UPDATE 1-Moody's cuts Prudential to two notches above junk

NEW YORK, March 18 (Reuters) - Prudential Financial Inc (PRU.N) was downgraded to the second-lowest investment grade by Moody's Investors Service on Wednesday, which cited the large life insurer's reduced profitability and potential for more capital strain if conditions worsen.

Moody's lowered Prudential's senior debt rating by two notches to "Baa2" from "A3," and the insurance financial strength rating of its Prudential Insurance Co of America unit by two notches to "A2" from "Aa3." The outlook is "negative," meaning another cut is possible within two years.

The rating agency also put the "Prime-1" short-term debt rating for the Prudential Funding LLC unit on review for downgrade, meaning a cut is possible within three months.

Moody's said Newark, New Jersey-based Prudential is being hurt by "very substantial exposure" to variable annuities with guarantees, as well as increased investment losses.

It said the two-notch downgrade, as opposed to a one-notch downgrade, reflects Prudential's greater sensitivity to falling stock prices than that of many peers, along with "sensitivity to further capital strain if conditions worsen."

A Prudential spokesman, Bob DeFillippo, said Moody's actions "reflect the unprecedented market volatility affecting the entire insurance industry, but we remain comfortable with our risk profile, and are in a strong position to manage through the current environment."

He also said Prudential Funding retains access to the U.S. Federal Reserve's Commercial Paper Funding Facility. The parent lost access following a Feb 19 downgrade by Fitch Ratings.

Prudential Funding had $4.35 billion of commercial paper and "master note" borrowings outstanding at year end, according to Prudential's annual report.

Prudential shares closed Wednesday up $3.98, or 19 percent, at $24.92, while the Standard & Poor's insurance index .GSPINSC rose 10.5 percent. Moody's announced the downgrade after U.S. markets closed. (Reporting by Jonathan Stempel; editing by Gunna Dickson)