Prudential Financial, Inc. — Q3 2015 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2015. Figures are unaudited and in U.S. dollars; financial amounts are in millions unless noted. Prudential provides insurance, annuities, retirement services, mutual funds and investment management. Effective January 2, 2015, it repurchased and canceled its Class B stock, changing its reporting structure and making some comparisons with 2014 less directly comparable.
Financial performance and position
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Total revenue | $13,599 | $12,380 | $42,863 | $38,380 |
| Income before tax and joint-venture earnings | $2,049 | $284 | $6,926 | $3,509 |
| Net income attributable to Prudential | $1,465 | $512 | $4,907 | $2,840 |
| Diluted EPS | $3.16 | $0.99 | $10.56 | $5.79 |
| Net investment income | $3,741 | $3,841 | $11,181 | $11,433 |
| Realized investment gains, net | $1,700 | $75 | $4,190 | $892 |
- Revenue and earnings: Revenue increased about 10% in Q3 and 12% year to date. Higher reported earnings were substantially affected by variable-annuity embedded derivative and hedge valuations, other derivative gains, and foreign-currency movements; they should not be read as a simple measure of underlying operating growth.
- Management’s segment measure: Adjusted operating income before tax was $1,463 in Q3 versus $1,353, and $5,049 for nine months versus $4,547. This non-GAAP segment measure excludes or adjusts for significant investment, market and other items; it is not a substitute for GAAP income.
- Cash flow: Nine-month operating cash flow was $11,830 versus $11,422. Investing activities used $5,163 versus $9,677; financing activities used $1,434 versus providing $4,118. Cash and cash equivalents increased $5,289 to $20,207.
- Balance sheet and debt: At September 30, assets were $754,527, total liabilities $711,757 and total equity $42,770. Investments totaled $416,950. Short- and long-term debt totaled approximately $22,162, down from $23,670 at year-end 2014. The $4,000 committed credit facility was undrawn.
- Capital and liquidity: Management reported $41,325 of capital, including equity excluding AOCI, junior subordinated debt and other capital debt. Domestic insurance RBC ratios were 498% for Prudential Insurance and 647% for PALAC at December 31, 2014; Japanese solvency margin ratios were 853% for Prudential of Japan and 927% for Gibraltar Life at June 30, 2015. These are not September 30 measures. Parent cash and short-term investments were $12,871 including intercompany liquidity-account borrowings, or $4,358 excluding them.
- Comprehensive income and valuation: Nine-month other comprehensive loss, net of tax, was $2,648, versus income of $4,828 a year earlier; comprehensive income was $2,324 versus $7,713. Net unrealized investment gains declined to $30,850 from $37,113 at year-end.
Material changes versus prior comparable periods
- GAAP pretax income rose to $2,049 from $284 in Q3 and to $6,926 from $3,509 year to date. Management attributed major favorable variances to variable-annuity embedded derivatives and related hedges, currency effects in Japanese operations, and other investment results; higher tax expense partly offset the gains.
- Net investment income was lower in both comparisons, reflecting lower income from non-coupon investments and lower reinvestment rates. Management expects ongoing reinvestment at lower yields to pressure portfolio returns.
- Segment results were mixed. Q3 adjusted operating income fell for Individual Annuities ($310 versus $367), Retirement ($242 versus $256) and Asset Management ($180 versus $200); improved for Individual Life ($183 versus $97) and Group Insurance ($44 versus a loss of $73); and declined for International Insurance ($812 versus $845).
- Individual Annuity account value was $150.2 billion at quarter-end, down from $156.8 billion a year earlier, reflecting market declines, benefits and charges. Nine-month net sales were $297 million versus $963 million.
- Assets under management were $946.5 billion at September 30, up from $933.5 billion at year-end 2014. Q3 market depreciation, particularly in retail assets, offset some positive flows and growth.
- Comparability is affected by the Class B stock cancellation: 2015 EPS reflects consolidated Prudential, while 2014 Common Stock EPS reflected the former Financial Services Businesses. The Closed Block division is treated as a divested business for 2015 segment reporting, unlike its 2014 presentation.
Outlook, risks and unusual items
- Low interest rates: Management expects portfolio yields to decline as scheduled payments and prepayments are reinvested. For approximately $52 billion of U.S. contracts with adjustable crediting rates, a hypothetical average 10-year Treasury rate of 2.10% through 2016, with credit spreads unchanged, implied an estimated unfavorable net-interest-margin impact of about $1 million in 2015 and $34 million in 2016. This is a limited scenario, not full-company earnings guidance; it excludes potential mitigants and other effects.
- Variable-annuity exposure: Earnings and liquidity can be affected by equity markets, interest rates, volatility, policyholder behavior and differences between hedge positions and the accounting liability. The living-benefit embedded derivative was a net liability of approximately $9.1 billion; its fair value depends on significant unobservable assumptions. Prudential reinsures approximately 50% of eligible new HDI v3.0 business under an agreement effective April 1, 2015, subject to stated limits.
- Investment and market risks: Credit spread widening reduced unrealized gains; nine-month OTTI recorded in earnings for PFI excluding the Closed Block division was $227 million, versus $64 million. The company cited energy exposure of approximately $14 billion, substantially investment grade, and noted potential further valuation declines or impairments if energy prices remain depressed. Foreign exchange, interest rates, equity markets, defaults and counterparty performance are also material sensitivities.
- Regulatory and legal: Prudential identified potential effects from proposed Department of Labor fiduciary rules, Dodd-Frank supervision and global systemically important insurer capital standards. Management said capital was expected to exceed initial BCR and HLA calibrations, while standards remain subject to change. The estimated aggregate range of reasonably possible litigation and regulatory losses in excess of accruals was less than $250 million for matters where an estimate could be made; outcomes remain uncertain.
- Other notable items: The company repurchased $750 million of common stock in the first nine months and declared $0.58 per share dividends in each 2015 quarter. The final price for the $651 million Class B stock repurchase remains subject to a shareholder dispute. Acquisitions involving Deutsche Bank’s India asset-management business and AFP Habitat were pending approvals and expected to close in 2016.
Key facts for investors to verify
- How much of GAAP earnings growth came from variable-annuity hedging, derivative valuations and currency movements, versus recurring segment performance?
- How the 2015 consolidated results should be compared with 2014 given the Class B cancellation and Closed Block reclassification.
- Whether reinvestment yields, crediting-rate flexibility and asset-liability actions preserve spreads under prolonged low interest rates.
- Current statutory capital and liquidity at insurance subsidiaries, including any effects of regulatory changes, collateral needs or limits on subsidiary dividends.
- Developments in significant litigation and regulatory matters, the Class B repurchase-price dispute, and the pending acquisitions.