PRUDENTIAL FINANCIAL INC quarterly report, Q2 FY2015

Prudential Financial, Inc. — Q2 2015 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2015. Unaudited U.S. GAAP interim results. Prudential provides insurance, annuities, retirement services, asset management and related financial products in the U.S. and internationally.

Comparability note: On January 2, 2015, Prudential repurchased and canceled its Class B shares. 2015 results and EPS reflect consolidated Prudential; 2014 Common Stock EPS reflected the former Financial Services Businesses and excluded the separately reported Closed Block Business. Certain year-over-year comparisons therefore are not directly comparable.

Key financial results

Metric	Q2 2015	Q2 2014	Six months 2015	Six months 2014
Revenue	$13.712 billion	$13.146 billion	$29.264 billion	$26.000 billion
Income before tax and joint-venture earnings	$2.129 billion	$1.507 billion	$4.877 billion	$3.225 billion
Net income attributable to Prudential	$1.406 billion	$1.090 billion	$3.442 billion	$2.328 billion
Diluted EPS	$3.03	$2.22	$7.40	$4.81
Dividends declared per common share	$0.58	$0.53	$1.16	$1.06

Management’s segment measure, adjusted operating income before tax, was $1.841 billion for Q2 2015 versus $1.623 billion, and $3.586 billion for the first half versus $3.194 billion. This is a non-GAAP measure and excludes or adjusts for investment and other items.
Six-month net investment income was $7.440 billion, down from $7.592 billion. Six-month realized investment gains were $2.490 billion versus $817 million, with derivative results a major source of volatility.
Comprehensive income attributable to Prudential was $796 million for the first half, versus $6.724 billion a year earlier. Net unrealized investment losses drove a $2.700 billion after-tax OCI loss; AOCI declined to $13.404 billion from $16.050 billion at year-end 2014.

Financial position, cash flow and liquidity

At June 30, total assets were $762.731 billion, including $411.944 billion of investments and $17.038 billion of cash and cash equivalents. Total liabilities were $720.439 billion; total equity was $42.292 billion.
Cash and cash equivalents increased $2.120 billion during the first half. Operating cash flow was $3.475 billion, investing cash flow was positive $714 million, and financing cash flow was negative $2.109 billion. Comparative 2014 amounts were $5.555 billion, negative $7.525 billion and positive $2.617 billion, respectively.
Consolidated short- and long-term borrowings were $23.885 billion, up from $23.670 billion at year-end. Reported short-term and long-term debt were $3.621 billion and $20.264 billion. Prudential had a $4.0 billion committed credit facility with no borrowings outstanding; the filing says debt covenants were met.
Management reported $39.806 billion of capital, including equity excluding AOCI and capital debt, and said capital was consistent with its ratings targets. Latest reported statutory capital ratios were 498% for Prudential Insurance and 647% for PALAC at December 31, 2014; Japanese subsidiary solvency margins were 844% and 882% at March 31, 2015. These are not June 30 figures.
The parent targeted at least $1.3 billion of cash liquidity. Prudential Financial reported $9.758 billion of cash and short-term investments, including intercompany liquidity balances; excluding net borrowings from that account, the amount was $5.716 billion.

Material changes and management commentary

Reported earnings increased, but results were materially affected by interest-rate and currency movements, hedging activity and the second-quarter annual review of actuarial and economic assumptions. The 2015 review was conducted in Q2; the 2014 review occurred in Q3, affecting period comparisons.
Q2 GAAP results included a $1.802 billion favorable pre-tax comparison from Prudential’s Capital Protection Framework interest-rate risk strategy and a $328 million favorable comparison from foreign-exchange movements on certain Japanese assets and liabilities. These gains and other favorable items were partly offset by weaker realized investment results excluding the relevant variable-annuity hedging effects, variable-annuity hedge-related impacts and higher taxes.
Segment adjusted operating income improved in Individual Annuities, Individual Life and Group Insurance, with assumption updates contributing to the increases. Retirement earnings declined on lower investment spreads; International Insurance earnings fell, including currency and assumption-review effects. Management cited business growth, sales and persistency as positives in some international operations.
Retirement revenue rose substantially, largely due to pension risk transfer transactions, including a significant payout annuity transaction in Q2; related policyholder benefits also increased. Asset Management AUM was $948.3 billion, up from $933.5 billion at year-end 2014.
Management expects prolonged low U.S. rates to lower reinvestment yields and pressure margins. Under a stated hypothetical of a 2.25% average 10-year Treasury rate through 2016 and unchanged credit spreads, it estimated an unfavorable pre-tax adjusted operating income impact of about $5 million in 2015 and $44 million in 2016 for a specified $51 billion block of contracts. This scenario excludes potential mitigants and other factors.
Prudential authorized a new common-stock repurchase program of up to $1.0 billion for July 2015–June 2016. It repurchased $500 million of common stock during the first half and paid $537 million of common dividends. The final price for the $651 million Class B repurchase remains subject to a purchase-price dispute.

Risks, contingencies and unusual items

Key exposures include low or changing interest rates, equity and credit-market movements, foreign exchange, investment defaults, mortality and policyholder behavior, reserve and DAC assumption changes, hedging effectiveness, and access to capital. The company also depends on subsidiary distributions to meet holding-company obligations, subject to regulatory restrictions.
Prudential is designated a global systemically important insurer. Proposed international higher-loss-absorbency requirements were expected to increase the basic capital requirement by an average of 20%, with application anticipated from 2019 if adopted. The company was evaluating the potential effect. New Jersey also asserted group-wide supervisory authority; additional requirements and costs were uncertain.
The proposed U.S. Department of Labor fiduciary rule could affect distribution and compliance costs. The filing also discusses resolution-plan requirements and the possibility that future regulation could constrain dividends and share repurchases.
Management estimated aggregate reasonably possible litigation and regulatory losses in excess of established accruals at less than $250 million where an estimate could be made. It cautioned that outcomes are uncertain and could materially affect a particular period; management did not expect the ultimate outcome, based on information then known, to materially affect financial position.
Other notable items include $62 million of first-half other-than-temporary impairments for PFI excluding the Closed Block division, including impairments on energy-sector limited partnership investments; and a $70 million Q2 tax expense related to remeasurement of Japanese deferred tax assets after a tax-rate reduction.

Important facts for investors to verify

Separate underlying operating performance from market-driven realized investment gains and losses, variable-annuity hedge results, and assumption-review effects; also confirm the non-GAAP adjusted operating income reconciliations.
Assess the impact of low rates on reinvestment yields, guaranteed crediting rates and spreads, including the limitations of management’s hypothetical scenario and mitigation assumptions.
Review the size, basis and sensitivity of variable-annuity guarantees and hedging, including counterparty, collateral and policyholder-behavior risks.
Check statutory capital and liquidity at the insurance-subsidiary level, potential capital effects of regulatory changes, and restrictions on upstream dividends; the stated RBC and solvency ratios are from earlier reporting dates.
Track the Class B repurchase price dispute, litigation and regulatory developments, and progress and funding implications of the pending AFP Habitat transaction.