Prudential Financial (NYSE:PRU) is expected to announce earnings for the second quarter of 2013 after the markets close on Wednesday, Aug. 7, with a conference call to discuss results on Aug. 8. The insurer’s stock has gained nearly 40% since it reported earnings for the first quarter in May, largely due to the recent hike in bond yields. The 10-year Treasury bond yield has climbed from 1.66% on May 2 to 2.63%.
Around 75% of Prudential’s assets are invested in fixed-maturity securities like government and corporate bonds. The returns from these investments are largely linked to interest rates which have been low in the last few years due to the Federal Reserve’s Quantitative Easing program, which includes $85 billion in monthly bond purchases. The program involves purchasing assets like long term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term interest rates. Prudential’s fixed-maturities yield fell from 5.3% in 2008 to 3% in 2012.
The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it might start increasing interest rates. Improving trends in the U.S. job market have led to speculation that the Fed might start tapering the program later this year sending bond yields soaring in the last few months. The unemployment rate in the U.S. has recovered from 10.1% observed during the financial crisis in 2009 and reached a four-year low of 7.5% in April, staying around 7.6% through May and June before dropping to 7.4% in July.
Investment income that accounts for 10% of Prudential’s revenue is very important for the insurer’s margins. Companies collect premiums from clients in exchange for coverage, and the income from these premiums is invested, primarily in "safe" securities like government and corporate bonds, to generate returns for the company. As the Quantitative Easing program comes to an end, the 10-year Treasury bond yield could easily climb back to the per-recession level of around 5.5%, pushing Prudential’s investment income higher.
However, the company will have to effectively manage its portfolio to ensure that the face value of its investments in fixed maturity securities is not overly affected by the rising rates, thus leading to unrealized capital losses. We remain conservative in our forecast for Prudential’s yield from fixed maturities with a long term increase as the QE program comes to an end. You can modify the interactive charts in this article to gauge the effect a change in our forecast would have on our price estimate.
Leading Market Position in the U.S.
The U.S. market saw a 7% increase in annualized premiums during the first quarter with a 10% increase in variable universal life products, an 8% increase in universal life products and a 7% increase in whole life products. However, the total number of policies declined 5% year on year with an 18% decline in universal life policies. The increase in premiums indicates the higher premium rates that insurers have been charging in lieu of low returns from their investments. We expect the industry to maintain growth through the second quarter. Last week, Prudential’s peer MetLife (NYSE:MET) reported a 6% year-on-year increase in retail premiums in the U.S. for the three months ending June.
Prudential is the third largest life insurer in the U.S. behind MetLife and Aflac Group, with a market share of 6.14%. The company offers insurance policies to individuals as well as group contracts to companies. Individual insurance accounts for 30% of the company’s U.S. insurance premiums while group insurance accounts for nearly 70%. Prudential has around 22,500 group institutional clients in the U.S. The company earns average monthly premiums of $18,574 per client.
Prudential’s individual insurance division has around 7 million policies in force, earning around $32 in average monthly premiums. Prudential has a market share of 3.1% in the U.S. individual life insurance market. The company had a market share of around 2.7% in 2011. In 2012, it acquired Hartford Financial Services Group's (NYSE:HIG) individual life insurance business for $615 million in cash. Hartford was the 14th largest life insurer in 2012 with a market share of 2.01%, its market share in the individual life insurance market was around 1%.
Taking total premiums for life insurance, annuity considerations, deposit type contract funds, accident and health and other considerations, Prudential is the second largest insurer in the U.S., behind MetLife, with a market share of 10.87%. We discuss the company’s prospects in the U.S. in detail in our article "A Look At Prudential's U.S. Life Insurance Business."
U.S. retirement solutions are an important business for Prudential accounting for 43% of the company’s revenues. While pension risk agreements with General Motors (NYSE:GM) and Verizon (NYSE:VZ) grabbed most of the headlines last year, the insurer also expanded its individual annuities business. According to sales data from LIMRA, Prudential was the highest seller of variable annuities in 2012, with a market share of 14%. The company took over the pole position from MetLife, which was the highest seller in 2011, but decided to cut back on the equity linked product to reduce risk in 2012. In terms of total annuity sales, Prudential is second in sales behind the U.S. subsidiary of its British namesake, Jackson National Life.
However, the company has recently been named as a non-bank systemically important financial institution (SIFI) by the Financial Stability Oversight Council. Prudential is currently contesting the decision which could impose higher capital requirements and stress tests, forcing it to cut back on capital intensive products like variable annuities. We will monitor the situation closely and update our models for the insurance companies once the Fed sheds some light on the regulations that will be imposed on the SIFIs. For more on Prudential’s retirement business, please read "A Look At Prudential's Individual Annuity Business."
Disclosure: No positions.