Prudential Financial, Inc. — Q1 2016 Form 10-Q
Business context and reporting period
Unaudited results cover the three months ended March 31, 2016, compared with Q1 2015; balance-sheet figures are compared with December 31, 2015. Prudential provides insurance, retirement, investment-management and related financial services in the U.S. and internationally. The filing reports four operating divisions, the Closed Block division and Corporate and Other. Amounts below are in U.S. dollars; financial statement amounts are in millions unless stated otherwise.
Key financial results and position
- Revenue and earnings: Total GAAP revenue was $14.329 billion, down 7.9% from $15.552 billion. Income before tax and equity in operating joint ventures was $1.732 billion, versus $2.748 billion. Net income attributable to Prudential was $1.336 billion, down 34.4% from $2.036 billion. Diluted EPS was $2.93 versus $4.37. The company declared dividends of $0.70 per share, compared with $0.58.
- Drivers and earnings quality: Net realized investment gains were $1.881 billion, down from $2.361 billion. Derivative gains were a major contributor, while fixed-maturity results shifted from gains to losses and impairment charges rose. Adjusted operating income before tax, a non-GAAP segment measure, fell to $1.325 billion from $1.745 billion. GAAP results also included material changes in variable-annuity embedded derivatives and hedges.
- Costs and margins: Benefits and expenses totaled $12.597 billion, down from $12.804 billion. DAC amortization rose to $1.202 billion from $789 million, while policyholder dividends fell to $266 million from $781 million. Operating performance varied by segment; for example, Individual Annuities adjusted operating income declined to $328 million from $529 million, while International Insurance declined to $779 million from $834 million. Revenue-based margins are not directly comparable across the insurer’s businesses.
- Cash flow: Operating activities provided $6.294 billion, versus $5.528 billion. Investing activities used $2.748 billion, compared with providing $1.648 billion; this included $532 million paid for the AFP Habitat investment. Financing activities provided $1.179 billion, compared with using $3.086 billion. Cash and cash equivalents rose $4.880 billion to $22.492 billion.
- Assets, equity and liquidity: Total assets were $772.995 billion, up from $757.255 billion at year-end; total equity was $49.265 billion, up from $41.923 billion. Net unrealized investment gains and other comprehensive income contributed to the increase: Q1 comprehensive income attributable to Prudential was $8.117 billion, including $6.785 billion of after-tax OCI. Separate-account assets and liabilities were each $281.501 billion.
- Debt and capital: Consolidated borrowings were $20.577 billion, down from $20.810 billion. Balance-sheet short-term debt was $969 million and long-term debt $19.608 billion. The company had a $4.0 billion committed credit facility with no amount outstanding. Management reported $41.809 billion of capital under its measure, including equity excluding AOCI and debt; this is not the same as total balance-sheet equity.
Material changes versus the prior period
- Q1 attributable net income and diluted EPS declined substantially, despite higher comprehensive income, which primarily reflected unrealized investment gains and currency translation.
- Adjusted operating income declined in Individual Annuities, Retirement, Asset Management and International Insurance; Individual Life improved modestly and Group Insurance was slightly lower. Corporate and Other losses widened.
- Individual Annuities’ variable-annuity account values were $149.2 billion, down from $157.6 billion a year earlier; quarterly net flows were negative $205 million. Asset Management AUM increased to $1.003 trillion from $961.7 billion a year earlier, with fixed-income growth offset in part by equity-market depreciation and outflows.
- Prudential completed the purchase of an indirect 40% interest in Chilean pension provider AFP Habitat for approximately $532 million, accounted for under the equity method. It also completed an India asset-management acquisition that management said had no material impact on results.
- Adoption of consolidation guidance deconsolidated certain CLOs and other investment structures, reducing assets and liabilities by $5.5 billion each at adoption. This accounting change should be distinguished from operating trends.
Outlook, risks, contingencies and unusual items
- Outlook: The filing provides no quantified company-wide earnings guidance. Management said persistent low rates are expected to reduce portfolio yields as assets mature and are reinvested. Under a specified hypothetical U.S. Treasury-rate scenario, estimated unfavorable net-interest-margin effects were approximately $15 million in 2016 and $69 million in 2017 for a defined group of adjustable-crediting-rate contracts; this is a scenario, not formal guidance.
- Interest-rate and market exposure: The Bank of Japan adopted negative interest rates in Q1. Management cited reinvestment risk, guaranteed policyholder crediting rates, equity-market and volatility exposure, foreign-currency movements, and credit losses. The company holds substantial Japanese government securities; it also reported $12.3 billion of direct and indirect energy-related exposure, with approximately $0.2 billion in net unrealized losses, and cautioned that further losses could occur if energy prices remain depressed.
- Variable annuity hedging: The GAAP living-benefit embedded-derivative liability was $11.0 billion at March 31, compared with $8.4 billion at year-end. Effective April 1, 2016, Prudential recaptured certain risks previously reinsured to Pruco Re and moved management of those risks to domestic insurance entities; management expects this to improve capital and liquidity efficiency and reduce capital volatility.
- Regulatory and legal matters: The April 2016 Department of Labor fiduciary rules, with implementation beginning in April 2017 and further compliance provisions in 2018, may increase costs, affect products and compensation, and increase legal exposure, particularly in annuities, retirement and distribution. Management estimated reasonably possible litigation and regulatory losses in excess of established accruals at less than $250 million where estimable, but outcomes remain uncertain. The filing discusses, among other matters, putative class actions concerning stable-value arrangements and securities-lending remediation as a forward-looking risk.
- Capital returns and financial reporting: Prudential repurchased $375 million of common stock and declared $316 million of dividends during the quarter; $1.125 billion remained under the 2016 repurchase authorization at quarter-end. Insurance-subsidiary dividends are subject to regulatory restrictions. Management stated that disclosure controls were effective and there had been no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Reconcile the decline in GAAP earnings with adjusted operating results and the large, market-sensitive derivative and variable-annuity hedge effects.
- Review segment-level trends, especially Individual Annuities, Retirement, International Insurance and Corporate and Other, and distinguish ongoing operating performance from investment and accounting effects.
- Assess exposure to prolonged low rates, policy guarantees, energy-sector credit deterioration, Japanese markets and foreign currencies, including sensitivity of reserves and hedges to assumptions.
- Check capital and liquidity at the regulated insurance-subsidiary level, potential limits on upstream dividends, and the effects of the April 1 variable-annuity risk recapture.
- Track the DOL rule implementation, litigation and regulatory developments, securities-lending indemnities, and any changes to contingency accruals.
- Verify the income-tax figure: the statement of operations reports $368 million of Q1 tax expense, while the MD&A elsewhere states $364 million. The filing text does not reconcile the difference clearly.