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Prudential Financial 2001 Annual Report - page 41 / 172





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Prudential Financial, Inc.

either estimated profits or premiums, depending on the type of contract. For products with amortization based on future premiums, the amortization rate is locked-in when the product is sold. However, for products with amortization based on estimated profits, the amortization rate is periodically updated to reflect current period experience or changes in assumptions that affect future profitability, such as lapse rates, investment returns, mortality experience, expense margins and surrender charges. These changes result in adjustments to DAC balances in the period that we change our assumptions as well as changes in prospective DAC amortization. For example, adverse market conditions in 2001 resulted in declines in the market values of assets supporting our variable life insurance and annuity products, which in turn resulted in lower expectations regarding our estimated future gross profits from fee-based income. As a result, we recorded a higher level of DAC amortization in 2001 for these products. DAC is also subject to periodic recoverability testing.

Reserves For Contingencies A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under GAAP, reserves for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial reserve reflects management’s best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure. Another example is the actual execution of a definitive management commitment to exit or restructure a business. When management formally commits to such an action, reserves are established based on the estimated cost of executing the action. These would typically include severance and employee benefit costs, facilities closure costs, and certain other direct incremental costs. For example, we established such reserves in connection with our disposition of our former healthcare business (see Note 3 to the Consolidated Financial Statements) and the restructuring of the capital markets business of Prudential Securities (see Note 4 to the Consolidated Financial Statements). The initial establishment of these reserves reflected management’s best estimate of the ultimate costs. Our results for subsequent periods reflected changes in these estimates to the extent that the actual costs of carrying out the plans were different from our original estimates.

Other Significant Estimates In addition to the items discussed above, the application of GAAP requires management to make other estimates and assumptions. For example, accounting for pension and other postretirement and postemployment benefits requires estimates of future returns on plan assets, expected increases in compensation levels and trends in health care costs. These are discussed in Note 16 to the Consolidated Financial Statements. Another example is the recognition of deferred tax assets, which depends on management’s assumption that future earnings will be sufficient to realize the deferred benefit. This is discussed in Note 17 to the Consolidated Financial Statements.

Consolidated Results of Operations In managing our business, we analyze our operating performance by separately considering our Financial Services Businesses and our Closed Block Business. In addition, within the Financial Services Businesses, we analyze our operating performance using a non-GAAP measure we call “adjusted operating income.” Prior to the date of demutualization, we also analyzed results of our Traditional Participating Products segment based on this non- GAAP measure. We calculate adjusted operating income by adjusting our income from continuing operations before income taxes to exclude certain items. The items excluded are:

  • realized investment gains, net of losses and related charges;

  • sales practices remedies and costs;

  • the gains, losses and contribution to income/loss of divested businesses that we have sold but that do not qualify

for “discontinued operations” accounting treatment under GAAP; and

  • demutualization costs and expenses.

Wind-down businesses that we have not divested remain in adjusted operating income. We exclude our discontinued healthcare operations from income from continuing operations before income taxes.

The excluded items are important to an understanding of our overall results of operations. You should not view adjusted operating income as a substitute for net income determined in accordance with GAAP, and you should note that our definition of adjusted operating income may differ from that used by other companies. However, we believe that the presentation of adjusted operating income as we measure it for management purposes enhances the understanding of our results of operations by highlighting the results from ongoing operations and the underlying profitability of our businesses. We exclude realized investment gains, net of losses and related charges, from

Prudential Financial 2001 Annual Report


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