The Prudential Series Fund

Pruco Life Insurance Company
Notes to Consolidated Financial Statements
11. DERIVATIVE INSTRUMENTS
Types of Derivative Instruments and Derivative Strategies
Interest rate swaps are used by the Company to manage interest rate exposures arising from mismatches between assets and
liabilities (including duration mismatches) and to hedge against changes in the value of assets it anticipates acquiring and other
anticipated transactions and commitments. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio
basis. Under interest rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between
fixed rate and floating rate interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no
cash is exchanged at the outset of the contract and no principal payments are made by either party. These transactions are entered
into pursuant to master agreements that provide for a single net payment to be made by one counterparty at each due date.
Exchange-traded futures are used by the Company to reduce risks from changes in interest rates, to alter mismatches between the
duration of assets in a portfolio and the duration of liabilities supported by those assets, and to hedge against changes in the value
of securities it owns or anticipates acquiring or selling. In exchange-traded futures transactions, the Company agrees to purchase
or sell a specified number of contracts, the values of which are determined by the values of underlying referenced securities, and
to post variation margin on a daily basis in an amount equal to the difference in the daily market values of those contracts. The
Company enters into exchange-traded futures transactions with regulated futures commissions merchants that are members of a
trading exchange.
Futures typically are used to hedge duration mismatches between assets and liabilities. Futures move substantially in value as
interest rates change and can be used to either modify or hedge existing interest rate risk.
Currency derivatives, including currency swaps, are used by the Company to reduce risks from changes in currency exchange
rates with respect to investments denominated in foreign currencies that the Company either holds or intends to acquire or sell.
Under currency swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between one
currency and another at an exchange rate and calculated by reference to an agreed principal amount. Generally, the principal
amount of each currency is exchanged at the beginning and termination of the currency swap by each party. These transactions
are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty for payments
made in the same currency at each due date.
Credit derivatives are used by the Company to enhance the return on the Company’s investment portfolio by creating credit
exposure similar to an investment in public fixed maturity cash instruments. With credit derivatives the Company can sell credit
protection on an identified name, or a basket of names in a first to default structure, and in return receive a quarterly premium.
With first to default baskets, the premium generally corresponds to a high proportion of the sum of the credit spreads of the
names in the basket. If there is an event of default by the referenced name or one of the referenced names in a basket, as defined
by the agreement, then the Company is obligated to pay the counterparty the referenced amount of the contract and receive in
return the referenced defaulted security or similar security. In addition to selling credit protection, the Company may purchase
credit protection using credit derivatives in order to hedge specific credit exposures in the Company’s investment portfolio.
Embedded Derivatives
As described in Note 8, the Company sells variable annuity products which contain embedded derivatives. The Company has
entered into reinsurance agreements to transfer the risk related to the embedded derivatives to affiliates. The Company also sells
certain universal life products that contain a no lapse guarantee provision. The Company entered into an agreement with an
affiliate (See Note 13 to the Consolidated Financial Statements) to reinsure these guarantees that are accounted for in the same
manner as the embedded derivative. These embedded derivatives are marked to market through ―Realized investment gains
(losses), net‖ based on the change in value of the underlying contractual guarantees, which are determined using valuation
models.
The Company invests in fixed maturities that, in addition to a stated coupon, provide a return based upon the results of an
underlying portfolio of fixed income investments and related investment activity. The Company accounts for these investments as
available for sale fixed maturities containing embedded derivatives. Such embedded derivatives are marked to market through
―Realized investment gains (losses), net,‖ based upon the change in value of the underlying portfolio.
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