Prudential Financial, Inc. — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. Figures are unaudited and, unless stated otherwise, in U.S. dollars. Prudential provides insurance, annuity, retirement, investment management and related financial services in the U.S. and internationally.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Total revenue | $14.439bn | $13.712bn | $28.768bn | $29.264bn |
| Income before tax and joint-venture earnings | $1.341bn | $2.129bn | $3.073bn | $4.877bn |
| Net income attributable to Prudential | $921m | $1.406bn | $2.257bn | $3.442bn |
| Diluted EPS | $2.04 | $3.03 | $4.97 | $7.40 |
| Net investment income | $3.789bn | $3.671bn | $7.459bn | $7.440bn |
| Realized investment gains, net | $1.433bn | $129m | $3.314bn | $2.490bn |
GAAP pre-tax income margin was approximately 9.3% in Q2 2016 versus 15.5% in Q2 2015, and 10.7% for the first half versus 16.7% a year earlier. Higher realized investment gains lifted reported revenue, but did not offset higher benefits and expenses and lower underlying segment earnings. Benefits and expenses rose to $13.098bn in Q2 from $11.583bn and to $25.695bn for the half-year from $24.387bn.
- Adjusted operating income before tax—Prudential’s non-GAAP segment measure—was $1.057bn in Q2, down from $1.841bn; first-half income was $2.382bn, down from $3.586bn.
- Q2 segment adjusted operating income: Individual Annuities $427m (prior year $548m); Retirement $236m ($237m); Asset Management $207m ($196m); Individual Life loss of $290m (income of $237m); Group Insurance $89m ($75m); International Insurance $803m ($842m); Corporate and Other loss of $415m ($294m).
- Cash flows from operations were $13.489bn for the first half, compared with $3.475bn; investing cash flow was a $7.789bn outflow versus a $714m inflow, and financing cash flow was a $619m inflow versus a $2.109bn outflow. Cash and equivalents ended at $24.142bn, up from $17.612bn at year-end. Operating cash flow was affected by large derivative and insurance-liability movements.
Financial position, debt and liquidity
- At June 30, 2016, total assets were $796.490bn, total liabilities $741.312bn and total equity $55.178bn. Available-for-sale fixed maturities were $332.270bn at fair value; commercial mortgage and other loans were $51.447bn.
- Short- and long-term debt totaled approximately $19.662bn, down from $20.810bn at December 31, 2015. The company repaid $750m of senior debt at maturity and repurchased $500m through a tender offer; related early-extinguishment costs included $36m of premium and fees.
- Prudential Financial reported $4.715bn of parent-level highly liquid assets, or $4.012bn excluding net intercompany liquidity-account borrowings. It targets a minimum parent cash balance of $1.3bn and had no borrowings outstanding on its $4bn committed credit facility.
- Management reported $42.118bn of capital, including equity attributable to Prudential excluding AOCI, junior subordinated debt and other capital debt. The latest reported statutory capital ratios were 484% for Prudential Insurance and 550% for PALAC at year-end 2015; Japan and Gibraltar Life solvency margin ratios were 801% and 928% at March 31, 2016. These are different regulatory measures and dates.
- Common dividends declared were $0.70 per share in each of Q1 and Q2; $750m of common shares were repurchased in the first half. In August 2016, after quarter-end, the board increased the 2016 repurchase authorization by $500m to $2.0bn.
Material changes and unusual items
- Net income attributable to Prudential fell 35% in Q2 and 34% for the first half. Management cited unfavorable comparisons from its Capital Protection Framework interest-rate strategy and annual updates to DAC, other costs and reserves. Favorable comparisons in realized investment gains and variable-annuity embedded-derivative and hedge results partly offset these items.
- The second-quarter actuarial review included a $444m pre-tax charge to recognize a “profits followed by losses” liability, predominantly for certain universal-life contracts. The liability will be updated as assumptions and experience change. Individual Life’s Q2 adjusted operating result also included a $148m out-of-period reserve adjustment, net of related DAC; management concluded that adjustment was not material to the quarter or prior periods.
- Realized derivative gains were a major source of period volatility: first-half realized gains included $1.382bn on interest-rate derivatives used for duration management and $1.351bn on product-related embedded derivatives and associated hedges. These results are not equivalent to recurring operating earnings.
- Other comprehensive income attributable to Prudential increased equity materially: accumulated other comprehensive income rose to $24.667bn from $12.285bn at year-end, primarily reflecting unrealized investment gains as rates declined. This is distinct from net income and is sensitive to market movements.
- Effective April 1, Prudential recaptured certain variable-annuity living-benefit and retirement risks previously ceded to Pruco Re, moving risks and supporting assets into originating insurers. Management said the change provided about $1.0bn of highly liquid assets at the parent and is expected to reduce future capital volatility. It began modifying the hedging strategy in Q3 2016.
- Acquisitions included an indirect 40% interest in Chilean pension provider AFP Habitat for approximately $532m, accounted for under the equity method, and completion of an India asset-management acquisition through a joint venture; the latter was not material to results.
Outlook, risks and contingencies
- Low interest rates: Management expects reinvestment yields to remain below portfolio yields, pressuring future spreads. For a hypothetical 10-year U.S. Treasury rate of 1.50% through year-end 2017, with credit spreads unchanged, it estimated an unfavorable pre-tax adjusted-operating-income impact of about $8m in 2016 and $64m in 2017 for a specified $53bn block of adjustable-crediting-rate contracts. This is a scenario, not company-wide guidance.
- For Japanese and Korean operations, a hypothetical 25-basis-point reduction in 2016 new-money yields was estimated to reduce 2016 pre-tax adjusted operating income by approximately $10m–$15m, subject to stated exclusions and assumptions. Japan’s low and sometimes negative yields, foreign-exchange movements and the U.K. referendum outcome could affect earnings, asset values and operations.
- Regulatory uncertainty includes proposed Federal Reserve capital and enhanced prudential standards for designated financial companies, NAIC principles-based life reserving, and the Department of Labor fiduciary rules. Prudential expected increased compliance costs and potential legal exposure from the DOL rules; their implementation and effects remained uncertain.
- Litigation and regulatory outcomes are uncertain. The company estimated aggregate reasonably possible losses in excess of established accruals at less than $250m for matters where an estimate could be made; this is not an estimate of maximum exposure and excludes matters that could not be estimated. Management did not expect the ultimate outcome, after reserves and indemnification, to materially affect financial position, while acknowledging an adverse resolution could affect results or cash flow.
- Other material risks cited include market and interest-rate fluctuations, investment defaults, reserve and policyholder-behavior assumptions, hedge effectiveness, foreign exchange, regulatory restrictions on subsidiary distributions, and access to capital and financing. Management stated that cash sources were sufficient for current liquidity needs under reasonably foreseeable stress scenarios. No full-year earnings guidance is provided in the supplied filing text.
Important facts for investors to verify
- How much of reported earnings and quarter-to-quarter volatility came from derivatives, variable-annuity valuations, and realized investment gains rather than recurring operating performance.
- The assumptions, sensitivity and future development of the $444m profits-followed-by-losses liability and the $148m out-of-period reserve adjustment.
- The effects of persistently low rates on investment spreads, guaranteed crediting rates, reserves and capital, including whether actual experience departs from management’s illustrative scenarios.
- Capital and liquidity after the variable-annuity recapture and hedging changes, including collateral requirements, regulatory constraints and the availability of subsidiary distributions.
- Investment credit quality and concentrations, especially Japanese sovereign exposure, energy-related holdings, mortgage loans and guarantees; also monitor litigation, regulatory rulemaking and the DOL fiduciary rules.