Prudential Financial, Inc. — Q3 2016 Form 10-Q
Business context and reporting period. This unaudited quarterly filing covers the three and nine months ended September 30, 2016; balance-sheet comparisons are with December 31, 2015. Prudential provides insurance, annuities, retirement services, and investment management in the U.S. and internationally. Results include four operating divisions, the Closed Block division, and Corporate and Other. Amounts below are U.S. dollars; financial statement figures are in millions unless noted.
Key financial metrics
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Total revenue | $16,961 | $13,599 | $45,729 | $42,863 |
| Net income attributable to Prudential Financial | $1,827 | $1,465 | $4,084 | $4,907 |
| Diluted EPS | $4.07 | $3.16 | $9.02 | $10.56 |
| Net investment income | $4,073 | $3,741 | $11,532 | $11,181 |
| Realized investment gains, net | $813 | $1,700 | $4,127 | $4,190 |
| Operating cash flow | Not provided by quarter in the supplied filing text | $17,038 | $11,830 |
Q3 pretax income from continuing operations before tax and equity earnings of operating joint ventures was $2,315 million, versus $2,049 million; nine-month income was $5,388 million, versus $6,926 million. Revenue less benefits and expenses produced a simple pretax margin of approximately 13.6% for Q3 and 11.8% for the first nine months; these consolidated ratios are affected by insurance and investment accounting and are not management’s adjusted operating margin.
- Balance sheet at September 30: total assets $819.9 billion; total liabilities $762.9 billion; total equity $57.0 billion, including $56.4 billion attributable to Prudential Financial. Equity was $41.9 billion at year-end 2015; the increase primarily reflects higher accumulated other comprehensive income, including unrealized investment gains.
- Cash and investments: investments $465.8 billion and cash and cash equivalents $24.7 billion, compared with $417.2 billion and $17.6 billion, respectively, at year-end 2015. Separate-account assets and liabilities were each $291.6 billion.
- Debt and liquidity: consolidated short- and long-term borrowings totaled $19.7 billion, down from $20.8 billion. Short-term debt was $0.9 billion and reported long-term debt was $18.8 billion. Prudential Financial, the holding company, had $4.6 billion of highly liquid assets including intercompany liquidity-account borrowings, or $3.5 billion excluding those borrowings; its targeted minimum cash balance is $1.3 billion. The filing says available sources are expected to meet liquidity needs under reasonably foreseeable stress scenarios.
- Capital: management reported $43.1 billion of capital available to support operations. Latest disclosed subsidiary capital ratios were Prudential Insurance RBC 484% and PALAC RBC 550% at December 31, 2015; Prudential of Japan solvency margin 840% and Gibraltar Life 987% at June 30, 2016. These are not September 30 ratios.
- Shareholder returns: common dividends declared were $0.70 per share in Q3 and $2.10 for the nine months. The 2016 repurchase authorization was increased to $2.0 billion; $1.375 billion had been spent through September 30.
Material changes versus comparable periods
- Q3 net income attributable to Prudential rose 25% year over year, while nine-month net income fell 17%. Q3 revenue increased 25%; nine-month revenue increased 7%.
- Premiums rose to $9.6 billion in Q3 from $6.0 billion and to $22.9 billion for nine months from $20.2 billion. Management attributed much of Retirement segment premium growth to pension risk transfer transactions, which also increased policyholder benefits; this revenue growth should not be read as equivalent growth in profit.
- Q3 realized investment gains fell by $887 million year over year, while nine-month realized gains were slightly lower. Results remain sensitive to derivatives, variable-annuity guarantee valuations, currency movements, and related DAC and reserve adjustments.
- Adjusted operating income before tax, a non-GAAP segment measure, was $1.56 billion in Q3 versus $1.46 billion, but $3.94 billion for nine months versus $5.05 billion. Management cited favorable Q3 changes in estimated business profitability and higher Individual Annuities results; nine-month comparisons were affected by unfavorable assumption updates and the Capital Protection Framework.
- Total equity increased $15.1 billion from year-end, with AOCI rising from $12.3 billion to $24.9 billion. Nine-month other comprehensive income, net of tax, was $12.7 billion, compared with a $2.6 billion loss in 2015.
- Operating cash flow increased to $17.0 billion from $11.8 billion; investing cash outflow was $13.1 billion versus $5.2 billion, including $532 million paid for the AFP Habitat investment. Financing cash flow was $2.8 billion versus an outflow of $1.4 billion.
Outlook, management commentary, risks and unusual items
- Interest rates: management expects reinvestment yields to remain below portfolio yields, pressuring future spreads. Under a stated hypothetical U.S. Treasury scenario, the estimated unfavorable impact on pre-tax adjusted operating income was about $2 million in 2016 and $47 million in 2017 for a specified group of adjustable-crediting-rate contracts; this is not company-wide guidance. Japan’s low and sometimes negative yields also remain a concern.
- Variable annuities: Prudential recaptured certain variable-annuity and retirement risks effective April 1, 2016, moving risks and assets into originating insurers and generating approximately $1.0 billion of highly liquid assets at the holding company, net of specified capital movements. In Q3 it changed its ALM strategy to combine fixed-income assets and derivatives. Management expects more efficient capital and liquidity management, but GAAP and adjusted results can differ because of valuation and accounting mismatches. The Q3 change produced a $515 million DAC and other-cost benefit; the GAAP embedded-derivative liability was approximately $12.9 billion, while the economic liability managed by the ALM strategy was $16.2 billion.
- Reserve and assumption items: a second-quarter $148 million out-of-period charge increased reserves for certain universal life products, net of related DAC. The filing says it was not material to current or previously reported periods. The second-quarter assumption review also recorded a $444 million Profits Followed by Losses liability, predominantly for certain universal life contracts; the liability is subject to quarterly updates.
- Regulatory and business risks: the filing discusses proposed Federal Reserve capital and enhanced prudential standards, principles-based life reserving, and the DOL fiduciary rule, whose implementation was scheduled to begin in April 2017. Management anticipates increased compliance costs and potential legal exposure from the DOL rule. Brexit could affect currency rates, asset prices, and regulation. Other stated risks include prolonged low rates, market volatility, mortality and persistency experience, investment losses, currency movements, and restricted subsidiary distributions.
- Legal matters and guarantees: management estimated aggregate reasonably possible litigation and regulatory losses in excess of established accruals at less than $250 million where estimable; this is not an estimate of expected or maximum loss. Securities-lending indemnities were $4.9 billion with $5.0 billion of related collateral and no accrued liability; management considers payments remote. Mortgage-servicing indemnification exposure was $1.34 billion, including $408 million of first-loss exposure, with a $13 million accrued liability.
- No formal company-wide earnings or EPS guidance is stated in the supplied filing text. Management reports effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Separate underlying operating performance from investment gains, derivative marks, variable-annuity guarantee changes, and the Q3 ALM-related DAC benefit; compare GAAP results with adjusted operating income reconciliations.
- Review the drivers and sustainability of pension risk transfer premiums, associated benefits and liabilities, and segment-level margins.
- Track reinvestment yields, guaranteed minimum crediting rates, variable-annuity guarantee assumptions and hedging effectiveness, and the sensitivity of results to rates, equity markets, volatility, and currency.
- Confirm holding-company liquidity separately from consolidated cash, and monitor regulatory limits on subsidiary dividends, debt maturities, and capital requirements.
- Follow developments in litigation, the DOL fiduciary rule, Federal Reserve standards, principles-based reserving, and any changes to the disclosed contingency estimates.