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Prudential Financial 2001 Annual Report - page 44 / 172

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Prudential Financial, Inc.

investment income resulting from the transfer of assets previously associated with our Traditional Participating Products segment to the Financial Services Businesses in connection with the establishment of the Closed Block Business on the date of demutualization. These declines were partially offset by a reduction in the charge for policyholder dividends, which excludes the portion of the dividend related to net realized investment gains, a reduction in amortization of deferred policy acquisition costs and a decline in operating expenses.

2000 to 1999 Annual Comparison. On a consolidated basis, adjusted operating income increased $263 million, or 13%, from 1999 to 2000. The increase came from a $231 million increase from the Closed Block Business and a $32 million increase from the Financial Services Businesses.

Adjusted operating income of our Financial Services Businesses increased $32 million, or 2%, from 1999 to 2000. The increase came primarily from increases of $89 million from our International division and $73 million from our U.S. Consumer division, partially offset by a $141 million decrease from Corporate and Other operations.

The $89 million increase in adjusted operating income from our International division came primarily from a $78 million increase from the International Insurance segment. The $73 million increase in adjusted operating income from our U.S. Consumer division came primarily from an increase of $65 million from the Retail Investments segment. The $141 million decrease from Corporate and Other operations came primarily from corporate-level activities, which included a one-time benefit of $114 million recognized in 1999 as a result of a reduction of recorded liabilities for our own employee benefits.

Adjusted operating income of the Closed Block Business increased $231 million, or 73%, from 1999 to 2000, primarily as a result of an increase in investment income net of interest expense and a decline in operating expenses.

Realized Investment Gains We have frequently used an active management strategy for a significant portion of our public fixed maturity investment portfolio to maximize the overall return on our investments, subject to our adjusted operating income objectives. The implementation of this strategy resulted in significant realized investment losses in 2000 and 1999. When applied during a period of generally declining interest rates, we expect that using this strategy will result in lower investment income partially offset by realized investment gains. Conversely, when applied during a period of generally rising interest rates, we expect that using this strategy will result in increased investment income offset by realized investment losses. The amount of our gains or losses also depends on relative value opportunities and other variables. In consideration of our adjusted operating income objectives, and other factors, we may choose, at times, to constrain our active management and, therefore, the magnitude of realized investment gains or losses.

In addition, we require most issuers of private fixed maturity securities to pay us make-whole yield maintenance payments when they prepay the securities. Prepayment levels are also driven by the interest rate environment and other factors not within our control. The prepayment of private fixed maturities we held contributed realized investment gains of $155 million in the year ended December 31, 2001, $74 million in 2000 and $155 million in 1999.

Realized investment gains, net of losses, also includes impairments on fixed income and equity assets, which we recognize on an ongoing basis. The level of impairments generally reflects economic conditions, and is expected to increase when economic conditions worsen and to decrease when economic conditions improve.

We use derivative contracts to hedge the risk that changes in interest rates or foreign currency exchange rates will affect the market value of certain investments. The vast majority of these derivative contracts do not qualify for hedge accounting and, consequently, we recognize the changes in fair value of such contracts from period to period in current earnings, although we do not necessarily treat the underlying assets the same way. Accordingly, our hedging activities contribute significantly to fluctuations in realized investment gains and losses.

The comparisons below discuss realized investment gains net of losses and related charges. These charges relate to policyholder dividends, DAC, and reserves for future policy benefits. Net realized investment gains is one of the elements that we consider in establishing the domestic dividend scale and in providing for dividends to Gibraltar Life policyholders, and the related charge for dividends to policyholders represents the estimated portion of our expense charge for policyholder dividends that is attributable to net realized investment gains that we consider in determining our dividend scale and the Gibraltar Life dividends. See “—Results of Operations for Financial Services Businesses by Division and Closed Block Business” below. We amortize deferred policy acquisition costs for interest sensitive products based on estimated gross profits, which include net realized investment gains on the underlying invested assets, and the related charge for amortization of deferred policy acquisition costs represents the amortization related to net realized investment gains. We adjust the reserves for some of our policies when cash

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Growing and Protecting Your Wealth

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