Prudential Financial, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Amounts are in U.S. dollars; financial statement amounts are in millions unless stated otherwise. Interim results are unaudited. Prudential provides insurance, annuities, retirement services, and investment management in the U.S. and internationally.
Financial performance and condition
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Total revenue | $16,148 | $16,313 | $44,560 | $43,424 |
| Benefits and expenses | $14,310 | $13,292 | $40,779 | $38,053 |
| Income before tax and joint-venture earnings | $1,838 | $3,021 | $3,781 | $5,371 |
| Net income attributable to Prudential | $1,672 | $2,238 | $3,232 | $4,098 |
| Diluted EPS | $3.90 | $5.09 | $7.51 | $9.29 |
| Adjusted operating income before tax | $1,668 | $1,784 | $5,050 | $4,672 |
Revenue was down about 1% for the quarter and up about 3% for the nine-month period. Net income attributable to Prudential fell about 25% and 21%, respectively. Income before tax as a share of revenue was approximately 11.4% versus 18.5% in Q3 and 8.5% versus 12.4% for the nine-month periods; these percentages are calculated from reported figures.
- Cash flow: Nine-month operating cash flow was $10.268 billion, investing cash flow was negative $12.941 billion, and financing cash flow was positive $809 million. Cash, cash equivalents, and restricted cash ended the period at $12.604 billion, down $1.932 billion from year-end 2017.
- Balance sheet: Total assets were $822.748 billion, versus $832.136 billion at December 31, 2017. Total equity was $47.082 billion, versus $54.511 billion; Prudential stockholders’ equity was $46.725 billion. AOCI fell to $9.150 billion from $17.074 billion, with the filing citing substantial unrealized investment losses and foreign currency effects.
- Investments: Total investments were $464.972 billion. Available-for-sale fixed maturities were $340.970 billion at fair value. Gross unrealized losses on fixed maturities increased to $6.072 billion from $1.776 billion at year-end; management attributed losses primarily to wider credit spreads, higher interest rates, and currency movements, and said it did not expect to be forced to sell the securities before recovery.
- Debt and liquidity: Short-term debt was $2.393 billion and long-term debt $17.421 billion; consolidated borrowings were $19.814 billion, up from $18.552 billion at year-end. Prudential reported compliance with debt covenants. Parent-company highly liquid assets were $6.340 billion; no amounts were drawn on committed credit facilities.
- Capital: Reported total capital was $50.936 billion. The latest reported domestic insurance RBC ratios were as of December 31, 2017; the composite major U.S. subsidiary ratio was 529%. Japan and Gibraltar solvency margin ratios, as of June 30, 2018, were 850% and 931%, respectively.
Material changes and notable drivers
- Q3 earnings were pressured by an unfavorable $718 million pre-tax year-over-year variance from variable-annuity embedded derivatives and related hedges, a $588 million unfavorable variance in realized investment gains and losses (excluding that hedge program), and an $84 million unfavorable variance from reserve, DAC, and other assumption updates. Lower tax expense partly offset these items.
- For the first nine months, the company cited a $1.389 billion unfavorable pre-tax comparative variance from reserve, DAC, and other cost updates; a $771 million unfavorable variance in realized investment gains and losses; and a $249 million unfavorable comparison in divested businesses. Favorable comparisons in variable-annuity hedging and taxes partly offset the decline.
- Long-Term Care, reported among divested businesses, recorded a $1.458 billion net charge in the first nine months from annual assumption updates, including removal of expected future morbidity improvement after experience was worse than previously expected. The charge was a major contributor to the nine-month decline in GAAP earnings.
- Adjusted operating income for the nine months rose to $5.050 billion from $4.672 billion, while GAAP net income declined. The two measures differ because adjusted operating income excludes specified investment, experience-rated, and divested-business items.
- Prudential adopted accounting changes in 2018, including recording fair-value changes on equity securities in net income rather than AOCI. It also early-adopted a standard allowing certain tax effects to be reclassified from AOCI to retained earnings. These presentation and accounting changes affect period comparisons.
Outlook, commentary, and risks
- Interest rates: Management said rising U.S. rates may improve reinvestment yields, while low rates—particularly in Japan—can pressure investment spreads and require reinvestment below existing portfolio yields or product guarantees. In illustrative scenarios, Prudential estimated a $1 million pre-tax adjusted operating income impact in 2018 and $3 million in 2019 for a specified U.S. rate path, and a $10–$15 million unfavorable 2019 impact under a specified lower-new-money-yield scenario in Japan and Korea. These are limited hypotheticals, not company-wide earnings guidance.
- Insurance assumptions and guarantees: Variable-annuity guarantees are sensitive to equity markets, interest rates, volatility, mortality, withdrawals, lapses, and hedge effectiveness. Management uses product features, asset-liability management, derivatives, and some reinsurance to manage exposures; derivative collateral needs can create material liquidity demands.
- Regulatory developments: In October 2018, after quarter-end, the Financial Stability Oversight Council rescinded Prudential’s designation as a non-bank financial company subject to Federal Reserve supervision. Prudential remains subject to insurance regulation, with New Jersey continuing as group-wide supervisor. The filing also describes evolving fiduciary and best-interest standards and changes to insurance capital rules.
- Accounting outlook: A new long-duration insurance-contract accounting standard is effective in 2021 and is expected to significantly affect financial statements and the timing of earnings; the magnitude was still under assessment. Prudential estimated that lease accounting adoption in 2019 would add a right-of-use asset and liability of less than $750 million.
- Tax and unusual items: The nine-month effective tax rate was 16.0%, versus 24.6% in 2017. Tax items included a $198 million tax benefit from IRS guidance on reserve deductions, a $40 million expense from resolving tax audit issues, and a $51 million net expense related to a Brazil tax election and deferred-tax remeasurement. Tax Act accounting remained incomplete and later adjustments could materially affect the tax provision.
- Legal and contingency matters: The company estimated aggregate reasonably possible litigation and regulatory losses in excess of established accruals at less than $250 million where an estimate could be made; this is not an estimate of expected or maximum loss. SEC discussions continued regarding securities-lending and foreign-tax-reclaim practices and potential remediation or financial remedies. Management said ultimate outcomes are uncertain and could affect results or cash flows.
- Other developments: Prudential repurchased $1.125 billion of shares and declared $1.149 billion in common-stock dividends during the first nine months. It sold its Poland subsidiary in October, with a gain expected in Q4, and had an agreement to sell its Italy subsidiary, subject to conditions. The filing provides no general earnings guidance.
Important facts for investors to verify
- How the Long-Term Care reserve charge and updated morbidity assumptions affect future reserves, statutory capital, and earnings.
- Variable-annuity guarantee exposure, hedge performance, collateral requirements, and the sensitivity of reported earnings to market assumptions.
- Whether fixed-income unrealized losses remain recoverable and how rate and credit-spread changes affect AOCI and capital.
- Current insurance-subsidiary capital ratios and the impact of revised RBC rules; the ratios disclosed here are not all measured at September 30.
- Potential outcomes and remediation costs from SEC matters, tax matters, and other litigation; stated loss estimates exclude matters for which a reasonable estimate could not be made.
- Comparability of 2018 and 2017 results, including accounting changes and the elimination of Gibraltar Life’s one-month reporting lag; the filing says the lag change was not material to the periods presented.