company for debt and financial instruments with similar terms and remaining maturities. For commercial paper issuances and other debt with a maturity of less than 90 days, the carrying value approximates fair value.

 

A portion of the senior secured notes issued by Prudential Holdings, LLC (the "IHC debt") is insured by a third-party financial guarantee insurance policy. The effect of the third-party credit enhancement is not included in the fair value measurement of the IHC debt and the methodologies used to determine fair value consider the Company's own non-performance risk.

 

Other Liabilities

 

Other liabilities are primarily payables, such as reinsurance payables, unsettled trades, drafts and accrued expense payables. Due to the short term until settlement of most of these liabilities, the Company believes that carrying value approximates fair value.

 

Separate Account Liabilities–Investment Contracts

 

Only the portion of separate account liabilities related to products that are investments contracts are reflected in the table above. Separate account liabilities are recorded at the amount credited to the contractholder, which reflects the change in fair value of the corresponding separate account assets including contractholder deposits less withdrawals and fees. Therefore, carrying value approximates fair value.

 

 


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