PRUDENTIAL FINANCIAL INC quarterly report, Q2 FY2018

Prudential Financial, Inc. — Q2 2018 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2018. Prudential provides insurance, annuity, retirement, and investment-management products in the U.S. and internationally. Amounts are in U.S. dollars; financial-statement amounts are in millions unless stated otherwise. Results are unaudited.

Financial performance and condition

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Total revenue	$14,655	$13,441	$28,412	$27,111
Income before tax and operating-joint-venture earnings	$250	$608	$1,943	$2,350
Net income attributable to Prudential Financial	$197	$491	$1,560	$1,860
Diluted earnings per share	$0.46	$1.12	$3.62	$4.21
Net investment income	$4,096	$4,089	$8,094	$8,150

Quarterly earnings fell despite higher revenue: Q2 attributable net income declined $294 million year over year. Benefits and expenses rose to $14.405 billion from $12.833 billion; pretax income fell to $250 million from $608 million.
Cash flow: Six-month operating cash flow was $6.675 billion, versus $4.711 billion in 2017; investing cash outflow was $6.489 billion, versus $2.647 billion. Financing cash inflow was $409 million. Period-end cash, cash equivalents, and restricted cash totaled $15.060 billion; balance-sheet cash and cash equivalents were $14.918 billion.
Balance sheet at June 30: Total assets were $819.860 billion, total liabilities $771.268 billion, and total equity $48.592 billion. Assets and liabilities were down from December 31, 2017, while Prudential Financial equity declined to $48.232 billion from $54.236 billion. Accumulated other comprehensive income fell to $11.655 billion from $17.074 billion, reflecting substantial investment-market losses.
Debt and liquidity: Consolidated borrowings were $18.788 billion, up from $18.552 billion at year-end; reported short-term and long-term debt were $2.056 billion and $16.732 billion. Prudential Financial reported $5.581 billion of highly liquid assets, and no amounts drawn on committed credit facilities. Management said liquidity was sufficient under reasonably foreseeable stress scenarios.
Capital and distributions: Management-reported capital was $48.402 billion. During the first half, Prudential repurchased $750 million of shares and declared $769 million of common dividends; declared dividends per share were $1.80 versus $1.50. The company had authorization to repurchase up to $1.5 billion in 2018.
Investment portfolio: Total investments were $464.519 billion. Available-for-sale fixed maturities had a fair value of $341.151 billion and gross unrealized losses of $5.168 billion. Management attributed most unrealized losses to wider credit spreads, higher interest rates, and foreign-exchange movements, and said it did not intend, and was not more likely than not required, to sell the affected securities before recovery.

Material changes versus prior periods

Q2 results included a $1.458 billion net charge in divested businesses, principally Long-Term Care, from the annual assumption review. Management removed its assumption of future morbidity improvement following unfavorable experience. Long-Term Care reported a $1.425 billion Q2 loss versus $35 million of income a year earlier; reserves were $6.6 billion at June 30. The business was closed to new sales in 2012, but management said further assumption changes may be needed as experience develops.
Management cited $1.302 billion of unfavorable Q2 year-over-year variance from reserve, DAC, and other-cost adjustments, including annual assumption reviews; this was partly offset by a $1.088 billion favorable pretax variance from changes in variable-annuity embedded derivatives and related hedges. Six-month comparison included the same major drivers.
Segment adjusted operating income before tax, a non-GAAP management measure, was $1.661 billion in Q2 versus $1.228 billion. Results improved sharply at Individual Life, primarily because the prior-year quarter included a $653 million assumption-review charge. Q2 adjusted operating income declined at Individual Annuities, Retirement, Group Insurance, and International Insurance, while PGIM increased.
Six-month GAAP net income attributable to Prudential fell to $1.560 billion from $1.860 billion, despite higher reported revenue. Results reflected the Long-Term Care charge, annual assumption changes, and investment and hedge effects. Six-month realized investment gains were $1.110 billion versus losses of $665 million in 2017; derivative results were a major source of the swing.
Prudential eliminated Gibraltar Life’s one-month reporting lag effective January 1, 2018. The change added an additional month of activity to 2018 results; management said the impact on statements of operations and other specified statements was not material, though it affected quarterly seasonality. Comparisons should be read with this change in mind.
New accounting guidance changed equity-security fair-value changes to flow through net income beginning in 2018, rather than accumulated other comprehensive income. The prior-period presentation was not restated. Prudential also adopted revenue-recognition guidance, with no material adoption-date impact.

Outlook, management commentary, risks, and contingencies

Interest rates: Management said U.S. rates remained below historical levels and expected portfolio yields to decline as assets mature and are reinvested at lower rates. For a stated hypothetical U.S. Treasury-rate scenario, it estimated an unfavorable pretax adjusted-operating-income impact of about $1 million in 2018 and $10 million in 2019 for the specified $56 billion contract block; the estimate excludes multiple potential offsets and other factors. A separate hypothetical 25-basis-point reduction in 2018 new-money yields in Japanese and Korean operations was estimated to reduce 2018 adjusted operating income by approximately $10–$15 million.
Capital outlook: Management expected to have resources to maintain its AA ratings targets despite anticipated effects of revised risk-based-capital factors and higher Long-Term Care reserves. Domestic insurer RBC ratios cited were for December 31, 2017, the latest statutory year-end in the filing; international solvency ratios were as of March 31, 2018.
Business actions: Prudential exited PGIM Brazil in Q2 and agreed to sell its Italian subsidiary, with closing expected by early 2019 subject to approvals and customary conditions. Group Insurance entered into a mortality-risk reinsurance agreement expected to modestly reduce segment adjusted operating income.
Legal and regulatory exposure: Litigation and regulatory matters remain subject to uncertainty. The company estimated reasonably possible losses above established accruals at less than $250 million for matters where an estimate could be made; this is not an expected-loss estimate or a maximum exposure. Management said an unfavorable outcome could materially affect results or cash flow in a particular period.
Other key risks: Investment credit deterioration or counterparty default; interest-rate, equity-market, and currency movements; variable-annuity guarantees and related hedging or collateral needs; mortality, morbidity, and policyholder behavior; liquidity and asset-liability mismatches; regulatory and tax changes; cybersecurity and operational failures; ratings changes; competition and reputation risks. Prudential identified no material change in its economic market-risk exposures from year-end 2017.
The filing does not provide a clear company-wide earnings forecast or formal full-year earnings guidance. Management stated interim results are not necessarily indicative of full-year results.

Important facts for investors to verify

Review the Long-Term Care reserve assumptions, the $1.458 billion charge, and sensitivity to future morbidity experience.
Separate recurring segment performance from GAAP earnings volatility caused by annual assumption updates, derivatives, and variable-annuity guarantees; reconcile adjusted operating income to GAAP results.
Assess the scale of unrealized fixed-maturity losses, interest-rate exposure, reinvestment yields, and potential derivative collateral demands.
Confirm the latest statutory capital ratios and the effect of RBC-framework revisions, as the ratios disclosed here predate June 30, 2018.
Track legal and regulatory developments, including potential losses beyond recorded accruals, and the closing and financial effects of the announced business exits.
Consider the reporting-lag change and new equity-security accounting when comparing 2018 with 2017.